Calculations of beta, cost of equity and WACC
The beta coefficient calculated using Hamada’s equation (Brigham & Houston, 2009). The equation incorporates the increase in risk associated with leverage into the beta coefficient. Project A has a beta of 0.912 at 20% leverage and 1.08 at 50% leverage level. Project B has a beta of 1.14 at 20% leverage and 1.35 at 50% leverage. Project C has a beta of 1.254 at 20% leverage and 1.485 at 50% leverage. Project D has a beta of 1.14 at 20% leverage and 1.35 at 50% leverage.
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) (Brigham & Houston, 2009). The cost of equity for project A is 9.8% at 0% leverage, 11.032% at 20% leverage and 12.88% at 50% leverage. Project B’s cost of equity is 12% at 0% leverage, 13.45% at 20% leverage and 15.85% at 50% leverage. Project C’s cost of equity is 13.1% at 0% leverage, 14.794% at 20% leverage and 17.335% at 50% leverage. Project D has a cost of equity of 12% at 0% leverage, 13.54% at 20% leverage and 15.85% at 50% leverage. CAPM is a good method for measuring the cost of capital because it is accurate. It, however, uses parameters whose estimation is a subject of debate including the risk free rate, where scholars argue on whether to take the long term or short term rate. Measuring the true risk premium in any market is also difficult (Brigham & Houston, 2009). Its accuracy, however, makes it a superior method.
The Weighted Average Cost of Capital (WACC) is calculated by multiplying the cost of capital from each source by its proportion in the capital structure (Macabacus, 2012). The WACC for project A is 9.8% for 0% leverage, 8.8354% for 20% leverage and 6.496% for 50% leverage. Project B’s WACC is 12% for 0% leverage, 10.8418% for 20% leverage and 7.9810% for 50% leverage. Project C’s WACC is 13.1% for 0% leverage, 11.854% for 20% leverage and 8.3275% for 50% leverage. Project D’s WACC is 12% for 0% leverage, 10.8418% for 20% leverage and 7.981% for 50% leverage.
Discussion on the projects
All projects show net present value (NPV) figures that are positive. Considering that all projects are mutually exclusive, information from NPV calculations is not conclusive to assist Mark in determining which one is unacceptable. The Internal Rate of Return (IRR) for all the projects is above Boeing’s cost of capital which is 15%. It, therefore, cannot be used to differentiate the projects. The Modified Internal Rate of Return (MIRR) is considered more realistic than IRR (Investopedia, 2012). Project A’s MIRR is below the cost of capital for a 50% leverage level. Project D’s MIRR is also below Boeing’s cost of capital. These two projects are therefore unacceptable based on this criterion. A graph of the NPV of each project for all leverage levels is presented on the on the excel sheet.
Based on the MIRR criterion, project B and C are acceptable because their MIRR is above Boeing’s cost of capital. Project C, however, has a higher NPV than project B for a 50% leverage level and a lower outlay of $14 Million which makes it more lucrative with the increased risk. Project C therefore ranks first and project B second.
I would recommend project C because it gives a relatively higher NPV than Project B.
The best capital structure is 50% debt and 50% equity because it gives a higher NPV and has a lower cost of capital. The net income for project C after 1 year is $2.1 Million.
Shortcomings of Mark’s Analysis
Mark’s analysis involves calculating rates of return without considering the opportunity cost of the outlay of capital. Mark calculates return and ranks projects disregarding the level of outlay. In order for his analysis to be more accurate, he must calculate the opportunity cost of the capital difference between projects that utilize the whole $20 Million available and those that utilize only a part of the financing.
References
Brigham, E. F., & Houston, J. F. (2009). Fundamentals of Financial Management, 10th ed. Boston, Massachusetts: Cengage Learning.
Investopedia. (2012). Modified Internal Rate Of Return – MIRR. Web.
Macabacus. (2012). Weighted-Average Cost of Capital. Web.