Wheel Industries is considering a three-year expansion project,

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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 project’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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