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Question: question 1 a small private firm has approached you for...

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question 1:

A small, private firm has approached you for advice on its capital structure decision. It is in the specialty retailing business, and it had earnings before interest and taxes last year of $ 500,000.

 

·      The book value of equity is $1.5 million, but the estimated market value is $ 6 million.

·      The firm has $ 1 million in debt outstanding, and paid an interest expense of $ 80,000 on the debt last year. (Based upon the interest coverage ratio, the firm would be rated AA, and would be facing an interest rate of 8.25%.)

·      The equity is not traded, but the average beta for comparable traded firms is 1.05, and their average debt/equity ratio is 25%.

 

a) Estimate the current cost of capital for this firm

b) Assume now that this firm doubles it debt from $1million to $2million, and that the interest rate at which it can borrow increases to 9%. Estimate the new cost of capital, and the effect on firm value.

 

Question2:

Gradient Ltd is evaluating a new project that has the same risk as the overall firm. The cost is estimated at $75,000 and the expected cash flows are:

Year   Cash Flow

1         $18,000

2         $25,400

3         $35,000

4         $17,900

Currently the company has 50% debt and 50% equity. The cost of Spark's debt is 9% and T-bills are yielding 5%. The market risk premium is 10% and Spark Ltd has a beta of 1.2. Tax rate is 30%. Should the project be accepted or rejected? why is that?  

 

question 3:

You are considering a new product. It will cost $966,000 to launch, have a 3-year life, and no salvage value. Depreciation is straight-line to zero. The required return is 20%, and the tax rate is 30%. Sales are projected at 80 units per year. Price per unit will be $40,000, variable cost per unit is $24,000 and fixed costs are $500,000 per year. Operating cash flows have been calculated for you as 642,600 per year.

 

a)   Suppose that the sales units, price per unit, variable cost per unit, and fixed cost projections above are accurate to within 15%. What are the new variables for the best case and worst case scenarios?

b)   What is the accounting break-even for this project?                              

What is the degree of operating leverage?   

c. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over a period exceeding one year. The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future. Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible.

 

Capital budgeting is hardly an exact science. If it were, companies would never make bad decisions about expansions, product development, equipment upgrades and other capital projects. The fact that companies do make these kinds of mistakes points to the limitations of capital budgeting. In your view, what are the limitations to capital budgeting?

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