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Solutions_ch11

# Solutions_ch11 - Problem 11.1 Houston Oil Company What is...

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Problem 11.1 Houston Oil Company What is Houston's weighted average cost of capital? Assumptions a) Values b) Values Houston's beta 1.10 0.80 Cost of debt, before tax 7.000% 7.000% Risk-free rate of interest 3.000% 3.000% Corporate income tax rate 25.000% 25.000% General return on market portfolio 8.000% 8.000% Optimal capital structure: Proportion of debt, D/V 60% 60% Proportion of equity, E/V 40% 40% Calculation of the WACC Cost of debt, after-tax 5.250% 5.250% kd x ( 1 - t ) Cost of equity, after-tax 8.500% 7.000% WACC 6.550% 5.950% WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ] ke = krf + ( km - krf ) β

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Problem 11.2 Carlton's Cost of Capital Calculate the cost of equity, debt, and WACC. Values used Original assumptions in Chapter in Chapter New Values 1.20 1.30 Cost of debt, before tax, kd 8.00% 7.000% Risk-free rate of interest, krf 5.00% 4.000% Corporate income tax rate, t 35.00% 30.000% General return on market portfolio, km 15.00% 9.000% Optimal capital structure: Proportion of debt, D/V 40% 50% Proportion of equity, E/V 60% 50% a) Cartlon's cost of equity 17.000% 10.500% b) Carlton's cost of debt, after tax 5.200% 4.900% kd x ( 1 - t ) c) Carlton's weighted average cost of capital 12.2800% 7.7000% WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ] One of the most interesting aspects of capital costs is how they have been trending downward in recent years as a result of lower interest rates, lower equity market returns, and in some countries, lower tax rates. As a result of the general decline in business and economic performance, many firms have been reducing their debt levels -- if possible -- in order to reduce their debt service requirements. But, one factor which has not necessarily fallen in value is the beta of the individual firm. Here Carlton's cost of capital has fallen dramatically, but its beta is actually higher than before due to more market volatility. Carlton's beta, β ke = krf + ( km - krf ) β
Problem 11.3 Sunshine Pipelines Inc. Assumptions Values Combined federal and state tax rate 40% Desired capital structure: Proportion debt 50% Proportion equity 50% Capital to be raised \$120,000,000 Cost of Cost of Cost of Cost of Domestic Domestic European European Costs of Raising Capital in the Market Equity Debt Equity Debt Up to \$40 million of new capital 12% 8% 14% 6% \$41 million to \$80 million of new capital 18% 12% 16% 10% Above \$80 million 22% 16% 24% 18% Incremental a. To raise \$120,000,000 Debt Market Debt Cost Equity Market Equity Cost WACC First \$40,000,000 European 6.00% Domestic 12.00% 7.80% Second \$40,000,000 European 10.00% European 16.00% 11.00% Third \$40,000,000 Domestic 16.00% Domestic 22.00% 15.80% Weighted average cost 10.67% 16.67% 11.53% (equal weights) (equal weights) Incremental b. To raise \$60,000,000 Debt Market Debt Cost Equity Market Equity Cost WACC First \$40,000,000 European 6.00% Domestic 12.00% 7.80% Additional \$20,000,000 European 10.00% European 16.00% 11.00% Weighted average cost 7.33% 13.33% 8.87% (2/3 & 1/3 weights)

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Problem 11.4
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Solutions_ch11 - Problem 11.1 Houston Oil Company What is...

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