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Cost of Capital - Solutions7

# Cost of Capital - Solutions7 - A 8.51 B 9.99 C 9.25 D 8.88...

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Old Exam Questions - Cost of Capital - Solutions Page 20 of 42 Pages A. 8.51% B. 9.99% C. 9.25% * D. 8.88% E. 9.62% Determine YTM: N = 20; PV = -1,074.39; PMT = 35; FV = 1,000; Solve for I/YR = 3.0 * 2 = 6.00% = YTM After-tax K D = (6%)(1-.40) = 3.6% K S = 0.04 + (0.06)(1.4) = 12.40% Alternatively, g = (0.15)(1 - 0.40) = 9% K S = \$1.53 / \$45.00 + 0.09 = 0.034 + 0.09 = 12.40% K e = \$1.53 / (\$44.00)(1 - 0.10) + 0.09 = 12.86% (Not needed for this problem.) Therefore, for very first dollar: WACC = (3.6%)(0.40) + (12.40%)(0.60) = 1.44% + 7.44% = 8.88% 23. Assume that an all equity firm has a return on assets (ROA) of 12.80 percent. And that the firm makes the decision to replace ¼ of its equity with debt that has a before-tax cost of 8 percent (note: this will give a D/E ratio of ( ¼ / ¾ ) = 1/3 ). Assuming that the firm’s tax rate is 40 percent, calculate the firm’s ROE after the debt has been issued and equity has been repurchased. A. 15.10% * B. 15.47% C. 14.73% D. 15.84% E. 14.36% AT K D = (8.00%)(1-.40) = 4.80% As discussed in class, after the issue and repurchase, the remaining equity shareholders will benefit from both a leverage effect and a tax shelter effect: ROE = 12.80% + (12.80% - 8.00%)(1/3) + (8.00% - 4.80%)(1/3) ROE = 12.80% + 1.60% + 1.07% = 15.47% The following is an illustration with some numbers that were “pulled from the air”: assets of \$1,200, then working backwards from an ROA of 12.80% to get EBIT of \$256.00.

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Old Exam Questions - Cost of Capital - Solutions Page 21 of 42 Pages Assets/Income Without Debt With Debt Assets \$1,200.00 \$1,200.00 Debt (1/4) \$ 0.00 \$ 300.00 Equity \$1,200.00 \$ 900.00 EBIT \$ 256.00 \$ 256.00 Interest (8%) \$ 0.00 - \$ 24.00 EBT \$ 256.00 \$ 232.00 Taxes (40%) - \$ 102.40 - \$ 92.80 Net Income \$ 153.60 \$ 139.20 ROA 12.80% 11.60% ROE 12.80% 15.47%
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