LAWN DEPOT, INC.

1
LAWN DEPOT, INC.

• Establishing the Optimal Capital Budget
• Paige Baccus
• Arif Hussain
• Ari Kempler
• Rupetrus Musamuli

2
OVERVIEW

• Background
• WACC / MCC
• IRR / IOS
• MIRR
• SML / CAPM
• Risk Adjustment

3
BACKGROUND / HISTORY

• National Retail Outlet Specializing in Garden
  Supplies and Equipment
  
• Family Owned and taken Public in 1983
• Future of Company relies on proper analysis of
  capital investment decisions

4
Cost of Capital Components
All figures are based on market values

ITEM VALUE WEIGHT
Short-term debt 50,000,000 5
Mortgage bonds 283,465,550 30
Preferred Stock 145,000,000 15
Common Equity 480,000,000 50
TOTAL 958,465,550 100
5
Weighted Average Cost of Capital
WACCRE KdWd (1-t) KpsWps KreWre KsdWsd
(1-t) .3.08(.6) .15.09 .5.166 .
05.07(.6) 11.3 WACCCS .3.125(.6) .
15.09 .5.191 .05.07(.6) 13.6
6
BREAK P0INT ANALYSIS

• Exhaustation of internal funds forces the firm
  to seek external capital.
  
• Flotation costs and effects of market
  pressures.
  
• Cost of retained earnings is less than the cost
  of issuing new equity.
  
• Break point analysis Re x b/ Equity Fraction
• .4(80,000)/ 0.5
• 64,000 non-cash exp.
• 64,000,000 60,000,000(depr)
• 124,000,000

7
MCC Schedule
13.5
11.4
0
124
Dollars in millions
8
ESTIMATED IRRs NPVs FOR PROJECTS
Project Initial Cost Cash Inflows Life
IRR NPV A 30.0
6.26 12yrs 18 9.8
A 30.0 7.81
8 20 9.62 B 160.0
27.36 15 15 N/A

9
IOS Schedule
20
18
15
30
60
90
120
150
180
210
240
Dollars in millions
10
MCC VS IOS

• MCC determined by WACC
• WACC found under relative certainty
• Therefore, MCC schedule has high degree of
  certainty

• IOS assumes cash flows under uncertainty
• IOS schedule will be less certain then MCC
  schedule

11
MCC Schedule and IOS Schedule
20
17
IOS
14
MCC
11
50 100 150 200 250
Dollars in millions
12
ACCEPT/REJECT DECISIONS

• All projects IRR are higher than WACC so accept
  all
  
• A and A are mutually exculsive
• The IRRs of both projects exceed the cost of
  capital
  
• NPVAA is greater than the NPVAA
• Conflicts between IRR and NPV of the projects
• Accept A, because NPV is higher
• Accept B, because IRR is above WACC

13
TAKING RISK INTO ACCOUNT

• Riskiness of projects absent from analysis
• In real world, must account for risk
• Two main methods to account for risk
• 1. Adjust firms cost of capital up or down to
  account for differential risk
  
• 2. Lower IRRs of riskier projects and raise
  IRRs of less risky projects

14
MIRR ANALYSIS

• IOS developed using IRR
• IRR assumes cash flows reinvested at IRR rate
• Using MIRR to determine IOS schedule will cause
  downward shift of IOS schedule
  
• Reason for downward shift is lower discount
  rate, or WACC, inherent in MIRR

15
MIRR EFFECT

• Example, Project A IRR 20 vs. MIRR
  14.55
  
• Project B has an IRR of 15
• Project B is barely above the MCC schedule or
  WACC of 13.6
  
• Under MIRR analysis, Project B would probably
  not be accepted
  
• Conclusion, projects accepted under IRR not
  necessarily accepted under MIRR

16
SML EQUATION

• All the figures were provided by Ibbotson
• Associates.
• KS KRF (KM - KRF)b
• 6 (12 - 6) 1.4
• 14.4

17
BEST ESTIMATE

• Cost of Equity used in WACC found using DCF
  (16.6)
  
• By using CAPM, Cost of Equity is 14.4
• Which method is superior?
• Company has only been public for 10 years, the
  Beta
  estimate is probably innacurate
  
• Beta more accurate for longer periods of time,
  converges toward 1
  
• The company probably in specific growth stage