Reference no: EM131883

Cost of capital to assess its restaurant capital investments

There are four questions. All questions are compulsory.

Question 1: You are considering investing in Facial Laboratories. Assume that Facial is currently undergoing expansion and is not expected to modify its cash dividend while expanding for the next four years. This means that its current annual $3.00 dividend will remain for the next four years. After the expansion is completed, higher earnings are expected to outcome causing a 30% increase in dividends each year for 3 years. After such three years of 30% growth, the dividend growth rate is expected to be 2% per year forever. When the required return for Facial's common stock is 11%, what is a share worth nowadays?

Question 2: You are considering three stocks for the investment purposes. The required return (rj) on the market portfolio is 14% and the riskless return is 9%. On the basis of information that follows, in which (if any) of the below stocks must you invest?

Stock  Beta    Current Price          Last Dividend           Growth Rate
A        1.3           $15.00                    $1.20                      5.00%
B        0.9           $28.00                    $1.30                    10.00%
C        1.1           $31.00                    $2.40                     8.00%

Question 3: Joe Brown and Fred Anthony are planning to invest in the Go Green project. The marginal tax rate is 26% and the company tax rate is 30%. Due to their lack of finance expertise, they have asked your assistance in finding out whether they must invest in Go Green or not.

They have provided you with the given information:

• The project has a life of 6 years.
• The equipment costs $280000 with an additional installation cost of $25000.
• The equipment will be sold at the end of the project life for $55,000
• Straight line technique is used in computing depreciation.
• The Fiji Tax Authority has given this kind of equipment an effective life of 5 years.
• Sales for the first year will be $85000 and sales are expected to grow at 7% pa for each year of the project.
• Cost of goods sold is 18 % of sales each and every year.
• Working capital will be 7% of sales revenues for each year. The working capital investment has to be made at the start of each and every period. All working capital will be recovered.
• Marketing costs will be 2% of sales per annum.
• The hurdle rate is 10%.

Required:

i) Compute NPV for Go Green project.

ii) Compute IRR for Go Green project by using interpolation method (trial and error method).

iii) Advice Joe Brown and Fred Anthony on the acceptability of Go Green project.

iv) Is IRR or NPV more reliable when selecting a project? Why?

Question 4: The cost of capital for a firm can vary from the cost of capital for each of its businesses. When a firm has multiple businesses, it is significant to use the cost of capital appropriate to the particular project under consideration, instead of the firm's overall cost of capital, when computing a proposed project. Renowned Cola, Inc.'s 2005 annual report describes that Renowned Cola's investments are expected to produce cash returns which exceed its "long-term cost of capital," which Renowned Cola estimated to be around 10% at year-end 2005. Renowned Cola has three main lines of business, soft drinks, notably Dr. Cola; snack foods, such as Fritos and restaurants. Restaurant investments comprise NPC, which has a beta of 0.80 and a debt-to-firm value ratio is 0.31. Renowned Cola did not report costs of capital separately for such three businesses. Below, we have available year-end data for 2005 provided by

Renowned Cola.                                                          Renowned Cola's Items Values (M = millions)
Cash and marketable securities                                    $1,498M (market value assumed)
Short-term debt                                                            $706M
Long-term debt                                                             $8,509M ($8,747M market value)
Common shares outstanding                                        788M
Year-end share price                                                     $55.875
Income tax rate                                                             34%
Renowned Cola's beta                                                  1.0
Long-term borrowing rate                                             6.75% Short-term riskless rate 5.13%
Intermediate-term riskless rate                                     5.50%
Long-term riskless rate                                                  6.00%
Short-term market risk premium                                    8.40%
Intermediate-term market risk premium                        7.40%
Long-term market risk premium                                     7.00%

Given the above information, answer the questions below:

i) Compute the market value of Renowned Cola's debt at year-end 2005. What is the book value of debt? Why do generally use market or book values for debt? Describe.

ii) To the nearest million, compute the market value of Renowned Cola's stockholders' equity at year-end 2005.

iii) Renowned Cola subtracts the value of its short-term debt from its total debt when computing its "net debt ratio." Renowned Cola believes that the market values for its traded debt are not precise as the bonds trade infrequently. Given this belief and their treatment of short-term debt, compute Renowned Cola's net debt ratio by using book values for debt and market value for equity.

iv) Calculate Leverage keeping the short-term debt as part of total debt. By using the CAPM calculate re for short-term, medium-term, and long-term investments. Calculate WACC for short-term, medium-term and long-term investments. Assume that you were considering a long-term capital investment project, which WACC would you use and why? You can suppose that the asset's risk profile for the project mirrors Renowned Cola's overall risk profile.

v) Must renowned Cola use its overall cost of capital to assess its restaurant capital investments? Beneath what conditions would it be correct to do so?