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Brooks Window Shielde, and DNA Labs accept the projects

1. The ABC Co. has no debt in its capital structure, a beta of 0.8, and raises all funds through sale of common stock. The current market rate for similar stock is 14% and the risk-free rate is 6%. The firm is considering a project with a return of 12.9%. Should it accept the project, and if so why (Show all work).

2. You have determined the profitability of a planned project by finding the present value of all the cash flow from that project. Which of the following would cause the project to look less appealing, that is, have a lower present value?

a.The discount rate decrease.
b. The Cash flows are extended over a longer period of time.
c. The discount rate increase.
d. B and C are both correct,
e. A and B are both correct.

3. Brooks Window Shielde, Inc. is trying to calculate its cost of capital for use in a capital budgeting decision. Ms. Glass, the vice president of finance, has given you the following information and has asked you to compute weighted average cost of capital.

The company currently has outstanding a bond with an 11.2 percent coupon rate and another bond with a 7.5 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 12.4 percent.

The common stock has a price of $54 and an expected dividend (D1) of $2.70 per share. The firm's historical growth rate of earnings and dividends per share has been 14.5 percent, but security analysts on Wall Street expect this growth to slow to 12 percent in future years.

The preferred stock is selling at $50 per share and carries a dividend of $4.75 per share. The corporate tax rate is 35 percent. The flotation cost is 2.8 percent of the selling price for preferred stock. The optimum capital structure for the firm seems to be 35 percent debt, 10 percent preferred stock, and 55 percent common equity in the form of retained earnings.

Compute the cost of capital for the individual components in the capital structure, and then calculate the weighted average cost of capital.

4) DNA Labs, Inc. has a $1,000 convertible bond outstanding that can be converted into 40 shares of common stock. The common stock is currently selling for $26.75 a share and the convertible bond is selling for $1,118.50.

a.What is the conversion value of the bond?
b.What is the conversion premium?
c.What is the conversion price?

Solution Preview

See attached file where formatting has been conserved
1. The ABC Co. has no debt in its capital structure, a beta of 0.8, and raises all funds through sale of common stock. The current market rate for similar stock is 14% and the risk-free rate is 6%. The firm is considering a project with a return of 12.9%. Should it accept the project, and if so why (Show all work).

We first calculate the required return on ABC Co stock using CAPM

CAPM (Capital Asset Pricing Model) equation is:
r A= r f + beta A (r m - r f)

risk free rate= r f = 6%
beta of stock= beta A= 0.8
return on market portfolio= r m = 14%
(I am assuming that " The current market rate for similar stock is 14%" implies that the return on market portfolio is 14%)
required return on stock r A = to be determined
Plugging in the values
r A = 12.4 % =6.%+0.8 x ( 14.% - 6.% )

Since the required rate of return @ 12.4 % is less than the project return of 12.90% ,accept the project

2. You have determined the profitability of a planned project by finding the present value of all the cash flow from that project. Which of the following would cause the project to look less appealing, that is, have a lower present value?
a.The discount rate decrease.
b. The Cash flows are extended over a longer period of time.
c. The discount rate increase.
d. B and C are both correct,
e. A and B are both correct.

Answer:
d. B and C are both correct,

Explanation:
a.The discount rate decrease.
This would cause the present value to increase. The lower the discount rate, the higher the present value

b. The Cash ...

Solution Summary

The solution answers questions on acceptance of projects, profitability of a planned project, cost of capital, Convertible bond (conversion value of the bond, conversion premium, conversion price) in an attached Excel file.

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