## Description

As a financial consultant, you have contracted with Wheel

Industries to evaluate their procedures involving the evaluation of long term

investment opportunities. You have agreed to provide a detailed report

illustrating the use of several techniques for evaluating capital projects

including the weighted average cost of capital to the firm, the anticipated

cash flows for the projects, and the methods used for project selection. In

addition, you have been asked to evaluate two projects, incorporating risk into

the calculations.

You have also agreed to provide an 8-10 page report, in good

form, with detailed explanation of your methodology, findings, and

recommendations.

Company Information

Wheel Industries is considering a three-year expansion

project, Project A. The project requires an initial investment of $1.5 million.

The project will use the straight-line depreciation method. The project has no

salvage value. It is estimated that the project will generate additional

revenues of $1.2 million per year before tax and has additional annual costs of

$600,000. The Marginal Tax rate is 35%.

Required:

A. Wheel has

just paid a dividend of $2.50 per share. The dividends are expected to grow at

a constant rate of six percent per year forever. If the stock is currently

selling for $50 per share with a 10% flotation cost, what is the cost of new

equity for the firm? What are the advantages and disadvantages of using this

type of financing for the firm?

B. The firm

is considering using debt in its capital structure. If the market rate of 5% is

appropriate for debt of this kind, what is the after tax cost of debt for the

company? What are the advantages and disadvantages of using this type of

financing for the firm?

C. The firm

has decided on a capital structure consisting of 30% debt and 70% new common

stock. Calculate the WACC and explain how it is used in the capital budgeting

process.

D. Calculate

the after tax cash flows for the project for each year. Explain the methods

used in your calculations.

E. If the

discount rate were 6 percent calculate the NPV of the project. Is this an

economically acceptable project to undertake? Why or why not?

F. Now

calculate the IRR for the project. Is this an acceptable project? Why or why

not? Is there a conflict between your answer to part C? Explain why or why not?

Wheel has two other possible investment opportunities, which

are mutually exclusive, and independent of Investment A above. Both investments

will cost $120,000 and have a life of 6 years. The after tax cash flows are expected

to be the same over the six year life for both projects, and the probabilities

for each year’s after tax cash flow is given in the table below.

Investment B

Investment C

Probability After

Tax

Cash Flow

Probability After Tax

Cash Flow

0.25 $20,000 0.30 $22,000

0.50 32,000 0.50

40,000

0.25 40,000 0.20

50,000

G. What is

the expected value of each projectâ€™s annual after tax cash flow? Justify your

answers and identify any conflicts between the IRR and the NPV and explain why

these conflicts may occur.

H. Assuming

that the appropriate discount rate for projects of this risk level is 8%, what

is the risk-adjusted NPV for each project? Which project, if either, should be

selected? Justify your conclusions.

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