Capital Budgeting Decision-Making

Finance The cost of debt is 13%. The cost of common stock, using CAPM, is as follows: The cost of preferred stock is (10/90)(1-(2/90) = (.11111) / (.9778) = 11.3% The company's WACC is (.3)(13)+(.16)(11.3)+(.54)(14.15) = 13.349% The expected cash flow from the investments is the weighted average: Smelting Paving $16,220 $15,800 The standard deviation for the smelting is 2133, while the standard deviation of paving is 10,234. The coefficient of variation for the smelting is 0.1315 for the smelting and .6478 for the paving. The paving option has the higher risk.

The standard deviation is a good measure of risk and the paving option has a much higher standard deviation. Further, it has a higher coefficient of variation as well. On both measures, the paving option has the higher risk. 7/8. The net present values and IRRs for these two are as follows.

First, the smelting: Smelting Year Flow -45000 16220 16220 16220 16220 d 0.13349 npv $2,898.16 irr 16% And then for the paving: Paving Year Flow -45000 15800 15800 15800 15800 d 0.16349 npv -$1,094.99 irr 15% According to the decision rules, the smelting project has a positive NPV and therefore would be acceptable. The IRR is higher than the cost of capital. However, the paving project was given a higher hurdle rate, based on the WACC + 3%, so it has a negative NPV, and would therefore be rejected.

In addition, it has the lower IRR, which means that it would be rejected when compared with the smelting project anyway, because they are mutually exclusive. There is, however, a conflict between the two methods. The use of a higher hurdle rate for the paving project is inconsistent. The point of using the company's WACC is that it reflects the risk associated with the company's ability to raise capital.

The two projects should be evaluated on the basis of the WACC -- whether the project is riskier or not is not reflective of whether it is expected to have a higher NPV. The.