Calculate the profitability index of the project

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Reference no: EM131944650

FINANCE Capital Budgeting Exercises -

Capital Budgeting Exercise 1 - You are considering the purchase of one of two machines used in your manufacturing plant. Machine A has a life of two years, costs $1500 initially, and then $400 per year in maintenance costs. Machine B costs $2000 initially, has a life of three years, and requires $300 in annual maintenance costs. Either machine must be replaced at the end of its life with an equivalent machine. Which is the better machine for the firm? The discount rate is 6% and the tax rate is zero.

Which machine do you choose? Explain.

Capital Budgeting Exercise 2 - Your Company has spent $250,000 on research to develop a new computer game. The firm is planning to spend $1,400,000 on a machine to produce the new game. Shipping and installation costs for the new machine total $200,000 and these costs will be capitalized and depreciated together with the cost of the machine. The machine will be used for 3 years, has a $200,000 estimated resale value at the end of three years, and will be depreciated straight line over 4 years. Revenue from the new game is expected to be $1,200,000 per year, with costs of $500,000 per year. The firm has a tax rate of 35 percent, a cost of capital (discount rate) of 6 percent, and it expects net working capital (NWC) to increase by $150,000 at the beginning of the project. This investment in NWC will be wholly recouped at the end of the project.

a) Complete the table (attached).

b) In the second table below calculate the Net Present Value (NPV) of the project.

c) Calculate the Profitability Index (PI) of the project.

d) Is the Internal Rate of Return (IRR) of the project greater than, equal to, or less than the cost of capital (discount rate)?

e) Should your company proceed with this project? Explain based on the decision criteria for NPV, PI, and IRR.

Financial Analysis Exercise -

Part A: Weighted Average Cost of Capital (WACC)

Here again is the formula for WACC. For simplicity the term for preferred stock has been removed:

WACC = (E/E+D)i_E + (D/E+D)i_D x (1-T_c)

1. Go to That's WACC! Website and enter the ticker symbol for the stock you selected and click on the tab entitled "Calculate WACC."

2. Complete the following tables:

Name of Company/Stock
Ticker Symbol

From the That's WACC! Website results for your company:

WACC
Cost of debt, i_D
Corporate tax rate, T_C
Total debt, D
Total equity, E
Total firm value, V
Cost of equity, i_E

CAPM Components

Beta, β
Historical market return, i_M	Assumed 11%
Risk-free rate, i_F	Assumed 3%

3. Using data in the table confirm the accuracy of the site's WACC calculation:

Weight of Equity
Weighted Average Cost of Equity
Weight of Debt
Pre-Tax Weighted Average Cost of Debt
After-Tax Weighted Cost of Debt
Weighted Average Cost of Capital

Part B: Dividend Payout and Growth Ratios

Recall from Module 1 the following two ratios:

Internal growth rate = (ROA · RR) / [1-(ROA · RR)]

where RR = Retention ratio = (Addition to retained earnings)/Net income

The internal growth rate measures the amount of growth a firm can sustain if it uses only internal financing (retained earnings) to increase assets

Sustainable growth rate = (ROE · RR) / [1-(ROE · RR)]

If the firm uses retained earnings to support asset growth, the firm's capital structure will change over time, i.e., the share of equity will increase relative to debt.

To maintain the same capital structure managers must use both debt and equity financing to support asset growth.

The sustainable growth rate measures the amount of growth a firm can achieve using internal equity and maintaining a constant debt ratio.

1. For the firm selected for Part A, calculate its internal growth rate for the last fiscal year:

2. Calculate the firm's sustainable growth rate for the last fiscal year:

Part C -

1. Consider your results for Parts A and B. If the chosen firm grows at its internal growth rate, increasing assets only with its retained earnings, how will this likely affect its WACC? Show calculations.

2. If the chosen firm grows at its sustainable growth rate with increases in both its retained earnings and debt, maintaining a constant debt ratio, how will this affect its WACC?

3. If the chosen firm attempts to grow faster than its sustainable growth rate with modest increases in its debt ratio, how will this likely affect its WACC? What about very large increases in its debt ratio? Explain.

Attachment:- Assignment Files.rar

Reference no: EM131944650

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