Purchase Solution

# Cost of Capital, Leverage Questions

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41.) A corporation has decided to replace an existing asset with a newer model. The new asset will cost \$70,000. The original asset, when purchased cost \$10,000, was being depreciated under a straight line methodology, using a five-year recovery period, and has been depreciated for four full years. The existing asset can be sold for \$8,000. If the assumed tax rate is 40 percent on ordinary income and capital gains, what is the initial investment?

42.) Cullum Creations produces hand warmers, selling 400,000 warmers a year. Each warmer produced has a variable operating cost of \$0.84 and sells for \$1.00. Fixed operating costs are \$28,000. The firm has annual interest charges of \$6,000, preferred dividends of \$2,000, and a 40% tax rate.

Calculate the operating breakeven point in units
Use the degree of operating leverage (DOL) formula to calculate DOL.
Use the degree of financial leverage (DFL) formula to calculate DFL.
Use the degree of total leverage (DTL) formula to calculate DTL.

43.) Jones Corp uses a cost of capital of 14% to evaluate average risk projects and adds/subtracts 2% points to evaluate projects of greater/lesser risk. Currently two mutually exclusive projects are under consideration. Both have a net cost of \$240,000 and last four years. Project A, which is riskier than average, will produce cash flows of \$97,000 each year. Project B, which is a less-than-average risk, will produce net cash flows of \$196,000 in years 3 and 4 only. What should Jones do?

44.) Ajax, Inc. has common stock outstanding that has a market price of \$48 per share. Last year's dividend was \$2.25 and is expected to grow at a rate of 4% per year, forever. The expected risk-free rate of interest is 2%, and the expected market premium is 5.5%. The company's beta is 1.2.
A) What is the cost of equity for Ajax using the dividend valuation model?
B.) What is the cost of equity for Ajax using the capital asset pricing model (CAPM)?

5.) Alpha, Inc. is expecting to issue new debt at par with a coupon rate of 6%, and to issue new preferred stock with a \$2.00 per share dividend at \$20 a share. Common stock is currently selling for \$25 a share. Alpha expects to pay a dividend of \$2.50 per share next year, and a market analysis indicates dividends will grow at a rate of 3% per year. The marginal tax rate is 40%.

A) What is the cost of debt, cost of preferred stock and cost of common stock?

B) If Alpha raises capital using a capital structure of 40% debt, 10% preferred stock and 50% common stock, what is the cost of capital for Alpha, Inc.?

**PLEASE SHOW ALL CALCULATIONS FOR ALL PROBLEMS

##### Solution Summary

Answers questions on Capital Budgeting, Leverage, Cost of Capital.

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41.) A corporation has decided to replace an existing asset with a newer model. The new asset will cost \$70,000. The original asset, when purchased cost \$10,000, was being depreciated under a straight line methodology, using a five-year recovery period, and has been depreciated for four full years. The existing asset can be sold for \$8,000. If the assumed tax rate is 40 percent on ordinary income and capital gains, what is the initial investment?

Cost of Original asset= \$10,000
Annual Depreciation using straight line method= (Initial Value - Estimated Residual Value)/ Useful life

Initial Value= \$10,000
Estimated Residual Value= \$0 (since no data is given on salvage value, assume it to be zero)
Useful Life= 5 years
Therefore, annual depreciation= \$2,000 =(\$10,000. - \$.) / 5
Total Depreciation for 4 years= \$8,000 =4 x \$2,000.
Therefore Book value of equipment at the end of = 4 years= \$2,000 =\$10,000. - \$8,000.

Sale price of equipment= \$8,000
Book value of equipment= \$2,000
Gain on sale of equipment= \$6,000
Tax rate= 40%
Tax= \$2,400 =40.% x \$6,000
Therefore, After tax cash flow on sale of equipment : \$5,600 =\$8,000.-\$2,400.

Initial Investment:
Purchase of new equipment= \$70,000
After tax cash flow on sale of equipment : \$5,600
Therefore, Initial Investment= \$75,600 =\$70,000. + \$5,600.

42.) Cullum Creations produces hand warmers, selling 400,000 warmers a year. Each warmer produced has a variable operating cost of \$0.84 and sells for \$1.00. Fixed operating costs are \$28,000. The firm has annual interest charges of \$6,000, preferred dividends of \$2,000, and a 40% tax rate.

Calculate the operating breakeven point in units

# of units= 400000
Selling Price= \$1.00 per unit
Variable cost= \$0.84 per unit
Fixed Operating Cost= \$28,000
Interest= \$6,000
Preference Shares Dividends= \$2,000
Tax Rate= 40%

Contribution margin per unit = Selling price per unit - variable cost per unit

Selling Price= \$1.00 per unit
Variable cost= \$0.84 per unit
Therefore Contribution margin per unit= \$0.16 per unit =\$1.-\$.84

Operating Break even units= Fixed Cost / Contribution margin per unit= 175,000 =\$28,000 / ...

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