chap013- finance

# chap013- finance - Solutions to Chapter 13 The Weighted...

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Solutions to Chapter 13 The Weighted Average Cost of Capital and Company Valuation 1. The yield to maturity for the bonds (since maturity is now 19 years) is the interest rate (r) that is the solution to the following equation: [\$80 × annuity factor(r, 19 years)] + [\$1,000/(1 + r) 19 ] = \$1,050 r = 7.50% Using a financial calculator, enter: n = 19, FV = 1000, PV = (-)1050, PMT = 90, and then compute i = 7.50% Therefore, the after-tax cost of debt is: 7.50% × (1 – 0.35) = 4.88% 2. 3. = [0.3 × 7.50% × (1 – 0.35)] + [0.2 × 10%] + [0.5 × 12.0%] = 9.46% 4. 5. The total value of the firm is \$80 million. The weights for each security class are as follows: Debt: D/V = 20/80 = 0.250 Preferred: P/V = 10/80 = 0.125 Common: E/V = 50/80 = 0.625 = [0.250 × 6% × (1 – 0.35)] + [0.125 × 8%] + [0.625 × 12.0%] = 9.475% 13-±

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6. Executive Fruit should use the WACC of Geothermal, not its own WACC, when evaluating an investment in geothermal power production. The risk of the project determines the discount rate, and in this case, Geothermal’s WACC is more reflective of the risk of the project in question. The proper discount rate, therefore, is not 12.3%. It is more likely to be 11.4%. 7. a. The weighted average cost of capital, with a tax rate of 40%, is: = [0.30 × 6% × (1 – 0.40)] + [0.70 × 11%] = 8.78% Free cash flow next year is: \$68 million – \$30 million = \$38 million Since the cash flows are in the form of a growing perpetuity, with a growth rate of 4%, the total value of Icarus is: million b. Since management will maintain the company’s debt at 30% of the present value of the company, the company’s equity is: 0.70 × \$795 million = \$389.55 million 8. The rate on Buildwell’s debt is 5 percent. The cost of equity capital is the required rate of return on equity, which can be calculated from the CAPM as follows: 4% + (0.90 × 8%) = 11.2% The weighted average cost of capital, with a tax rate of 40%, is: = [0.30 × 5% × (1 – 0.40)] + [0.70 × 11.2%] = 8.74% 9. The internal rate of return, which is 12%, exceeds the cost of capital. Therefore, BCCI should accept the project. The present value of the project cash flows is: \$100,000 × annuity factor(8.74%, 8 years) = This is the most BCCI should pay for the project. 13-±
10. Line numbers in the table below are from the text: Year 1 2 3 4 3. EBITDA 80 100 115 120 4. Depreciation 20 30 35 40 5. Profit before tax = 3 – 4 60 70 80 80 6. Tax at 40% 24 28 32 32 7. Profit after tax = 5 – 6 36 42 48 48 8. Operating cash flow = 4 + 7 56 72 83 88 9. Investment 12 15 18 20 10. Free cash flow = 8 – 9 44 57 65 68 Since free cash flow from year 5 onward will remain unchanged at year-4 levels, the horizon value at year 4 is: million The company’s total value is: million Since the capital structure is 30% debt, the value of the firm’s debt is: 0.30 × \$744.3 million = \$223.3 million The value of the equity is: 0.70 × \$744.3 million = \$521.0 million

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## chap013- finance - Solutions to Chapter 13 The Weighted...

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