Question 1: Concepts of cost of capital: Mace Manufacturing is in the process of analyzing its investment decision making procedures. Two projects evaluated by the firm recently involved building new facilities in different regions; North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table.
|
Basic variables
|
North
|
South
|
|
cost
|
$6 million
|
$5 million
|
|
life
|
15 years
|
15 years
|
|
expected return
|
8%
|
15%
|
|
least-cost financing
|
7%
|
|
|
source
|
debt
|
equity
|
|
cost (post tax)
|
7%
|
15%
|
|
decision
|
|
|
|
action
|
invest
|
don't invest
|
|
reason
|
8%>7% cost
|
12%<16% cost
|
A. An analyst evaluating the North facility expects that the project will be financed by debt that costs the firm 7%. What recommendations do you think this analyst will make regarding the investment?
B. Another analyst assigned to study the South facility believes that funding for the project will come from the firm’s retained earnings at a cost of 16%. What recommendation do you expect this analyst to make regarding the investment?
C. Explain why the decision in part A and B may not be in the best interest of the firm’s investors? North is 8% >7% and South is 12%<16%
D. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table.
E. If both analysts had used the weighted average cost calculated in part D, what recommendations would they recommendations would they have made regarding the North and South facilities?
F. Compare and contrast the analyst’s initial recommendations with your findings in part E. Which decision method seems more appropriate? Explain why?
Question 2: The cost of debt:
Gronseth Drywall Systems, Inc. is in discussions with its investment bankers regarding the issuance of the bonds. The investment banker has informed the firm that different maturities will carry different coupon rates and sell at different prices. The firm must choose among several alternatives. In each case, the bonds will have a $1000.00 par value and floatation costs will be $30 per bond. The company is taxed at a rate of 40%. Calculate the after-tax cost of financing with each of the following alternatives:
|
Alternative
|
Coupon rate
|
Time to maturity (years)
|
Premium or discount
|
|
A
|
9%
|
16
|
$250.00
|
|
B
|
7%
|
5
|
50
|
|
C
|
6%
|
7
|
PAR
|
|
D
|
5%
|
10
|
-75
|
Question 3: Cost of preferred stock:
Taylor Systems has just issued preferred stock. The stock has 12% annual dividend and a $100 par value and was sold at $95.50 per share. In addition, floatation costs of $2.50 per share must be paid.
A. Calculate the cost of the preferred stock.
B. If the firm sells the preferred stock with a 10% annual dividend and nets $90.00 after floatation costs, what is its cost?
Question 4: Cost of common stock equity: kn=D1+g /Nn
Ross textiles wish to measure its cost of common stock equity. The firm’s stock is currently for $57.50. The firm expects to pay a $3.40 dividend at the end of the year (2016). The dividends for the past 5 years are shown in the following table:
|
Year
|
Dividend
|
|
2015
|
$3.10
|
|
2014
|
$2.92
|
|
2013
|
$2.60
|
|
2012
|
$2.30
|
|
2011
|
$2.12
|
After underpricing and flotation costs, the firm expects to net $52 per share on a new issue.
A. Determine the growth rate of dividends from 2011-2015
B. Determine the net precedes Nn that the firm will actually receive.
C. Using the constant growth variation model, determine the cost of retained earnings, Rr.
D. Using constant growth valuation model, determine the cost of new common stock, Rn.
Question 5: WACC: book weights and market weights
Webster Company has compiled the information shown in the following table.
|
Source of Capital
|
Book value
|
Market value
|
After-tax cost
|
|
Long-term debt
|
$4,000,000
|
$3,840,000
|
6.00%
|
|
Preferred stock
|
40,000
|
60,000
|
13
|
|
Common stock equity
|
1,060,000
|
3,000,000
|
17
|
|
totals
|
5,100,000
|
6,900,000
|
|
A. Calculate the weighted average cost of capital using the book value weights.
B. Calculate the weighted average cost of capital using the market value weights.
C. Compare your answers obtained in part A and B. explains the differences.