As a financial consultant, you have contracted with Wheel Industries
to evaluate their procedures involving the evaluation of long term
investment opportunities. You have agreed to provide a detailed report
illustrating the use of several techniques for evaluating capital
projects including the weighted average cost of capital to the firm, the
anticipated cash flows for the projects, and the methods used for
project selection. In addition, you have been asked to evaluate two
projects, incorporating risk into the calculations.

You have also agreed to provide an 8-10 page report, in good form,
with detailed explanation of your methodology, findings, and
recommendations.

Company Information

Wheel Industries is considering a three-year expansion project,
Project A. The project requires an initial investment of $1.5 million.
The project will use the straight-line depreciation method. The project
has no salvage value. It is estimated that the project will generate
additional revenues of $1.2 million per year before tax and has
additional annual costs of $600,000. The Marginal Tax rate is 35%.

Required:

  1. Wheel has just paid a dividend of $2.50 per share. The
    dividends are expected to grow at a constant rate of six percent per
    year forever. If the stock is currently selling for $50 per share with a
    10% flotation cost, what is the cost of new equity for the firm? What
    are the advantages and disadvantages of using this type of financing for
    the firm?
  2. The firm is considering using debt in its capital structure. If the
    market rate of 5% is appropriate for debt of this kind, what is the
    after tax cost of debt for the company? What are the advantages and
    disadvantages of using this type of financing for the firm?
  3. The firm has decided on a capital structure consisting of 30% debt
    and 70% new common stock. Calculate the WACC and explain how it is used
    in the capital budgeting process.
  4. Calculate the after tax cash flows for the project for each year. Explain the methods used in your calculations.
  5. If the discount rate were 6 percent calculate the NPV of the
    project. Is this an economically acceptable project to undertake? Why or
    why not?
  6. Now calculate the IRR for the project. Is this an acceptable
    project? Why or why not? Is there a conflict between your answer to part
    C? Explain why or why not?

Wheel has two other possible investment opportunities, which are
mutually exclusive, and independent of Investment A above. Both
investments will cost $120,000 and have a life of 6 years. The after tax
cash flows are expected to be the same over the six year life for both
projects, and the probabilities for each year’s after tax cash flow is
given in the table below.

Investment B Investment C

Probability

After Tax

Cash Flow

Probability

After Tax

Cash Flow

0.25

$20,000

0.30

$22,000

0.50

32,000

0.50

40,000

0.25

40,000

0.20

50,000

  1. What is the expected value of each project’s
    annual after tax cash flow? Justify your answers and identify any
    conflicts between the IRR and the NPV and explain why these conflicts
    may occur.
  2. Assuming that the appropriate discount rate for projects of this
    risk level is 8%, what is the risk-adjusted NPV for each project? Which
    project, if either, should be selected? Justify your conclusion.
  3. Correctly
    calculated the cost of new equity and explained the calculations, as
    well as the advantages and disadvantages of using this type of financing
    for the firm. (CO4)
    20
    Correctly calculated the cost of new debt
    and explained the calculations, as well as the advantages and
    disadvantages of using this type of financing for the firm. (CO4)
    20
    Correctly calculated the weighted average
    cost of capital and explained how and why it is used in the capital
    budgeting process. (CO4)
    20
    Correctly calculated the annual cash flows for the projects and explained the methods used in the calculations. (CO1) 44
    Evaluated the projects using the NPV method and came to the correct conclusions based on the decision rules for the NPV. (CO2) 44
    Evaluated the projects using the IRR
    method and came to the correct conclusion based on the decision rules
    for the IRR. Identified any conflicts between the IRR and the NPV and
    explained why these conflicts may occur. (CO 3)
    44
    Correctly introduced risk into the
    evaluation by using the expected values as the cash flows and evaluated
    these cash flows using risk adjusted discounted rates. (CO 5)
    44
    Written in a clear, concise, and
    organized manner; demonstrated ethical scholarship in accurate
    representation and attribution of sources; displayed accurate spelling,
    grammar, and punctuation.
    64
    Total: 300