In the given scenario, all the three projects are favorable as all three projects yield a higher IRR than the cost of capital (which is assumed to be 10%, since NPC is calculated by discounting future earnings at that rate).
If we have to choose based on shareholder value maximization, I would recommend to choose Project C. Since share value is based on discounted cash flow of future earnings, the Project with highest NPV is best.
Project Rankings as per different capital budgeting criteria:
(ii) Immediate writing off of capital expenditure of bring down profits and reduce current tax burden of small businesses. This ultimate form of accelerated depreciation is beneficial to companies and they shall have to pay lower taxes in current year and would have a better liquidity position.
Going by the second statement that the benefit to the companies depends on the salvage value of the asset at the time it is sold and that at Salvage value > Book Value, accelerated depreciation is less attractive, I would state that this is true as with accelerated depreciation, higher taxes would have to be paid at the time of sale of assets owing to increase in profits due to sale.
I disagree with the statement of the third colleague that depreciation being non-cash expenses only impacts accounting entries. Depreciation although a non-cash expenses, plays a role in evaluation of Net profit and taxes which is cash expenditure. I would agree to the first and second colleague. The Obama Policy is actually attractive considering time value of money.
(iii) The cost of capital here would be the Weighted Average cost of capital of Equity and Debt.
WACC = (Kd * Weight of Debt) + (Ke * (1-Weight of Debt))
Since the target capital structure of the acquisition is 50% debt, we will ensure a mix of capital in a way that the total debt component in the acquisition remains 50%. Rest shall be through equity.
Cost of Debt for American Chemical shall be 7.65% as its Bond rating is BBB.
For the equity component,
Cost of Equity = Risk Free Rate + Beta Coefficient × Market Risk Premium
We have the Beta Coefficient of American Chemical available and also the market risk premium available.
We need the Risk free rate to assess Cost of equity. Then we need to apply the cost of equity and cost of debt in the WACC formula to evaluate the cost of capital.
Effective YTM on Bonds issued by We Works competitors 5 years ago is 7.95%. (Calculation in spreadsheet attached)
Par value $1,000.00
Current Price $910.88
Coupon rate 3.25%
To calculate YTM, we shall use the trial and error method.
Since, the bond is sold at a discount; we know YTM is greater than Coupon rate
In excel, we have used the goal seek Formula
YTM = 3.90%
Therefore YTM = 3.90% 7.95%
The coupon rate at which WeWork could issue the 10-year Par bonds today should be 2% (1.96% rounded off to 2%) or greater. This has been calculated by taking current market price similar to competitors market price and yield of 3%.
The Bonds issued by the competitor 5 years ago are trading below par as the YTM is greater than coupon rate for the bond.
Risks on bonds have changed drastically over time. In the fluctuating market scenario, interest rate risk, credit risk, inflation risk, reinvestment risk, liquidity risk etc. play a key role in determining investor decisions.
Nowadays, Investors are more concerned about the interest rate risk and the credit risk of the competitors bonds as these help evaluate the current price of the bond they are interested in. Any change in competitors bond prices owing to these factors are likely to affect the concerned bond prices too.
(ii) If, required return increases to 7.5% with ROE remaining at 12.5%, then there would be no change to dividend in short term but the intrinsic value per share would come down to $ 120. (6/(7.5%-2.5%))
If, the firm expects to increase its ROE to 15%, then the dividend payout shall also increase. There would be no change to intrinsic value.
(i) No, CDS should not undertake the trial or establish the in-store clinic. The projects NPV is negative. Also, its IRR is lower than the required rate.
(Calculation shown in spreadsheet)
Assumption: Consultant’s fees are assumed to be sunk cost. Alternatively, even if consultants fees is considered, the NPV would be further negative.
(ii) In the given scenario, CDS would have a further loss of $ 703,953 by not undertaking the trial.
Since, the loss by undertaking the trial is lower; CDS would prefer to undertake the trial and try to find scope of earning. CDS would therefore invest in the trial.
(Calculation shown in attached spreadsheet)
Loss in EBIT due to not undertaking the trial 1,00,000.00
Loss in Net Earnings 60,000.00
immediate investment in WC required 1,50,000.00
Total annual reduction in cash flow 2,10,000.00
PV of 5 year reductions -703952.5706 (loss)
EPS (now) 6.100961538 Now, if the stock continues to trade at a PE multiple of 13.33%,
the share price would be: $81.35
Stock appreciation percentage = 8.46%
This is due to increase in EPS after Buy Back.
No. of shares repurchased = 49,17,258
Approach: We have assumed the PE ratio to be constant before and after buyback. Initially, we assumed the share price of 75 to arrive at new share price and then used the new share price to calculate the number of shares.
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