# finance 26

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**Introduction **

You will assume that you still work as a financial analyst for the Coca Cola Co. The company is considering a capital investment and you are in charge of helping them launching a new product based on (1) a given rate of return of 13% (Task 4) and (2) the firm’s cost of capital (Task 5).

**Task 4. Capital Budgeting for a Product**

A few months have now passed and Coca Cola Co. is considering launching a new product – a flavored soda! The anticipated cash flows for the project are as follows:

**Year 1 $1,350,000**

**Year 2 $1,580,000**

**Year 3 $1,900,000**

**Year 4 $930,000**

**Year 5 $2,400,000**

You have now been tasked with providing a recommendation for the project based on the results of a Net Present Value Analysis. Assuming that the required rate of return is 12% and the initial cost of project is $5,000,000:

1. What is the project’s IRR? (10 pts)

2. What is the project’s NPV? (10 pts)

3. Calculate the project’s payback period. (10 pts)

4. In order to conduct this project, Coca Cola has hired a market analyst to determine demand for the new product. The cost of these services will be $400,0000. How would this cost be incorporated into the project cash flows? Explain your rationale (10 pts)

5. Provide examples for each the following concepts as they relates to the project. **Please make sure that your examples are applicable to Coca Cola’s idea of launching a new product.** (5 pts each)

a. Allocated Costs

b. Incremental Costs

c. Financing Costs

6. Explain how you would conduct a scenario and sensitivity analysis of the project. What would be some project specific risks and market risks related to this project? (20 pts)

**Task 5: Cost of Capital **

Coca Cola Co. is now considering that the appropriate discount rate for the new product should be the cost of capital and would like to determine it. You will assist in the process of obtaining this rate.

1. Compute the cost of debt.

a. Assume that Coke has received a loan from a bank for 5% annual interest for the next seven years. If the tax rate for Coke is 24%, what is the after tax cost of debt? (5 pts)

b. Would you expect the cost of debt to be higher or lower than the cost of equity? Explain your rationale. (5 pts)

c. Explain how Coca Cola Co. can estimate the cost of debt using market observation of rates. Compare and contrast this method to using YTM of bonds. (10 pts)

d. Assume that instead Coke uses the YTM method. They have currently bonds that sell for $1045, offer a coupon of 8% and mature in 5 years. What is the YTM of these bonds? (5 pts)

2. Compute the cost of common equity using the CAPM model. For beta, use the average beta of three selected competitors. Assume the risk free rate to be 3% and the market risk premium to be 9%.

a. What is the cost of common equity? (5 pts)

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b. Explain how flotation costs affect the cost of common equity. (5 pts)

c. Explain why is said that the cost of retained earnings is the same as the cost of equity, except for flotation costs. (5 pts)

3. Cost of preferred equity

a. Why would the cost of preferred equity be lower than the cost of common equity? (5 pts)

b. What would be the price of preferred equity for Coke assuming dividends of $5 at the end of the year and the cost of preferred stock is 8%? (5 pts)

4. Assuming that the market value weights of these capital sources are 30% bonds, 40% common equity and 30% preferred equity, what is the weighted cost of capital of the firm? (10 pts)

5. Should the firm use market or book values to compute the cost of capital? Explain and provide examples as appropriate. (10 pts)

6. Explain how hard rationing and soft rationing may affect your recommendation on pursuing this project. (5 pts)