Solution to Case 23
Evaluating Project Risk
It’s Better to Be Safe Than Sorry!
1. What seems to be wrong with the way the NPV of each project has been calculated? Indicate without any calculations, how Pete and John should go about recalculating the projects’ NPVs.
The NPV of each project has been calculated by discounting the cash flows at the 8% before-tax cost of debt. This is incorrect. Since the company has debt, preferred stock and common stock in its capital structure the weighted average cost of capital must be calculated and used to discount the projects’ cash flows. The weight of each component of the target capital structure (based on market values of outstanding securities) should be calculated and used along with their respective component costs to calculate the weighted average cost of capital. Next, the Present values of the projects’ cash flows should be used to compute the equivalent annuity that had been used by the managers when discounting at 8%. These annual cash flows should then be discounted at the weighted average cost of capital to recalculate the projects’ NPVs.
2. Why does John need to know the retention rate of the firm? What impact will retained earnings have on the calculations?
The retention rate multiplied by the return on equity can be used to estimate the sustainable growth rate of the firm. The growth rate can be then used to determine the cost of retained earnings and of new equity. Retained earnings are also considered internal equity. The retained earnings available for growth can help reduce the need for outside financing. Accordingly, the level of retained earnings will affect the marginal cost of capital.
3. Why is the target capital structure of concern to John? How should it be determined?
The target capital structure determines the weights that are used when calculating a firm’s average cost of capital. Although a firm can generally raise all the money it needs for a particular project from just one source, i.e. debt or equity, by doing so, it would be reducing its capacity to use that source for future projects. Thus, in corporate finance, it is typically assumed that firms have a target capital structure, which will be adhered to over the long run. The target capital structure can be determined by dividing the market value of each type of security issued by the firm (i.e. bonds, preferred stock, common stock) by the total value of all the components. Only long-term sources of capital should be used.
|TABLE 2 | |Market data regarding outstanding securities | | | | | | | | | | | | |Type |Par Value |Current Price |Number Outstanding |Market Value |Proportion | | | | | | | | |10%, 20-Year Bonds |$1,000 |$900 |10,000 |$9,000,000 |22.5% | |6% Preferred Stock |$10 |$12 |500,000 |$6,000,000 |15.0% | |Common Stock |$1 |$25 |1,000,000 |$25,000,000 |62.5% | | | | | |$40,000,000 | |
4. Pete collects the necessary data and prepares Table 6 . Accordingly, calculate the component costs of debt, preferred...
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