# Finance 3200 sheet 1

**Topics:**Weighted average cost of capital, Stock, Net present value

**Pages:**6 (800 words)

**Published:**November 24, 2013

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 yield-to-maturity is 12%. The 5 million outstanding shares of Luxury stock are selling for $20 per share. The required return on Luxury stock is 18%, and the tax rate is 25%. Calculate the weighted average cost of capital for the Luxury Porcelain Company.

D = 60*1.20 = 72, E = 5*20 =100, Firm Value = 172

WACC = (72/172)*0.12*(1-0.25) + (100/172)*0.18

WACC = 0.037674 + 0.104657

WACC = 14.23%

4. The equity beta for Adobe Online Company is 1.29. Adobe Online has a debt-to-equity ratio of 1.0. The expected return on the market is 13%. The risk free rate is 7%. The cost of debt capital is 7%. The corporate tax rate is 35%.

a) What is Adobe Online’s cost of equity?

Cost of Equity = Rf + βe * (RM - Rf)

Cost of Equity = 0.07 + 1.29*(0.13-0.07) = 0.1474 = 14.74%

b)What is Adobe Online’s WACC?

B/S = 1

Thus B/(S+B) = S/(S+B) = 0.5

WACC = 0.5*(1-0.35)*0.07 + 0.5*0.1474 = 0.09645 = 9.65%

5. Calgary Industries, Inc., is considering a new project that costs $25 million. The project will generate after-tax (year-end) cash flows of $7 million for five years. The firm has a debt-to-equity ratio of 0.75. The cost of equity is 15% and the cost of debt is 9%. The corporate tax rate is 35%. It appears that the project has the same risk as the overall firm. Should Calgary take on the project? (Please show your calculations)

B/S = 0.75

B/(S+B) = 3/7

S/(S+B) = 4/7

WACC = (3/7)*0.09 + (4/7)*0.15 = 0.1243 = 12.43%

Year

Cash Flow

Discounted Cash Flow

0

-25

-25

1

7

6.226175

2

7

5.537894

3

7

4.9257

4

7

4.381182

5

7

3.896858

Project’s NPV = -$32,190.60

Calgary Industries Inc pass on the project.

6.Mercer Inc has three operating divisions:

Division

Percentage of Firm value

Frozen foods

20

fresh foods

30

Not so fresh foods

50

The firm wants to find the cost of capital for each division. It has identified the following three competitors:

Competitor for

the division:

Estimated equity beta

of...

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