Cost of Capital, Capital Structure,

and Capital Budgeting Analysis

1. Purpose of the project:

In this project, you are supposed to be a financial manager to apply the knowledge learn from Financial Management (FINC6352) to perform financial ratio analysis, estimate capital structure, cost of debt, preferred stock and common equity, and weighted average cost of capital (WACC) for a publicly traded corporation of your choice (United Parcel Service or UPS was selected). You will then use the estimated WACC as the discount rate to perform capital budgeting analysis for a hypothetical project (the project data is given) under the consideration by your selected company, and decide whether the project should be taken.

(2) Financial Ratio Analysis (40 points)

You are expected to retrieve the most recent 5 years’ financial statements your selected company (UPS) and apply the knowledge learned in Financial Management and Financial Statement Analysis (ACCT6351) to calculate and analyze the key financial ratios for the firm.

– Perform trend analysis of the key financial ratios (i.e., liquidity ratios, asset management ratios, debt ratios, profitability ratios, market value ratios) for 5 years.

– Perform industry (or benchmark companies) comparison analysis of the key financial ratios of the company for the most recent year.

– Based on the financial ratio analysis results, discuss/evaluate the financial performance of the firm.

(3) Estimate Capital Structure (20 points)

– Estimate the firm’s weights of debt, preferred stock, and common stock using the firm’s balance sheet (book value) using the most recent year data.

– Estimate the firm’s weights of debt, preferred stock, and common stock using the market value of each component using the most recent year data.

(4) Compute Weighted Average Cost of Capital (WACC) (40 points)

– Estimate the firm’s before-tax and after-tax component cost of debt; (Note: If the information about the current corporate tax rate is not available, you can estimate the tax rate based on the firm’s historical tax payments).

– Estimate the firm’s component cost of preferred stock if the firm has issued preferred stocks.

– Use three approaches (CAPM, DCF, bond-yield-plus-risk-premium) to estimate the component cost of common equity for the firm.

– Calculate the firm’s weighted average cost of capital (WACC) using the market-based capital structure weights obtained from Step (3).

(5) Cash Flow Estimation (40 points)

– We assume that the company that you selected is considering a new project. The project has 11 years’ life. This project requires initial investment of $700 million to purchase equipment, and $39 million for shipping & installation fee. The fixed assets fall in the 10-year MACRS class. The salvage value of the fixed assets is 16.5% of the purchase price. The number of units of the new product expected to be sold in the first year is 1,500,000 and the expected annual growth rate is 5.0%. The sales price is $233 per unit and the variable cost is $183 per unit in the first year, but they should be adjusted accordingly based on the estimated annualized inflation rate of 5.7%. The required net operating working capital (NOWC) is 10% of sales. Use the corporate tax rate obtained in Step (4) for the project. The project is assumed to have the same risk as the corporation, so you should use the WACC obtained in Step (4) as the discount rate for this hypothetical project. The capital budgeting analysis template Ch11 P18 Build a Model.xls is just for your reference, and you don’t need to follow the model in this template. Actually, you are encouraged to build the capital budgeting analysis model by yourself.

– Compute the depreciation basis and annual depreciation of the new project. You can refer to Table 11A-2 MACRS allowances on pp.496 of the textbook.

– Estimate annual cash flows for the 8 years.

– Draw a time line of the cash flows.

(6) Capital Budgeting Analysis (40 points)

– Using the WACC obtained from in Step (4) as the discount rate for this project, apply capital budgeting analysis techniques (NPV, IRR, MIRR, PI, Payback, Discounted Payback) to analyze the new project.

– Perform a sensitivity analysis for the effects of key variables (e.g., sales growth rate, cost of capital, unit costs, sales price) on the estimated NPV or IRR in order to demonstrate the sensitivity of the model. The Scenario analysis of several variables simultaneously is encouraged (but not required). A document Sensitivity Analysis using Data Table in Excel is provided for the introduction of the Data Table function in Excel.

– Discuss whether the project should be taken and summarize your report.