A capital budgeting case - in which of the proposed capital

Question

A CAPITAL BUDGETING CASE

The E-Check Company (Company), a manufacturer of pollution detection systems, has enjoyed considerable success. In 2011, the company completed its twelfth year in business and generated a return on common equity of 20%. Rusty Rivet, Company C.E.O., is certain the Company can continue this performance. One thing that contributes towards his confidence is that almost all of the Company's sales are to governmental programs that, in order to help control pollution, force residents in communities located next to interstate highways to pay a fee to have their vehicle emissions systems tested. Given the high test pass-rates, the pollution in these areas obviously comes largely from traffic passing through the communities rather than from the local's vehicles, but governments have come to rely on the income emission testing generates and are reluctant to cut the testing requirements. Another reason for his confidence is the fact that most of the Company's top managers hold an advanced engineering degree awarded by a variety of prestigious universities. Rusty also believes that stockholders like the fact that the Company pays out all earnings not needed to pay preferred dividends as common dividends (and because he is the majority stockholder in the Company it is unlikely this policy will change). Managers estimate that the common dividend will continue to grow annually at an 8% rate.

In January 2012, managers of the Company have expansion plans; they have just completed an evaluation of six capital budgeting projects. The net cash flows and risk assessment of each project are shown below. Company policy requires that average risk projects have an IRR at least equal to the Company's weighted average cost of capital (WACC). Policy also requires that the hurdle rate be increased (decreased) by 250 basis points when evaluating projects that are above (below) average risk. Management has determined that the Company's WACC is 9.63% and, therefore, management is making plans raise $52 million to implement all of the projects except Project E. As a part of your management training, you have been asked to review the analysis. In particular, management wants you to verify both the WACC calculation and project selection.

Project	A	B	C	D	E	F
0	(10)	(12)	(15)	(5)	(11)	(10)
1	3.15	4.3	7	2	0	1
2	3.15	4.3	6.4	2	0	3
3	3.15	4.3	5.5	1	0	5
4	3.15	4.3		.5	0	3
5	3.15			.5	0	.55
6				.5	0
7					0
8					22
Risk	High	Ave.	Ave.	Low	Ave.	Low

The Company has one outstanding bond issue. It has an annual stated rate of 8% with annual interest payments. $50,000,000 of the bond issue, with an original term to maturity of 15 years was publicly placed 7 years ago at face value. The most recent price at which a bond traded on the secondary market was $900 (a $100 discount from face value). Any new long-term debt would be raised in the form of a new bond issue. Matilda Angle, E-Check's treasurer, has pointed out that the company would like any new bond issue to have an initial maturity of 15 years to lock in the interest rate for a long time, and she also points out that the good news is that the yield curve at this time is essentially flat. In addition, any new bond issues will be privately placed so there will be no flotation costs.

The company has 10 million shares of $1 par common stock outstanding. These shares are currently trading for $2.00 per share on the Cincinnati Stock Exchange. The company paid total dividends of $1,700,000 on these shares during 2011. The company's underwriter will charge flotation costs equal to 10% of the value of any new shares sold.

The company also has 100,000 shares of $200 par preferred stock outstanding. These shares are currently trading at $175 per share. The preferred share annual dividend (paid quarterly) is 9.5%. The underwriter will charge flotation costs of 5% of the value of new shares sold.

Management's WACC Calculation

Shown below are E-Check's simplified financial statements for 2010. Managers used information from the balance sheet to come up with the weights for their WACC calculation.

E-Check Balance Sheet December 31, 2011
Current assets	30,000,000	Current liabilities	30,000,000
Long-term assets	88,000,000	Long-term liabilities	50,000,000
Total assets	118,000000	Total liabilities	80,000,000
		Common shares	10,000,000
		Preferred shares	20,000,000
		Retained earnings	8,000 000
		Total equity	38,000,000
		Total liabilities & equity	118,000,000

 

E-Check  Income Statement  2011
Revenues	200,000,000
Cost of goods sold	110,000,000
Gross profit margin	90,000,000
Operating expenses	80,000,000
Operating income	10,000,000
Interest expense	4,000,000
Taxable income	6,000,000
Income tax	2,400,000
Net income	3,600,000

Specifically, the WACC was calculated as follows:

WACC = (K_d * wt_d) + (K_p * wt_p) (K_e * Wt_e)

= (8 * (80/118)) + (9.5 * (20/118)) + (17 * (18/118))

= 5.423 + 1.61 + 2.593

= 9.63%

Maria Sliderule, Company controller, has explained to you that 8% was used as the cost of debt because this is the stated rate of interest on the firm's existing bond issue; 9.5% was used as the cost of preferred shares because this is the dividend rate on the Company's preferred stock, 17% was used as the cost of equity because dividends of $1.7 million were paid on the common shares with a book value of $10 million; and that the weights in the WACC calculation were derived directly from the balance sheet.

Internal announcement of the expansion possibilities has fostered some debate. One manager, Mel Lever, asserts that the Company should raise all the money needed in the form of debt, and since the cost of debt is only 8%, all projects should be accepted. Olm Meter, a Norwegian engineer who just joined the E-Check management team, argues that it makes no sense to invest in a project with an IRR less than the WACC. The input of all these individuals cannot be ignored because each is a valuable member of the management team and highly respected in the area of pollution detection technology. This is why you have been asked to review the analysis. Please address the comments of Mr. Lever and Mr. Meter and Specify:

1. In which of the proposed capital budgeting projects should the Company invest?

2. What do you think is the Company's WACC?

3. Any errors in the 9.63% calculation?