HW10_Answers - Q10-1. Explain when firms should discount...

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Q10-1. Explain when firms should discount projects using the cost of equity. When should they use the WACC instead? When should they use neither? A10-1. Only firms with no debt in their capital structure should use the cost of equity to discount project cash flows, and only those projects that are very similar to a firm’s existing assets should be discounted using that rate. Firms with both debt and equity should use the WACC as long as they are evaluating a project that is similar to their existing assets. When a firm is making an investment that is very different from its existing investments, then it shouldn’t use the company’s cost of equity or its WACC. Q10-8. In what sense could one argue that if managers make decisions using breakeven analysis, they are not maximizing shareholder wealth? How can breakeven analysis be modified to solve this problem? A10-8. A problem with break-even analysis is that it uses accounting numbers – earnings before interest and taxes and earnings per share. Accounting numbers can be manipulated, and may not represent cash flows. Financing – the amount of interest a firm pays – will affect its break-even analysis. More debt financing means a higher break-even point. This all relates to maximizing shareholder wealth. A firm with debt financing cannot use the cost of equity to discount its cash flows. It must look at the costs associated with both debt and equity financing and include both in its discount rate. Q10-13. Your company is selling the mineral rights to several hundred acres of land it owns that are believed to contain silver deposits. The current price of silver is $5 per ounce, but of course, future prices are uncertain. Would you expect the mineral rights to sell for more or less if investors believe that silver prices will be more volatile in the future than they have been in the past? Explain. A10-13. Rights would be more valuable if the price of silver is volatile. If the price is volatile, there will be periods when the price is very high and periods when it is very low. When the price is high, you can extract the silver and make a lot of money. When the price is low, you simply wait, avoiding the extraction costs. P10-2.
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This note was uploaded on 08/02/2008 for the course BUSFIN 1030 taught by Professor Zutter during the Spring '08 term at Pittsburgh.

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HW10_Answers - Q10-1. Explain when firms should discount...

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