FIN 370 - AOL ASSIGNMENT
CASE ANALYSIS: The Case of the Junior Analyst
Mark was recently hired by Boeing as a junior budget analyst. He is working for the
Venture Capital Division and has been given six capital budgeting projects to evaluate.
He must give his analysis and recommendation to the capital budgeting committee on
Tuesday December 8.
Mark has a B.S. in accounting from CWU (2006) and passed the CPA exam (2006).
He has been in public accounting for 2 years. During that time he earned an MBA from
Seattle U. He would like to be the CFO of a company someday--maybe Boeing-- and
this is an opportunity to get onto that career track and to prove his ability.
As Mark looks over the financial data collected, he is trying to make sense of it all. He
already has the most difficult part of the analysis complete--the estimation of cash flows.
Through some internet research and application of finance theory (learned in Dr. Young’s
FIN 370 at CWU), he has also determined the unlevered betas for each project.
Here is the information that Mark has accumulated so far:
The Capital Budgeting Projects
He must choose one of the four capital budgeting projects listed in Table 1:
Table 1 shows the expected after-tax operating cash flows for each project. The tax rate
used in his calculations is 30%. All projects are expected to have a 4 year life. The
projects differ in size (the cost of the initial investment) and their cash flow patterns are
different. They also differ in risk as indicated by their unlevered betas. The capital
budget is $20 million and the projects are mutually exclusive.
Capital Structures
In addition to recommending one of the four capital budgeting projects, Mark has also
been asked to evaluate alternative capital structures for financing the chosen project.
He has decided to evaluate 3 capital structures: no debt, 20% debt, and 50% debt.
If debt is used, the cost of the debt will depend upon the amount of leverage in the capital
structure. At 20% leverage, the before tax cost of debt will be 7%. At 50% leverage, the
cost of debt rises to 16% for all projects
Cost of Capital
Mark knows that in order to evaluate the projects he will have to determine the cost of
capital for each of them. Boeing’s cost of capital is 15% based on a dividend plus growth
model, but the project’s risk levels are different from the company and from each other.
Also the projects have no long term growth, they have an expected life of 4 years. Mark
thinks the dividend/growth model is inappropriate for these projects and plans to
calculate the cost of equity using the CAPM model. The unlevered betas for each project
are given in Table 1. The project’s betas are based on the betas of companies that are in
the same industries (“pure plays”). The betas have been adjusted (using the Hamada
equation), so that they represent the unlevered betas of these pure play companies. If the
projects are financed with leverage, the betas will increase and so too will the cost of
capital. Mark plans to use the Hamada equation to estimate the levered betas. The
unlevered project betas, the risk free rate and the expected market return are given in
Table 1. He will use the WACC as both the discount rate and the reinvestment rate in his
capital budgeting analysis.
Mark knows that Boeing executives have favored IRR in the past for making their capital
budgeting decisions. His professor at Seattle U. said NPV was better than IRR. His
textbook says that MIRR is also better than IRR. He is the new kid on the block and
must be prepared to defend his recommendations.
First, however, he must finish the analysis and write his report. To begin, he has
formulated the following questions that need to be answered:
1. What is the beta for each project at 20% and 50% leverage? 8
2. What is the cost of equity for each project at 0, 20%, and 50% leverage? 12 Do you
think the CAPM model is an appropriate way to calculate the cost of equity for these
projects? Why or why not. 6
3. What is the WACC for each project at 0, 20%, and 50% leverage? 12
4. Calculate all relevant capital budgeting measures for each project (complete Table 2)?
36
5. Which of the projects are unacceptable and why? 10 Include on a single graph the
NPV profile for each project. 10
6. Rank the projects that are acceptable, according to your criterion of choice. 10
7. Which project do you recommend and why? 10
8. For the capital budgeting project you selected, which capital structure do you
recommend and why? 10
9. For the project and capital structure that you have selected, calculate the project’s net
income after-tax for the first year of operation. 10
10. Is there anything that you think Mark is doing incorrectly or overlooking in his
analysis?
Instructions
Your answers should be word processed.
Questions 2, 5, 7, 8, and 10 are discussion questions.
Your calculations should be done on Excel.
Place your numerical solutions in Table 2.