Cost of Capital, Capital Structure, and Capital Budgeting Analysis

University of Houston-Victoria

FINC 6352- Financial Management

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Individual Final Project

Cost of Capital, Capital Structure,

and Capital Budgeting Analysis

1. Purpose of the project:

In this project, you are supposed to be a financial manager to apply the knowledge obtained from the Financial Management (FINC6352) course to estimate 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 corporation of your choice. You will use the estimated WACC as the discount rate to perform capital budgeting analysis for a hypothetical project (the data is given below) that is under consideration by the selected company, and decide whether the project should be accepted.

2. Outline for the project:

(1) Executive Summary (10 points)

– Summarize the major findings, results, and the analysis of the report.

(2) Financial Ratio Analysis (40 points)

You are expected to retrieve the most recent 3-5 years historical financial statements the selected company and apply the knowledge obtained in Financial Management and Financial Statement Analysis (ACCT6351) to calculate and analyze the key financial ratios of the firm.

– Perform trend analysis of the key financial ratios (i.e., liquidity ratios, asset management ratios, debt management ratios, profitability ratios, market value ratios) of the company for 3-5 years.

– Perform industry (or benchmark companies) comparison analysis of the key financial ratios of the company during the most recent year.

– Based on the financial ratio analysis results, discuss/evaluate the financial performance of the company.

(3) Estimate Capital Structure (25 points)

– 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.

(4) Compute Weighted Average Cost of Capital (WACC) (35 points)

– Estimate the firm’s before-tax and after-tax component cost of debt; (Note: If the information about the current corporate tax rate is not available, you need to estimate the tax rate based on the historical tax payments).

– Estimate the firm’s component cost of preferred stock if the firm has issued preferred stocks.

– Use three approaches (CAPM, DCF, bond-yield-plus-risk-premium) to estimate the component cost of common equity for the firm.

– Calculate the firm’s weighted average cost of capital (WACC) using the market-based capital weights.

(5) Cash Flow Estimation (40 points)

– We assume that the company you selected is considering a new project. The project has 8 years’ life. This project requires initial investment of $550 million to purchase equipment, and $28 million for shipping & installation fee. The fixed assets fall in the 7-year MACRS class. The salvage value of the fixed assets is 10% of the purchase price (including the shipping & installation fee). The number of units of the new product expected to be sold in the first year is 2,560,000 and the expected annual growth rate is 10%. The sales price is $285 per unit and the variable cost is $230 per unit in the first year, but they should be adjusted accordingly based on the estimated annualized inflation rate of 2.0%. The required net operating working capital (NOWC) is 10.8% of sales. Use the corporate tax rate obtained in Step (4) for the project. 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. Note: you may revise the partial model in the file Ch11 P18 Build a Model.xls on the website of the textbook (also posted in this final project learning module in Blackboard) for capital budgeting analysis, but you are NOT required to strictly follow the partial model. Actually, you are encouraged to build a better model by yourself.

– Compute the depreciation basis and annual depreciation of the new project. You can refer to Table 11A-2 MACRS allowances on pp.496 in the textbook.

– Estimate annual cash flows for the 8 years.

– Draw a time line of the cash flows.

(6) Capital Budgeting Analysis (40 points)

– Using the WACC obtained from in Step (4) as the discount rate for this project, apply capital budgeting analysis techniques (NPV, IRR, MIRR, PI, Payback, Discounted Payback) to analyze the new project.

– Perform a sensitivity analysis for the effects of key variables (e.g., sales growth rate, cost of capital, unit costs, sales price) on the estimated NPV or IRR in order to demonstrate the sensitivity of the model. The Scenario analysis of several variables simultaneously is encouraged (but not required). A document Sensitivity Analysis in Excel is provided in this learning module. It introduces the Data Table function that you can use to conduct sensitivity analysis in Excel.

– Discuss whether the project should be taken and summarize your report.

3. Other information regarding the project:

(1) Choose a publicly-traded company in the Materials sector (i.e. Chemicals, Construction materials, metals and mining, papers and forest products). You need to inform the instructor the company that you intend to analyze. Different students should use different companies for their projects. If two students happen to select the same company, the student who informed the instructor first has the priority, and the other student need to find another company.

(2) Your project should be well-organized and typed in a Word document and attach the important tables with your report. The style and organization of the project is also very important. It accounts for 10 points. Do not directly copy any contents from any other resources. List the cited references in your project.

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