Graph the internal rates of retun on investment projects against
the marginal cost of capital for the following 6 projects. Which
projects should be selected? Use Excel.
| Project | Cost (M) | IRR |
| 1 | $ 7,000,000.00 | 8.73% |
| 2 | $ 7,000,000.00 | 8.40% |
| 3 | $ 8,000,000.00 | 9.60% |
| 4 | $ 5,000,000.00 | 9.14% |
| 5 | $ 5,000,000.00 | 8.20% |
| 6 | $ 8,000,000.00 | 8.18% |
EXHIBIT 1
Wyoming Energy Development, Inc.
/Balance SheetFor Year Ending April 30, 1991.A
ssets1991
Cash$9,000.000
Accounts receivable31,000.000
Inventories12,000.000
Total current assets$52,000.000
Net fixed assets193,000.000
Goodwill7,000.000
Total assets$252,000.000
Liabilities and EquityAccounts payable$850.000
Current debt10,000.000
Accrued taxes1,150.000
Total current liabilities$12,000.000
Long-term debt72,000.000
Preferred stock43,000,000
Common stock114,000.000
Retained earnings11,000.000
Total liabilities and equity$ 252,000.000
To determine a weighted average cost of capital for WED, it was
necessary for LindaBellich to examine the costs associated with
each source of funding used. In the past, thelargest sources of
funding had been the issuance of new common stock and
internallygenerated funds. Through conversationswith the
comptroller and other members of theboard of directors, Bellich
learned that the firm, in fact, wished to maintain its
currentfinancialstructure since it is in accordance with the book
value weights shown in Exhibit I.She further determined that the
strong growth patterns that WED had exhibited over thepast 10 years
were expected to continue indefinitely because of the dwindling
supply ofU.S. and Japanese domestic oil and the growing importance
of, and U.S. and Japanesedependence on, coal and other alternative
energy resources. Through further investigation,Bellich learned
that WED could issue additional shares of common stock, which had a
parvalue of $25 per share and were selling at a current market
price of $45. The expecteddividend for the next period would be $2
pershare,withexpectedgrowthatarateof6 percent per year for the
foreseeable future. The underwriting commission paid to
WED’sinvestment banker would amount to$2 per share and would be for
insuring the issue againstthe risk of adverse market fluctuations
in the stock’s selling price during the distributionprocess, in
addition to performing the function of actually selling the
security and providingadvice as to the timing and pricing of the
issue
Preferred stock at 6 percent also could be issued with the help
of an investment banker at$97 per share with a par value of $100
per share. Of this $97, 3.1 percent would go to theinvestment
banker for his help in marketing the issue, with the remainder of
the funds goingto WED.
Finally, Bellich learned that it would be possible for WED to
raise an additional $1 millionthrough a one-year loan from WED’s
Chicago bank at 9 percent. Any amount raised over$1 million would
cost WED 14 percent., Short-term debt has always been used
byWyoming to finance capital expenditures, and as WED grows, it is
expected to maintain itsproportion in the capital structure to
support capital expansion. Also, $6 million could beraised through
a bond issue with 30 years’ maturity with a 10 percent coupon at 98
percentof face value. On this issue, 2 percent of the face value
would be charged as anunderwriting commission. If it became
necessary to raise more funds via long-termdebt,$3 million more
could be accumulated through the issuance of additional 30 year
bondssold at 95 percent of face
value,withthecouponratebeingraisedto11percentand2 percent of the
face value being charged as an underwriting commission. While
anyadditional funds raised via long-term debt would necessarily
have a 30-year maturity with a14 percent coupon yield and be sold
at 95 percent of face value, 2 percent of this face valuewould be
charged as an underwriting fee. Here again, this fee would go to
the investmentbanker for hishelp in marketing the issue.
In the past, WED has calculated a weighted average of these
sources of funds to determineits cost of capital. In discussions
with the current comptroller, the point was raised thatwhile this
served as an appropriate calculation for externally generated
funds, it did not takeinto account the fact that much of the funds
used for capital expenditures by WED wereinternally generated. For
example, WED is expected to produce $5 million in
depreciation-generated funds in addition to retaining $4 million of
its earnings during the coming period.The comptroller agreed that
there should be some cost associated with retained
earningsfinancing incorporated into the calculations, but
depreciation charges should not beincluded since they, as opposed
to all other financing methods, do not appear on theliability side
of the balance sheet. Although Bellich was not completely convinced
by thecomptroller’s logic, she continued with her work
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