I have to answer the questions below.
In light of Time Warner’s current operations, as well as trends in the national economy and the organization’s industry, what changes, if any, would you recommend in Time Warner’s approach towards determining its cost of capital? How would you adjust the discount rate for riskier projects? Why?
Need to answer this question to better understand an assignment i have due.
Identify specific reasons why the cost of capital may differ with Harley Davidson relative to other companies in this industry. What does this say about Harley Davidson’s past financial performances and future prospects?
Kocher Steel typically achieves one of three production levels in any given year: 8 million pounds of steel, 10 million pounds of steel, or 16 million pounds of steel. In tracking some of its costs, Kocher Steel’s controller discovered one cost that was $10 per pound at a production level of 8 million pounds, $8 per pound at a production level of 10 million pounds, and $5 per pound at a production level of 16 million pounds. This is an example of a ________.
a) variable cost
b) fixed cost
c) semivariable cost
d) semifixed cost
e) sunk cost
The cost of capital is important to capital decision making and any manipulation on cost of capital will affect to the situation of any company. Discuss the importance of cost of capital with respect to the actual financial problem of most manufacturing companies.
Company issued $100 par value preferred stock 12 years ago. The stock provided a 9% yield at the time of the issue. The preffered stock is now selling for $72. What is the current yield or cost of preffered stock? (disregard flotation costs)
Here is the company’s balance sheet:
Assets:
Cash- $2,000,000
Accts. Receivable- $28,000,000
Inventories- $42,000,000
Net Fixed Assets- $133,000,000
Total Assets- $205,000,000
Liabilities:
Accts. Payable- $18,000,000
Notes Payable- $40,000,000
Long-Term Debt- $60,000,000
Preferred Stock- $10,000,000
Common Equity- $77,000,000
Total Liabilities- $205,000,000
Other Info:
Last Year’s Sales- $225,000,000
– The Company has 60,000 bonds with a 30-year life outstanding, with 15 years till maturity. The bonds carry a 10% semi-annual coupon and are currently selling for $874.78.
– They also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00. Any new issues of preferred stock would incur a $3.00 per share float cost.
-They have 10 million shares of common stock outstanding with a current price of $14.00 a share. The stock exhibits a constant growth rate of 10%. The last dividend(Do) was $.80. New stock could be sold with flotation costs, including market pressure, of 15%.
-The risk free rate is currently 6% and the rate of return on the stock market as a whole is 14%. The company stock’s beta is 1.22.
-Stockholders require a risk premium of 5% above the return on the firms bonds.
-The firm expects to have additional retained earnings of $10 million in the coming year and expects a depreciation expenses of $35 million.
-The firm does not use notes payable for long-term financing.
-The firm considers its market value capital structure to be optimal and wishes to maintain that structure.
-The firm’s federal+state marginal tax rate is 40%.
-The firm’s dividend payout ration is 50% and net profit margin was 8.89%.
Now, with all this information, I am supposed to find the cost of the following individual capital components:
A. long-term debt
B. preferred stock
C. retained earnings (supposed to use the average of CAPM, DCF, and the bond yield + premium approach)
D. new common stock
Need help in anwering Finace Problems.
See attached files containing two problems on “The Cost of Capital”
1) Canyon Inc. has two divisions: Division A makes up 50 percent of the company, while Division B makes up the other 50 percent. Canyon’s beta is 1.2. Looking at stand-alone competitors, Canyon’s CFO estimates that Division A’s beta is 1.5, while Division B’s beta is 0.9. The risk-free rate is 5 percent and the market risk premium is 5 percent. The company is 100 percent equity-financed. (WACC = ks, the cost of equity).
Division B is considering the following projects given below. Each of the projects has the same risk and all have the same risk as a typical Division B project.
Project Capital required IRR
1 $400 million 14.0%
2 300 million 10.7
3 250 million 10.5
4 320 million 10.0
5 230 million 9.0
The company is debating which cost of capital they should use to evaluate Division B’s projects. Tom Flood argues that Canyon inc should use the same cost of capital for each of its divisions, and believes it should base the cost of equity on Canyons overall beta. Marvin barnes argues that the cost of capital should vary for each division, and that Division B’s beta should be used to estimate the cost of equity for Division B’s projects.
If the company uses Marvin Barnes’s approach, how much larger will the capital budget be than if it uses Tom Floods approach?
a. Capital budget is $320 million larger using Marvin Barnes’s approach.
b. Capital budget is $550 million larger using Marvin Barnes’s approach.
c. Capital budget is $870 million larger using Marvin Barnes’s approach.
d. Capital budget is $1,200 million larger using Marvin Barnes’s approach.
e. The capital budget is the same using the two approaches.
Which of the following statements is most correct?
a. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock for the tax exclusion of 70 percent of dividend income.
b. We ideally would like to use historical measures of the component costs from prior financings in estimating the appropriate weighted average cost of capital.
c. The cost of common stock (rs) will increase if the market risk premium and risk-free rate decline by a substantial amount.
d. Statements b and c are correct.
e. None of the statements above is correct.
1) Projects c and d both have normal cash flows. In other words, there is an up-front cost followed over time by a series of positive cash flows. Both projects have the same risk and a WACC equal to 10 percent. However, Project c has a higher internal rate of return than Project d. Assume that changes in the WACC have no effect on the projects? cash flow levels. Which of the following statements is most correct?
a. Project c must have a higher net present value than Project d.
b. If Project c has a positive NPV, Project d must also have a positive NPV.
c. If Project C’s WACC falls, its internal rate of return will increase.
d. If Projects c and d have the same NPV at the current WACC, Project d would have a higher NPV if the WACC of both projects was lower.
e. Statements b and c are correct.
Reason for answer ?
2) Marlowe corp is considering two mutually exclusive projects. Project A has an internal rate of return of 18 percent, while Project B has an internal rate of return of 30 percent. The two projects have the same risk, the same cost of capital, and the timing of the cash flows is similar. Each has an up-front cost followed by a series of positive cash flows. One of the projects, however, is much larger than the other. If the cost of capital is 16 percent, the two projects have the same net present value (NPV); otherwise, their NPVs are different. Which of the following statements is most correct?
a. If the cost of capital is 12 percent, Project B will have a higher NPV.
b. If the cost of capital is 17 percent, Project B will have a higher NPV.
c. Project B is larger than Project A.
d. Statements a and c are correct.
e. Statements b and c are correct
Reason for answer?
My good old pal Joe the bartender called me into his place the other day with what he thought was a great riddle for me. He told me that if I get it right, he will send a case of fresh orange juice to me. He said two mutually exclusive projects are being considered. First, a short-term project might have a higher ranking under the NP criterion if the cost of capital is high. However, and here is where he lost me, a long-term project might be better if the cost of capital is low. Why is that?
As a bonus, he asked me if changes in the cost of capital would ever create a change in the IRR ranking of these two projects. What do you say?
A firm is applying capital budgeting to a foreign investment opportunity in England. The risk-free rate in England is 3.83 percent and the risk-free rate in the United States is 3.56 percent. Regressing the firmâ??s return against the FTSI results in a beta of 1.20. The historical return on the FTSI is 9 percent. Calculate the cost of capital to evaluate the project if the cash flows are in pounds and hedged against currency risk. Assume all equity financing.
Please show calculations.
Zinger Corporation manufactures industrial type sewing machines. Zinger Corp. received a very large order from a few European countries. In order to be able to supply these countries with its products, Zinger will have to expand its facilities. Of the required expansion, Zinger feels it can raise $75 million internally, through retained earnings. The firm’s optimum capital structure has been 45% debt, 10% preferred stick and 45% equity. The company will try to maintain this capital structure in financing this expansion plan. Currently Zinger’s common stock is traded at a price of $20 per share. Last year’s dividend was $1.50 per share. The growth rate is 8%. THe company’s preferred stock is selling at $50 and has been yielding 6% in the current market. Flotation cost have been estimated at 8% of common stock and 3% preferred stock. Zinger Corp. has bonds outstanding at 10% but its investment banker has informed that company that interest rates for bonds of equal risk are currently yielding 9%. Zinger’s tax rate is 46%.
a) Compute the cost of Kd, Kp, Ke, Kn
b) Calculate the weighted average cost of capital using Ke.
c) How large a capital structure can the firm support with retained earnings financing?
Cape Cod Enterprises Inc. has a capital structure consisting of $30 million in long-term debt and $20 million in common equity. There is no preferred stock outstanding.
The interest rate paid on the long-term debt is 12%. Cape Cod is in the 30% tax bracket.
On the common equity (stock), the Company pays an annual dividend of $1.20 and expects to increase the dividend by 5% per year. The market price of the stock is $50.
Based on this information, answer the following questions.
1.Calculate Cape Cod’s weighted average cost of capital (WACC). Work as follows: first, compute the after-tax cost of debt; then, compute the cost of equity. Cite both formulas, and show all your work.
Secondly, determine the weightings of debt and equity in the capital structure.
Lastly, using your answers to the above questions, calculate the WACC.
2. If Cape Cod were to increase the weighting of debt in its capital structure, what would happen to the WACC ? No calculation is necessary- simply relay what would happen and why.
3. Identify and explain the benefits and the risks of debt in the capital structure. If a company’s Rd is less than its Re, does that factor, alone, mean that the company should continue to issue more debt in order to raise capital ? Why or why not ?
Crypton Electronics has a capital structure consisting of 40% common stock and 60% debt. A debt issue of $1,000 par value 6 percent bonds, maturing in 15 years and paying annual interest, will sell for $975. Flotation cost for the bonds will be $15 per bond. Common stock of the firm is currently selling for $30 per share. The firm expects to pay $2.25 dividend next year. Dividends have grown at the rate of 5% per year and are expected to continue to do so for the foreseeable future. Flotation costs for the stock issue are 5% of the market price. What is Crypton’s cost of capital where the firm’s tax rate is 30%?
Company A has $2 million of outstanding debt and 100,000 outstanding shares of stock selling at $30 per share. The book value of the stock is $10 per share. There is no preferred stock. Its current borrowing rate is 8%. Company A will be paying a dividend of $3 per share and is expected to grow at annual rate of 5%. Find the weighted average cost of capital: a) assuming no taxes and b) assuming a 25% corporate tax rate.
a. Find the weighted average cost of capital assuming there is no debt.
b. Assume the overall corporate tax rate is 25%. Find the weighted average cost of capital.
When would a firm use different costs of capital for different divisions with the firm? If the firm was to try to determine cost of capital for different divisions, what problems could occur? What techniques could you use to estimate each divisions cost of capital?
Answer the below questions with at least five sentences each, >>>thoroughly and in your own words<<<
? What impact does the globalization of capital markets have on a manager’s estimate of an appropriate cost of capital used to estimate the value of a subsidiary headquartered in a foreign country?
? What are the characteristics of a cyclical company? How does the valuation of a cyclical company differ from the valuation of a noncyclical company? Compare and contrast the differences of evaluating firms in the electric generation industry compared to firms in the automotive manufacturing industry.
? How does increasing competition impact business fluctuations, and how does it impact a firm’s price power?
? As the import of the business cycle declines, how should this affect the pattern of share prices for a formerly cyclically impacted firm?
? Why does the cost of capital differ in various nations?
? What is a transfer price?
? In interpreting profits and cash flows, why would a value analyst be concerned by generally accepted accounting standards of the various nations in which your units operate?
? How does the reliability and transparency of published financial data of firms in various parts of the world compare with the published data of U.S. firms, especially since the financial scandals in the United States in recent years?
Mini Case
The balance sheet that follows indicates the capital structures for Nealon Inc. Flotation costs are (a) 15 percent of market value for a new bond issue, and (b) $2.01 per share for preferred stock. The dividends for common stock were $2.50 last year and are projected to have an annual growth rate of 6 percent. The firm is in a 34 percent tax bracket. What is the weighted average cost of capital if the firm’s finances are in the following proportions?
Type of Financing Percentage of Future Financing
Bonds (8%, 1,000 par 16-year maturity) 38%
Preferred stock (5,000 shares outstanding,
$50 par, $1.50 dividend) 15%
Common equity 47%
Total ——-
100%
A) Market prices are $1,035 for bonds, $19 for preferred stock, and $35 for common stock. There will be sufficient internal common equity funding (i.e., retained earnings) available such that the firm does not plan to issue new common stock. Calculate the firm’s weighted average cost of capital.
B) In part (a) we assumed that Nealon would have sufficient retained earnings such that it would not need to sell additional common stock to finance its new investments.Consider the situation now, when Nealon’s retained earnings anticipated for the coming year are expected to fall short of the equity requirement of 47 percent of new capital raised. To facilitate the sale of shares, Nealon’s investment banker has advised management that they should expect a price discount of approximately 7 percent, or $2.45 per share. Under these terms, the new shares should provide net proceeds of about $32.55. What is Nealon’s cost of equity capital when new shares are sold, and what is the weighted average cost of the added funds involved in the issuance of new shares?
Here is the condensed balance sheet for Skye Computer Company (in thousands of dollars:
Current Assets $2000
Net Fixed Assets $3,000
Total Assets $5,000
Current Liabilities $900
Long-Term Debt $1,200
Preferred Stock $250
Common Stock $1,300
Retained Earnings $1,350
Total Common Equity $2,650
Total Liabilities and Equity $5,000
Skye Computer’s earnings per share last year were $3.20; the stock sells for $55, and last year’s dividend was $2.10. A flotation cost of 10 percent would be required to issue new common stock. Skye’s preferred stock pays a dividend of $3.30 per share, and new preferred stock could be sold at a price to net the company $30 per share. Security analysts are projecting that the common dividend will grow at a rate of 9 percent per year. The firm can issue additional long-term debt at an interest rate (before-tax cost) of 10%, and its marginal tax rate is 35%. The market risk premium is 5%, the risk-free rate is 6%, and Skye’s beta is 1.516. In its cost of capital calculations, the company considers only long-term capital; hence it disregards current liabilities for that purpose.
a. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock, the cost of equity from retained earnings, and the cost of newly issued common stock. Use the DCF method to find the cost of common equity.
b. Now calculate the cost of common equity from retained earnings using the CAPM method.
c. What is the cost of new common stock, based on CAPM? (Hint: Find the difference between Ke and Ks as determined by the DCF method, and add that differential to the CAPM value for Ks.)
d. If Skye Computer continues to use the same capital structure, what is the firm’s WACC assuming (1) that it uses only retained earnings for equity and (2) that it expands so rapidly that it must issue new common stock?
1. You are given the following information about Shoven Gambling Company.
Long-term debt outstanding $300,000
Current yield to maturity of long-term debt 8%
Number of shares of common stock 10,000
Price per share $50
Book Value per share $25
Expected rate of return on common stock 15%
a. What is Shoven Company’s cost of capital? You can ignore taxes.
b. How would the expected rate of return on equity and the cost of capital change if Shoven’s stock fell to $25 due to poor profits? You can assume that the debt is still safe (no default risk) and that the business risk is unchanged.
I need help answering the following questions regarding the attached WACC calculations:
1. What does calculating the weighted average cost of capital tell you about Foust Company’s financial strategy including the level of risk involved in the business?
2. How could the company use WACC calculations in determining future investments?
Why should a firm use different costs of capital for different projects?
“What is the after tax cost of debt on a $500,000 loan given a 7% interest rate and 35% tax bracket?”
Answer
“$22,750 “
2.45%
4.55%
“$35,000
You are considering a new investment. The rate on T-bills is 3.3% and the return on the S&P 500 is 10.5%. You have measured the non-diversifiable risk of the investment you are considering to be .7. What rate of return will you require on the investment?
Answer
5.04%
5.28%
8.34%
13.80%
2.35%
Suppose a firm estimates its cost of capital for the coming year to be 10 percent. What are reasonable costs of capital for evaluating average-risk projects, high-risk projects, and low-risk
projects?
Please see the attached file.
(10-1) After- Tax Cost of Debt
Calculate the after- tax cost of debt under each of the following conditions:
a. Interest rate, 13%; tax rate, 0%.
b. Interest rate, 13%; tax rate, 20%.
c. Interest rate, 13%; tax rate, 35%.
(10-2) After-Tax Cost of Debt
LL Incorporated’s currently outstanding 11% coupon bonds have a yield to maturity of 8%. LL believes it could issue at par new bonds that would provide a similar yield to maturity. If its marginal tax rate is 35%, what is LL’s after- tax cost of debt?
(10-4) Cost of Preferred Stock with Flotation Costs
Burnwood Tech plans to issue some $ 60 par preferred stock with a 6% dividend. The stock is selling on the market for $ 70.00, and Burnwood must pay flotation costs of 5% of the market price. What is the cost of the preferred stock?
(10-5) Cost of Equity: DCF
Summerdahl Resorts common stock is currently trading at $ 36 a share. The stock is expected to pay a dividend of $ 3.00 a share at the end of the year (D1 $ 3.00), and the dividend is expected to grow at a constant rate of 5% a year. What is the cost of common equity?
(10-9) Bond Yield and After- Tax Cost of Debt
A company’s 6% coupon rate, semiannual payment, $ 1,000 par value bond that matures in 30 years sells at a price of $ 515.16. The company’s federal plus state tax rate is 40%. What is the firms component cost of debt for purposes of calculating the WACC? (Hint: Base your answer on the nominal rate.)
(10-10) Cost of Equity
The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per year in the future. Shelby’s common stock sells for $ 23 per share, its last dividend was $ 2.00, and the company will pay a dividend of $ 2.14 at the end of the current year.
a. Using the discounted cash flow approach, what is its cost of equity?
b. If the firms beta is 1.6, the risk- free rate is 9%, and the expected return on the market is 13%, what will be the firms cost of equity using the CAPM approach?
c. If the firms bonds earn a return of 12%, what will rs be using the bond yield plus risk premium approach? (Hint: Use the midpoint of the risk premium range.)
d. On the basis of the results of parts a through c, what would you estimate Shelby’s cost of equity to be?
During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that has been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to estimate Harry Davis’s cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task:
(1) The firm’s tax rate is 40%.
(2) The current price of Harry Davis’s 12% coupon, semiannual payment, non-callable bonds with 15 years remaining to maturity is $ 1,153.72. Harry Davis does not use short- term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
(3) The current price of the firms 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Harry Davis would incur flotation costs equal to 5% of the proceeds on a new issue.
(4) Harry Davis’s common stock is currently selling at $ 50 per share. Its last dividend (D0) was $ 4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Harry Davis’s beta is 1.2, the yield on T- bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield- plus-risk premium approach, the firm uses a 4 percentage point risk premium.
(5) Harry Davis’s target capital structure is 30% long- term debt, 10% preferred stock, and 60% common equity.
To structure the task somewhat, Jones has asked you to answer the following questions.
a. (1) What sources of capital should be included when you estimate Harry Davis’s weighted average cost of capital (WACC)?
(2) Should the component costs be figured on a before- tax or an after-tax basis?
(3) Should the costs be historical (embedded) costs or new (marginal) costs?
b. What is the market interest rate on Harry Davis’s debt and its component cost of debt?
c. (1) What is the firms cost of preferred stock?
(2) Harry Davis’s preferred stock is riskier to investors than its debt, yet the preferred yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.)
d. (1) What are the two primary ways companies raise common equity?
(2) Why is there a cost associated with reinvested earnings?
(3) Harry Davis doesn’t plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis’s estimated cost of equity?
e. (1) What is the estimated cost of equity using the discounted cash flow (DCF) approach?
(2) Suppose the firm has historically earned 15% on equity (ROE) and retained 35% of earnings, and investors expect this situation to continue in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this consistent with the 5% growth rate given earlier?
(3) Could the DCF method be applied if the growth rate was not constant? How?
f. What is the cost of equity based on the bond- yield- plus- risk- premium method?
g. What is your final estimate for the cost of equity, rs?
h. What is Harry Davis’s weighted average cost of capital (WACC)?
i. What factors influence a company’s WACC?
j. Should the company use the composite WACC as the hurdle rate for each of its divisions?
k. What procedures are used to determine the risk- adjusted cost of capital for a particular division? What approaches are used to measure a division’s beta?
l. Harry Davis is interested in establishing a new division, which will focus primarily on developing new Internet- based projects. In trying to determine the cost of capital for this new division, you discover that stand- alone firms involved in similar projects have on average the following characteristics:
 Their capital structure is 10% debt and 90% common equity.
 Their cost of debt is typically 12%.
 The beta is 1.7.
Given this information, what would your estimate be for the divisions cost of capital?
m. What are three types of project risk? How is each type of risk used?
n. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by reinvesting earnings.
o. (1) Harry Davis estimates that if it issues new common stock, the flotation cost will be 15%. Harry Davis incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, taking into account the flotation cost?
(2) Suppose Harry Davis issues 30- year debt with a par value of $ 1,000 and a coupon rate of 10%, paid annually. If flotation costs are 2%, what is the after- tax cost of debt for the new bond issue?
p. What four common mistakes in estimating the WACC should Harry Davis avoid?
SEE ATTACHMENT
About AirJet Best Parts, Inc.
AirJet Best Parts, Inc. is a company dedicated to the design and manufacturing of aviation and airplane technologies and parts. The company has commercial and military clients worldwide.
Task 1: Assessing loan options for AirJet Best Parts, Inc.
The company needs to finance $8,000,000 for a new factory in Mexico. The funds will be obtained through a commercial loan and by issuing corporate bonds. Here is some of the information regarding the APRs offered by two well-known commercial banks.
Bank APR Number of Times Compounded
National First Prime Rate + 6.75% Semiannually
Regions Best 13.17 Monthly
1. Assuming that AirJet Parts, Inc. is considering loans from National First and Regions Best, what are the EARs for these two banks? Hint for National Bank: Go to the St. Louis Federal Reserve Board’s website (http://research.stlouisfed.org/fred2/). Select “Interest Rates” and then “Prime Bank Loan Rate”. Use the latest MPRIME. Show your calculations.
2. Based on your calculations above, which of the two banks would you recommend and why? Explain your rationale.
3. AirJet Best Parts, Inc. has decided to take a $6,950,000 loan being offered by Regions Best at 8.6% APR for 5 years. What is the monthly payment amount on this loan? Do you agree with this decision? Explain your rationale.
Task 2: Evaluating Competitor’s Stock
AirJet Best Parts, Inc. is concerned regarding recent changes in its stock prices for the company and would like to determine the stock prices for key competitors. Key competitors include Raytheon, Boeing, Lockheed Martin, and the Northrop Grumman Corporation.
1. Using the dividend growth model and assuming a dividend growth rate of 5%, what is the rate of return for one of three key competitors? Use Yahoo Finance to obtain the latest dividend amount and price for one selected company.
2. Using the rate of return above, what should be the current share price of AirJet Best Parts, Inc. if the company maintains a constant 1% growth rate in dividends and the most recent dividend per share paid on the stock was $1.50? Show your calculation.
3. Assume AirJet Best Parts has also a preferred stock issue. The most recent dividend per share paid on the stock was also $1.50, the same as the common stock. Which one would you think has a higher price, the preferred stock or the current stock? Explain your rationale.
4. What would happen with the price you computed above if AirJet Best Parts, Inc. announces that dividends at the end of the year will increase? What if the required rate of return increases? What changes in dividends will affect the stock price and how?
Task 3: Bond Evaluation
AirJet Best Parts, Inc. would like to issue 20-year bonds to obtain remaining funds for the new Mexico plant. The company currently has 7.5% semiannual coupon bonds in the market that sell for $1,062 and mature in 20 years.
1. What coupon rate should AirJet Best Parts set on its new bonds to sell them at par value?
2. What is the difference between the coupon rate and the YTM of bonds?
3. What factors will contribute to the riskiness of these bonds? Explain in detail your rationale.
4. What type of positive and negative covenants may AirJet Best Parts, Inc. use in future bond issues?
Please see the attached file for full problem description.
? Complete problems 1, 3, 4, 7, 10, & 12 on text pp. 383-386 of Ch. 12.
1. Calculate the after-tax cost of a $25 million debt issue that Pullman
Manufacturing Corporation (40 percent marginal tax rate) is planning to
place privately with a large insurance company. This long-term issue will yield
6.6 percent to the insurance company.
3. Calculate the after-tax cost of preferred stock for Bozeman-Western Airlines,
Inc., which is planning to sell $10 million of $4.50 cumulative preferred stock
to the public at a price of $48 a share. The company has a marginal tax rate of
40 percent.
4. The following financial information is available on Fargo Fabrics, Inc.:
Current per-share market price 5 $20.25
Current per-share dividend 5 $1.12
Current per-share earnings 5 $2.48
Beta 5 0.90
Expected market risk premium 5 6.4%
Risk-free rate (20-year Treasury bonds) 5 5.2%
Past 10 years earnings per share:
20X1 $1.39 20X6 $1.95
20X2 1.48 20X7 2.12
20X3 1.60 20X8 2.26
20X4 1.68 20X9 2.40
20X5 1.79 20Y0 2.48
This past-earnings growth trend is expected to continue for the foreseeable
future. The dividend payout ratio has remained approximately constant over
the past 10 years and is expected to remain at current levels for the foreseeable
future.
Calculate the cost of equity capital using the following methods:
a. The constant growth rate dividend capitalization model approach
b. The Capital Asset Pricing Model approach
7. The Ewing Distribution Company is planning a $100 million expansion of its
chain of discount service stations to several neighboring states. This expansion
will be financed, in part, with debt issued with a coupon interest rate of 6.8
percent. The bonds have a 10-year maturity and a $1,000 face value, and they
will be sold to net Ewing $990 per bond. Ewing’s marginal tax rate is 40 percent.
Preferred stock will cost Ewing 7.5 percent after taxes. Ewing’s common
stock pays a dividend of $2 per share. The current market price per share is $35.
Ewing’s dividends are expected to increase at an annual rate of 5 percent for the
foreseeable future. Ewing expects to generate sufficient retained earnings to
meet the common equity portion of the funding needed for the expansion.
Ewing’s target capital structure is as follows:
Debt 5 20%
Preferred stock 5 5%
Common equity 5 75%
Calculate the weighted cost of capital that is appropriate to use in evaluating
this expansion program.
10. The Comfort Corporation manufactures sofas and tables for the recreational
vehicle market. The firm’s capital structure consists of 60 percent common
equity, 10 percent preferred stock, and 30 percent long-term debt. This capital
structure is believed to be optimal. Comfort will require $120 million to
finance expansion plans for the coming year. The firm expects to generate
enough internal equity to meet the equity portion of its expansion needs. The
cost of retained earnings is 18 percent. The firm can raise preferred stock at a
cost of 15 percent. First-mortgage bonds can be sold at a pretax cost of 14
percent. The firm’s marginal tax rate is 40 percent.
Calculate the cost of capital for the funds needed to meet the expansion
goal.
12. Rolodex, Inc. would like to estimate its average cost of capital for the coming
year. The capital budgeting plans call for funds totaling $200 million for the
coming year. These funds will be raised from long-term debt, preferred stock,
and common equity in the same proportions as their book values in the firm’s
balance sheet shown below:
Discussions between the firm’s financial officers and the firm’s investment
and commercial bankers have yielded the following information:
? Rolodex’s maximum borrowing is $80 million from its bank at a pretax
cost of 13 percent.
? Preferred stock can be issued at a pretax cost of 16.5 percent.
? Rolodex expects to generate $140 million in net income. Any earnings
remaining after meeting the equity portion of the $200 million capital
expenditure budget will be paid out as dividends.
? The risk-free rate of return is 5.5 percent. The market risk premium is assumed
to equal 10 percent and Rolodex’s beta is estimated to be 1.2.
? Rolodex’s marginal tax rate is 40 percent.
Compute Rolodex’s weighted average cost of capital for the coming year.
If Wild Widgets, Inc., (WWI) were an all-equity firm, it would have a beta of 0.9.WWI has a target debt-to-equity ratio of 0.50.The expected return on the market portfolio is 16 percent, and Treasury bills currently yield 8 percent per annum. WWI one-year, $1,000 par value bonds carry a 7 percent annual coupon and are currently selling for $972.73.The yield on WWI’s longer term debt is equal to the yield on its one-year bonds. The corporate tax rate is 34 percent.
a. What is WWI’s cost of debt?
b. What is WWI’s cost of equity?
c. What is WWI’s weighted average cost of capital?
Mini Case,
a. 1) What sources of capital should be included when you estimate Cox’s weighted average cost of capital (WACC)?
2) Should the component costs be figured on a before-tax or an after-tax basis?
3) Should the costs be historical (embedded) coasts or new (marginal) cost?
b. What is the market interest rate on Cox’s debt and its component cost of debt”
c. 1) What is the firm’s cost of preferred stock?
2) Cox’s preferred stock is riskier to investors than its debt, yet the preferred’s yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes)
Please also use the attached Spreadsheet!
During the last few years, Cox Technologies has been too constrained by the high cost of capital to make many
capital investments. Recently, though, capital costs have been declining, and the company has decided to look
seriously at a major expansion program that had been proposed by the marketing department. Assume that you
are an assistant to Jerry Lee, the financial vice-president. Your first task is to estimate Cox’s cost of capital.
Lee has provided data that he believes is relevant to your task.
(1) The firm’s tax rate is 40%
(2) The current price of Cox’s 12 percent coupon, semiannual payment, noncallable bonds with 15 years remaining
to maturity is $1,153.72. Cox does not use short-term interest-bearing debt on a permanent basis. New bonds
would be privately placed with no flotation costs.
(3) The current price of the firm’s 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10
Cox would incur a flotation cost of $2.00 per share on a new issue.
(4) Cox’s common stock is currently selling at $50 per share. Its last dividend (Do) was $4.19, and dividends are
expected to grow at a constant rate of 5% in the foreseeable future. Cox’s beta is 1.2, the yield on T-bonds is
7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-risk-premium approach,
the firm uses a 4 percentage point risk premium.
(5) Cox’s target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common
equity.
Sources of Capital
Long-term debt
Preferred Stock
Common Equity
The cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the firm uses
to finance its assets, or its WACC. There is an overall, or corporate, WACC which reflects the average riskiness
of all the firm’s assets. However, since different assets may have more or less risk than the average, the overall
WACC must be adjusted up or down to reflect the riskiness of different proposed capital budgeting projects.
Tax effects associated with financing either in capital budgeting cash flows or in costs of capital. Most firms
incorporate tax effects in the cost of capital, therefore focus on after-tax costs. After-tax costs only effect the cost
of debt. This is due to interest on debt being tax deductible.
Please solve the following:
A) David Ortiz Motors has a target capital structure of 40$ debt and 60% equity. The yield to maturity on the company’s outstanding bonds is 9%, and the company’s tax rate is 40%. Ortiz’s CFO has calculated the company’s WACC as 9.96%. What is the company’s cost of equity capital?
B) On January 1, the total market value of Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm’s [resent market value capital structure, shown below, is considered to be optimal. Assume there is no short term debt.
Debt $30,000,000
Common Equity 30,000
Total capital $60,000,000
New bonds will have 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. Stockholders’ required rate of return is estimated to be 12%, consisting f a dividend yield of 4% and an estimated constant growth rate of 8%. (The next expected dividend is $1.20, so $1.20/$30 = 4%) The marginal corporate tax rate is 40%.
To maintain the present capital structure, how much of the new investment must be financed by common equity?
Assume that there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing additional shares of equity. What is the WACC?
Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC?
Use Excel format for this question:
A firm’s current balance sheet is as follows:
Assets $100 Debt $10
Equity $90
a. What is the firm’s weighted-average cost of capital at various combinations of debt and equity, given the following information?
Debt/Assets After-Tax Cost of Debt Cost of Equity Cost of Capital
0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?
b. Construct a pro forma balance sheet that indicates the firm’s optimal capital structure. Compare this balance sheet with the firm’s current balance sheet. What course of action should the firm take?
Assets $100 Debt $?
Equity $?
c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
d. If a firm uses too much debt financing, why does the cost of capital rise?
1.A firm’s current balance sheet is as follows:
Assets $100 Debt $10
Equity $90
a.)What is the firm’s weighted-average cost of capital at various combinations of debt and equity, given the following information?
Debt/Assets After-Tax Cost of Debt Cost of Equity Cost of
Capital
0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?
b.)Construct a pro forma balance sheet that indicates the firm’s optimal capital structure. Compare this balance sheet with the firm’s current balance sheet. What course of action should the firm take?
Assets $100 Debt $?
Equity $?
c.)As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
d.)If a firm uses too much debt financing, why does the cost of capital rise?
A) Firm A is an all equity financed firm. Its current equity price is £1.06 cum dividend. Also, its current earnings per share (eps) and current dividend payment are 20p and 12p, respectively. The market expects the ratio of eps to dividend to stay the same in the future. Firm A’s rate of return on reinvested funds is equal to its equity cost of capital. Estimate firm A’s cost of capital.
b) Firm B has the same business risk as firm A and it is also all equity financed. Firm B’s current market capitalization is £25 million. It makes no profit currently, but is expected to make a constant profit of £1 million two and three years from now. All profits are paid out as dividends in the second and third years. After that profits grow at a constant rate forever, allowing the firm to pay out £1 million in dividends in year four and retaining 50% of the profits. From then on Firm B plans to retain the same fraction of profits each year and return the remainder to shareholders. Estimate firm B’s rate of return on reinvested funds.
c) Firm C also has the same business risk as firm A, however it is a levered company: C’s book value ratio of debt to equity is 1/4 and market value ratio of debt to equity is 1/3. The market risk premium is 6% and the risk free interest rate is 3%. Firm C’s debt beta is 0.2. Assuming that CAPM holds and corporate tax is 0%, estimate firm C’s equity cost of capital.
d) What is firm C’s cost of capital if corporate tax is 30%?
Recall the determined the cost of capital for Rondo. Rondo’s cost of capital is the appropriate discount rate for evaluating company investment projects and we applied it to evaluating Option 1. Now I introduce a twist. When evaluating an acquisition, the appropriate discount rate is not the acquirer’s cost of capital but rather the target company’s cost of equity. Why? The acquirer’s cost of capital is most likely less than the target company’s cost of equity. Why accept a lower return than the street would require? In the acquisition, aren’t you, in essence, buying the equity of the target firm (plus assumption of their debt)?
The acquisition price should then be negotiated around the stock price of the target firm based on the target firm’s cost of equity (retained earnings, not their new common). The actual financing may be at the acquirer’s cost of capital or simply debt and/or equity.
The direction I want you to take in analyzing the Poly Pipe acquisition is the projected price of Poly’s stock. It has a presumed market price of $36 and Poly management wants a 50% premium. Back into your proposed price using the constant growth model. That would be the price Rondo should consider in negotiating the acquisition. I am looking at price not as a lump sum but either as the required return to Rondo and/or the offer price per share to Poly management. This can also be stated as the number of shares of Rondo stock to be exchanged for Poly stock. Here are some additional hints:
1. Poly does not pay any dividends. How can you use the constant growth model? You could use Rondo’s payout since Rondo management would most likely want to receive a dividend. You need to find Rondo’s dividend payout ratio.
2. The growth rate for Poly is not given but you can get the ROE from Poly’s financial statements and apply Rondo’s dividend payout to obtain the retention rate. You then can calculate the sustainable growth.
3. What do you feel is Poly’s required return? Applying the constant growth formula with Poly’s market price, applying Rondo’s dividend payout, and Poly’s sustainable growth, you can back into the required return. How does it compare to Rondo’s?
The formula for the constant growth model is:
. Re-arranging the terms:
Please process your valuation analysis with supportive dialogue on how to proceed negotiations.
Week 4 – Problem 3
McCoy, Inc., has equity with a market value of $37 million and
debt with a market value of $19 million.
The cost of the debt is 7 percent semi-annually.
Treasury bills that mature in one year yield 5.5 percent per annum,
and the expected return on the market portfolio over the
next year is 13 percent.
The beta of McCoy’s equity is 0.75 .The firm pays no taxes.
a. What is McCoy’s debt-equity ratio?
b. What is the firm’s weighted average cost of capital?
c. What is the cost of capital for an otherwise identical all-equity firm?
Over the past few years, My Company has been too constrained by the high cost of capital to make amny capital investmens. However, recently, capital costs have been declining, and the company has decided to look at a major expansion program.
The information below is provided to estimate the company cost of capital:
1. The company’s tax rate is 40% .
2. The current price of the company’s 12% coupon, semiannual payment, noncallable bond with 15 years remaining until maturity is $1,153.72 The company does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
3. The current pfirm of the company’s 10%, $100 par vlaue, quarterly divident, perpetual preferred stock is $113.10. The wompany will incur flotation costs of $2.00 per share on a new issue.
4. The company’s common stock is currently selling at $50 per share. Its last divident was $4.19, and dividends are expected to grow at a constant rate of 5% in the near future. The company’s beta is 1.2; the yield on t-bonds is 7%; and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4 percentage point risk premium.
5. The company’s target capital structure is 30% long-term debt, 10% preferred stock, and 6-% common equity.
Based on the above information, answer the following questions (provide step-by-step calculations):
1. What sources of capital should be included when the company’s weighted average cost of capital (WACC) is estimated?
2. What is the company’s weighted average cost of capital (WACC)?
3. What is the market interest rate on the company’s debt and its component cost of debt?
4. What are the two primary wasy companies raise common equity? And, if the dompany doesn’t plan to ussue new shares of common stock. Using the CAPM approach, what is the company’s estimated cost of equity?
5. What is the cost of equity based on the bond-yield-plus-risk premium method?
6. What four common mistakes in estimating the company’s WACC should be avoided?
A firms current balance sheet is as follows:
Assets $100 Debt $10
Equity $90
What is the firm’s weighted average cost of capital at various combinations of debt and equity, given the following information?
Show work
Debt/Assets After tax cost of debt Cost of equity Cost of Capital
0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?
Consider three companies: Borders, Clorox, and Amazon. Reflect on the nature of the business of these three companies. You are recommended to also get to the web site of one company in each of these categories. You might also check what the beta of each of these companies is.
what would you recommend should the capital structure (total liabilities or debt and equity proportions) be for each of the three companies? Note that you are not asked to provide specific numbers, just ‘low debt ratio’, ‘medium debt ratio’ or ‘high debt ratio’. (Do not quote the actual company’s capital structure or their debt-to-equity ratios as per their balance sheet.)
Explain your recommendations for each of these three companies. Consider the nature of their business, the riskiness of the company, and the advantages and disadvantages of debt over equity financing in your answers.
798 words
Would you be able to assist with this question? Particularly need help with e), f), g).
Xhat Inc has 12,000 bonds outstanding that have a 6% coupon rate. The bonds are selling at 98% of face value, pay interest semi-annually, and mature in 28 years. There are 400,000 shares of 9% $100 preferred stock outstanding with a current market price of $83 a share. In addition, there are 1.40 million shares of common stock outstanding with a market price of $54 a share and a beta of 1.2. The common stock paid a total of $1.80 in dividends last year and expects to increase those dividends by 4% annually. The firm’s marginal tax rate is 34%. The overall stock market is yielding 12% and the Treasury bill rate is 4.0%.
a. What is the cost of equity based on the dividend growth model? (2)
b. What is the cost of equity based on the security market line?(2)
c. What is the cost of financing using preferred stock? (2)
d. What is the pre-tax cost of debt financing? (2)
e. What weight should be given to equity in the weighted average cost of capital computation? (2)
f. What would be the cost of new financing (for each of 28-year bonds, preferred shares and common shares), assuming that flotation costs would be 5% of the proceeds of the issue? (12)
g. If net income in the next year is expected to be $8,000,000, what would be the common equity breakpoint for new financing, assuming the current capital structure is considered optimal? (3)
I would be grateful for an explanation to the attached problem.
Companies A and B have the same business risks and are both solely financed by equity. The retention ratio for A is 60%, while that for B is 40%. The firms are identical in all other respects, and share the following characteristics:
· current earnings £373,000
· depreciation £100,000
· number of shares 1 million
· rate of return on reinvested funds 21%
· share price cum div £2.15
Estimate the cost of capital for each firm. Which company will generate more shareholder value?
2. The flotation costs of issuing new securities
A.decrease the cost of capital.
B.encourage the retention of earnings.
C.encourage external financing.
D.don’t affect the cost of capital.
4.Which of the following statements about the cost of debt is correct?
A.The cost of debt is less than the cost of equity.
B.The cost of debt is greater than the cost of equity.
C.The cost of debt is equal to the firm’s interest rate.
D.The cost of debt is greater than the cost of preferred stock.
6.The optimal capital structure involves
A.minimizing the cost of all funds.
B.maximizing the cost of all funds.
C.minimizing the weighted average of the cost of funds.
D.maximizing the weighted average of the cost of funds.
Use the information in the following table to answer Questions 7, 8, 9, 10,
and 11.
7.According to the information provided in the table, what is the cost of
debt?
A.2.45 percent
B.4.55 percent
C.6.25 percent
D.7.0 percent
8. According to the information in the table, what is the cost of preferred
stock?
A.8 percent
B.9 percent
C.10 percent
D.12 percent
9.According to the information in the table, what is the cost of equity using
the capital asset pricing model (CAPM)?
A.12 percent
B.13.2 percent
C.13.95 percent
D.14.4 percent
10.
According to the information in the table, what is the cost of equity using
the bond yield plus risk premium method?
A.12 percent
B.13.2 percent
C.13.95 percent
D.14 percent
11. According to the information in the table, what is the cost of equity using
the expected growth method?
A.12 percent
B.13.2 percent
C.13.95 percent
D.14.4 percent
13. Which of the following statements about retained earnings is correct?
A.Retained earnings have no cost.
B.Retained earnings are the firm’s cheapest source of funds.
C.Retained earnings have the same cost as new shares of stock.
D.Retained earnings are cheaper than the cost of new shares.
Use the following information to complete Questions 14, 15, 16, and 17.
A firm has two investment opportunities. Each investment costs $2,000, and
the firm’s cost of capital is 8 percent. The cash flows of each investment
are shown in the following table:
14. According to the information in the table, the NPV for Investment A is
A.$871.
B.$1,300.
C.$2,871.
D.$3,300.
15. According to the information in the table, the NPV for Investment B is
A.$980.
B.$1,600.
C.$2,980.
D.$3,600.
16.Based on the information in the table, if the investments are mutually
exclusive, the firm should select
A. the higher NPV investment.
B.both investments.
C.neither investment.
D.the higher payback investment.
17. Based on the information in the table, if the investments are independent,
the firm should select
A.the higher IRR investment.
B.all investments with an IRR that’s greater than 8 percent.
C.all investments with an IRR that’s less than 8 percent.
D.only one investment if the IRR is greater than 8 percent.
20.Which of the following statements about the marginal cost of capital is
correct?
A.The marginal cost of capital is a firm’s cost of debt and equity finance.
B.The marginal cost of capital is constant once the optimal capital structure
is determined.
C.The marginal cost of capital declines as flotation costs alter equity
financing.
D.The marginal cost of capital refers to the cost of additional funds.
A. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
b. If a firm uses too much debt financing, why does the cost of capital rise?
McCoy, Inc. has equity with a market value of $40 million and debt with a market value of $20 million. The cost of the debt is 6 percent semi-annually. Treasury bills that mature in one year yield 5 percent per annum, and the expected return on the market portfolio over the next year is 15 percent. The beta of McCoy’s equity is 0.8. The firm pays no taxes.
What is McCoy’s debt-equity ratio?
What is the firm’s weighted average cost of capital?
what is the cost of capital for an otherwise identical all-equity firm?
PLEASE RESPOND IN EXCEL WITH FORMULAS FOR EACH STEP.
Please see attached document.
The founders were relatively wealthy, mid-30s individuals when they started the company, and had enough confidence in their concept to commit most of their own funds to the new venture. Still, the capital requirements brought on by extremely rapid growth soon exhausted their personal funds. They were forced to borrow heavily, and, eventually, to float an issue of common stock. The stock trades on the over-the-counter market, recently selling in the neighborhood of $50 per share.
Virtual Assist.com’s the current year balance sheet, which is shown in Table 1.
(1) Virtual Assist.com’s long-term debt consists of 13 percent coupon, semiannual payment bonds with 15 years remaining to maturity. The bonds currently trade at a price of $1,230.58 per $1,000 par value bond. The bonds are not callable, and they are rated BBB.
(2) The founders have an aversion to short-term debt, so Virtual Assist.com uses such debt only to fund cyclical working capital needs.
(3) Virtual Assist.com’s federal-plus-state tax rate is 40 percent.
Table 1
Virtual Assist.com: Balance Sheet
for the Current Year Ended December 31
(In Millions of Dollars)
Cash and
Securities 22.9
Accounts
Receivable 118.8
Inventory 27.5
Current assets 169.2
Net fixed assets 343.4
______
Total Assets $ 512.6
Accounts 17.1
payable
Accruals 22.5
Notes payable 5.9
________
Current
Liabilities 45.8
Long-term debt 183.6
Preferred stock 43.6
Common stock 239.9
_________
Total claims 512.6
(4) The company’s preferred stock pays a dividend of $2.50 per quarter; it has a par value of $100; it is noncallable and perpetual; and it is traded in the over-the-counter market at a current price of $113.10 per share. A flotation cost of $2.00 per share would be required on a new issue of preferred.
(5) The firm’s current (i.e., last) dividend (D0) was $1.73, and dividends are expected to grow at about a 10 percent rate in the foreseeable future. Some analysts expect the company’s recent growth rate to continue, others expect it to go to zero as new competition enters the market; the majority anticipate that a growth rate of about 10 percent will continue indefinitely. Virtual Assist.com common stock now sells at a price of about $50 per share. The company has 7.5 million common shares outstanding.
(6) The current yield on long-term T-bonds is 7 percent, and a prominent investment banking firm (one of the few still solvent) has recently estimated that the market risk premium is 6 percentage (since current market return is estimated at 13%). The firm’s historical beta, as measured by several analysts who follow the stock, is 1.2.
(7) The required rate of return on an average (A-rated) company’s long-term debt is 9 percent.
(8) Virtual Assist.com is forecasting end of current earnings available to the common stockholders of $6 million, and a dividend pay out ratio of 10%.
(9) Depreciation of $13,500,000 is expected for the coming year.
(10) Virtual Assist.com’s investment bankers believe that a new common stock issue would involve total flotation costs (including underwriting costs, market pressure from increased supply, and market pressure from negative signaling effects) of 30 percent.
(11) The market value target capital structure calls for 30 percent long-term debt, 10 percent preferred stock, and 60 percent common stock.
1. a. What is your estimate of Virtual Assist.com’s cost of debt?
b. Should flotation costs be included in the component cost of debt calculation? Explain.
c. Should the nominal cost of debt or the effective annual rate be used? Explain.
d. How valid is an estimate of the cost of debt based on 15 year bonds if the firm normally issues 30 year long term debt?
e. Suppose Virtual Assist.com’s outstanding debt had not been recently traded; what other methods could be used to estimate the cost of debt?
2. a. What is your estimate of the cost of preferred stock?
b. Virtual Assist.com’s preferred stock is more risky to investors than its debt, yet you should find that its before tax yield to investors is lower than the yield on Virtual Assist.com’s debt. Why does this occur? Is this evidence of an inefficient market for securities? Why or why not.
3. a. Why is there a cost associated with retained earnings?
b. What is Virtual Assist.com’s estimated cost of retained earnings using the CAPM approach?
c. Why might one consider the T bond rate to be a better estimate of the risk free rate than the T bill rate? Can you think of an argument that would favor the use of the T-bill rate?
d. Would Virtual Assist.com’s historical beta be a better or a worse measure of its future market risk than the historical beta for an average NYSE company would be for its (the average NYSE company’s) future market risk? Explain your answer.
e. How can Virtual Assist.com obtain a market risk premium for use in a CAPM cost-of-equity calculation? Discuss both the possibility of obtaining an estimate from some other organization, and also the ways in which Virtual Assist.com could calculate a market risk premium in-house.
Part A. Micro Spinoffs, Inc. is issued a 20-year debt a year ago at par value with a coupon rate of 8%, paid annually. Today the debt is selling at $1,050. If the firm’s tax bracket is 35%, what is its after-tax cost of debt?
Part B. Micro Spinoffs also has preferred stock outstanding. The stock pays a dividend of $4/share, and the stock sells for $40. What is the cost of the preferred stock?
Show your work.
1.Suppose a firm estimates its cost of capital for the coming year to be 10 percent. What are reasonable
costs of capital for evaluating average-risk projects, high-risk projects, and low-risk
projects?
Assignment: Weighted Average Cost of Capital
2. The following tabulation gives earnings per share figures for the Foust Company during the
preceding 10 years. The firm’s common stock, 7.8 million shares outstanding, is now (1/1/03)
selling for $65 per share, and the expected dividend at the end of the current year (2003) is
55 percent of the 2002 EPS. Because investors expect past trends to continue, g may be based
on the earnings growth rate. (Note that 9 years of growth are reflected in the data.)
YEAR EPS YEAR EPS
1993 $3.90 1998 $5.73
1994 4.21 1999 6.19
1995 4.55 2000 6.68
1996 4.91 2001 7.22
1997 5.31 2002 7.80
The current interest rate on new debt is 9 percent. The firm’s marginal tax rate is 40 percent.
Its capital structure, considered to be optimal, is as follows:
Debt $104,000,000
Common equity 156,000,000
Total liabilities and equity $260,000,000
a. Calculate Foust’s after-tax cost of new debt and common equity. Calculate the cost of equity
as
b. Find Foust’s weighted average cost of capital.
Acetate, Inc., has equity with a market value of $20 million and debt with a market value of $10 million. The cost of the debt is 14 percent per annum. Treasury bills that mature in one year yield 8 percent per annum, and the expected return on the market portfolio over the next year is 18 percent. The beta of Acetate’s equity is 0.9. The firm pays no taxes.
What is Acetate’s debt-equity ratio?
What is the firm’s weighted average cost of capital?
What is the cost of capital for an otherwise identical all-equity firm?
Please tell me how to find K given the parameters in the problem for #9.50. You can see how I’m trying to do it, but I can’t figure out what to plug in for Cd and Ce from what’s given.
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