Question 1: Capital Budgeting

Good Energy has conducted an analysis of the market potential, costs and revenues associated with its new cereal line, Granola Good Energy.

Here is some information gathered:

The project requires an initial investment of $230,000

Years 1-5 would have the following cash flows: 

Revenues                               $188,000

Labor Costs                           $60,500

Other Production Cost        $50,750

Depreciation                          $15,000

The firm's tax rate is 30%.

Required rate of return 5%.

You have now been tasked with providing a recommendation for the project based on the results of a Net Present Value Analysis.

1. What is the yearly cash flow for Years 2-5?

2. At which rate is the project's net present value equal to zero?

3. What is the project's NPV?

4. Should the company accept this project based on the NPV rule. Why (or why not)?

5. What is the project's payback period in months?

6. Provide examples of at least one of the following as it relates to the project: mutually exclusive investments, erosion costs, forecasting risk.

7. Explain how managerial options would impact your decision regarding the project. What would be some project-specific risks and market risks related to this project?

Task 2: Cost of Capital

Good Energy Cereals. is now considering that the appropriate discount rate for the new product line should be the cost of capital and would like to determine it. You will assist in the process of obtaining this rate. 

1. Compute the cost of debt. Assume Good Cereals. is considering issuing new bonds. Select current bonds of Kellogg as a benchmark.

a. What is the YTM of the Kellogg's bond? You may use a number of sources, but we recommend Morningstar. Find the YTM of one 15 or 20 year bond with the highest possible creditworthiness. You may assume that new bonds issued by Good Cereals. are of similar risk and will require the same return.
You need to copy and paste your information found here in the form of a snapshot.

b. Explain what other methods you could have used to find the cost of debt for Good Cereals.

c. Explain how tax laws make the cost of debt higher or lower for Good Cereals. Given current tax laws, would the company be more or less prone to use debt in its capital structure?

2. Compute the cost of common equity using the CAPM model. For beta, use the current beta of Kellogg. You may obtain the betas from Yahoo Finance. Assume the risk free rate to be 5% and the market risk rate to be 8%.

a. What is the cost of common equity?

b. How can you use the cost of common equity found above under (a) to compute the cost of retained earnings? Assuming the company is privately held, would you expect them to rely more heavily on equity or retained earnings? Explain your rationale.

3. Compute the cost of preferred equity using Kellogg's stock as a benchmark. You can obtain the current dividend and price information from finance.yahoo.com.

a. What is the cost of preferred equity for Kellogg?

b. Is there any other method to compute this cost? Explain.

4. Assuming that the market value weights of these capital sources are 20% debt, 50% common equity and 30% preferred equity, what is the weighted cost of capital of the firm?

5. Should the firm use this WACC for all projects? Explain and provide examples as appropriate.

6. Should the firm use book or market values to compute the cost of capital? Please explain your rationale.

7. Recompute the net present value of the project based on the cost of capital you found. Do you still believe that your earlier recommendation for accepting or rejecting the project was adequate? Why or why not?