Finance 3200 sheet 1
Fin 3322
Cost of Capital Homework
1. Suppose Garageband.com has a 28% cost of equity capital and a 10% cost of debt capital. The firm’s debt-to-equity ratio is 1.5. Garageband is interested in investing in a telecomm project that will cost $1,000,000 and will provide $600,000 annually for the next 4 years. Given the project is an extension of their current operations, what is the net present value of the this project if the corporate tax rate is 35.
D/E = 1.5, D/V = 1.5/2.5, E/V = 1/2.5, re = 28%, rd = 10%
WACC = (1.5/2.5)*0.10*(1-0.35) + (1/2.5) *0.28 = 15.1%
FV = 0, PMT = 600,000, n =4, r = 15.1% → PV = 1,709,527.73
NPV = 1,709,527.73-1,000,000.00 = 709,527.73
Take the project
2. Suppose the market value of a firm’s equity is worth $100m and the market value of its debt is worth $50m. Also, assume equity beta and debt beta to be 1.2 and 0.3 respectively. Return on debt is 6%. If the market risk premium is 10% and the risk free rate is 3%, calculate:
a) Expected return on equity
0.03 + 1.2(0.10) = 15%
b) WACC using the return on equity from above and the return on debt.
(100/150)*0.15 + (50/150)*0.06 = 12%
c) Asset beta using the equity beta and debt beta.
(100/150)*1.2 + (50/150)*0.3 = 0.9
Suppose the firm discussed above decides to alter its capital structure by repurchasing $20m in equity. It repurchases the $20m in equity by raising $20m in debt. Assume that the debt beta increases to 0.5
d) What is the market value of the firm?
150: The value of the company will not change
e) What is the asset beta?
0.9: The beta of the assets will not change
f) What is the new equity beta? 0.9 = (80/150)*X + (70/150)*.5 0.9 = 0.533X + 0.466*0.5 0.666666 = 0.533X → βe = 1.25
g) What is the return on equity?
E(re) = 0.03 + 1.25*(0.10) = 15.5%
3. The book value of Luxury’s outstanding debt is $60 million. Currently, the debt is trading at 120% of book value and the
Cost of Capital Homework
1. Suppose Garageband.com has a 28% cost of equity capital and a 10% cost of debt capital. The firm’s debt-to-equity ratio is 1.5. Garageband is interested in investing in a telecomm project that will cost $1,000,000 and will provide $600,000 annually for the next 4 years. Given the project is an extension of their current operations, what is the net present value of the this project if the corporate tax rate is 35.
D/E = 1.5, D/V = 1.5/2.5, E/V = 1/2.5, re = 28%, rd = 10%
WACC = (1.5/2.5)*0.10*(1-0.35) + (1/2.5) *0.28 = 15.1%
FV = 0, PMT = 600,000, n =4, r = 15.1% → PV = 1,709,527.73
NPV = 1,709,527.73-1,000,000.00 = 709,527.73
Take the project
2. Suppose the market value of a firm’s equity is worth $100m and the market value of its debt is worth $50m. Also, assume equity beta and debt beta to be 1.2 and 0.3 respectively. Return on debt is 6%. If the market risk premium is 10% and the risk free rate is 3%, calculate:
a) Expected return on equity
0.03 + 1.2(0.10) = 15%
b) WACC using the return on equity from above and the return on debt.
(100/150)*0.15 + (50/150)*0.06 = 12%
c) Asset beta using the equity beta and debt beta.
(100/150)*1.2 + (50/150)*0.3 = 0.9
Suppose the firm discussed above decides to alter its capital structure by repurchasing $20m in equity. It repurchases the $20m in equity by raising $20m in debt. Assume that the debt beta increases to 0.5
d) What is the market value of the firm?
150: The value of the company will not change
e) What is the asset beta?
0.9: The beta of the assets will not change
f) What is the new equity beta? 0.9 = (80/150)*X + (70/150)*.5 0.9 = 0.533X + 0.466*0.5 0.666666 = 0.533X → βe = 1.25
g) What is the return on equity?
E(re) = 0.03 + 1.25*(0.10) = 15.5%
3. The book value of Luxury’s outstanding debt is $60 million. Currently, the debt is trading at 120% of book value and the