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PS4_Solutions

# PS4_Solutions - Finance 221 Problem Set 4(Practice Problems...

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Finance 221 Problem Set 4 (Practice Problems) Solutions This problem set is to provide practice for the capital budgeting portion of midterm 2. You will not be required to submit your answers for credit. 1. Midwest Electric Company (MEC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 10 percent as long as it finances at its target capital structure, which calls for 45 percent debt and 55 percent common equity. Its last dividend was \$2, its expected constant growth rate is 4 percent, and its stock sells at a price of \$20. MEC’s tax rate is 40 percent. Two projects are available: Project A has a rate of return of 13 percent, while Project B has a rate of return of 10 percent. All of the company’s potential projects are equally risky and as risky as the firm’s other assets. (a) What is MEC’s cost of common equity? Recall that we can use the Gordon Growth Model to solve for the cost of equity is we have a forecast of expected dividend growth: r e = D 1 P 0 + E ( g ) . Here, D 0 = \$2, so D 1 = 2(1 . 04) = \$2 . 08. So the cost of equity is r e = 2 . 08 20 + 0 . 04 = 0 . 144 = 14 . 4% . (b) What is MEC’s WACC? WACC = parenleftbigg D D + E parenrightbigg r d (1 - τ c )+ parenleftbigg E D + E parenrightbigg r e = (0 . 45)(10%)(1 - 0 . 40)+(0 . 55)(14 . 4%) = 10 . 62% (c) Which projects should MEC select? We compare the firm’s WACC to the rate of return on the investments ( IRR ). We see that Project A’s return exceeds the cost of capital, while Project B offers a return less than the cost of capital. Hence, we accept Project A and reject Project B.

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2. A firm has a capital structure consisting of 35% debt, 45% common stock, and 20% preferred stock. The preferred stock pays an annual dividend of \$3.50, and the current market price for preferred stock is \$50 per share. The company has \$20 million in bonds outstanding, each with a face value of \$1,000. The bonds pay an 8% annual coupon and have a maturity of 7 years. The bonds currently have a market price of \$850. If the firm issues new debt, it expects to have the same yield-to-maturity as its outstanding debt. The firm’s common stock has a beta of 1.25. The risk-free rate is 2% and the market risk premium is 9%. The firm faces a marginal tax rate of 35%. What is this firm’s WACC? Recall that the formula for the firm’s (after-tax) WACC is WACC = parenleftbigg D D + E + P parenrightbigg r d (1 - τ c ) + parenleftbigg E D + E + P parenrightbigg r e + parenleftbigg P D + E + P parenrightbigg r p . The fractions of each type of security in the firm’s capital structure are given in the problem, so we just need to find the cost for each security: r d = YTM on marginal debt = 11.20% (1,000 FV -850 PV 80 PMT 7 N CPT I/Y ).
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