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CASE

Melissa Stone, financial manager of Ozark Industries, is developing the firm's optimal capital budget for the coming year. She has identified the five potential projects shown below. Projects B and B* are mutually exclusive, while the remainder are independent. Neither B nor B* are essential to the firm's operations, so replication is not mandatory. Project Cost Net CF1-N Life (N) IRR NPV _______ ________ _________ ________ ______ ______ A $600,000 $178,989 5 15.00% B 300,000 85,295 5 13.00 B* 300,000 53,096 10 12.00 C 150,000 40,586 5 11.00 D 450,000 117,952 5 9.75 The following information was developed for purposes of determining Ozark's corporate cost of capital: Interest rate on new debt 7.5% Tax rate 40.0% Debt ratio 55.0% Current stock price, P0 $24.00 Last dividend, D0 $2.54 Expected growth rate, g 4.0% Flotation cost on common, F 15.0% Expected addition to retained earnings $225,000 Ozark adjusts for differential project risk by adding or subtracting 2 percentage points to the firm's marginal cost of capital. a. Calculate the WACCs, and then plot the company's IOS and MCC schedules. What is the firm's marginal cost of capital for capital budgeting purposes? ANSWER: Step 1: ks = D1/P0 + g = [($2.54)(1.04)]/$24.00 + 4% = $2.64/$24.00 + 4% = 15.0%. ke = D1/[P0(1 - F)] + g = [($2.54)(1.04)]/[($24.00)(1 - 0.15)] + 4% = $2.64/$20.40 + 4% = 16.9%.

Step 2:

WACC1 = wd k d (1 - T) + wce k s = (0.55)(7.5%)(0.6) + 0.45(15.0%) = 9.2%. WACC2 = wd k d (1 - T) + wce k e = (0.55)(7.5%)(0.6) + 0.45(16.9%) = 10.1%.

Step 3: BPRE =

R . E. $225,000 = = $500,000. 0 Equity fraction 0.45

The IOS schedule is a plot of the projects being considered plotted in descending order of IRR. Note that Ozark actually faces two IOS
___________________________________________ ___________________________________________ Copyright 1996 by The Dryden Press. All rights reserved. Chapter 10 - 21 SOLUTION TO MINI CASE

schedules--one with Projects A, B, C, and D, and another with Projects A, B*, C and D. The firm's WACC shows a break point at $500,000 of new capital. A firm's corporate cost of capital is defined by the intersection of the IOS and MCC schedules. Therefore, Ozark's corporate k is 10.1 percent regardless of whether it accepts B or B*.

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b.

Assume initially that all five projects are of average risk. Ozark's optimal capital budget? Explain you answer fully.

What is

ANSWER: If a project has average risk, then its cost of capital is the firm's corporate k. Thus, assuming average risk, all projects should be discounted at the firm's 10.1 percent corporate k. Since the IRR and NPV rules lead to the same accept/reject decisions for independent projects, all independent projects with IRRs above 10.1 percent should be accepted. Thus, independent Projects A and C are acceptable, but Project D is not. However, conflicts can arise between NPV and IRR when evaluating mutually exclusive projects, and, to be safe, mutually exclusive projects should be evaluated using the NPV rule. Therefore, Ozark should choose between Projects B and B* on the basis of which one has the higher NPV when discounted at the firm's 10.1 percent corporate cost of capital: NPVB* = $24,855, and NPVB = $22,511. Thus, Ozark's optimal capital budget consists of Projects A, B*, and C, and it totals $1,050,000.

c.

(1)

How would the IOS schedule look if it had been constructed on the basis of each project's modified IRR (MIRR) rather than its regular IRR?

ANSWER: Recall the equation for the MIRR:

PV of COF =

t =0

n-t (CIFt )(1 + k )

(1 + MIRR )

TV .0 (1 + MIRR )n

Recall also the equation for the regular IRR, set up similarly to the MIRR equation:

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CASE Chapter 10 - 23

PV of COF =

t =0

n-t (CIFt )(1 + IRR )

(1 + IRR )

TV .0 (1 + IRR )t

The significance in the two equations is that MIRR compounds at the cost of capital, k, while IRR compounds at the IRR rate itself. Therefore, if IRR > k, then TV will be higher in the IRR formula, and, hence, IRR will exceed MIRR. Conversely, if k > IRR, then TV will be larger in the MIRR formula, and, hence, MIRR will exceed IRR. As a general rule, MIRR is less than IRR for any project whose IRR is greater than the cost of capital, while MIRR is greater than IRR if k > IRR. Further, in our example, the reduction in rate of return would be greatest for Project A, since it has the highest IRR, and least for Project C. The MIRR for Project D would be higher than its regular IRR because its IRR is less than the firm's MCC. The net effect is to rotate the IOS schedule counterclockwise slightly about the MCC intersection.

c.

(2)

Could the use of MIRR change the size of the optimal capital budget? In answering this question, assume that Ozark uses the IOS/IRR analysis to establish a cost of capital and then uses this cost of capital in an NPV analysis; it does not rank and accept projects on the basis of IRR (or MIRR). Therefore, the question is, "Could the use of MIRR versus IRR change the cost of capital which is used in the NPV analysis, and could that decision then affect the set of projects the firm selects?" Explain your answer.

ANSWER: Normally, the use of MIRR versus IRR would merely rotate the IOS line around the same intersection point with the MCC schedule, and hence there would be no change in the corporate k used in the capital budgeting process. However, if mutually exclusive projects that differ greatly in size were involved, then basing the IOS curve on the IRR or the MIRR could produce a different intersection point, and hence a different corporate k, which in turn could lead to a different set of projects. Even here, though, it is not clear that an iterative analysis would not lead to another change, and ultimately to the same result regardless of whether we started with IRR or MIRR. This point is not of enough practical significance to worry about it, though.

c.

(3)

Could you foresee any problems with conducting the analysis with MIRR rather than IRR? If so, can you think of a solution?

ANSWER: MIRR cannot be calculated until the firm's corporate k is estimated, and hence it is easiest to construct the IOS schedule using the projects' regular IRRs. Combined with the fact that it does not matter much if at all whether IRR or MIRR is used as the starting point to get a corporate k for use in an NPV analysis, we see no reason for not using IRR in the first place.

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d.

Now assume that the retained earnings break point occurred at $1,350,000 of new capital. What effect would this have on the firm's MCC schedule and its optimal capital budget?

ANSWER: If the break point occurred at $1,350,000 of new capital, then the MCC schedule would intersect Project D at that point. Thus, Project D's $450,000 of capital would be financed with $300,000 of low-cost 9.2 percent capital and $150,000 of higher-cost 10.1 percent capital. The overall cost of capital for Project D is thus (2/3)(9.2%) + (1/3)(10.1%) = 9.50%, and with an IRR of 9.75 percent, Project D becomes acceptable. In this situation, the firm's MCC is technically 10.1 percent, but we would use an average of the 9.2 percent and 10.1 percent in deciding whether or not to accept Project D. The corporate cost of capital's normal purpose is to provide a single discount rate that can be applied to all projects of average risk. However, if projects are discrete, then it may be necessary to use as the discount rate an average of two (or more) MCCs.

e.

Now suppose it was discovered that Ozark has $200,000 of depreciation and deferred tax cash flow that had not been included in the analysis thus far. Discuss how this might affect the firm's MCC schedule and its optimal capital budget.

ANSWER: Depreciation and deferred tax cash flows have an opportunity cost equal to the firm's lowest WACC. Thus, these flows have a cost of 9.2 percent. Since these flows are available to fund the projects in the IOS schedule, then the break point must be moved to the right by the dollar amount of these flows, or by $200,000, so it occurs at $700,000. In our example, this does not affect the decision (thus far), but it is easy to see that the extension could (1) make projects that were previously rejected acceptable and (2) by changing the corporate k (from 10.1% to 9.2%) lead to ranking changes for mutually exclusive projects. Thus, it is critically important to take depreciation and deferred taxes into account.

f.

Now disregard the $200,000 of depreciation and deferred taxes, and return to the situation in Part a, with the $500,000 break point. Suppose Project A is reexamined, and it is judged to be a high-risk project, while Projects C and D are, upon reexamination, judged to have low risk. Projects B and B* remain average-risk projects. How would these changes affect Ozark's optimal capital budget?

ANSWER: Since the firm adjusts for differential risk by adding/subtracting 2.0 percentage points, Ozark's differential risk-adjusted hurdle rates are as follows:

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Project Risk ___________

Hurdle Rate ___________

Projects ________

Low 8.1% C,D Average 10.1 B,B* High 12.1 A Project A's hurdle rate is now 12.1 percent, but since its IRR is 15.0 percent, it still has NPV > 0 and hence is still acceptable. The hurdle rate for Project C and D drops to 8.1 percent, and, with a 9.75 percent IRR, D is now acceptable. When differential risk is considered, Ozark's optimal capital budget consists of Projects A, B (or B*), C, and D, for a total of $1,500,000. Risk adjustments could, of course, have lowered the optimal capital budget.

g.

In reality, companies like Ozark have hundreds of projects to evaluate each year, and hence it is generally not practical to draw the IOS and MCC schedules which include every potential project. Now suppose this situation exists for Ozark. Suppose also that the company has 3 divisions, L, A, and H, with low, average, and high risk, respectively, and that the projects within each division can also be grouped into three risk categories. Describe how Ozark might go about structuring its capital budgeting decision process and choosing its optimal set of projects. For this purpose, assume that Ozark's corporate k is estimated to be 11 percent. As part of your answer, find appropriate divisional and project hurdle rates when differential risk is considered.

ANSWER: The process begins with rough estimates of the firm's MCC schedule and size of the capital budget. With these data, the firm's corporate k can be estimated. With an 11.0 percent corporate k, Division L's divisional cost of capital would be 9.0 percent, while H's would be 13.0 percent. Finally, projects are evaluated for risk within each division. The end result is this set of hurdle rates:

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Division ________ L

Project Risk Within Division _______________

Project k _________

Low 7% Average 9 High 11 _____________________________________________________ Low 9 A Average 11 High 13 _____________________________________________________ Low 11 H Average 13 High 15 Thus, Ozark's projects would be evaluated using hurdle rates ranging from 7.0 to 15.0 percent, depending on the divisional and project risks involved. To be sure, the entire process of risk assessment and incorporation is rough. However, well-managed firms, like experienced individual investors, must consider risk when making investment decisions, and risk-adjusted discount rates are a logical part of the process.

h.

(1)

On the basis of information given in the problem, does Ozark appear to be subject to capital rationing? Explain, and refer to your MCC/IOS graph as a part of your explanation.

ANSWER: No, Ozark does not appear to be subject to capital rationing. If it were, it would have projects whose IRR exceeded their relevant k's, yet were not accepted because the firm had insufficient capital to fund all such projects. Here the company seems to be willing to accept all projects with IRR > project k (and, hence, NPV > 0). In terms of the graph, we would have a vertical line drawn at the amount of the capital limit, and if the capital rationing constraint were binding, then the IOS curve would be above the MCC schedule at the constraint--there would be a gap between the MCC and the IOS, rather than an intersection.

h.

(2)

If a company is subject to capital rationing, how should it attempt to maximize shareholder wealth, subject to the capital rationing constraint?

ANSWER: If a company is subject to binding capital rationing, then it should select, from among all sets of projects whose costs do not exceed the constraint, that particular set whose NPV is largest. Linear programming can solve this problem if large numbers of projects are involved. However, if investments in multiple years and projects of different degrees of risk are involved, the solution process is essentially unworkable. Note, though, that capital rationing is not a problem for a rational firm, because rational firms do not ration capital--rather, they invest out to the point where MCC = IRR for the marginal project, and thus maximize the firm's value.

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CASE Chapter 10 - 27