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Cost of Capital, Risk/Return, and Capital Budgeting

December 11, 2023

Instructions

INSTRUCTIONS
	Complete the Cost of Capital tab
	o Find the cost of Equity using the Capital Asset Pricing Model (CAPM)
	o Find the Weighted Average Cost of Capital (WACC)
	Complete the Payback tab
	o Complete the After-tax Cash Flow re-evaluation table
	o Complete the DCF Payback timeline
	o Complete the questions on the tab
	Complete the Budget Projections tab
	o Revenue increases 4% annually
	o Expense increases 2¾% annually

Cost of Capital

Instructions:
	1	Find the cost of Equity using the Capital Asset Pricing Model (CAPM)
	2	Find the Weighted Average Cost of Equity (WACC)
1
	RF		ꞵ	RM	= CAPM
————————————–
2
						E
						D
						Total Capital (V)	$ – 0
						Last Fiscal Year End Interest Expense
						Tax Rate (TC)
		1. Find the weight of equity = E / (E + D).
		2. Find the weight of debt = D / (E + D).
	Re	3. Find the cost of equity using CAPM.
	Rd	4. Find the cost of debt.
	WACC	5. Find the weighted average cost of capital.

WACC Information from Largo Global
a. As of today, Largo Global market capitalization (E) is $6,373,341,000.1
b. Largo Global’s Market value of debt is $761,000,000.
c. Cost of Equity = CAPM from question 1
d. Cost of Debt = Last Fiscal Year End Interest Expense2 / Market Value of Debt (D).
e. Use the tax rates given in Project 4 Tab 3.

_________
1 Market value of equity (E), also known as market cap, is calculated using the following equation:
Market Cap = Share Price x Shares Outstanding from Project 1
2 From Project 1. Note that the Cost of Debt formula expressed at here is different from the cost of debt formula introduced in most textbooks. Most textbooks only consider the long-term debt (i.e., bond) as the debt and use the bond valuation formula when calculating the cost of debt and WACC.

Payback

Payback Table View
			Table 1 – Data
Cost of new equipment (at year 0)				191.10	million
Corporate income tax rate – Federal				26.0%
Corporate income tax rate – State of Maryland				8.0%
Discount rate for the project using WACC
Loan Amount					million
Loan Interest rate (Prime + 2)				5.25%
			Table 2 – After-tax Cash Flow Table
	(all figures in $ millions)
Year	Projected Cash Inflows from Operations	Projected Cash Outflows from Operations	Depreciation Expense	Interest Expense	Projected Taxable Income	Projected Federal Income Taxes	Projected State Income Taxes	Projected After-tax Cash Flows	PV	NPV1	IRR	NPV2
Excel function to use :			SLN	IPMT					PV	NPV	IRR	NPV
0
1	$850.0	$840.0	$23.89	$0.00	($13.89)	($3.61)	($1.11)	$14.72
2	$900.0	$810.0
3	$990.0	$870.0
4	$1,005.0	$900.0
5	$1,200.0	$1,100.0
6	$1,300.0	$1,150.0
7	$1,350.0	$1,300.0
8	$1,320.0	$1,300.0
								PV
NPV1 – calculated NPV including interest expense								NPV
NPV2 – calculated NPV at the lower discount rate of 5.02%								IRR
	Payback Timeline View Example of Actual Cash Flows
		0	1	2	3	4	5	6	7	8
		\|	\|	\|	\|	\|	\|	\|	\|	\|
	Cash Flow	($191.10)	$8.76	$62.18	$82.63	$73.42	$70.84	$104.60	$39.40	$20.44	$271.17
	Cummulative Cash Flow
		($191.10)	($182.34)	($120.16)	($37.53)	$35.89	$106.73	$211.33	$250.73	$271.17
	Payback Period						3	years	6	months
		0	1	2	3	4	5	6	7	8	PV
		\|	\|	\|	\|	\|	\|	\|	\|	\|	$0.00
	Discounted Cash Flow (DCF)										$0.00
											$0.00
	Cummulative DCF
	Payback Period							years		months
ANSWER THESE QUESTIONS:
	1. What is the total depreciation for tax purposes?
	2. What is the total PV of the Cash Flows using the WACC rate?
	3. What is the NPV using the WACC rate?
	4. What is the NPV using the alternative rate?
	5. What is the IRR?
	6. What is the payback period using the DCF?
	7. Should the project be accepted? Why?

After-Tax Cash Flow Re-evlauation and Payback Timelines Instructions
Technologically advanced distribution equipment proposal re-evaluation
The CFO has asked you to re-evaluate the cash flow projections associated with the equipment purchase proposal due to the proposed loan agreement, and recommend whether the purchase should go forward. Table 1 shows the data and Table 2 shows projections of the cash inflows and outflows that would occur during the first eight years using the new equipment.

Keep the following in mind: Row 34 has a suggested Excel function to use. Complete all the blank cells within the tables.

I. In the Data Table:
A. Use the WACC calulated on the Cost of Capital tab
B. Calulate the loan amount with a 10% down payment
II. In the After-tax Cash Flow:
C. Complete the Depreciation Expense from Project 4 (straight line, $0 Salvage)
D. Complete the interest expense using the loan interest rate.
E. Complete the After-tax Cash Flow Table including the interest expense
F. Compute the PV, NPV1, IRR, and adjusted NPV2
III. In the Payback Timeline View:
G. Complete the discounted cash flow Payback Timeline View of Discounted Cash Flows
i) complete the timeline amounts based on the DCF (DCF is the same as PV)
ii) complete the timeline amountss for the Cummulative DCF
iii) calulate the payback period in years and months
IV. Answer the following questions:

1. What is the total depreciation for tax purposes?
2. What is the total PV of the Cash Flows using the WACC rate?
3. What is the NPV using the WACC rate?
4. What is the NPV using the alternative rate?
5. What is the IRR?
6. What is the payback period using the DCF?
7. Should the project be accepted? Why?

Budget Projections

INSTRUCTIONS:
1). Complete the budget projections for years 2023-2026 using the following information
	Revenue increases 4% annually
	Expense increases 2¾% annually
	For Depreciation and Interest expenses assume the Acutal 2022 figure as the base for the budget and and forecast then add the amount calculated in the Payback tab for both budget and forecast.
2). Answer the question below the forecast.
1).	Largo Global Income Statement of December 31, 2022 (millions)
		ACTUAL	BUDGET	FORECAST
		2022	2023	2024	2025	2026
	Sales (net sales)	$2,013
	Cost of goods sold	1400
	Gross profit	613	0	0	0	0
	Selling, general, and administrative expenses	125
	Earnings before Interest, taxes, depreciation, and amortization (EBITDA)	488	0	0	0	0
	Depreciation and amortization	174
	Earning before interest and taxes (EBIT) Operating income (loss)	314	0	0	0	0
	Interest expense	141
	Earnings before taxes (EBT)	173	0	0	0	0
	Taxes (34%)	59
	Net earnings (loss)/Net Income	$ 114	0	0	0	0
2). Based on the changes suggested throughout the 5 projects, is Largo Global in a better financial position?

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