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Unformatted text preview: Solutions to Lab Problems for Chapter 20 26. Section: 20.7 The Cost of Capital and Investment Learning Objective: 20.5, 20.6 and 20.7 Level of difficulty: Difficult
Solution:
We must first determine the firm’s cost of equity. We have enough information to
estimate ke using either the CAPM or the constant dividend growth model.
CAPM
ke= RF + B(ERM – RF)
= 0.02 + 2.1(0.1 – 0.02) = 18.80%
Dividend Growth
ke= D1 ÷ P0 + g
= 3(1.04)/25 + 0.04 = 16.48%
We can now estimate the cost of debt from the information given.
I = $1,000[rf + 3%] = 1000(0.05) = $50
kb = (1 – T) × I ÷ NPb = (1 – 0.4) × 50 ÷ 1,000 = 3%
From the ranges of costs we have derived, we can now solve for the firm’s weighted
average cost of capital.
k = B × Ki ÷ V + E × Ke ÷ V
k = 0.35 × 0.03 + 0.65 × 0.1880 = 13.27%
OR
k = 0.35 × 0.03 + 0.65 × 0.1648 = 11.76%
We can now perform a net present value calculation:
NPV = –12 + 2 ÷ 0.1327 = 3.0716 million
NPV = –12 + 2 ÷ 0.1176 = 5.0068 million
The net present value calculations indicate that the project should be undertaken at both
discount rates.
27. Section: 20.7 The Cost of Capital and Investment Learning Objective: 20.5, 20.6 and 20.7 Level of difficulty: Difficult
Solution:
We first compute the costs of each source of funds:
Debt:
NP = $975; Assuming annual coupons I = (0.075)($1,000) = $75; n = 15 So we have: 1 Solving for Ki, as shown in Chapter 6, we get: By financial calculator: PMT = 75(1 –0.45) = $41.25; PV =
975; FV = 1,000; N = 15. Then compute I/Y will give 4.36%, which is the firm’s annual after
tax cost of debt. Preferred: kp = Dp ÷ NPp = 0.05 ÷ 0.95 = 5.26%
Equity: kne = ke × Pe ÷ NPe = (0.15) *(8 × 1.12) / ( 8) = 16.80%
We next compute the market value of each component:
Debt: The market value of debt outstanding is:
B= × 1,800 = $2,197,224 Preferred: The market value is the total dividend payments divided by the market
capitalization rate.
P = 0.06 × ($1,200,000) ÷ 0.05 = $1,440,000
Equity: Shares are currently trading at (8 × 1.12) = $8.96
E = 300,000 ($8.96) = $2,688,000
Note the value of retained earnings is incorporated into the current market price of equity.
Total market value
=V=B+P+E
= $2,197,224 + 1,440,000 + $2,688,000
= $6,325,224
Finally we can compute the weighted average cost of capital: 29. Section: 20.7 The Cost of Capital and Investment Learning Objective: 20.5, 20.6 and 20.7 Level of difficulty: Difficult Solution: a. Cost of LT debt: NP = $996.50; Semi
annual coupons I = (0.115/2)($1,000) = $57.50; n = 25*2 = 50 So we have: Solving for Ki, as shown in Chapter 6, we get: By financial calculator: PMT = 57.50(1
.50) = $28.75; PV =
996.5; FV = 1,000; N = 50. 2 Then compute I/Y will give 2.89%, which is the firm’s semi
annual after
tax cost of debt. So, their annual after
tax cost of debt = (1.0289)2 – 1 = 5.86% b. Cost of Preferred Shares: c. and d. Cost of Common Equity Financing: (i) Dividend Growth Model Approach: (ii) CAPM Approach: E. Using ke, we get: f. g. Since $10m > break point of $6.67m, , and we obtain, 3 ...
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This note was uploaded on 01/10/2012 for the course TEFLER 2350 taught by Professor Rentz during the Winter '11 term at University of Ottawa.
 Winter '11
 Rentz

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