1. Prepare a presentation for Williams regarding the concept of WACC.

The weighted average cost of capital, or WACC, is the cost of financing the
assets of a company. It is a weighted average of the costs of the various sources of
capital (debt and equity) utilized in the capital structure of a firm. The WACC is an
after-tax cost calculated using the after-tax cost of each source of capital. As the
interest payments of a business are tax-deductible, the cost of debt must be converted
to an after-tax cost by multiplying the before-tax interest rate by one minus the marginal
income tax rate of a firm. The WACC of a company is also known as the marginal cost
of capital, or what a company must pay for its next dollar of capital. Since firms employ
the WACC to assess potential long-term expenditures (capital projects), it only
considers long-term capital sources. As a result, most businesses do not factor in the
cost of short-term debt in their calculations. To compute WACC, a company must first
calculate the cost of each source of capital and then establish the ideal mix of debt and
equity it will utilize.

2. Calculate St. Louis Chemical’s WACC (round to the nearest whole number).
What arguments should be made to convince Williams of the advantage of using
long-term debt in the firm’s capital structure?

WACC = wdrd(1-T)+wprp+wcrs
WACC = .30(.10)(1-.30)+.70(.16)
WACC = .03(.70)+.112
WACC = .021+.112
WACC = .133 0r 13.30%
 Calculating the WACC of the firm with and without debt is the best argument for
convincing the Board to use debt capital in its capital structure. The cost of capital of St.
Louis Chemica without debt is 16% (cost of capital and cost of equity are the same),
while with 30% debt, it is 13.30%. As lower-cost debt capital is replaced for higher-cost
equity capital, the cost of capital is reduced when debt is used. Since the holder of debt
bears less risk, debt has a lower cost than equity. Debt carries a lower risk than equity
since debt payments (interest and principal) are more predictable than equity payments
(dividends and stock appreciation). As interest and principal payments are legal
obligations related to debt, they must be made before paying equity stockholders. Debt
providers are content with a lower but more predictable return because there is less risk
associated with debt.

3. Since the used equipment will be financed with internal capital and the new
equipment with a bank loan, should the same discount rate be used to evaluate
each alternative? Explain.

The discount rate used to evaluate the project reflects the risk level of the project
and not its cost of financing, while the cost of capital represents the risk level of the
assets of the firm. As both alternatives appear to have the same risk level as the firm's
existing assets, the cost of capital should be used to evaluate each alternative.

4. Explain why an accurate WACC is important to a firm’s long-term success.

The WACC of a company is used to evaluate investment decisions. Assets must

return at least the cost of capital to the company (what it must pay for the capital to
acquire the asset). Shareholders will not receive their necessary return if the return of
an asset is less than the WACC. If a company underestimates its WACC, it risks
investing in assets (projects) that do not generate the required return. If a company
overestimates its WACC, it may not invest in assets that generate the required return
(missed opportunities). Either mistake will cause issues. If the WACC is underestimated,
the company risks losing equity capital as dissatisfied investors take their funds
elsewhere, or it will have trouble raising capital in the future. If the WACC is
overestimated, the company may miss out on lucrative growth opportunities.

5. Evaluate the strengths and weaknesses of the NPV, IRR and Cash Payback
capital expenditure budgeting methods. Prepare a recommendation for Williams
regarding the capital budgeting method or methods to use in evaluating the
expansion alternatives. Support your answer.

The number of years it takes a company to recoup its initial investment is known
as the cash payback period. The Payback Period would be two years if a capital project
required a P10,000 investment and is expected to repay P5,000 each year for the next
four years. The Payback Period has the following advantages: 1) it is simple to calculate
and explain, 2) it focuses on future cash flows, and 3) it prioritizes liquidity (i.e. a quick
return of the investment). The Payback Period, on the other hand, has the following
drawbacks: 1) ignores the time value of money (i.e., a dollar received in year three is
presumed to be worth the same as a dollar received today), 2) ignores cash flows
beyond the payback period, and 3) lacks an accept/reject option.
Net Present Value (NPV) method is determined by 1) calculating the present
value of the future cash flows (using the WACC as the discount rate) and 2) deducting
the cost of the project from the present value of the future cash flows. If the present
value of the future cash flows exceeds the project's cost, the project is said to have a
positive NPV. If the project's value (the present value of its future cash flows) exceeds
its cost, the project is a good investment and should be accepted. The advantages of
this method include: 1) focuses on future cash flows, 2) takes into account time value of
money, 3) considers all cash flows associated with the project, and 4) includes an
accept/reject feature. However, the disadvantages of this method include: 1) relatively
difficult to explain and calculate, and 2) requires knowledge of the WACC of a firm.
 The Internal Rate of Return (IRR) method is derived by calculating the discount
rate at which the present value of future cash flows equals the project's cost. The
project's internal rate of return (IRR) is the discount rate. The project should be
accepted if the IRR surpasses the firm's WACC. This method has the following
advantages: 1) it focuses on future cash flows, 2) it considers time value of money, 3) it
analyzes all cash flows involved with the project, and 4) it does not require knowledge of
a firm's WACC. The disadvantages of this method are that it is 1) difficult to explain and
calculate, and 2) numerous IRRs may result if the project's future cash flows include
some years with cash outflows rather than cash inflows.
All evaluation methods should be used in recommendations because each one
provides valuable information about a future project. The NPV method's conclusions
should be given priority since it compares the project's value (the present value of future
cash flows, calculated using the firm's WACC as the discount rate) to the project's cost.
A project is a good investment if its value exceeds its cost.

6. Calculate the NPV, IRR and Cash Payback for each alternative by completing
Schedules One and Two. For these calculations, assume a WACC of 13%.
Based strictly on the results of these methods, should either option be selected?
Why? How could the analysis be improved? Solution requires preparation of a
spreadsheet.
Schedule One
Used Equipment
Year 0 Year 1 Year 2
Sales Volume (drums) 170,000 190,000 215,000
Selling Price (per drum) 35 35 35
Drum Filling Cost (per drum) 1.75 1.75 1.75
Material Variable Cost (per drum) 30.5 30.5 30.5
Total Variable Cost (per drum) 32.25 32.25 32.25
Tax Rate 30% 30% 30%
WACC 13% 13% 13%
Working Capital (% of Sales) 10% 10% 10%
Required Working Capital ($) 595,000 665,000 752,500
Required Increase in Working
Capital ($) 70,000 87,500
Acquisition Cash Flow
Equipment Costs
Increase in WC (10% of sales)
Total Project Cost
Operating Cash Flow
Projections
Sales 5,950,000 6,650,000 7,525,000
Variable Costs 5,482,500 6,127,500 6,933,750
Gross Profit 467,500 522,500 591,250
Depreciation Expense 283,800 387,000 129,000
Earnings Before Taxes 183,700 135,500 462,250
Income Taxes 55,110 40,650 138,675
Earnings After Taxes 128,590 94,850 323,575
Depreciation Expense 283,800 387,000 129,000
Operating Cash Flows 412,390 481,850 452,575
Increase in Working Capital 70,000 87,500
Annual Cash Flow 412,390 411,850 365,075

Terminating Cash Flow Year 3

Sale of Equipment 50,000
Book Value
Taxable Gain
Income Taxes
Cash Flow From Sale of
Equipment
Liquidation of Working Capital
Terminal Cash Flow
Year 0 Year 1 Year 2 Year 3
Cash Flows ($)
*Year 3 Operating Cash Flow and
Terminal Cash Flow

NPV
IRR
Cash Payback Period
Cumulative
Cash Flow CF
Year 0
Year 1
Year 2
Year 3
End of Year 3 (Terminal CF)

Schedule Two

New Equipment

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Sales Vol. - Total 170,00 190,00 215,00 235,00 275,00 310,00 370,00
(drums) 0 0 0 0 0 0 0

Selling Price ($/per

drum) 35 35 35 35 35 35 35

Filling Cost ($/per

drum) 1 1 1 1 1 1 1

Matl. Var. Cost ($/per

drum) 30.5 30.5 30.5 30.5 30.5 30.5 30.5

Total Var. Cost ($/per

drum) 31.5 31.5 31.5 31.5 31.5 31.5 31.5

Tax Rate 30% 30% 30% 30% 30% 30% 30%

WACC 13% 13% 13% 13% 13% 13% 13%

WC as Percent of
Sales 10% 10% 10% 10% 10% 10% 10%

595,00
Required WC 0

Required Increase in
WC 70,000
Acquisition Cash
Flow Year 0

Equipment Costs

Increase in WC

Total Project Cost

Operating Cash
Flow Projections

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

5,950,0 6,650,0 7,525,0 8,225,0 9,625,0 10,850, 12,950,

Sales 00 00 00 00 00 000 000

5,355,0 5,985,0 6,772,5 7,402,5 8,662,5 9,765,0 11,655,

Variable Costs 00 00 00 00 00 00 000

595,00 665,00 752,50 822,50 962,50 1,085,0 1,295,0

Gross Profit 0 0 0 0 0 00 00

347,20 620,00 421,60 322,40 223,20 223,20 223,20

Depreciation Expense 0 0 0 0 0 0 0

Earnings Before 247,80 330,90 500,10 739,30 861,80 1,071,8

Taxes 0 45,000 0 0 0 0 00

150,03 221,79 258,54 321,54

Income Taxes 74,340 13,500 99,270 0 0 0 0

173,46 231,63 350,07 517,51 603,26 750,26

Earnings After Taxes 0 31,500 0 0 0 0 0

347,20 620,00 421,60 322,40 223,20 223,20 223,20

Depreciation Expense 0 0 0 0 0 0 0

520,66 651,50 653,23 672,47 740,71 826,46 973,46

Operating Cash Flows 0 0 0 0 0 0 0

130,84 147,00
Increase in WC 0 1,730 19,240 68,240 85,750 0

520,66 520,66 651,50 653,23 672,47 740,71 826,46

Annual Cash Flows 0 0 0 0 0 0 0

Terminal Cash Flow Year 7

 120,00
Sale of Equipment 0

Book Value

Taxable Gain

Income Taxes

Cash Flow From Sale

Liquidationof WC

Terminal Cash Flow

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Cash Flows ($)

NPV

IRR

Cash PaybackPeriod

Cash Cumula
Flow tive CF

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

After completing schedules one and two, the cash flows and NPV and IRR of
both alternatives are as follows:

Used Equipment New Equipment

NPV IRR NPV IRR

$35,002.81 14.33% $168,352.07 14.59%

 First, the IRR of each project must be higher than the cost of capital of the
company, which is 13%. Based on the results, both projects have an IRR close to 14%,
therefore the two alternatives can be accepted. Given that both IRRs are similar and
both lead to the same conclusion, a comparison of the NPV of both projects is
necessary.
When comparing NPV, as long as NPV is higher than 0 and mutually exclusive,
choose the one with the higher NPV. However, the two projects have different time
horizon, thus for a right decision, the EAA (Equivalent Annual Annuity) should be
calculated about NPV to have the same time horizon and compare the alternatives,
because NPV is more robust than IRR:

Used Equipment New Equipment

$14,824.46 $38,066.22

Taking this into account and comparing the EAA of both projects, the new
equipment has the highest EAA, thus St. Louis Chemical should choose the new
equipment project.
The Cash Payback Period assumes annual operating cash flows are received
evenly over the course of the year while the NPV and IRR assume operating cash flows
are received at the end of the year. The Cash Payback Period for the used equipment is
3 years. The full amount of the investment is not recovered until the project is
terminated. Based on the results of the evaluation methods, the new equipment would
be selected because of the higher NPV.

7. The projected cash flow benefits of both projects did not include the effects of
inflation. Future cash flows were determined using a constant selling price and
operating costs (real cash flows). The cash flows were then discounted using a
WACC that included the impact of inflation (nominal WACC). Discuss the
problem with using real cash flows and a nominal WACC when calculating a
project’s NPV or IRR.
 Using "real" future cash flows and a "nominal" WACC will result in an understated
NPV and IRR or both will have a downward bias. If inflation is neutral, impacting
revenues and costs equally, the NPV and IRR will be underestimated. Since revenues
are usually greater than costs, revenues will increase by a greater amount than costs.
The exact impact of combining "real" cash flows and a "nominal" discount rate can only
be determined by removing the impact of inflation from the discount rate or adding the
impact of inflation to the future cash flows.

8. What other issues should be considered before a final decision regarding the
expansion alternatives is made?
The analysis is based on a single point estimate, and it is highly unlikely that
future sales volume will exactly equal projected sales. Although both alternatives appear
to be highly profitable, it would be beneficial to evaluate profitability at lower sales
volumes.