Course project overview and implementation framework

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 risk is ultimately built into the probability table. Nevertheless, the decision would be the same because the smelting project has a higher IRR and if the discount rate used on each project was the same, this would mean that the smelting project would have the higher NPV.