capital budgeting and the cost of capital case 1
Module 3 – Case
Capital Budgeting and the Cost of Capital
Assignment Overview
Before starting on this assignment, make sure to thoroughly review the required background materials. Make sure you fully understand both the basic concepts as well as how to calculate payback period, NPV, IRR, and WACC. Submit your answers in a Word document. Make sure to show your work for all quantitative questions and fully explain your answers using references to the background readings for any conceptual questions. Questions 1 and 2 will require Excel. Attach an Excel file to show your computations for Questions 1 and 2.
Case Assignment
 The table below gives the initial investment and expected cash flows over the next five years for two different projects. Assume that the industry you are in expects a return of 10%, which you use as the discount rate in net present value (NPV) calculations and as the required rate of return for purposes of deciding on projects. Also, assume that management only wants to invest in projects that pay off within four years.
For each project, compute the payback period, NPV, and internal rate of return (IRR). Then explain whether each project should be accepted based on these three criteria.
Project A 
Project B 

Initial Investment 
$40,000 
$28,000 
Year 
Cash Flows 

1 
$10,000 
$10,000 
2 
$10,000 
$13,000 
3 
$10,000 
$5,000 
4 
$10,000 
$5,000 
5 
$10,000 
$6,000 
 Suppose you are planning on becoming a vendor at the arena where your favorite sports team plays. You are trying to decide between opening up a souvenir stand selling Tshirts, caps, etc., with your sports teamâ€™s logo or opening up a hot dog and beer stand. It is more expensive to open up the hot dog and beer stand because you need to purchase a license to serve alcohol and you need to spend money to comply with health department regulations. Revenue from the souvenir stand is likely to be unpredictable because fans of your favorite team tend to want to purchase hats and Tshirts only when the team is winning. Revenue from hot dogs and beer seem to be a little more steady since fans want to eat and drink regardless of whether the team is winning.
Below is a table with the initial investment cost of each type of stand and the annual payments you expect over the next five years. The annual payments will be different depending on how well your team does. Therefore, you will estimate how much cash flow you will get depending on whether your team does better than expected (optimistic), the same as the past few years (most likely), and worse than expected (pessimistic). Use a discount rate of 8%.
Based on the table below, answer the following items:
 Calculate the net present value (NPV) for each type of stand under each of the three scenarios. Calculate the range of possible NPV values for each type of stand.
 Based on your answer to A) above and your own guesses about how well you think your favorite team will do over the next five years, which type of stand would you rather invest in?
Souvenir Stand 
Hot Dog and Beer Stand 

Initial Investment 
$100,000 
$150,000 
Annual Cash Inflows (5 Years) 

Outcome 

Pessimistic 
$30,000 
$50,000 
Most likely 
$50,000 
$60,000 
Optimistic 
$70,000 
$70,000 
 Suppose you are a corn farmer in your home state. You have to decide between two projects. One project is to purchase new equipment for your farm that will help boost your profits for the next 10 years. You also find out that you can purchase a large banana farm in Brazil for the same price as the equipment, and at the current market price for bananas you will make a lot more profit than you would from purchasing new corn farming equipment.
After asking around, you find out that the standard discount rate for evaluating the NPV of the farming project is 6%. Most farmers in your home state seem to use this rate successfully. However, you donâ€™t know any other banana farmers and you donâ€™t know too much about farming in Brazil, so you have to make a guess on an appropriate discount rate for the Brazilian banana farm. Based on the concepts from the background readings, would you say the Brazilian banana farm will need a lower or higher discount rate? A lot larger or smaller, or only a little?
 Calculate the following:
 The cost of equity if the riskfree rate is 2%, the market risk premium is 8%, and the beta for the company is 1.3.
 The cost of equity if the company paid a dividend of $2 last year and is expected to grow at a constant rate of 7%. The stock price is currently $40.
 The weighted average cost of capital (WACC) if the company has a total value of $1 million with a market value of its debt at $600,000 and a market value of its equity at $400,000. Its cost of debt is 6% and its cost of equity is 15%. The tax rate it pays is 25%.
 Suppose you own a chain of dry cleaners and the WACC youâ€™ve been using to make decisions on new purchases of dry cleaning equipment is a steady 9%. Recently, gambling has been made legal in your home town so you decide to expand and open up a casino. Should you use the same WACC to evaluate purchases of casino equipment? Why or why not? What are some alternatives to using the same WACC to make decisions on casino equipment? Explain your reasoning, and make references to concepts from the background readings.
Assignment Expectations
 Answer the assignment questions directly.
 Stay focused on the precise assignment questions. Do not go off on tangents or devote a lot of space to summarizing general background materials.
 For computational problems, make sure to show your work and explain your steps.
 For short answer/short essay questions, make sure to reference your sources of information with both a bibliography and intext citations. See the Student Guide to Writing a HighQuality Academic Paper, including pages 1114 on intext
Module 3 – Background
Capital Budgeting and the Cost of Capital
Start off the module by viewing these videos from Professor Roberts of the Wharton School of Business at the University of Pennsylvania and Professor Roberts of Rice University. These videos will give you a general overview of the key concepts of capital budgeting and the cost of capital:
Roberts, M. (2017). Decision criteria. Coursera. Retrieved from:
https://zh.coursera.org/learn/whartonfinance/lecture/hRuBX/decisioncriteria
Weston, J. (2017) Putting it all together as WACC (weighted average cost of capital). Coursera. Retrieved from:
https://www.coursera.org/learn/financefornonfinance/lecture/07ldB/puttingitalltogetherasthewaccweightedaveragecostofcapital
Ross, S., Westerfield, R., & Jordan, B. (2007) Chapter 8: Net present value and other investment criteria.
Essentials of Corporate Finance. McGraw Hill.
http://novellaqalive2.mheducation.com/sites/dl/free/007000000x/484691/Part5_Chap8.pdf [If the link is down, click
Net Present Value or
Fundamentals of Corporate Finance for an alternative link]
Ross, S., Westerfield, R., & Jordan, B. (2007) Chapter 12: Cost of capital.
Essentials of Corporate Finance. McGraw Hill. Retrieved from:
http://novellaqalive2.mheducation.com/sites/dl/free/007000000x/484691/Part7_Chap12.pdf
[If the link is down, click
Cost of Capital or
Fundamentals of Corporate Finance for an alternative link] Finally, check out the following video that will show you how to make capital budgeting calculations using Excel: Graulich, V. (2012). How to calculate NPV and IRR. IHateMath.com. Retrieved from:
https://www.youtube.com/watch?v=kCnwCplibAk&t=230s Codible (2019). NPV and IRR in Excel 2010. Retrieved 08/19/2019 from
https://www.youtube.com/watch?v=qAhV3xG0i8s If you still have difficulty with the material after reviewing the required materials, check out the optional materials below. Included are two additional videos, including one on using Excel to compute NPV and IRR. Also included are some additional book chapters that cover the same material but explain it in a slightly different way with different examples.Optional Reading
BlueBookAcademy.com. (2015). Learn it FAST: Weighted average cost of capital explained. Retrieved from:
https://www.youtube.com/watch?v=JIvokDfW9AQ&t=48s Girvin, M. (2010). Investment criteria: NPV, IRR, payback, AAR, profitability index. Retrieved from:
https://www.youtube.com/watch?v=U2aH4xH5Fz0 Fabozzi, F. J., & Peterson Drake, P. (2009). Chapter 14: Capital budgeting techniques.
Finance: Capital markets, financial management, and investment management. Wiley. Available in the Trident Online Library. Clive, M. (2012). Chapter 14: The cost of capital.
Financial management for nonfinancial managers. Kogan Page. Available in the Trident Online Library. Block, S. & Hirt, G. (2008). Chapter 12: The capital budgeting decision. Foundations of Financial Management. McGrawHill, Retrieved from:
http://studylib.net/doc/8149455/12thecapitalbudgetingdecision
 citations. Another resource is the â€œWriting Style Guide,â€ which is found under â€œMy Resourcesâ€ in the TLC Portal.