1. What are some other names by which the cost of capital is known?
2. Your friend is willing to lend you $500 at 7% and your cousin is willing to lend you $1,500 at 12%. If your tax rate is 40%, what is your WACC?
3. What are the 3 main components of the WACC?
4. How do the before- and after-tax component costs of capital differ?
5. Which component cost of capital needs to be adjusted for taxes and why only this one?
6. How do we compute capital structure weights using (a) book values; and (b) market values? Identify where examples of these methods are presented in the text. Which of these do investors and analysts prefer?
7. Fulton has $30 million in equity, $20 million in debt and $5 million in preferred stock. Component costs of capital are 10%, 7%, and 6%, respectively. If Fulton's tax rate is 40%, what is its WACC?
8. We've discussed two ways of adjusting the WACC for the risk of a proposed project. List the steps involved in each of these two methods. Identify where examples of these methods are presented in the text.
9. Use the graph with lines for the overall WACC and the risk-adjusted WACC to label the following situations if the overall WACC is used to evaluate all projects regardless of their degree of risk:
(A) Acceptance of high risk projects that are bad investments
(B) Acceptance of low-risk projects that are good investments
(C) Rejection of low-risk projects that are good investments
(D) Rejection of high-risk projects that are bad investments
10. An all-equity firm is considering a project that is only 2/3 as risky as average for the firm. If the annual rate on 3-month T-bills is 2%, the expected return on the market is 10%, and the firm's tax rate is 35%, what is the WACC for this firm?
1. For the NPV and IRR, how would you (a) describe each method; (b) do the calculation involved; and (c) use the resulting value to decide to accept or reject a project?
2. Consider a project's cash flows in order: -$500, $200, $150, $300. Go to Excel, compute the PV of each of the cash flows by typing in the PV formula. Sum the discounted cash flows to find the NPV. Now do the same using Excel's NPV formula and compare your answers. Are the two NPVs the same? If not, why not? If not, which is the correct NPV? Calculate the NPV by hand to check which is correct.
3. By what process do we find the IRR? What is the key relationship we learned in chapter 3 that is at the heart of this method? How do you check to see if a proposed discount rate is indeed the IRR? What did we solve for in chapter 6 by using the very same method? Make up a numerical example to illustrate this process.
4. Use the NPV profile graph to illustrate that for a single independent project, the NPV and IRR methods will always give the same accept/reject recommendation.
5. What are the two situations for which we cannot rely on the IRR? Illustrate graphically how relying on the IRR in these situations would lead to an incorrect decision.
6. What do we check to see if there could be multiple IRRs?
7. What is the "crossover" rate? What are equal at this rate? Where is it on the NPV profile graph? What is its significance?
1. For the NPV and IRR, how would you (a) describe each method; (b) do the calculation involved; and (c) use the resulting value to decide to accept or reject a project?
2. Consider a project's cash flows in order: -$500, $200, $150, $300. Go to Excel, compute the PV of each of the cash flows by typing in the PV formula. Sum the discounted cash flows to find the NPV. Now do the same using Excel's NPV formula and compare your answers. Are the two NPVs the same? If not, why not? If not, which is the correct NPV? Calculate the NPV by hand to check which is correct.
3. By what process do we find the IRR? What is the key relationship we learned in chapter 3 that is at the heart of this method? How do you check to see if a proposed discount rate is indeed the IRR? What did we solve for in chapter 6 by using the very same method? Make up a numerical example to illustrate this process.
4. Use the NPV profile graph to illustrate that for a single independent project, the NPV and IRR methods will always give the same accept/reject recommendation.
5. What are the two situations for which we cannot rely on the IRR? Illustrate graphically how relying on the IRR in these situations would lead to an incorrect decision.
6. What do we check to see if there could be multiple IRRs?
7. What is the "crossover" rate? What are equal at this rate? Where is it on the NPV profile graph? What is its significance?