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Unformatted text preview: W EEK F IVE H OMEWORK S OLUTIONS The problems below represent the textbook version of the assignment and may differ slightly from the Quizzes version. However, these are more inclusive of the topics and solving them as presented here will give you the information needed to enter the solutions in the Quizzes . Problem 11-2 Speedy Delivery Systems can buy a piece of equipment that is anticipated to provide an 8 percent return and can be financed at 5 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 15 percent return but would cost 17 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firms capital structure. a. Compute the weighted average cost of capital. b. Which project(s) should be accepted? The Solution Part a The Weighted Average Cost of Capital (WACC) is simply the cost of each type of capital times its weight in the capital structure. We are told we can finance the first project with debt at 5%, so we have to assume for this problem this is an after-tax cost of debt. In this problem we have only two sources of capital (debt and common equity) so our formula is: WACC = [ D * r debt ] + ( E * r equity ) V V WACC = 50% * 5% + 50% * 17% WACC = 0.50 * 0.05 + 0.50 * 0.17 WACC = 0.1100 = 11.00% Part b We would only want to accept a project if its return exceeds our WACC in this case, we only want projects with a return exceeding 11.00%. The second project (the new machine with a return of 15%) is the only one of the two we would accept. Notice this is different from what we would have thought just by glancing at the problem a quick look would lead us to believe the first project (with a cost of 5% and a return of 8%) would be the one we would accept. However, it fails to meet our WACC, meaning the true cost of the projects funding. Problem 11-12 Kerr-McGee Corp. is planning to issue debt that will mature in 2027. In many respects the issue is similar to currently outstanding debt of the corporation. Using Table 11-2, identify: is similar to currently outstanding debt of the corporation....
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- Fall '09