What is the underlying cause of ranking conflicts

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Reference no: EM133433327

Question: Jason was recently hired by Freechoice Telecom as a junior budget analyst. He is working for the Venture Capital Division and has been given for capital budgeting projects to evaluate. He must give his analysis and recommendation to the capital budgeting committee.
Jason has a B.S. in accounting from CWU (2015) and passed the CPA exam (2017). He has been in public accounting for several years. During that time he earned an MBA from Seattle U. He would like to be the CFO of a company someday--maybe Freechoice Telecom-- and this is an opportunity to get onto that career track and to prove his ability.
As Jason looks over the financial data collected, he is trying to make sense of it all. He already has the most difficult part of the analysis complete -- the estimation of cash flows. Through some internet research and application of finance theory, he has also determined the firm's beta.

The capital budget is $20 million and the projects are mutually exclusive.
Capital Structures
Freechoice Telecom has the following capital structure, which is considered to be optimal:
Debt 40% Preferred Equity 5% Common Equity 55%
100%
Cost of Capital
Jason knows that in order to evaluate the projects he will have to determine the cost of capital for each of them. He has been given the following data, which he believes will be relevant to his task.
(1)The firm's tax rate is 35%.
(2) Freechoice Telecom has issued a 9% semi-annual coupon bond with 10 years term to maturity. The current trading price is $1022.
(3) The firm has issued some preferred stock which pays an annual 7.5% dividend of $100 par value, and the current market price is $89.
(4) The firm's stock is currently selling for $47 per share. Its last dividend (D0) was $2.50, and dividends are expected to grow at a constant rate of 6.5%. The current risk free return offered by Treasury security is 2.8%, and the market portfolio's return is 9.5%. Freechoice Telecom has a beta of 1.4. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 3.5%.
(5) The firm adjusts its project WACC for risk by adding 2.5% to the overall WACC for high-risk projects and subtracting 2.0% for low-risk projects.
Jason knows that Freechoice Telecom executives have favored IRR in the past for making their capital budgeting decisions. His professor at Seattle U. said NPV was better than IRR. His textbook says that MIRR is also better than IRR. He is the new kid on the block and must be prepared to defend his recommendations.
First, however, Jason must finish the analysis and write his report. To help begin, he has formulated the following questions:
1. What is the firm's cost of debt?
Tax rate of firm: 35% Coupon Rate: 9%

2. What is the cost of preferred stock for Freechoice Telecom?

3. Cost of common equity
(1)What is the estimated cost of common equity using the CAPM approach?

(2)What is the estimated cost of common equity using the DCF approach?

(3)What is the estimated cost of common equity using the bond- yield-plus-risk-premium approach?

(4) What is the final estimate for rs? Taking the above results:

4. What is Freechoice Telecom's overall WACC?

5. Do you think the firm should use the single overall WACC as the hurdle rate for each of its projects? Explain.

6. What is the WACC for each project? Place your numerical solutions in Table 2.
7. Calculate all relevant capital budgeting measures for each project and place your numerical solutions in Table 2.
Table 2
ABCD
WACC
NPV IRR MIRR
8. Comment on the commonly used capital budgeting measures. What is the underlying cause of ranking conflicts? Which criterion is the best one, and why?
The commonly used capital budgeting include IRR, NPV, profitability Index (comparing NPV to initial investment). Ranking conflicts tend to arise mainly because of magnitude of cash flows and the timing of the cash flows.
9. Which of the projects are unacceptable and why?
10. Rank the projects that are acceptable, according to Jason's criterion of choice.
11. Which project should Jason recommend and why? Explain why each of the projects not chosen was rejected.

Reference no: EM133433327

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