Deck 15: Capital-Budgeting Decisions

Question 1

The Sweeney Paper Company is planning to sell $10 million worth of long-term bonds with an 11% interest rate. The company believes that it can sell the $1,000 par value bonds at a price that will provide a yield to maturity of 13% to its investors. The flotation costs will be 1.9%. If Sweeney's marginal tax rate is 35%, what is its annual after-tax cost of debt

Answer 1

The fifteenth chapter that is in the textbook has to do with various capital budgeting decisions an engineer may have to make for a firm. This includes various ways to finance a project, determination of the cost of capital, and budgeting decisions that may take place.
In this problem, we have a paper company which wants to sell $10,000,000.00 worth of long-term bonds with an 11.00% interest rate attached. They feel that they can sell the $1,000.00 par value bonds at a value which would result in a return of 13.00% to investors. With a flotation cost of 1.90% and their marginal tax rate is 35.00%, what is the annual after-tax cost of debt
The best way to handle a problem like this is to first determine what the price the bonds should be at for an investor to purchase at. This crucial first step is vital in getting the proper answer for the question at hand. The following formula and calculations are shown below for one to use given the circumstances here:
…… (1)
Where…
- P = present value of the sum of money,
- F = future value of the sum of money,
- A = the annual cash flow amount for the sum of money,
- i = interest rate (which is unknown in this case), and
- n = number of terms that the money is for.
With the equation in hand, let's throw the numbers that are applicable to the situation. In this situation, it is important to note that one gets the factor values properly in their places here as one wrong move could yield bigger problems than what one would want to have. The calculations begin below:
The next step that one has to do here is to mosey on back to Appendix B in the latter part of the textbook. In this appendix, there are a number of factor value tables that one will need to use and become familiar with very quickly. In this situation, one would want to look at the fifth column for the first factor value here for
and then the second column for the other
. We continue below with the applicable factor values applied to the equation:
P = $891.48
Thus, the present worth or the bond offering price in this case should be $891.48. The next step that one would need to do here is to determine the amount that one would need to raise in order to get the targeted $10,000,000.00. As one can see here, the equation that is used here is a little bit different because one would first need to determine the flotation costs that applicable to the problem at hand. Note that the formula shown below is a little different since the flotation cost must be added into the overall financing package to get the desired amount. This and the applicable calculations are shown below for one to see:
….. (2)
Where…
- FC = the flotation costs,
- FCI = the flotation cost interest rate, and
- P = the principal amount of the loan needed to be taken out.
All one would need to do is to add some numbers to the problem so that we can get the appropriate factor here. This is shown below for one to see:
FC = $10,193,680.00
Thus, the amount of money that would need to be added to the principal in order to cover costs for the loan is approximately $193,680.00. As we move along, the third step in the process here is to determine how many bond units one would need to sell in order to get the desired result here. Note that the original bond offering price would apply here. When the value above is divided by the answer to the first formula, one would get approximately 11,435 bond units (when rounded up) as the required quantity here.
The final part of the problem that one would need to answer here has to do with finding the annual debt interest payment that is applicable here. This is done by executing the following formula below:
….. (3)
Where…
- ADIP = the annual debt interest payment,
- TS = total number of shares needed to be sold here,
- PV = the par value of the bond in question,.
- BR = the bond rate applicable, and
- TR = the applicable / marginal tax rate.
All one would need to do now is to apply the core pieces of information to the formula below to get the answer needed here. Please take a moment to look at the calculations here:
ADIP = $817,602.50
Thus, the annual debt interest payment applicable to the situation at hand is approximately $817,602.50 per year.

Question 2

The Mobil Appliance Company's earnings, dividends, and stock price are expected to grow at an annual rate of 12%. Mobil's common stock is currently traded at $18 per share. Mobil's last cash dividend was $1.00, and its expected cash dividend for the end of this year is $1.12. Determine the cost of retained earnings ( k r ).

Answer 2

The fifteenth chapter that is in the textbook has to do with various capital budgeting decisions an engineer may have to make for a firm. This includes various ways to finance a project, determination of the cost of capital, and budgeting decisions that may take place.
In this problem, we have an appliance company which has a projected growth rate of their stock price, dividends, and earnings (before and after taxes) of 12.00%. The current stock price is $18.00 per share and the projected cash dividend that is going to be paid is $1.12 per share. Given this information, what is the actual cost of retained earnings here
The best way to handle a problem like this is to apply a simple formula to determine the cost of retained earnings. This is denoted in the formula below as the variable k r. Here is the formula and required calculations:
…… (1)
Where…
- D 1 = a dividend value at the end of the current year focused on ,
- P 0 = the current and present stock price, and
- g = the projected growth rate.
With the equation in hand, let's throw the numbers that are applicable to the scenario at hand into the formula to get the proper answer here. The calculations begin below this passage:
k r = 18.22%
Thus, the cost of retained earnings applicable to the situation at hand is approximately 18.22%.

Question 3

Refer to Problem, and suppose that Mobil wants to raise capital to finance a new project by issuing new common stock. With the new project, the cash dividend is expected to be $ 1.10 at the end of the current year, and its growth rate is 10%. The stock now sells for $18, but new common stock can be sold to net Mobil $15 per share.
(a) What is Mobil's flotation cost, expressed as a percentage
(b) What is Mobil's cost of new common stock
Problem
The Mobil Appliance Company's earnings, dividends, and stock price are expected to grow at an annual rate of 12%. Mobil's common stock is currently traded at $18 per share. Mobil's last cash dividend was $1.00, and its expected cash dividend for the end of this year is $1.12. Determine the cost of retained earnings ( k r ).

Answer 3

The fifteenth chapter that is in the textbook has to do with various capital budgeting decisions an engineer may have to make for a firm. This includes various ways to finance a project, determination of the cost of capital, and budgeting decisions that may take place.
In this problem, we have an appliance company which has a projected growth rate of their stock price, dividends, and earnings (before and after taxes) of 12.00%. They have a new project which is projected to bring in $1.10 of cash dividends at the end of the year and the growth rate is 10.00%. With the stock now selling for $18.00 but the new common stock price for the company at $15.00 per share, what is the flotation cost expressed as a percentage Also, what is the company's cost of stock (as denoted by the variable k e )
a) The best way to handle the first part of the problem like this is to apply a simple formula to determine the flotation cost as a percentage. The formula shown below is an easy formula to compute because we have all the necessary information to do such. Shown below is the applicable formula as well as the necessary calculations:
…… (1)
Where…
- MP = the current stock price that it can be sold in the marketplace and
- SP = the current stock price that is available for one to purchase.
With the equation in hand, let's throw the numbers that are applicable to the scenario at hand into the formula to get the proper answer here. The calculations begin below this passage:
f c = 0.1667 or 16.67%
Thus, the flotation costs in terms of a percentage value is approximately 0.1667 or 16.67%. We can now turn to the other part of the problem which is just as easy to calculate.
b) The second half of the problem that one would need to do here is to find out the cost of new common stock to the company. Much like we have before, this is a fairly easy thing to calculate because we would need to apply the following formula and calculations below:
…… (2)
Where…
- D = the amount of cash dividend that will be paid out,
- f c = the flotation cost (calculated above),
- GR = the growth rate applicable to the problem, and
- SP = the current stock price that is available for one to purchase.
With the equation in hand, let's throw the numbers that are applicable to the scenario at hand into the formula to get the proper answer here. The calculations begin below this passage:
k e = 0.1733 or 17.33%
Thus, the cost of new common stock to the company at hand is approximately 0.1733 or about 17.33%.

Question 4

The Callaway Company's cost of equity is 22%. Its before-tax cost of debt is 13%, and its marginal tax rate is 40%. The firm's capital structure calls for a debt-to-equity ratio of 45%. Calculate Callaway's cost of capital.

Question 5

The Delta Chemical Corporation is expected to have the capital structure for the foreseeable future as given in Table.
TABLE 10
The flotation costs are already included in each cost component. The marginal income tax rate ( t m ) for Delta is expected to remain at 40% in the future.
(a) Determine the cost of capital ( k ).
(b) If the risk-free rate is known to be 6% and the average return on the S P 500 is about 12%, determine the cost of equity with ß = 1.2 based on the capital-asset pricing principle.
(c) Determine the cost of capital on the basis of the cost of equity obtained in part (b).

Question 6

Matsushita Machining (MPM) is considering acquiring a new precision cutting machine at a cost of $120,000. The need for this particular machine is expected to last only five years, after which the machine is expected to have a salvage value of $30,000. The annual operating cost is estimated at $20,000. The addition of this machine to the current production facility is expected to generate an additional revenue of $70,000 annually and will be depreciated in the seven-year MACRS property class. The income tax rate applicable to Charleston is 36%. The initial investment will be financed with 60% equity and 40% debt. The before-tax debt interest rate, which combines both short-term and longterm financing, is 12% with the loan to be repaid in equal annual installments. The equity interest rate (Q, which combines the two sources of common and preferred stocks, is 18%.
(a) Evaluate this investment project by using net equity flows.
(b) Evaluate this investment project by using k.

Question 7

The Optical World Corporation, a manufacturer of peripheral vision storage systems, needs $10 million to market its new robotics-based vision systems. The firm is considering two financing options: common stock and bonds. If the firm decides to raise the capital through issuing common stock, the flotation costs will be 6%, and the share price will be $25. If the firm decides to use debt financing, it can sell a 10-year, 12% bond with a par value of $1,000. The bond flotation costs will be 1.9%.
(a) For equity financing, determine the flotation costs and the number of shares to be sold to net $10 million.
(b) For debt financing, detennine the flotation costs and the number of $1,000 par value bonds to be sold to net $10 million. What is the required annual interest payment

Question 8

The Huron Development Company is considering buying an overhead pulley system. The new system has a purchase price of $100,000, an estimated useful fife and MACRS class life of five years, and an estimated salvage value of $30,000. Tt is expected to allow the company to economize on electric power usage, labor, and repair costs, as well as to reduce the number of defective products. A total annual savings of $45,000 will be realized if the new pulley system is installed. The company is in the 30% marginal tax bracket. The initial investment will be financed with 40% equity and 60% debt. The before-tax debt interest rate, which combines both short-term and long-term financing, is 15% with the loan to be repaid in equal annual installments over the project life. The equity interest rate ( i e ), which combines the two sources of common and preferred stocks, is 20%.
(a) Evaluate this investment project by using net equity flows.
(b) Evaluate this investment project by using k.

Question 9

Games, Inc., is a publicly traded company that makes computer software and accessories. Games's stock price over the last five years is plotted in Figure 1, Games's earnings per share for the last five years are shown in Figure 2, and Games'., dividends per share for the last five years are shown in Figure 3. The company currently has 1,000.000 shares outstanding and a long-term debt of $12,000,000. The company also paid $1,200,000 in interest expenses last year, has other assets of $5,000,000, and had earnings before taxes of $3,500,000 last year.
Figure 1

Figure 2

Figure 3

Games has decided to manufacture a new product. In order to make the new product, Games will need to invest in a new piece of equipment that costs $10,000,000. The equipment is classified as a seven-year MACKS property and is expected to depreciate 30%' per year. Equipment installation will require 20 employees working for two weeks and charging $50 per hour each. Once the equipment has been installed, the facility is expected to remain operational for two years.
Games intends to maintain its current debt-to-equity ratio and therefore plans on borrowing the appropriate amount today to cover the purchase of the equipment. The interest rate on the loan will be equal to its current cost of debt. The loan will require equal annual interest payments over its life (i.e., the loan rate times the principal borrowed for each year).
The principal will be repaid in full at the end of year two. Games plans on issuing new stock to cover the equity portion of the investment. The underwriter of the new stock issue charges an 11% flotation cost.
Games estimates that its new product will acquire 20% of all market share within the United States. Even though this product has never been produced before. Games has identified an older product that should have market attributes similar to those of the new product. The older product's unit market sales for the entire United States for the last five years are shown in Figure 1. It is estimated that the new product will sell for $20 per unit (in today's dollars). Costs are estimated at 80% of the selling price for the first year and 60% of the selling price for the second year. Inflation is estimated at 10% per annum for the new product.
Figure 1

Due to the large size of the investment required to manufacture the new product, Games's analysts predict that once the decision to accept the project is made, investors will revalue the company's stock price. Because you are the chief engineering economist for Games, you have been requested by upper management to determine how manufacturing this new product will change Games's stock price. Management would like answers to the following questions.
(a) Games's investors usually use the corporate value model (CVM) to determine the total market value of the company. In its most basic form, the CVM states that a firm's market value is nothing more than the present value of its expected future net cash I lows plus the value of its assets. Using this logic, what must investors currently assess the present value of Games's future net cash flows to be (not including the investment in the new product)
(b) Determine Games's tax rate.
(c) Determine an appropriate MARR to use in the analysis when the financing source is known. Now do the same when the financing source is unknown.
(d) Assuming that the new-product venture is accepted and the new piece of equipment is disposed of at the end of year two, what is a most-likely estimate for Games's stock price
(e) Now assume that the new piece of equipment is not disposed of in year two and that Games has not decided how the $ 10,000,000 for the equipment will be financed. Instead, assume that the revenues generated from the new product will continue indefinitely. Estimate a pessimistic, a most-likely, and an optimistic estimate for Games's stock price. 10

Question 10

Consider the two mutually exclusive machines given in Table.
TABLE 13
The initial investment will be financed with 70% equity and 30% debt. The before-tax debt interest rate, which combines both short-term and long-term financing, is 10% with the loan to be repaid in equal annual installments over the project life. The equity interest rate ( i e ), which combines the two sources of common and preferred stock, is 15%. The firm's marginal income tax rate is 35%.
(a) Compare the alternatives using i e = 15%. Which alternative should be selected
(b) Compare the alternatives using k. Which alternative should be selected
(c) Compare the results obtained in parts (a) and (b).

Question 11

Consider a project whose initial investment is $500,000 financed at an interest rate of 9% per year. Assuming that the required repayment period is six years, determine the repayment schedule by identifying the principal as well as the interest payments for each of the following methods:
(a) Equal repayment of the principal
(b) Equal repayment of the interest
(c) Equal annual installments

Question 12

The DNA Corporation, a biotech engineering firm, has identified seven R D projects for funding. Each project is expected to be in the R D stage for three to five years. The IRR figures shown in Table represent the royalty income from selling the R D results to pharmaceutical companies.
DNA Corporation can raise only $100 million. DNA's borrowing rate is 18%, and its lending rate is 12%. Which R D projects should be included in the budget
TABLE 14

Question 13

The National Food Processing Company is considering investing in plant modernization and plant expansion. These proposed projects would be completed in two years, with varying requirements of money and plant engineering. Management is willing to use the somewhat uncertain data in Table in selecting the best set of proposals. The resource limitations are as follows:
• First-year expenditures: $450,000
• Second-year expenditures: $420,000
• Engineering hours: 11,000 hours
The situation requires that a new or modernized production line be provided (project 1 or project 2 which are mutually exclusive). The numerical control (project 3) is applicable only to the new line. The company obviously does not want to both buy (project 6) and build (project 5) raw-material processing facilities; it can, if desirable, rely on the present supplier as an independent firm. Neither the maintenance-shop project (project 4) nor the delivery-truck purchase (project 7) is mandatory.
(a) Enumerate all possible mutually exclusive alternatives without considering the budget and engineering-hour constraints.
(b) Identify all feasible mutually exclusive alternatives.
(c) Suppose that the firm's marginal cost of capital will be 14% for raising the required capital up to $1 million. Which projects would be included in the firm's budget
TABLE ST 15.2

Question 14

Consider the following investment projects and their interdependencies:
• Projects A and E are mutually exclusive.
• Projects C and D are independent projects.
• Project B is contingent on Project C.
• Project E is contingent on project F.
The following indicates the cost of capital as a function of budget:
(a) Formulate the entire list of mutually exclusive decision alternatives.
(b) What is the optimal capital budget What is the appropriate MARR for capital budgeting purpose
(c) If the firm has a budget limit placed at $800, which projects would be funded What is the appropriate MARR

Question 15

A chemical plant is considering purchasing a computerized control system. The initial cost is $200,000, and the system will produce net savings of $100,000 per year. If purchased, the system will be depreciated under MACRS as a five-year recovery property. The system will be used for four years, at the end of which time the firm expects to sell it for $30,000. The firm's marginal tax rate on this investment is 35%. Any capital gains will be taxed at the same income tax rate. The firm is considering purchasing the computer control system either through its retained earnings or through borrowing from a local bank. Two commercial banks are willing to lend the $200,000 at an interest rate of 10%, but each requires different repayment plans (Table). Bank A requires four equal annual principal payments with interest calculated on the basis of the unpaid balance. Bank B offers a payment plan, with five equal annual payments.
(a) Determine the cash flows if the computer control system is to be bought through its retained earnings (equity financing).
(b) Determine the cash flows if the asset is financed through either bank A or bank B.
(c) Recommend the best course of financing the project. (Assume that the firm's MARR is known to be 10%.)
TABLE 3

Question 16

Consider the investment projects given in Table.
Suppose that you have only $3,500 available at period 0. Neither additional budgets nor borrowing is allowed in any future budget period. However, you can lend out any remaining funds (or available funds) at 10% interest per period.
(a) If you want to maximize the future worth at period 3, which projects would you select What is that future worth (the total amount available for lending at the end of period 3) No partial projects are allowed.
(b) Suppose in part (a) that at period 0 you are allowed to borrow $500 at an interest rate of 13%. The loan has to be repaid at the end of year one. Which project would you select to maximize your future worth at period 3
(c) Considering a lending rate of 10% and a borrowing rate of 13%, what would be the most reasonable MARR for project evaluation
TABLE ST 15.3

Question 17

The Edison Power Company currently owns and operates a coal-fired combustion turbine plant that was installed 20 years ago. Because of degradation of the system, 65 forced outages occurred during the last year alone and two boiler explosions during the last seven years. Edison is planning to scrap the current plant and install a new, improved gas-turbine plant that produces more energy per unit of fuel than typical coal-fired boilers produce.
The new 50-MW gas-turbine plant, which runs on gasified coal, wood, or agricultural wastes, will cost Edison $65 million. Edison wants to raise the capital from three financing sources: 45% common stock, 10% preferred stock (which carries a 6% cash dividend when declared), and 45% borrowed funds. Edison's investment banks quote the following flotation costs:
(a) What are the total flotation costs to raise $65 million
(b) How many shares (both common and preferred) or bonds must be sold to raise $65 million
(c) If Edison makes annual cash dividends of $2 per common share and annual bond interest
payments are at the rate of 12%, how much cash should Edison have available to meet both the equity and debt obligation (Note that whenever a firm declares cash dividends to its common stockholders, the preferred stockholders are entitled to receive dividends of 6% of par value.)

Question 18

The American Chemical Corporation (ACC) is a multinational manufacturer of industrial chemical products. ACC has made great progress in reducing energy costs and has implemented several cogeneration projects in the United States and Puerto Rico, including the completion of a 35-megawatt (MW) unit in Chicago and a 29-MW unit in Baton Rouge. The division of ACC being considered for one of its more recent cogeneration projects is a chemical plant located in Texas. The plant has a power usage of 80 million kilowatt hours (kWh) annually. However, on the average, it uses 85% of its 10-MW capacity, which would bring the average power usage to 68 million kWh annually. Texas Electric currently charges $0.09 per kWh of electric consumption for the ACC plant, a rate that is considered high throughout the industry.
Because ACC's power consumption is so large, the purchase of a cogeneration unit would be desirable. Installation of the unit would allow ACC to generate its own power and to avoid the annual $6,120,000 expense to Texas Electric. The total initial investment cost would be $10,500,000, including $10,000,000 for the purchase of the power unit itself (which is a gas-fired 10-MW Allison 571), engineering, design, and site preparation, and $500,000 for the purchase of interconnection equipment (such as poles and distribution lines) that will be used to interface the co-generator with the existing utility facilities.
ACC is considering two financing options:
• ACC could finance $2,000,000 through the manufacturer at 10% for 10 years and the remaining $8,500,000 through issuing common stock. The flotation cost for a common-stock offering is 8.1%, and the stock will be priced at $45 per share.
• Investment bankers have indicated that 10-year 9% bonds could be sold at a price of $900 for each $1,000 bond. The flotation costs would be 1.9% to raise $10.5 million.
(a) Determine the debt-repayment schedule for the term loan from the equipment manufacturer.
(b) Determine the flotation costs and the number of common stocks to sell to raise the $8,500,000.
(c) Determine the flotation costs and the number of $1,000 par value bonds to be sold to raise $10.5 million.

Question 19

Calculate the after-tax cost of debt under each of the following conditions:
(a) Interest rate, 12%; tax rate, 25%
(b) Interest rate, 14%; tax rate, 34%
(c) Interest rate, 15%; tax rate, 40%

Question 20

After ACC management decided to raise the $10.5 million by selling bonds (Problem), the company's engineers estimated the operating costs of the cogeneration project. The annual cash flow is composed of many factors: maintenance, standby power, overhaul costs, and miscellaneous expenses. Maintenance costs are projected to be approximately $500,000 per year. The unit must be overhauled every three years at a cost of $1.5 million. Miscellaneous expenses, such as the cost of additional personnel and insurance, are expected to total $1 million. Another annual expense is that for stand-by power, which is a service provided by the utility in the event of a cogeneration unit trip or scheduled maintenance outage. Unscheduled outages are expected to occur four times annually with each averaging two hours in duration at an annual expense of $6,400. Overhauling the unit takes approximately 100 hours and occurs every three years, requiring another power cost of $ 100,000. Fuel (spot gas) will be consumed at a rate of $8,000 BTU per kWh, including the heat recovery cycle. At $2.00 per million BTU, the annual fuel cost will reach $1,280,000. Due to obsolescence, the expected life of the cogeneration project will be 12 years, after which Allison will pay ACC $1 million for the salvage of all equipment.
Revenue will be incurred from the sale of excess electricity to the utility company at a negotiated rate. Since the chemical plant will consume (on average) 85% of the unit's 10-MW output, 15% of the output will be sold at $0.04 per kWh, bringing in an annual revenue of $480,000. ACC's marginal tax rate (combined federal and state) is 36%, and the company's minimum required rate of return for any cogeneration project is 27%. The anticipated costs and revenues are summarized in Table.
(a) If the cogeneration unit and other connecting equipment could be financed by issuing corporate bonds at an interest rate of 9% compounded annually, with the flotation expenses as indicated in Problem, determine the net cash flow from the cogeneration project.
(b) If the cogeneration unit can be leased, what would be the maximum annual lease amount that ACC is willing to pay
TABLE ST 15.5
Problem
The American Chemical Corporation (ACC) is a multinational manufacturer of industrial chemical products. ACC has made great progress in reducing energy costs and has implemented several cogeneration projects in the United States and Puerto Rico, including the completion of a 35-megawatt (MW) unit in Chicago and a 29-MW unit in Baton Rouge. The division of ACC being considered for one of its more recent cogeneration projects is a chemical plant located in Texas. The plant has a power usage of 80 million kilowatt hours (kWh) annually. However, on the average, it uses 85% of its 10-MW capacity, which would bring the average power usage to 68 million kWh annually. Texas Electric currently charges $0.09 per kWh of electric consumption for the ACC plant, a rate that is considered high throughout the industry.
Because ACC's power consumption is so large, the purchase of a cogeneration unit would be desirable. Installation of the unit would allow ACC to generate its own power and to avoid the annual $6,120,000 expense to Texas Electric. The total initial investment cost would be $10,500,000, including $10,000,000 for the purchase of the power unit itself (which is a gas-fired 10-MW Allison 571), engineering, design, and site preparation, and $500,000 for the purchase of interconnection equipment (such as poles and distribution lines) that will be used to interface the co-generator with the existing utility facilities.
ACC is considering two financing options:
• ACC could finance $2,000,000 through the manufacturer at 10% for 10 years and the remaining $8,500,000 through issuing common stock. The flotation cost for a common-stock offering is 8.1%, and the stock will be priced at $45 per share.
• Investment bankers have indicated that 10-year 9% bonds could be sold at a price of $900 for each $1,000 bond. The flotation costs would be 1.9% to raise $10.5 million.
(a) Determine the debt-repayment schedule for the term loan from the equipment manufacturer.
(b) Determine the flotation costs and the number of common stocks to sell to raise the $8,500,000.
(c) Determine the flotation costs and the number of $1,000 par value bonds to be sold to raise $10.5 million.