# Cost of Capital Problems

1.(Defining Capital structure weights)Company is considering the acquisition of a chain of cemeteries for $430 million. Since the primary asset of this business is real estate, the company?s management has determined that they will be able to borrow the majority of the money needed to buy the business. The current owners have no debt financing but Templeton plans to borrow $310 million and invest only $120 million in equity in the acquisition. What weights should the company use in computing the WACC for this acquisition?

The appropriate w/d weight is ________% (Round to tow decimal places)

1a. Same example different numbers: Acquisition for $230 million/borrow $260 million/invest $90 million.

The appropriate w/d weight is _________% (Round to tow decimal places)

2.(Individual or component cost of capital) Compute the cost of capital for the firm for the following:

A bond that has a $1,000 per value (face value) and a contract or coupon interest rate of 10.9%. The bonds have a current market value of $1,126 and will mature in 10 years. The firm?s marginal tax rate is 34%.

The cost of capital from this bond is ______% (Round to tow decimal places)

2a. Same example different numbers: $1,000 per value/10.6%/market value $1,122

The cost of capital from this bond debt is _______% (Round to two decimal places)

3. (Individual or component cost of capital) Your firm is considering a new investment proposal and would like to calculate its weighted average cost of capital. To help with this, compute the cost of capital for the firm the following:

A bond that has a $1,000 per value (face value) and a contract or coupon interest rate of 10.9%. The bonds have a current market value of $1,126 and will mature in 10 years. The firm?s marginal tax rate is 34%.

The cost of capital from this bond debt is _______% (Round to two decimal places)

3a. Same scenario different numbers: $1,000 per value/11.3%/market value $1,128

The cost of capital from this bond debt is _______% (Round to two decimal places)

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Integrative Problem Chapter 22 Questions and Chapter 21 problem #3

Integrative Problem Chapter 22 Questions

1. You purchase machinery for $23,958 that generates cash flow of $6,000 for five years. What is the internal rate of return on the investment?

2. The cost of capital for a firm is 10 percent. The firm has two possible investments with the following cash inflows:

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A B

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Year 1 $300 $200

2 200 200

3 100 200

a. Each investment costs $480. What investment(s) should the firm make according to net present value?

b. What is the internal rate of return for the two investments?

Which investment(s) should the firm make?

Is this the same answer you obtained in part a?

c. If the cost of capital rises to 14 percent, which investment(s) should the firm make?

3) A firm has the following investment alternatives:

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Cash Inflows

A B C

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Year 1 $1,100 $3,600 -

2 1,100 - -

3 1,100 - $4,562

Each investment costs $3,000; investments B and C are mutually exclusive, and the firm's cost of capital is 8 percent.

a. What is the net present value of each investment?

b. According to the net present values, which investment(s) should the firm make?

Why?

c. What is the internal rate of return on each investment?

d. According to the internal rates of return, which investment(s) should the firm make?

Why?

e. According to both the net present values and internal rates of return, which investments should the firm make?

f. If the firm could reinvest the $3,600 earned in year one from investment B at 10 percent, what effect would that information have on your answer to part e?

Would the answer be different if the rate were 14 percent?

g. If the firm's cost of capital had been 10 percent, what would be investment A's internal rate of return?

h. The payback method of capital budgeting selects which investment?

Why?

4. The chief financial officer has asked you to calculate the net present values and internal rates of return of two $50,000 mutually exclusive investments with the following cash flows:

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Project A Project B

Cash Flow Cash Flow

Year 1 $10,000 $ 0

2 25,000 22,000

3 30,000 48,000

If the firm's cost of capital is 9 percent, which investment(s) would you recommend?

Would your answer be different if the cost of capital were 14 percent?

Chapter 21

3. A firm's current balance sheet is as follows:

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Assets $100 Debt $10

Equity $90

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

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

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0% 8% 12% ?

10 8 12 ?

20 8 12 ?

30 8 13 ?

40 9 14 ?

50 10 15 ?

60 12 16 ?

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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?

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Assets $100 Debt $?

Equity $?

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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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