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# Capital Structure, Cost of Capital

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A firm's current balance sheet is as follows:

Assets \$100 Debt \$10
Equity \$90

A. What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?

Debt/Assets After-Tax Cost of Debt Cost of Equity Cost of Capital

0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?

B. Construct a pro forma balance sheet that indicates the firm's optimal capital structure. Compare this balance sheet with the firm's current balance sheet. What course of action should the firm take?

Assets \$100 Debt \$?
Equity \$?

C. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
D. If a firm uses too much debt financing, why does the cost of capital rise?

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#### Solution Preview

Please see attached file:

A firm's current balance sheet is as follows:

Assets \$100 Debt \$10
Equity \$90

A. What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?

Debt / Assets After-Tax Cost of Debt Cost of Equity Cost of Capital
0% 8% 12% 12.00% =0.%x1200.%+(100% - 0.%) x12.%
10% 8% 12% 11.60% =10.%x1200.%+(100% - 10.%) x12.%
20% 8% 12% 11.20% =20.%x1200.%+(100% - 20.%) ...

#### Solution Summary

Answers to questions on Capital Structure, Cost of Capital. It calculates a firm's weighted-average cost of capital at various combinations of debt and equity. It constructs a pro forma balance sheet that indicates the firm's optimal capital structure. It provides answers to what happens to the cost of capital when the firm initially substitutes debt for equity financing and why the cost of capital rises if a firm uses too much debt financing.

\$2.19

## Cost of Capital, Capital Budgeting, Capital Structure, Forecasting, and Working Capital Management

Please see attachment use word or excel but please show how you got the answer.

Question 1: (Cost of Capital)

You are provided the following information on a company. The total market value is \$38 million. The company's capital structure, shown here, is considered to be optimal.
(see attached file for data)

a. What is the after-tax cost of debt? (assume the company's effective tax rate = 40%)
b. Assuming a \$4 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 1%, the expected return on the stock market is 7%, 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)

It's time to decide how to use the money your firm is expected to make this year. Two investment opportunities are available, with net cash flows as follows:
(See attached file for data)

a. Calculate each project's Net Present Value (NPV), assuming your firm's weighted average cost of capital (WACC) is 7%
b. Calculate each project's Internal rate of Return (IRR).
c. Plot NPV profiles for both projects on a graph).
d. Assuming that your firm's WACC is 7%:
(1) If the projects are independent which one(s) should be accepted?
(2) If the projects are mutually exclusive which one(s) should be accepted?

Question 3: (Capital Structure)

Aaron Athletics is trying to determine its optimal capital structure. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
(See attached file for data)

The company's tax rate, T, is 40 percent. The company uses the CAPM to estimate its cost of common equity, Rs. The risk-free rate is 1 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (i.e., its "unlevered beta," bU, equals 1.0.)

On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

Question 4: (Forecasting)

A firm has the following balance sheet:
(See attached file for data)

Sales for the year just ended were \$6,000, 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 20 percent next year, the expected net profit margin is 5 percent, and the dividend payout ratio is 80 percent.

How much additional funds (AFN) will be needed next year, if any?

Question 5: Working Capital Management

The Chickman Corporation has an inventory conversion period of 60 days, a receivables collection period of 30 days, and a payables deferral period of 30 days. Its annual credit sales are \$6,000,000, and its annual cost of goods sold (COGS) is 60% of sales.

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 company's inventory turnover ratio?
d. Identify three ways in which the company could reduce its cash conversion cycle?
e. What are the possible risks of reducing the cash conversion cycle per your recommendations in part d?

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