You have been asked to make recommendations regarding capital budgeting for XYZ,

Question

You have been asked to make recommendations regarding capital budgeting for XYZ, Inc. Specifically,

the company has identified 4 projects that it is considering undertaking. The projects are independent of

each other, and if resources allowed, the company would be willing to undertake all projects. However,

due to resource constraints, the company is able to undertake, at most, projects with a total initial

investment of $600,000 or less. Expected betas and annual cash flows for these projects are:

YEAR

-The riskless rate is 2%, and the company wishes to base its analysis on an expected market premium of

6%. The company’s tax rate is 40%.

-The company has 3 million shares of common stock outstanding. The most recent dividend on these

shares was $2.25, and dividends are expected to grow at 5%. The shares trade in the market at $30.

-The company’s other source of funding is a 10-year bond issue, with $50 million face value and a 5%

coupon paid semiannually, currently trading to yield 3.78%.

1) For each project, calculate NPV, Payback, and Modified IRR according to chapter 11. Use the company’s

WACC as the financing and reinvestment rates to calculate the MIRR.

2) Create a table containing the values of these criteria for each project. Include a brief description of each

criteria for the CEO, who does NOT have a finance background.

3) State clearly which project(s) you recommend the company undertake, and briefly explain your reasoning.

Project Beta 0 1 2 3 4 a .08 -125,000 60,000 75,000 80,000 55,000 b 0.9 -160,000 90,000 70,000 60,000 80,000 c 1.0 -60,000 10,000 15,000 14,000 32,000 d 1.2 -260,000 100,000 95,000 80,000 105,000

Explanation / Answer

Recomendation is given above. total outflow required is $605000 but capital available is $ 600000, so project c will not be taken up.

Project Beta Risk free return r Market return m Cost = r+Beta(m-r) % a 0.08 2 6 2.32 b 0.9 2 6 5.60 c 1 2 6 6.00 d 1.2 2 6 6.80

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