Cost of Capital and Capital Budgeting

Cost of Capital and Capital Budgeting

Leland Industries, Inc.


As she headed toward her boss's office, Mary Tobin, Chief Operating Officer for the Leland Industries Inc., a multinational diversified company, wished she could remember more of her training in financial theory that she had been exposed to in graduate school.  Mary had just completed summarizing the financial aspects of three capital investment projects that were open to Leland Industries during the coming year, and she was faced with the task of recommending which ones should be selected.  What concerned her was the knowledge that her boss, Karen Hinton, a "street smart" chief executive, with no background in financial theory, would immediately favor the project that promised the quickest payback.  Mary knows that selecting projects purely on that basis would be incorrect; but she wasn't sure of her ability to convince Karen, who tended to assume financial analysts thought up fancy methods just to show how smart they were.
As she prepared to enter Karen's office, Mary pulled her summary sheets from her briefcase and quickly reviewed the details of the three projects, all of which she considered to be equally risky.
1.	The chemical division is proposing an expansion of its chlorine production plant in Augusta, Georgia.  The total cost of this plant expansion is estimated to be $15,550,000.  In return, the plant would allow Leland Industries to increase its production of chlorine and lower its production cost. (See Figure 1 for details of specific year to year free cash flows.)
2.	A proposal to start a transportation logistics company which would have a total cost of $24,500,000, but it would allow the firm to develop a cost saving routing and tracking system for its current fleet of trucks and sell logistic services to other customers.  (See Figure 1 for details of specific year to year free cash flows.)
3.	Leland- retail division has also proposed an expansion of stores to other geographic areas. The expansion is expensive but the additional stores should provide for a larger market base.  The total expansion cost would be $31,950,000.  (See Figure 1 for details of specific year to year free cash flows.)
In her mind, Mary quickly went over the evaluation methods she had used in the past: internal rate of return (IRR), modified internal rate or return (MIRR), net present value (NPV).  Mary knew that Karen liked the payback method as her own evaluation technique, but she hoped she could talk Karen out of using it this time.  Mary favored the net present value method or modified internal rate of return, but she had always had a tough time getting Karen to understand them.  How was she going to explain these other techniques to Karen?

Figure 1
Expected Cash Flows
Proposed Capital Projects for 2009
Capital Projects 
for 2009	Cash 
Outlay	2010	2011	2012	2013	2014
Project 1:
(Expand Chlorine Plant)	$15,550,000	$1,625,000 	$2,725,000 	$4,750,000 	$6,900,000 	$7,900,000 
Project 2:
(Start Logistics firm)	$24,500,000	$3,950,000 	$5,530,000 	$6,230,000 	$8,913,000 	$12,900,000 
Project 3:
(Buy Chain of 
Computer Stores)	$31,950,000	$5,280,000 	$6,486,000 	$7,860,000 	$10,995,000 	$16,225,000 

Another issue that Mary had to deal with before she could properly evaluate the three proposals was to determine the appropriate discount rate for these projects.  Mary knew that in the last board meeting the target capital structure of Leland Industries had been debated heavily and the consensus opinion was that the firm should have 30% in debt, 30% in preferred stock, and 40% in common stock.  
Listed below are some of the factors that Mary must consider in deciding on the proper discount rate for the firm, even if additional external capital is not used:
1.	The corporate tax rate is 40, percent. 
2.	All of the following terms would apply to new capital offerings
a.	Debt:  New 20 year maturity bonds could be sold with a coupon rate of 9.15 percent, paid semi-annually, and these bonds are currently selling in the bond market for $965.00.  
b.	Preferred Stock: Leland- preferred stock has a current market price of $100.00 per share and a PAR Value of $100 pays an annual 9.35% dividend per share.  New Preferred Stock is issued at the current market price.  If new Preferred Stock is issued a 4.0% flotation cost will be incurred. 
c.	Common stock:  Last year the firm paid a dividend of $1.22 per share, and its stock currently sells at a price of $18.50 per share.  The firm expects that it will be able to sustain a 12.15% growth rate for the foreseeable future.  If new Common Stock is issued a 4.25% flotation cost will be incurred. 
As she closed her briefcase and walked toward Karen's door, Mary reminded herself to have patience; Karen might not trust financial analysis, but she would listen to sensible arguments.  Mary only hoped her financial analysis sounded sensible!  This is where you can help Mary, by your assignments listed below:
YOUR REQUIRED ANALYSIS:
1.	Calculate the Weighted Average Cost of Capital (WACC) for Mary to present to Karen in her defense of using external capital. (15 points)
 
Please use the following table format to summarize your WACC calculations.  Component cost and WACC calculations should be rounded to 4 decimal places.

Table 1
Summary of Findings
Weighted Average Cost of Capital
Types of External Funding	Weight	After-tax
Component
Cost	Weighted
Average Cost 
of Capital
Bonds	%		            %
Preferred Stock	%		            %
Common Stock	%		            %
WACC (Totals)	%		            %

2.	Write an explanation of why the WACC is the proper discount rate for evaluating capital projects. (10 points)
3.	Compute the Regular Payback Period for each of the three alternatives, compute to 2 decimal places, based on their respective free cash flows and determine which project or projects should be accepted if Leland Industries requires that projects have a payback period of 4 years or less.  (15 points)
4.	Calculate the Net Present Value (NPV) for each of the projects and determine which project or projects should be selected based on the NPV criteria.  (Remember, these are NOT mutually exclusive projects.) (15 points)
5.	Calculate the Internal Rate of Return (IRR) for each of the projects and determine which project or projects should be selected based on the IRR criteria. (15 points)
6.	Calculate the Modified Internal Rate of Return (MIRR) for each of the projects and determine which project or projects should be selected based on the MIRR criteria. (15 points)
Please use the following table format to summarize your finding for the required capital budgeting techniques.
Table 2
Summary of Findings
Capital Budgeting Techniques
Capital
Projects	Regular
Payback
Period	Net
Present
Value
(NPV)	Internal
Rate of
Return
(IRR)	Modified
Internal
Rate of
Return
(MIRR)
Project 1:
(Chlorine Plant)				
Project 2:
(Logistics firm) 				
Project 3:
(Computer Stores)				


7.	Which of these evaluation methods do you think Mary should recommend to Karen as the BEST evaluation method for capital projects and why?  Based on all of the evaluation methods you have used for these capital projects, which projects should Leland Industries actually accept (if any)?  Explain why you think these projects are acceptable.  (15 points)