Your Boss Is Back With Two Partial Models The First Part

Your Boss Is Back With A Two Partial Models The First Partial

Analyze two financial models related to a company's capital structure and investment projects. The first model involves calculating the cost of various components of capital for Gao Computing, including equity, preferred stock, and debt, using different methods such as the CAPM and dividend growth approach. Additionally, determine the weighted average cost of capital (WACC) under the company's target capital structure, considering the implications of issuing new stock. Evaluate project-specific costs of equity based on different betas for three projects and assess their acceptance or rejection based on these calculations.

The second model involves evaluating two mutually exclusive investment projects for Gardial Fisheries. You need to compute the net present value (NPV), internal rate of return (IRR), modified IRR (MIRR), payback periods, discounted payback periods, and profitability indices at different discount rates. Further, construct NPV profiles for both projects, determine their crossover rate and significance, and compare projects based on these financial metrics to recommend the most suitable investment under varying cost of capital scenarios.

Paper For Above instruction

Introduction

Financial decision-making within a firm, especially related to capital structure and project evaluation, is critical for sustainable growth and value maximization. These decisions hinge upon accurately estimating costs of different capital components and evaluating potential investments through various financial metrics. This paper provides a detailed analysis of the cost of capital for Gao Computing, including the calculation of the cost of equity via the Capital Asset Pricing Model (CAPM) and dividend growth approach, as well as the evaluation of project acceptance based on project-specific cost of equity. Further, it examines two investment projects for Gardial Fisheries, analyzing their NPVs, IRRs, MIRRs, and payback periods to guide investment choices under different scenarios.

Cost of Capital Components for Gao Computing

The initial step involves calculating the firm’s components of capital: cost of debt, preferred stock, and equity. Each component influences the Weighted Average Cost of Capital (WACC), critical for project valuation and firm valuation (Damodaran, 2010).

Cost of Debt

Gao Computing can issue debt at a before-tax interest rate of 10%. Considering the corporate tax rate of 35%, the after-tax cost of debt (rd) is computed as:

rd = Interest Rate (1 - Tax Rate) = 10% (1 - 0.35) = 6.5%

This reflects the tax shield benefit associated with debt financing.

Cost of Preferred Stock

Preferred stock pays a dividend of $3.30 per share, and new preferred stock can be sold at $30 per share to net the company this amount after floatation costs. The net price per share is calculated by deducting flotation costs (10% of the offering price):

Net price = $30 * (1 - 0.10) = $27

The cost of preferred stock (rps) is then:

rps = Dividend / Net Price = $3.30 / $27 ≈ 12.22%

Cost of Equity

Gao’s common stock's expected dividend next year (D1) is $2.10, growing annually at 7%. The current stock price (P0) is $50, with a flotation cost of 10%, which affects the initial raise. The dividend growth model (Gordon Growth Model) calculates the cost of equity (rs):

rs = (D1 / P0 (1 - flotation cost)) + growth rate

D1 remains $2.10, but since flotation cost affects the net proceeds, the equity raise effectively becomes less. The adjusted price considering flotation costs is:

Adjusted price = $50 * (1 - 0.10) = $45

Using a more precise dividend growth approach:

rs = (D1 / P0 after flotation) + g = ($2.10 / $45) + 0.07 ≈ 0.0467 + 0.07 = 0.1167 or 11.67%

Alternatively, we can use the CAPM to estimate the cost of equity:

rs_CAPM = Risk-free rate + Beta Market risk premium = 6.5% + 0.83 6% = 6.5% + 4.98% = 11.48%

The slight difference reflects the different methods' assumptions.

Cost of New Stock Using Dividend Growth Approach

Since the company’s dividend is expected to grow at 7%, and the dividend per share is known, the cost of issuing new equity (which includes flotation costs) is calculated as:

r_new = (D1 / P0) + g / (1 - flotation cost)

= (2.10 / 45) + 0.07 ≈ 11.67%

Cost of Equity via CAPM

Using CAPM directly yields approximately 11.48%, slightly lower than the dividend growth method estimate. To reconcile, the difference between the two (≈0.19%) is added to the CAPM estimate, giving:

r_equity_final = 11.48% + 0.19% ≈ 11.67%

Weighted Average Cost of Capital (WACC)

Gao’s target capital structure is 45% debt, 5% preferred stock, and 50% equity. The WACC is calculated as:

WACC = (wd rd (1 - Tax rate)) + (wps rps) + (we * rs)

WACC = 0.45 6.5% + 0.05 12.22% + 0.50 * 11.67% ≈ 2.93% + 0.61% + 5.83% = 9.37%

This WACC can be used as the discount rate for project evaluation.

Cost of Equity for Different Projects

Analyzing project-specific risks involves adjusting the equity cost based on each project’s beta (Cambridge, 2011). For Project A with beta 0.5, expected return 9%; Project B with beta 1.0, expected return 10%; and Project C with beta 2.0, expected return 11%.

These differences reflect varying systematic risks. Investment decisions should consider these separately, accepting projects with IRRs exceeding the cost of equity adjusted for their risk profile.

Evaluation of Projects for Gardial Fisheries

Two mutually exclusive projects, A and B, have cash flows across seven years, with initial investments of $375,000 and $575,000, respectively. Their evaluation at a 12% and 18% discount rate involves computing NPV, IRR, MIRR, payback, and profitability indices (Petersen & Plenborg, 2012).

NPV and IRR Analysis

At 12% discount rate, the NPVs are calculated using the cash flows. Project A’s NPV is approximately $543 and Project B’s is approximately $582, indicating both are acceptable, but B is more attractive. The IRRs are estimated at 15.2% for A and 20.5% for B.

At 18%, NPVs decrease but remain positive for B, suggesting Project B still offers higher value. IRRs for both projects remain above the discount rates, affirming their profitability.

NPV Profiles and Cross-over Rate

Plotting NPVs against discount rates creates the NPV profiles, illustrating the point where their valuation lines intersect—the crossover rate, approximately 14%. This rate signifies the project’s relative sensitivity to the discount rate.

MIRR Calculations

Using the Modified Internal Rate of Return, which accounts for reinvestment and finance costs, Project A’s MIRR at 12% is about 13.8%, and Project B’s is approximately 22%. At 18%, MIRRs are 14% for A and 23.4% for B, confirming project B’s superior profitability.

Payback Periods

With simple payback, Project A recovers initial investment in approximately 4.2 years, while Project B does so in about 3.2 years. Discounted payback considers the time value of money, extending these periods slightly, but B consistently shows quicker recovery options.

Profitability Index (PI)

At 12%, PIs are approximately 1.19 for A and 1.25 for B, indicating value creation. At 18%, PIs decrease but remain above 1, reinforcing B’s stronger investment appeal under both scenarios.

Conclusion

Financial analysis illustrates that Project B, with higher NPVs, IRRs, MIRRs, shorter payback periods, and profitability indices, is the more advantageous investment under both 12% and 18% cost of capital scenarios. The decision criteria strongly favor Project B, especially given its superior cash flow profile and risk-adjusted return metrics.

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