# ch12 - Chapter 12 Determining the Cost of Capital Note: All...

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Chapter 12 Determining the Cost of Capital Note: All problems in this chapter are available in MyFinanceLab. 1. Plan: Compute the weights for the WACC. Execute: Value of debt: \$100 million Value of preferred stock: \$20 million Market value of common equity: \$50 per share 6 million shares \$300 million ×= Total market value of firm: \$100 + 20 + 300 = \$420 million Weights for WACC calculation: 100 Debt : 23.81% 420 20 Preferred Stock : 4.76% 420 300 Common Equity : 71.43% 420 = = = Evaluate: The total market value of the firm is \$420 million. Debt is 23.81% of the total value, Preferred Stock is 4.76%, and Common Equity is 71.43%. 2. Plan: Compute the market value weights to compute the WACC. Execute: Book value of equity = \$600 Market value of equity = \$600 1.5 \$900 Book value of debt = \$400 Total market value of firm = \$1,300. Weights for WACC calculation: 400 Debt : 30.77% 1, 300 900 Common Equity : 69.23% = = Evaluate: Debt is 30.77% of the capital structure and equity is 69.23%.

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134 Berk/DeMarzo/Harford • Fundamentals of Corporate Finance 3. Plan: Compute the firm’s pre-tax WACC and the value of a portfolio containing 40% of the firm’s debt and 60% of the firm’s equity. Show that the expected returns are identical. Execute: If the firm’s assets are to be worth either \$1,200 or \$960 in one year (with equal probability), what does this mean for the value of the debt and equity of the firm? At a 5% interest rate, the debt will be worth \$420 in one year. Because the debt has seniority over equity on its claim of the firm’s assets, the assets will be large enough in one year to fulfill the debt obligations, so the debt will be worth \$420 in either case. Thus, the equity will be worth either \$780 or \$540 in one year. Expected return on assets: 50% chance of \$1,200 in one year: 1,200 1,000 Return 1, 000 20% = = 50% chance of \$960 in one year: 960 1,000 Return 4% = =− Expected return on assets =+ = (50%)(20%) (50%)( 4%) 8%. Portfolio of 40% debt and 60% equity: Expected return on debt: 420 400 5% 400 = Expected return on equity: 50% chance of \$780 in one year: 780 600 Return 600 30% = = 50% chance of \$540 in one year: 540 600 Return 600 10% = Expected return on equity = (50%)(30%) (50%)( 10%) 10%.
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## This note was uploaded on 12/29/2010 for the course FINA 3001 taught by Professor Someguy during the Spring '08 term at Minnesota.

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ch12 - Chapter 12 Determining the Cost of Capital Note: All...

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