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Defining the Cost of Capital, Risks, Rates, and Depreciation

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1. Cost of Capital - If you were going to start a company, let's say a restaurant, and I was going to take $400,000 to get it opened, how would you finance the initial investment? Things to consider are debt, equity, terms, and sources.
2. Risk & Return - Given that you know the risk as well as the expected return for two stocks, discuss what process you might utilize to determine which of the two stocks is better to buy.
3. Hurdle Rate - Explain why the cost of capital is referred to as the "hurdle" rate in capital budgeting.
4. Cost Structure - You own a firm with a single new product that is about to be introduced to the public for the first time. Your marketing analysis suggests that the annual demand for this product could be anywhere between 500,000 units and 5,000,000 units. Given such a wide range, discuss the safest cost structure alternative for your firm.
5. Depreciation - How is the MACRS depreciation method under IRS rules different from the straight-line depreciation allowed under GAAP rules? What is the implication on incremental after-tax free cash flows from firms' investments?
6. Call Option - What variables affect the value of a call option?

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Solution Summary

This solution provides explanations for the following concepts: cost of capital, risk and return, hurdle rate, cost structure, depreciation, and call option.

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Financial management

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Multiple Choice (also attached)

1. The following data is associated with a proposed new project:
The initial cost of the project is estimated to be $15,000; the project's estimated life is 5 years; depreciation is based on a five-year straight line method; there will be initial increases of $1,000 in the levels of inventory and accounts receivable; the project's annual estimated pre-tax earnings (without regard to depreciation) are $6,000; the cost of capital is 16 percent; and the corporate tax rate is 34 percent. At the end of the project's life there will be a corresponding decrease in the levels of inventory and accounts receivable, with a reversion to cash of the original $1,000. The NPV for the project is:

a. $4,122.
b. $782.
c. $306.
d. ($9,041).

2. Whereas business risk arises through a variation in a firm's operating performance as measured by EBIT and financial risk is the variation in ROE and EPS arising from financial leverage:

a. the variation in ROE and EPS for an un leveraged firm is identical to its variation in EBIT.
b. in a leveraged firm, the variation in ROE and EPS is always greater than the variation in EBIT.
c. financial risk is the additional variation in ROE and EPS arising from the use of financial leverage.
d. all of the above

3. Following are the cash flows of a proposed stand-alone capital project being considered: (see attachment)
With a cost of capital of 12 percent, the net present value of this proposed investment is:
a. ($22,899).
b. ($17,284).
c. ($7,647).
d. $9,435.

4. Assume you are an American BMW dealer and the most recent direct quote for deutsche marks is .6959. If you were to import a BMW 525i with a cost of 45,983 deutsche marks, you would pay U.S. dollars in the amount of:
a. $66,078.
b. $32,000.
c. $69,590.
d. none of the above

5. Whereas financial leverage involves substituting debt for equity in the firm's capital structure, operating leverage involves.
a. substituting variable costs for fixed costs.
b. substituting fixed costs for variable costs.
c. incrcased financial risk.
d. none of the above

6. Assume a firm has 20-year, 8 percent coupon bonds with a current market yield of 10 percent. With a combined federal and state corporate tax rate of 40 percent, the firm's after-tax cost of debt is:
a. 3.2%.
b. 4.0%.
c. 4.8%.
d. 6.0%.

7. Assume the following information about a firm's capital components: (see attachment)
The firm's WACC is:
a. 11.00%.
b. 11.90%.
c. 12.20%.
d. 12.05%.

8. Consider the following facts about a firm: (see attached)
At what level in EBIT would the firm be encouraged to undertake the additional debt being contemplated, assuming no likely variability of earnings?
a. $50,000
b. $100,000
c. $200,000
d. none of the above

9. The management of a target company would not undertake which of the following defensive tactics if a takeover was already underway?
a. issue debt and repurchase its own shares
b. adopt poison pills
c. take antitrust action
d. seek a white knight

10. A merger of two airline companies is an example of:
a. a vertical merger.
b. a product extension merger.
c. a conglomerate merger.
d. a horizontal merger.

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