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Unformatted text preview: The WACC is: WACC = .0501(5.15/14.27) + .1370(9.12/14.27) = .1056 or 10.56% Notice that we didn’t include the (1 – tC) term in the WACC equation. We simply used the aftertax cost of debt in the equation, so the term is not needed here. 14. a. We will begin by finding the market value of each type of financing. We find: MVD = 200,000($1,000)(0.93) = $186,000,000 MVE = 8,500,000($34) = $289,000,000 And the total market value of the firm is: V = $186,000,000 + 289,000,000 = $475,000,000 So, the market value weights of the company’s financing is: D/V = $186,000,000/$475,000,000 = .3916 E/V = $289,000,000/$475,000,000 = .6084 b. For projects equally as risky as the firm itself, the WACC should be used as the discount rate. First we can find the cost of equity using the CAPM. The cost of equity is: RE = .05 + 1.20(.07) = .1340 or 13.40% The cost of debt is the YTM of the bonds, so: P0 = $930 = $37.5(PVIFAR%,30) + $1,000(PVIFR%,30) R = 4.163% YTM = 4.163% × 2 = 8.33% And the aftertax cost of debt is: RD = (1 – .35)(.0833) = .0541 or 5.41% Now we can calculate the WACC as: WACC = .1340(.6084) + .0541(.3916) = .1027 or 10.27% 314 15. a. b. Projects Y and Z. Using the CAPM to consider the projects, we need to calculate the expected return of each project given its level of risk. This expected return should then be compared to the expected return of the project. If the return calculated using the CAPM is lower than the project expected return, we should accept the project; if not, we reject the project. After considering risk via the CAPM: E[W] = .05 + .75(.11 – .05) E[X] = .05 + .90(.11 – .05) E[Y] = .05 + 1.20(.11 – .05) E[Z] = .05 + 1.50(.11 – .05) = .0950 < .10, so accept W = .1040 > .102, so reject X = .1220 > .12, so reject Y = .1400 < .15, so accept Z c. Project W would be incorrectly rejected; Project Y would be incorrectly accepted. 16. a. b. He should look at the weighted average flotation cost, not just the debt cost. The weighted average flotation cost is the weighted average of the flotation costs for debt and equity, so: fT = .05(.75/1.75) + .08(1/1.75) = .0671 or 6.71% c. The total cost of the equipment including flotation costs is: Amount raised(1 – .0671) = $20,000,000 Amount raised = $20,000,000/(1 – .0671) = $21,439,510 Even if the specific funds are actually being raised completely from debt, the flotation costs, and hence true investment cost, should be valued as if the firm’s target capital structure is used. 17. We first need to find the weighted average flotation cost. Doing so, we find: fT = .65(.09) + .05(.06) + .30(.03) = .071 or 7.1% And the total cost of the equipment including flotation costs is: Amount raised(1 – .071) = $45,000,000 Amount raised = $45,000,000/(1 – .071) = $48,413,125 Intermediate 18. Using the debtequity ratio to calculate the WACC, we find: WACC = (.65/1.65)(.055) + (1/1.65)(.15) = .1126 or 11.26% Since the project is riskier than the company, we need to adjust the project discount rate for the additional risk. Using the subjective risk factor given, we find: Project discount rate = 11.26% + 2.00% = 13.26% 315 We would accept the project if the NPV is positive. The NPV is the PV of the cash outflows plus the PV of the cash inflows. Since we have the costs, we just need to find the PV of inflows. The cash inflows are a growing perpetuity. If you remember, the equation for the PV of a growing perpetuity is the same as the dividend growth equation, so: PV of future CF = $3,500,000/(.1326 – .05) = $42,385,321 The project should only be undertaken if its cost is less than $42,385,321 since costs less than this amount will result in a positive NPV. 19. We will begin by finding the market value of each type of financing. We will use D1 to represent the coupon bond, and D2 to represent the zero coupon bond. So, the market value of the firm’s financing is: MVD1 = 40,000($1,000)(1.1980) = $47,920,000 MVD2 = 150,000($1,000)(.1820) = $27,300,000 MVP = 100,000($78) = $7,800,000 MVE = 1,800,000($65) = $117,000,000 And the total market value of the firm is: V = $47,920,000 + 27,300,000 + 7,800,000 + 117,000,000 = $200,020,000 Now, we can find the cost of equity using the CAPM. The cost of equity is: RE = .04 + 1.10(.07) = .1170 or 11.70% The cost of debt is the YTM of the bonds, so: P0 = $1,198 = $35(PVIFAR%,50) + $1,000(PVIFR%,50) R = 2.765% YTM = 2.765% × 2 = 5.53% And the aftertax cost of debt is: RD1 = (1 – .40)(.0553) = .0332 or 3.32% And the aftertax cost of the zero coupon bonds is: P0 = $182 = $1,000(PVIFR%,60) R = 2.880% YTM = 2.88% × 2 = 5.76% RD2 = (1 – .40)(.05.76) = .0346 or 3.46% Even though the zero coupon bonds make no payments, the calculation for the YTM (or price) still assumes semiannual compounding, consistent with a coupon bond. Also remember that, even though the company does not make interest payments, the accrued interest is still tax deductible for the company. 316 To find the required return on preferred stock, we can use the preferred stock pricing equation, w...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of TexasTyler.
 Spring '10
 eshmalwi
 Finance, Corporate Finance

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