Part -1:
Weighted Average Cost of Capital (WACC):
Give answers to the following problems. Show all calculations.
i. Burnwood Tech plans to issue some $60 par preferred stock with a 6% dividend. A similar stock is selling on the market for $70. Burnwood must pay flotation costs of 5% of the issue price. What is the cost of the preferred stock?
ii. Summerdahl Resort's 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, and the dividend is expected to grow at a constant rate of 5% a year. What is its cost of common equity? {Ch. 9 #9-51
iii. Booher Book Stores has a beta of 0.8. The yield on a 3-month T-bill is 4% and the yield on a 10-year T-bond is 6%. The market risk premium is 5.5%, and the return on an average stock in the market last year was 15%. What is the estimated cost of common equity using the CAPIVI?
iv. Shi Importer's balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common equity. Shi's tax rate is 40%, rd = 6%, = 5.8%, and rs = 12%. If Shi has a target capital structure of 30% debt, 5% preferred stock, and 65% common,stock, what is its WACC?
v. On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm's market value capital structure, shown below, is considered to be optimal. There is no short-term debt.
Debt $30,000,000
Common equity 30,000,000
Total capital $60,000,000
New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The stockholders' required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is $1.20/$30 = 4%.) The marginal tax rate is 40%.
a. In order to maintain the present capital structure, how much of the new investment must be financed by common equity?
b. Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of equity, what is its WACC?
c. 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? No numbers are required to answer this question.
vi. Talbot Industries is considering an expansion project. The necessary equipment could be purchased for $9 million, and the project would also require an initial $3 million investment in net operating working capital. The company's tax rate is 40%.
a. What is the initial investment outlay?
b. The company spent and expensed $50,000 on research related to the project last year. Would this change your answer? Explain.
c. The company plans to house the project in a building it owns but is not now using. .The building could be sold for $1 million after taxes and real estate commissions. How would this affect your answer?
Part -2:
1. Suppose Stan holds a portfolio consisting of a $10,000 investment in each of 8 different common stocks. The portfolio's beta is 1.25. Now suppose Stan decided to sell one of his stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35. What would the portfolio's new beta be?
a) 1.17
b) 1.23
c) 1.29
d) 1.36
e) 1.43
2. The $10.00 million mutual fund Henry manages has a beta of 1.05 and a 9.50% required return. The risk-free rate is 4.20%. Henry now receives another $5.00 million, which he invests in stocks with an average beta of 0.65. What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium, then fired the new portfolio beta.)
a) 8.83%
b) 9.05%
c) 9.27%
d) 9.51%
e) 9.74%
3. Joel Foster is the portfolio manager of the SF Fund, a $3 million hedge fund that contains the following stocks. The required rate of return on the market is 11.00% and the risk-free rate is 5.00%. What rate of return should investors expect (and require) on this fund?
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Stock
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Amount
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Beta
|
|
A
|
$1,075,000
|
1.20
|
|
B
|
675,000
|
0.50
|
|
C
|
750,000
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1.40
|
|
D
|
500,000
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0.75
|
|
|
$3,000,000
|
|
a) 10.56%
b) 10.83%
c) 11.11%
d) 11.38%
e) 11.67%
4. Fiske Roofing Supplies' stock has a beta of 1.23, its required return is 11.75%, and the risk-free rate is 4.30%. What is the required rate of return on the market?
a) 10:36%
b) 10.62%
c) 10.88%
d) 11.15%
e) 11.43%
5. Barker Corp. has a beta of 1.10, the real risk-free rate is 2.00%, investors expect a 3.00% future inflation rate, and the market risk premium is 4.70%. That is Barker's required rate of return?
a) 9.43%
b) 9.67%
c) 9.92%
d) 10.17%
e) 10.42%
6. Nystrand Corporation's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the Market risk premium?
a) 5.80%
b) 5.95%
c) 6.09%
d) 6.25%
e) 6.40%
Exhibit 1
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
Assets
Current assets $ 38,000,000
Net plant, property, and equipment 101,000,000
Total assets $139,000,000
Liabilities and Equity
Accounts payable $ 10,000,000
Accruals 9,000,000
Current liabilities $ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities $ 59,000,000
Common stock (10,000,000 shares) 30,000,000
|
Retained earnings
Total shareholders' equity
Total liabilities and shareholder& equity
|
50,000,000
80,000,000
$139,000,000
|
|
|
|
The stock is currently selling for $15.25 per share, and its non-callable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
7. Refer to Exhibit 1. What is the best estimate of the after-tax cost of debt?
a) 4.64%
b) 4.88%
c) 5.14%
d) 5.40%
e) 5.67%
8. Refer to Exhibit 1. Based on the CAPM, what is the firm's cost of common stock?
a) 11.15%
b) 11.73%
c) 12.35%
d) 13.00%
e) 13.65%
9. Refer to Exhibit 1. Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?
a) 18.67%
b) 19.60%
c) 20.58%
d) 21.61%
e) 22.69%
10, Refer to Exhibit 1. What is the best estimate of the firm's WACC?
a) 10.85%
b) 11.19%
c) 11.53%
d) 11.88%
e) 12.24%
11. You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF 5.00%, RPM = 6.00%, and b 1.25. (3). DI = $1.20, Po = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?
a) 1.13%
b) 1.50%
e) 1.88%
d) 2.34%
e) 2.58%
12. Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?
a) 8.72%
b) 9.08%
c) 9.44%
d) 9.82%
e) 10.22%
13. Kenny Electric Company's non-callable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. lithe firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?
a) 4.35%
b) 4.58%
c) 4.83%
d) 5.08%
e) 5.33%
14. To help estimate its cost of common equity, Maxwell and Associates recently hired you. You have obtained the folloWing data: Do = $0.90; Po = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings?
a) 9.29%
b) 9.68%
c) 10.08%
d) 10.50%
e) 10.92%
15. Which of the following statements is NOT a disadvantage of the regular payback method?
a) Ignores cash flows beyond the payback period
b) Does not directly account for the time value of money
c) Does not provide any indication regarding a project's liquidity or risk
d) Does not take account of differences in size among projects
e) Lacks an objective, market-determined benchmark for making decisions
16. You are on the staff of O'Hara Inc. The CFO believes project acceptance should be based on the NPV, but Andrew O'Hara, the president, insists that no project should be accepted unless its IRR exceeds the project's risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and -$100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?
a) You should recommend that the project be rejected because, although its NPV is positive, it has an MR that is less than the WACC.
b) You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that the firm's value will increase if the project is accepted.
c) You should recommend that the project be rejected. Although its NPV is positive it has two IRRs, one of which is less than the WACC, which indicates that the firm's value will decline if the project is accepted.
d) You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the WACC, and that indicates that the firm's value will decline if it is accepted.
e) You should recommend that the project be rejected because its NPV is negative and its ERR is less than the WACC.
17. Ellmann Systems is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected.
WACC: 9.00%
Year 0 1 2 3
Cash flows -$1,000 $500 $500 $500
a) $265.65
b) $278.93
c) $292.88
d) $307.52
e) $322.90
18. Last month, Standard Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project took place, the Federal Reserve changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected.
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Old WACC:
|
10.00%
|
New
|
11.25%
|
|
|
|
|
WACC:
|
|
|
|
Year
|
0
|
1
|
2
|
3
|
|
Cash flows
|
-$1,000
|
$410
|
$410
|
$410
|
a) -$18.89
b) -$19.88
c) -$20.93
d) -$22.03
e) -$23.13
19. Hart Corp. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the WACC or negative, in both cases it will be rejected.
|
Year
|
0
|
1
|
2
|
3
|
|
Cash flows
|
-$1,000
|
$425
|
$425
|
$425
|
a) 12.55%
b) 13.21%
c) 13.87%
d) 14.56%
e) 15.29%
20. Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?
a) Shipping and installation costs
b) Cannibalization effects
c) Opportunity costs
d) Sunk costs that have been expensed for tax purposes
e) Changes in net working capital
21. The CFO of Cicero Industries plans to calculate a new project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
a) All sunk costs that have been incurred relating to the project.
b) All interest expenses on debt used to help finance the project.
c) The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life.
d) Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
e) Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.
22. Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
a) A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products.
b) A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
c) A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
d) A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products.
e) A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.
23. A firm is considering a new project whose risk is gr‘ eater than the risk of the firm's average project, based on all methods for assessing risk, In evaluating this project, it would be reasonable for management to do which of the following:
a) Increase the estimated NPV of the project to reflect its greater risk
b) Reject the project, since its acceptance would increase the firm's risk
c) Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets
- d) Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk
e) Increase the estimated IRR of the project to reflect its greater risk
24. Taylor Inc., the company you work for, is considering a new project whose data are shown below. What is the project's Year 1 cash flow?
|
Sales revenues, each year
|
$62,500
|
|
Depreciation
|
$8,000
|
|
Other operating costs
|
$25,000
|
|
Interest expense
|
$8,000
|
|
Tax rate
|
35.0%
|
a) $25,816
b) $27,175
c) $28,534
d) $29,960
e) $31,458
25. Weston Clothing Company is considering manufacturing a new style of shirt, whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other Weston's products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)
|
WACC
|
10.0%
|
|
Pre-tax cash flow reduction for other products (cannibalization)
|
$5,000
|
|
Investment cost (depreciable basis)
|
$80,000
|
|
Straight-line depreciation rate
|
33.333%
|
|
Sales revenues, each year for 3 years
|
$67,500
|
|
Annual operating costs (excl. depreciation)
|
$25,000
|
|
Tax rate
|
35.0%
|
a) $3,636
b) $3,828
c) $4,019
d) $4,220
e) $4,431