Reference no: EM133160692

QUESTION 1 - There is a company by the name of Blackbelt Communications Inc. which is considering a undertaking a major expansion program that has been suggested by the information technology department of the company. The company decided that before proceeding with the expansion, the company must estimate its cost of capital. Suppose you are an assistant to Henry Taylor, the financial vice president. Your first task is to estimate Blackbelt's cost of capital. Taylor has provided you with the following data, which he believes may be relevant to your task:

1. The firm's tax rate is 40%.

2. The current price of Blackbelt's 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Blackbelt's does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

3. The current price of the firm's 10%, $100.00 par value, quarterly dividend, perpetual preferred stock is $111.10.

4. Blackbelt's common stock is currently selling for $50.00 per share. Its last dividend (Do) was $4.19, and dividends are expected to grow at a constant annual rate of 5% in the foreseeable future. Blackbelt's beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach; the firm uses a risk premium of 4%.

5. Blackbelt's target capital structure is 30% debt, 10% preferred stock, and 60% common equity.

To structure the task somewhat, Taylor has asked you to answer the following questions.

1. What sources of capital should be included when you estimate Blackbelt's WACC? (1)

2. What is the market interest rate on Blackbelt's debt and its component cost of debt?

3. What is the firm's cost of preferred stock?

4. What is Blackbelt's estimated cost of common equity using the CAPM approach?

5. What is the estimated cost of common equity using the DCF approach?

6. What is the bond-yield-plus-risk-premium estimate for c Blackbelt's cost of common equity?

7. What is your final estimate for rs?

8. What are two approaches that can be used to adjust for flotation Costs?

9. Blackbelt estimates that if it issues new common stock, the flotation cost will be 15%. Blackbelt incorporates the flotation costs into the DCF approach.

QUESTION 2 - There is a company by the name of Sunshine Holdings who has earnings, dividends, and stock prices which are expected to grow at 7% per year in the future, Sunghine Holdinge common stock sell for 923 per share, its last dividend was 92,00, and the company will pay a dividend of 82.14 at the end of the current year

a) Using discounted cash, flow approach, what is the cost of equity?

b) If the firm's beta is 1.0, the risk-free rate is 0% and the expected return on the market is 13%, what will be the firm's cost of equity using the CAPM approach?

c) If the firm' bonds ear a rate of return of 12%, what will r& be using the bond-yield-plus-fisk-premium approach? Use the midpoint of the risk premium range

d) Based on the results of part a through c, what would you estimate Sunshine Holdings' cost of equity to be?

QUESTION 3 - Village Enterprises' CFO is reviewing 4 projects with the same average risk and the data shown below:

The CFO thinks that Village Enterprises (VE) can issue debt at 10%, preferred stock at $49 per share with a $5 annual dividend. Its common stock trades at $36 per share and he expects the next dividend to be $3.50 and grow at a constant rate of 6%. VE's tax rate is 25% and the CFO's target capital structure is 15% debt, 10% preferred and 75% equity.

1. What is the cost of each capital component?

2. What is VE's WACG?

3. Which projects should the CFO accept?

QUESTION 4 - You are a new financial analyst at the ABC Company. The company happens to be a large manufacturing firm that is currently looking into diversification opportunities. The vice president of marketing is particularly interested in a venture that is only marginally connected with what the firm does now. Other managers have suggested enterprises in more closely related fields. The proponents of the various ideas have all provided you with business forecasts from which you have developed financial projections including project cash flows. You have also calculated each project's IRR with the following results:

You are now in a meeting with senior managers that was called to discuss the options. You have just presented your analysis ending your talk with the preceding information. After your presentation, the vice president of marketing stands, congratulates you on a fine job, and states that the figures clearly show that Project A is the best option He also says that your financial analysis shows that project A has the full backing of the finance department. All eyes, including the CFO's, turn to you: How do you respond?

QUESTION 5 - 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, provide a 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.

QUESTION 6 - You have been asked to join a prestigious company, Blue Lagoon Inc. as a financial analyst. Blue Lagoon Inc. uses about $1M of inventory per month. Seeking help, the purchasing manager has come to you for help with a buying decision. He can get a big discount on $15M of inventory by buying it all at once. However, there is some risk of obsolescence when buying that far in advance. He understands that large purchases are frequently analyzed by means of capital budgeting techniques and asks for your help in deciding whether to buy the specially priced inventory. How would you advise him? Is capital budgeting appropriate?