1. You’re the newly hired CFO of a small construction company. The privately held firm is capitalized with $2 million in owner’s equity and $3 million in variable rate bank loans. The construction business is quite risky, so returns of 20% to 25% are normally demanded on equity investments. The bank is currently charging 14% on the firm’s loans, but interest rates are expected to rise in the near future. Your boss, the owner, started his career as a carpenter and has an excellent grasp of day-to-day operations. However, he knows little about finance. Business has been good lately, and several expansion projects are under consideration. A cash flow projection has been made for each. You’re satisfied that these estimates are reasonable.
The owner has called you in and confessed to being confused about the projects. He instinctively feels that some are financially marginal and may not be beneficial to the company, but he doesn’t know how to demonstrate this or to choose among the projects that are financially viable.
Assuming the owner understands the concept of return on investment, write a brief memo explaining the ideas of IRR and cost of capital and how they can solve his problem. Don’t get into the detailed mechanics of the calculations, but do use the figures given above to make a rough estimate of the company’s cost of capital, and use the result in your memo.
2. You’re the CFO of a small company that is considering a new venture. The president and several other members of management are very excited about the idea for reasons related to engineering and marketing rather than profitability. You’ve analyzed the proposal by using capital budgeting techniques, and found that it fails both IRR and NPV tests using a cost of capital based on market returns. The problem is that interest rates have risen steeply in the last year, so the cost of capital seems unusually high.
You’ve presented your results to the management team, who are very disappointed. In fact, they’d like to find a way to discredit your analysis, so they can justify going ahead with the project. You’ve explained your analysis, and everything seems well understood except for one point. The group insists that the use of returns currently available to investors as a basis for the cost of capital components doesn’t make sense. The vice president of marketing put his objection as follows. “Two years ago we borrowed $1 million at 10%. We haven’t paid it back, and we’re still making interest payments of $100,000 every year. Clearly, our cost of debt is 10% and not the 14% you want to use. If you’d use
our “real” cost of debt, as well as of equity and preferred stock, the project would easily qualify financially.” How do you respond?
(The appropriate response is relatively short. It’s worth noting that this kind of thing happens all the time in corporations. Marketing and engineering people often get carried away with “neat” projects that don’t make sense financially. The CFO has to watch the bottom line and it’s not unusual to be seen as a wet blanket who wants to spoil the others’ fun!)
3. The engineering department at Digitech Inc. wants to buy a new, state-of-the-art computer. The proposed machine is faster than the one now being used, but whether the extra speed is worth the expense is questionable, given the nature of the firm’s applications. The Chief Engineer (who has an MBA and a reasonable understanding of financial principles) has put together an enormously detailed capital budgeting proposal for the acquisition of the new machine. The proposal concludes that it’s a great deal.
You’re a financial analyst for the firm, and have been assigned to review the engineering proposal. Your review has highlighted two problems. First, the cost savings projected as a result of using the new machine seem rather optimistic. Second, the analysis uses an unrealistically low cost of capital.
With respect to the second point, the engineering proposal contains the following exhibit documenting the development of the cost of capital used:
Digitech’s capital structure is 60% debt and 40% equity
The manufacturer is offering financing at 8% as a sales incentive
Cost of capital = 8%´.6 = 4.8%
After tax this is 4.8% (1-T) = 4.8%(.6) = 2.9%
You’ve checked the market and found that Digitech’s bonds are currently selling to yield 14% and the stock is returning about 20%. How would you proceed? That is, explain the chief engineer’s error(s) and indicate the correct calculations.
4. Whitefish Inc. operates a fleet of 15 fishing boats in the North Atlantic Ocean. Fishing has been good in the last few years, as has the market for product, so the firm can sell all the fish it can catch. Charlie Bass, the vice president for operations, has worked up a capital budgeting proposal for the acquisition of new boats. Each boat is viewed as an individual project identical to the others, and shows an IRR of 22%. The firm’s cost of capital has been correctly calculated at 14% before the retained earnings break and 15% after that point. Charlie argues that the capital budgeting figures show that the firm should acquire as many new boats as it possibly can, financing them with whatever means it finds available. You are Whitefish’s CFO. Support or criticize Charlie’s position. How should the appropriate number of new boats be determined? Does acquiring a large number of new boats present any problems or risks that arent immediately apparent from the financial figures?
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