Case Study 23 1.

: Danforth & Donnalley Laundry Products Company

We are not agreed that the cost from marketing testing as cash outflow because it should be considered as sunk cost. In this case, the $ 200,000 of working capital should be considered in outflow and inflow at the end of the project because the capital will used for expenditure in pa roll, in!entories and other emergenc cash needs as well as recei!ables from customer. "or most of project, the expenditure in plant and e#uipment in!ol!e major cash outflows. $ence, these expenditures normall will increase in working capital needs. It should not charger against &last because the current production occup excess capacit and it do not ha!e an increment in cash flows. (he cash flows resulting from erosion of sales from current laundr detergent products should be included in this project because if the sales erosion are not consider, then the project ha!e high possibilit be rejected and it will encourage the competitor to accept this project and compete with new introduction. *o, because if the interest pa ments associated with this new debt be considered cash flow, it will result in double counting.

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+. Year 0 1.) +.10 11.1) 1) *34 *34 3I I66 Include Sales Erosion ,2,200,0002/0,000 x %.010/ %)0,000 x ,+.1''+ .%.010/2)0,000 x ,0.+0+1 2 +.1''+200,000 x 0.2%1%1 Amount ,2,200,0001,0+1,'22 /2%,/%0 %+),%0) '0,/0/ 1/,)00 5 $1/,)00 5 1.0''0 5 7pproximate to 118 *34 3I I66 E clude Sales Erosion ,2,200,0002)0,000 x ,%.010/%1),000 x ,+.1''+ . %.010/22),000 x ,0.+0+1 2 +.1''+200,000 x 0.2%1%1 Amount ,2,200,0001'0,000 0'1,''0 %2/,/%0.)0 '0,/0/ ,1%',1%/5 .$1%',1%0.)0 5 0.1%10 5 18

(he similar product introduced b competitor so e!aluation of the project on include sales erosion. 3roject should be accepted because of *34 show positi!e !alue and 3I greater than 1.

!ini Case: Chapter "# $"2e% $&'""e% ' (he Cost of Capital a.1. 9ommon stock, preferred stock, long term assets, notes pa able, accounts pa able and accruals and short.term debt component. a.2. (he stockholders onl will concern on the cash flows which are contributed to pa di!idends and normall the di!idends are paid after tax. :o, the calculations should be done after tax basis. a.%. It should be new marginal costs because the cost of capital will be used in raising new fund. b.1. * 5 %0, 34 5 ,1,1)%.02-, 3;( 5 +0, "4 5 1,000, I 5 )8 rd,1 . (- 5 10.08 x ,1 . 0.'05 +.08. b.2. (he flotation costs will not be considered because the actual component costs of new debt will be higher than ).'8. b.%. 3re.tax estimate is the nominal cost of debt 5 18 :ince the firm<s debt has semiannual coupons, its effecti!e annual rate is 1.28= ,1.0')-2 . 1.0 5 1.012 . 1.0 5 0.012 5 1.28. We choose the nominal rates because the capital budgeting and cash flows are more consistent. &esides that, the cost of capital usuall been used in capital budgeting cash which is occurred at end ear.
> ps 3n

c.1. rps

5 5

0.1,$100$1%%.10 $2.00
$10 $111.10

5 1.08. c.2. ;ostl , the corporate in!estors own preferred stock as 00 percent of di!idends are nontaxable. $ence, preferred has a lower before.tax ield that the before tax ield on debt. (hen, the after tax ield to a corporate in!estor and he after tax cost to the issuer are higher on preferred stock than on debt.

d.1. Issuing new common stock and retaining earnings. d.2. (he firm can paid out retained earnings as di!idends or rein!ested in business. If the firm retained the earnings, so the shareholders ha!e opportunit to recei!e cash in and to rein!est it. d.%. rs 5 0.00 ? ,0.0+-1.2 5 1'.28 e.1. r s

>1 30
> 0 ,1 + g +g 30
$'.11 ,1.0)+ 0.0) $)0

5 1%./8. e.2. @stimating the growth rate b retention growth model= g 5 ,1 . 3a out 6atio-6A@ 5 ,0.%)-0.1) 5 ).2)8. (his is consistent with the )8 rate. e.%. We could find the 34 of the di!idends during the non constant growth period and add this !alue to the 34 of the series of inflows when growth is assumed constant. f. n 5 %0, 34 5 .11)%.02, pmt 5 +0, and "4 5 1000, rB2 5 i 5 )8 ,semiannual rate-, annual rate, r 5 108., risk premium 5 '8 rs 5 compan Cs own bond ield ? risk premium. 5 0.10 ? 0.0' 5 1'8. 1'.28 1%./ 1'.0 1'.08

g.

973; >9" &A*> DI@E> ? 6.3. 74@67F@

h.

W799 5 wdrd,1 . (- ? wpsrps ? wce,rs5 0.%,0.10-,0.+- ? 0.1,0.01- ? 0.+,0.1'5 11.18.

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"actors can be controlled b "irm 1. (ax rates 2. Ee!el of interest rates "actors cannot be controlled b firm 1. In!estment polic 2. >i!idends polic %. 9apital :tructure polic

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*o, because the risk for e!er project are different. (he W799 onl show with a!erage risk so that the firm should make adjustment in W799 for e!er each project. 3rocedures= 1. ;ake adjustments to W799. 2. @stimate what the cost of capital 7pproaches= 1. 3ure pla approach 2. 7ccounting beta approach.

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r6" ? ,r; . r6"-b>I4. 08 ? ,+8-1.0 10.28. 5 Wdrd,1 . (- ? Wcrs 5 0.1,128-,0.+- ? 0.1,10.285 1+.28.

W799>I4.

9orporate W799 5 11.18 >i!isionCs W799 5 1+.28. (he di!isionCs market risk is greater than the firmCs a!erage projects. (here is high possibilit the di!isionCs project would be accepted as their returns are 1+.28. m. ;arket 6isk 9orporate 6isk :tand.7lone 6isk When a firm would like to raise fund either loan from bank or in!estors, there will ha!e cost which are rate of return re#uired b in!estors or interest b bank. *ormall , the in!estors will re#uire return as e#ual to their opportunit cost.
>0 ,1 ? g- ? g 30 ,1 . "$'.11,1.0)5 ? ).08 $)0,1 . 0.1)$'.'0 5 ? ).08 5 1).'8. $'2.)0

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re 5

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* 5 %0, 34 5 ,1.0.02-,1000- 5 1/0, pmt 5 .,1.0.'0-,100- 5 .+0, "4 5 .1000 (he i is +.1)8, after.tax cost of debt. 1. @stimating the risk premium for the 973; approach but do not subtract the current long.term t.bond rate from the historical a!erage return on stocks. 2. @stimate the weights for the capital structure without book weights. %. 6emember that capital components are sources of funding which are come from in!estors. ', Gse the current cost of debt and do not appl the coupon rate on a firmCs existing debt as the pre.tax cost of debt.