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.