Capital Budgeting Decison

Course Project Part II Introduction You will assume that you still work as a financial analyst for the Coca Cola Co. The company is considering a capital investment and you are in charge of helping them launching a new product based on (1) a given rate of return of 12% (Task 4) and (2) the firm- cost of capital (Task 5). Task 4. Capital Budgeting for a Product A few months have now passed and Coca Cola Co. is considering launching a new product - a flavored soda! The anticipated cash flows for the project are as follows: Year 1 $1,200,000 Year 2 $1,500,000 Year 3 $1,750,000 Year 4 $1,900,000 Year 5 $2,100,000 You have now been tasked with providing a recommendation for the project based on the results of a Net Present Value Analysis. Assuming that the required rate of return is 12% and the initial cost of project is $4,500,000: 1. What is the project- IRR? (10 pts) TIP: the internal rate of return is the interest rate or discount rate that makes the net present value of a project zero. The simplest way to calculate rate of return is using an XLS spreadsheet as shown on page 244 of your textbook. You can also use an online calculator. The following calculator will allow you to compute the net present value, IRR and payback of the project: http://zenwealth.com/BusinessFinanceOnline/CB/CBCalculator.html You need to remember to include in your calculations the initial cost of the project is $4.5 million. Because this is an outflow it should be represented by a negative side on the calculator. Alternatively, you can calculate the present value of the cash flows for years 1 to 5 and then deduct the $4.5 million from that amount. Remember that IRR is always a rate or percentage, never a dollar amount! 2. What is the project- NPV? (15 pts) TIP: the same applies here. You can use the calculator above or you can simply compute the present value of each cash flow. That is an example on page 126 of the textbook, example 5.3. 3. Please write a brief two paragraph memo to your boss explaining why you would or would not accept this project. Explain your rationale in detail. TIP: You need to find out the rules for accepting a project based on its present value and IRR. Describe the rule and if it applies to the project above based on your findings in your memo. 4. Will depreciation increase or decrease the project's NPV? Why? Explain in detail your rationale. (10 pts) TIP: Here are the key is to differentiate between a cash and a non-cash item. There is an explanation on page 29 on non-cash items. You need to remember that there is a difference between income and cash flow, but that your net income would also depend on your depreciation expense, because depreciation affects your tax due amount. 5. Provide on example of each the following as it relates to the project. Please make sure that your examples are applicable to Coca Cola- idea of launching a new product. (5 pts each) a. Sunk Cost b. Opportunity cost c. Erosion You need to provide one example of each of this. Therefore, at least one example of a sunk cost, one of an opportunity cost and one of erosion cost. Please read pages 269-271 of your textbook. 6. Explain how you would conduct a scenario and sensitivity analysis of the project. What would be some project-specific risks and market risks related to this project? (20 pts) TIP: Please see pages 285 to 289 of the textbook, as well as exercise 9.2 on page 293.


 Task 5: Cost of Capital TIP: read your lecture, it has a link to an example of computing cost of capital!! http://www.expectationsinvesting.com/tutorial8.shtml Coca Cola Co. is now considering that the appropriate discount rate for the new product 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 Coca Cola Co. is considering issuing new bonds. Select current bonds from one of the main competitors as a benchmark. Key competitors are Pepsi Co and Dr. Pepper Snapple Group. a. What is the YTM of the competitor- bond? You may use a number of sources, but we recommend Morningstar. Find the YTM of one 10 or 15 year bond with the highest possible creditworthiness. You may assume that new bonds issued by Coca Cola. are of similar risk and will require the same return. Please copy/paste a snapshot of your findings to obtain credit for this question. (5 pts) TIP: there is a document on their Doc Sharing "Finding_Stock_Info.pdf " that shows how to find the yield to maturity of bonds using MorningStar.com. Please use this document to update this information and if you have any questions, please post them on the Q&A section. Remember the YTM is always a percentage amount, not a dollar amount. There is no need for calculations here. You only need to observe the YTM posted on Morningstar for the bond. b. What is the after-tax cost of debt if the tax rate is 24%? (5 pts) TIP: Use the following formula: Cost of debt (Bonds) = Current YTM of Bonds x (1-t) where t is the tax rate of 24% 
and the YTM is the YTM you found under (a) above. For instance, if the YTM you found is 5%, you will use the formula as follows: Cost of debt = 0.05 x (1-0.24) Remember the cost of any capital is always a percentage amount, not a dollar amount. 
c. Explain how you can use the "observation" method to find the cost of debt for Coca Cola Co, assuming you know the ratings of its bonds. (10 pts) TIP: Please refer back to our lecture under the Cost of Debt Section and page 384 of your textbook. 

d. Which is more relevant to the cost of debt the YTM or the coupon rate? Explain your rationale. (5 pts) TIP: Please refer back to the Cost of Debt Section under page 384 of the textbook.
 2. Compute the cost of common equity using the CAPM model. For beta, use the average beta of three selected competitors. You may obtain the betas from Yahoo Finance. TIP: there is a document on their Doc Sharing "Finding_Stock_Info.pdf " that shows how to find the beta for a stock. Assume the risk free rate to be 2.5% and the market risk premium to be 6%. a. What is the cost of common equity? (5 pts) TIP: See formula 12.2, page 382. Remember the cost of any capital is always a percentage amount, not a dollar amount. b. Explain the advantages and disadvantages to use the CAPM model as the method to compute the cost of common equity. Compare and contrast this method with the dividend growth model approach. (10 pts) TIP: Please read pages 380-383 of the textbook. For the dividend growth model, read page 206 as well. 

3. Compute the cost of preferred equity assuming the dividend paid for preferred stock is $3 and the current value of the stock is $82 per share. a. What is the cost of preferred equity? (5 pts) TIP: Use formula 12.3 under page 384 b. Is there any other method to compute this cost? Explain. (5 pts) TIP: Read last paragraph of page 384 
4. Assuming that the market value weights of these capital sources are 20% bonds, 60% common equity and 20% preferred equity, what is the weighted cost of capital of the firm? (10 pts) TIP: Please use formula 12.7, there is also a great example under the lecture. Remember that for the cost of debt, you do not need to multiply by (1-t), you already did this. You can simply substitute for the cost of debt you found under 1(b) above. Therefore: WACC = (0.2 x after-tax cost of debt) + (0.6 x cost of common equity) + (0.2 x cost of preferred equity). These three costs are the ones you found above. Cost of debt under 1(B), cost of common equity under 2(A) and cost of preferred equity under 3(A). Your result should be a rate or percentage amount!

 5. Should the firm use this WACC for all projects? Explain and provide examples as appropriate. (10 pts) TIP: See pages 395-397 of your textbook. 6. Recompute the net present value of the project based on the cost of capital you found (on question 4 above). Do you still believe that your earlier recommendation for accepting or rejecting the project was adequate? Why or why not? (5 pts) TIP: Instead of using the required rate of return of 12% provided above, use the rate or percentage amount (cost of capital) you found under item 4 above.