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# Cost of Capital and Capital Budgeting Problems 1. Assume a corporation has earnings before depreciation and taxes of \$90,000, depreciation of...

Cost of Capital and Capital Budgeting
Problems

1. Assume a corporation has earnings before depreciation and taxes of \$90,000, depreciation of \$40,000, and that it is in a 30 percent tax bracket. Compute its cash flow using the format below.

Earnings before depreciation and taxes _____
Depreciation _____
Earnings before taxes _____
Taxes @ 30% _____
Earnings after taxes _____
Depreciation _____
Cash flow _____

2. a. In problem 1, how much would cash flow be if there were only \$10,000 in depreciation? All other factors are the same.
b. How much cash flow is lost due to the reduced depreciation between problems
1 and 2a?

3. Assume a firm has earnings before depreciation and taxes of \$200,000 and no depreciation. It is in a 40 percent tax bracket.
a. Compute its cash flow.
b. Assume it has \$200,000 in depreciation. Recompute its cash flow.
c. How large a cash flow benefit did the depreciation provide?

4. Bob Cole, the president of a New York Stock Exchange-listed firm, is very short term oriented and interested in the immediate consequences of his decisions. Assume a project that will provide an increase of \$3 million in cash flow because of favorable tax consequences, but carries a three-cent decline in earning per share because of a write-off against first quarter earnings. What decision might Mr. Cole make?

5. Assume a \$100,000 investment and the following cash flows for two alternatives.
Year Investment A Investment B
1 \$30,000 \$40,000
2 50,000 30,000
3 20,000 15,000
4 60,000 15,000
5 — 50,000
Which of the two alternatives would you select under the payback method?

6. X-treme Vitamin Company is considering two investments, both of which cost \$10,000. The cash flows are as follows:
Year Project A Project B
1 \$12,000 \$10,000
2 8,000 6,000
3 6,000 16,000
a. Which of the two projects should be chosen based on the payback method?
b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.
c. Should a firm normally have more confidence in answer a or answer b

7. Rambo Exterminator Company bought a “Bug Eradicator” in April of 2008 that provided
a return of 7 percent. It was financed by debt costing 6 percent. In August, Mr. Rambo came up with an “entire bug colony destroying” device that had a return of 12 percent.
The Chief Financial Officer, Mr. Roach, told him it was impractical because it would require the issuance of common stock at a cost of 13.5 percent to finance the purchase.
Is the company following a logical approach to using its cost of capital?

8. Royal Petroleum Co. can buy a piece of equipment that is anticipated to provide a 9 percent return and can be financed at 6 percent with debt. Later in the year, the firm turns down
an opportunity to buy a new machine that would yield a 16 percent return but would cost
18 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firm’s capital structure.
a. Compute the weighted average cost of capital.
b. Which project(s) should be accepted?

9. Burger Queen can sell preferred stock for \$70 with an estimated flotation cost of \$2.50.
It is anticipated the preferred stock will pay \$6 per share in dividends.
a. Compute the cost of preferred stock for Burger Queen.
b. Do we need to make a tax adjustment for the issuing firm?

10. If risk is to be analyzed in a qualitative way, place the following investment decisions in order from the lowest risk to the highest risk:

a. New equipment.
b. New market.
c. Repair of old machinery.
d. New product in a foreign market.
e. New product in a related market.
f. Addition to a new product line.

Cost of Capital and Capital Budgeting Problems 1. Assume a corporation has earnings before depreciation and taxes of \$90,000, depreciation of \$40,000, and that it is in a 30 percent tax bracket. Compute its cash flow using the format below. Earnings before depreciation and taxes _____ Depreciation _____ Earnings before taxes _____ Taxes @ 30% _____ Earnings after taxes _____ Depreciation _____ Cash flow _____ 2. a . In problem 1, how much would cash flow be if there were only \$10,000 in depreciation? All other factors are the same. b . How much cash flow is lost due to the reduced depreciation between problems 1 and 2a? 3. Assume a firm has earnings before depreciation and taxes of \$200,000 and no depreciation. It is in a 40 percent tax bracket. a . Compute its cash flow. b . Assume it has \$200,000 in depreciation. Recompute its cash flow. c . How large a cash flow benefit did the depreciation provide? 4. Bob Cole, the president of a New York Stock Exchange-listed firm, is very short term oriented and interested in the immediate consequences of his decisions. Assume a project that will provide an increase of \$3 million in cash flow because of favorable tax consequences, but carries a three-cent decline in earning per share because of a write-off against first quarter earnings. What decision might Mr. Cole make? 5. Assume a \$100,000 investment and the following cash flows for two alternatives. Year Investment A Investment B 1 \$30,000 \$40,000 2 50,000 30,000 3 20,000 15,000 4 60,000 15,000 5 50,000 Which of the two alternatives would you select under the payback method? 6. X-treme Vitamin Company is considering two investments, both of which cost \$10,000. The cash flows are as follows:
Year Project A Project B 1.................... \$12,000 \$10,000 2.................... 8,000 6,000 3.................... 6,000 16,000 a . Which of the two projects should be chosen based on the payback method? b . Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent. c . Should a firm normally have more confidence in answer a or answer b 7. Rambo Exterminator Company bought a “Bug Eradicator” in April of 2008 that provided a return of 7 percent. It was financed by debt costing 6 percent. In August, Mr. Rambo came up with an “entire bug colony destroying” device that had a return of 12 percent. The Chief Financial Officer, Mr. Roach, told him it was impractical because it would require the issuance of common stock at a cost of 13.5 percent to finance the purchase. Is the company following a logical approach to using its cost of capital? 8. Royal Petroleum Co. can buy a piece of equipment that is anticipated to provide a 9 percent return and can be financed at 6 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 16 percent return but would cost 18 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firm’s capital structure. a . Compute the weighted average cost of capital. b . Which project(s) should be accepted? 9. Burger Queen can sell preferred stock for \$70 with an estimated flotation cost of \$2.50. It is anticipated the preferred stock will pay \$6 per share in dividends. a . Compute the cost of preferred stock for Burger Queen. b. Do we need to make a tax adjustment for the issuing firm? 10. If risk is to be analyzed in a qualitative way, place the following investment decisions in order from the lowest risk to the highest risk: a. New equipment. b. New market. c. Repair of old machinery. d. New product in a foreign market. e. New product in a related market. f. Addition to a new product line.

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