Cost of Capital, Capital

Structure, and Capital Budgeting Analysis

Purpose of the project

In this project, you are

supposed to be a financial manager working for a big corporation and you have

to apply the knowledge obtained from this course to determine the cost of debt,

cost of preferred stock, cost of common equity, capital structure, and the

weighted average cost of capital (WACC) for a publicly-traded company of your

choice. You will use the WACC as the discount rate to conduct capital budgeting

analysis for a project that the firm is considering and then decide whether it

should be accepted or not.

Outline for the project

1. Executive Summary

Summarize the results and

analysis of the report.

2. Estimate Capital Structure

Estimate the firm’s weights of

debt, preferred stock, and common stock using the firm’s balance sheet (book

value).

Estimate the firm’s weights of debt, preferred

stock, and common stock using the market value of each capital component.

3. Compute Weighted Average

Cost of Capital (WACC)

Estimate the firm’s before-tax and after-tax

component cost of debt;

Estimate the firm’s component cost of

preferred stock;

Use three approaches (CAPM,

DCF, bond-yield-plus-risk-premium) to estimate the component cost of common

equity of the firm.

Calculate the firm’s weighted average cost of

capital (WACC) using market-based capital weights or book value of debt.

4. Cash Flow Estimation &

Capital Budgeting Analysis

We assume that the company you

selected is considering a new project. The project has 6 years’ life. This

project requires initial investment of $180 million to construct building, and

purchase equipment, and $12 million for shipping & installation fee. The

fixed assets fall in the 5-year MACRS class. The salvage value of fixed assets

is $25 million. The number of units of the new product expected to be sold in

the first year is 870,000 and the expected annual growth rate is 10%. The sales

price is $250 per unit and the variable cost is $175 per unit in the first

year. The required net operating working capital (NOWC) is 18%. The company is

in the 33% tax bracket. The project is assumed to have the same risk as the

corporation, so you should use the WACC you obtained from prior steps as the

discount rate. The project is assumed to have the same risk as the corporation,

so you should use the WACC you obtained from prior steps as the discount rate.

Compute the depreciation basis

and annual depreciation of the new project. (Please refer to table 11 A-2 MACRS

allowances)

Estimate annual cash flows for

the 6 years.

Draw a time line of the cash flows.

For this section of the project, students

should follow and use the Cash Flow Estimation Excel Template File provided

under the “Example Files for Term Project” folder.

5. Capital Budgeting Analysis

Using the WACC you obtained from step (3) for

the publicly-traded company as discount rate, apply capital budgeting analysis

techniques (NPV, IRR, PI, and Payback Period) to analyze the new project.

Discuss whether the project should be taken

and summarize your report.

Other information regarding the project

You will inform the instructor of the company

you choose for approval. Students have to choose different companies. If

several students want to use the same company, the first student to inform the

instructor will have priority; the others will have to pick another company.

Please make sure to post your company selection under the “Term Project”

discussion thread.

Students should submit two files:

A Microsoft Word file which is the written

report of your analysis. Your project should be well-organized and typed in a

Word, document but you must attach the necessary Excel workbook with your

report. The style and organization part of the project account for 10 percent

of the grade.

An Excel file which is the outcome of your

analysis. Please note that you should show formulas in Excel for all

calculations.

Avoid firms that are losing money (airlines

and other distressed firms).

Try to choose a small firm that operates in an

industry that’s familiar to you. Try to avoid firms that operate in several

industries (conglomerates such as GE) or companies whose performance depends on

commodity prices (XOM, VLO, PD, ABX) so your analysis doesn’t become too

complex.

DO NOT USE THE COMPANIES BELOW

AAPL, CVS, COST, GOOG, HD, SBUX, TGT, WMT, WAG, OMX.

This project should be

well-organized and typed in a Word document but you must attach the necessary

Excel workbook with your report.

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