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CHAPTER 19

# Weknowfrompartathattheformulais

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Unformatted text preview: quity (E) is equal to: 256.2 ´ \$59 = \$15,115.8 so that: V = \$6,268 + \$15,115.8 = \$21,383.8 D/V = \$6,268/\$21,383.8 = 0.293 E/V = \$15,115.8/\$21,383.8 = 0.707 WACC = (0.707 ´ 9.28%) + (0.293 ´ 0.65 ´ 7.4%) = 7.97% b. Step 1. Calculate the opportunity cost of capital. Opportunity cost of capital = r = rD ´ (D/V) + rE ´ (E/V) = 7.4% ´ 0.293 + 9.28% ´ 0.707 = 8.73% Step 2. Estimate the cost of debt and calculate the new cost of equity. Assume that the interest rate on the debt falls to 7.2% so that: rE = r + (r ­ rD) ´ (D/E) = 8.73% + (8.73% ­ 7.2%) ´ (0.25/0.75) = 9.25% Step 3. Recalculate WACC. WACC = (0.75 ´ 9.25%) + (0.25 ´ 0.65 ´ 7.2%) = 8.11% 19. The company weighted­average cost of capital is appropriate for evaluating capital budgeting projects that are exact replicas of the firm as it currently exists. If the project in question is more like the industry as a whole than it is like the company, then the industry weighted­average cost of capital would be a better choice. Challenge Questions 1. a. For a one­period project to have zero APV: Rearranging gives: For a one­period project, the left­hand side of this equation is the project IRR. Also, (D/ ­C0) is the project’s debt capacity. Therefore, the minimum acceptable return is: b. For a company that follows Financing Rule 2, all of the variables in the Miles­Ezzell formula are constant. For example, we know that debt is assumed to be a constant proportion of market value, so tha...
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