Ch 16 B8_Correct

# Ch 16 B8_Correct - Alternatively rearranging Equation 16.3...

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Chapter 16- B8. Dick’s Pet-Way Corporation is a Chain of pet stores that has an expected cash inflow of \$2,160 each year forever. DPC’s (after-tax) required return is 18% per year. All cash flow streams in this problem are perpetuities, and all of DPC’s income is paid out to the firm’s investors. a) If DPC’s corporate tax rate is 35%, it is all-equity financed and there are no personal taxes, what is DPC worth (after taxes) in an otherwise-perfect capital market? b) Suppose DPC borrows \$4,000 at a debt rate of 12%. What will DPC be worth in an otherwise perfect capital market? c) What will DPC’s WACC be after it borrows the \$4,000 (in part b)? d) What will be the required return on DPC’s equity after it borrows the \$4,000? Book Solution: B8. a. V U = I (1 - T)/r = 2,160 (1 - 0.35)/0.18 = 1,404/0.18 = \$7,800 b. V L = V U + T D = \$7,800 + 0.35 x 4,000 = \$9,200 c. L = D/V L = 4,000/9,200 = 0.4383; and WACC = r(1 – TL) = 0.18(1 - 0.35x0.4383) = 15.2609%

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Unformatted text preview: Alternatively, rearranging Equation 16.3, WACC = 1,404/9,200 = 15.2609% d. Rearranging WACC = (1 - L)r e + L(1 - T)r d , which is Equation 16.1, we have r e = (WACC - L(1 - T)r d )/(1 - L) = (15.2609% - 0.4383(1 - .35)12%)/(1 - .4383) = 21.08% (a more precise answer is 21.00% if you avoid rounding error) Correct Solution : a. V U = I (1 - T)/r = 2,160 (1 - 0.35)/0.18 = 1,404/0.18 = \$7,800 b. V L = V U + T D = \$7,800 + 0.35 x 4,000 = \$9,200 c. L = D/V L = 4,000/9,200 = 0.43478; and WACC = r(1 – TL) = 0.18(1 - 0.35x0.43478) = 15.2609% Alternatively, rearranging Equation 16.3, WACC = 1,404/9,200 = 15.2609% d. Rearranging WACC = (1 - L)r e + L(1 - T)r d , which is Equation 16.1, we have r e = (WACC - L(1 - T)r d )/(1 - L) = (15.2609% - 0.43478(1 - .35)12%)/(1 - .43478) = 21.000% 4000/9200 does NOT equal .4383, it equals .43478. When using the CORRECT weights, the answer will equal 21.000%, not 21.08%....
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## This note was uploaded on 09/18/2011 for the course FIN 303 taught by Professor Bernile during the Spring '11 term at University of Miami.

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Ch 16 B8_Correct - Alternatively rearranging Equation 16.3...

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