Question 1: (Cost of Capital)
You are provided the following information on a company. The total market value is $40 million. The capital structure, shown here, is considered to be optimal.
Accounting Value Market Value
Bonds, $1000 par, 7% coupon, 7% YTM $10,000,000 $10,000,000
Preferred Stock, 7%, $100 par, 100,000 shares $10,000,000 $8,000,000
Common Stock, $1 par, 100,000 shares $100,000
Capital in excess of par $400,000 $22,000,000 *
Retained Earnings $13,500,000
* Total market value of common equity
a. What is the after-tax cost of debt? (assume the company's effective tax rate = 40%)
b. Assuming a $7 dividend paid annually, what is the required return for preferred shareholders (i.e. component cost of preferred stock)? (assume floatation costs = $0.00)
c. Assuming the risk-free rate is 3%, the expected return on the stock market is 12%, and the company's beta is 1.0, what is the required return for common stockholders (i.e., component cost of common stock)?
d. What is the company's weighted average cost of capital (WACC)?
Question 2: (Capital Budgeting)
The Seattle Corporation has been presented with an investment opportunity which will yield end-of-year cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10 percent.
b. Should the project be accepted or rejected?
Question 3: (Capital Structure)
You have the following data on Joe's Corporation:
Tax rate: 40%
Cost of Equity: 10% (before borrowing) 12% (after borrowing)
Joe's is a zero growth firm, and is currently financed entirely with equity (in other words, it currently has no debt).
One of the corporate officers has suggested that since interest rates are so low, Joe might be better off if he borrowed some money and used it to buy back stock, thereby making use of debt financing in the firm. He presents the following data in his analysis:
Amount of debt proposed: $1,000,000
Interest rate: 6%
Cost of equity after the proposal is adopted: 12%
Joe has come to you for advice. Prepare an analysis for him that indicates whether or not the proposal should be accepted.
(Hint: Compare the value of the firm with no debt and at the proposed debt level similar to the way you did it in homework problem 16-9, but note the amount to borrow is given.)
Question 4: (Forecasting)
A firm has the following balance sheet:
Cash $ 20 Accounts payable $ 20
Accounts receivable 20 Notes payable 40
Inventory 20 Long-term debt 80
Fixed assets 180 Common stock 80
Retained earnings 20
Total assets $240 Total liabilities & Equity $240
Sales for the year just ended were $400, and fixed assets were used at 80 percent of capacity. Current assets and accounts payable vary directly with sales. Sales are expected to grow by 5 percent next year, the expected net profit margin is 5 percent, and the dividend payout ratio is 60 percent.
How much additional funds (AFN) will be needed next year, if any?
Question 5: Working Capital Management
The Hamlin Corporation has an inventory conversion period of 57 days, a receivables collection period of 35 days, and a payables deferral period of 25 days. Its annual credit sales are $5,000,000, and its annual credit purchases are $3,500,000.
a. What is the length of the firm's cash conversion cycle?
b. What is the firm's investment in accounts receivable?
c. What is the firm's level of accounts payable?
d. Calculate how many times a year the company's inventory is turned over.
e. Identify three ways in which the company could reduce its cash conversion cycle? What are possible risks in reducing it?
The solution explains some finance questions relating to cost of capital, capital budgeting, capital structure, forecasting and working capital