# WACC, Required Return on Equity, CAPM, IRR & Present Value

WACC: Common stock of the company KewCo. has a beta of 1.3. Treasury Bills provide a return of 4% and the market risk premium is 16%. Suppose KewCo. total value is composed of 60% equity and 40% debt (by market value). Debt yields of 8%. There are no shares of preferred stock in circulation.

a. Find the cost of equity capital for KewCo

b. Suppose KewCo. has a total value, V of $1,000,000,000. If there are 15,000,000 shares of KewCo stock outstanding, what is the current price of a share of KewCo equity?

c. What is the WACC if the firm faces an average tax rate of 40%

d. Suppose KewCo is considering a project with an IRR of 12%, should it accept the project? Why or why not?

e. Suppose KewCo is considering a product line that will provide expected new net cash flows of $100,000 per year for 4 years. What is the maximum amount KewCo would be willing to pay for this new product line today?

In excel format.

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#### Solution Summary

The solution provide a classic example to compute cost of equity, cost of debt, WACC, share price, whether to accept project based on IRR and present value of new cash flows for a project. Attached in Excel.

Corporate Finance TF: Diversification, CAPM, NPV, IRR, MIRR, Risk, WACC, equity

True/False questions:

T F 1. Diversification eliminates unsystematic risk. (According to portfolio the theory and CAPM.)

T F 2. With as little as 10 or less securities, we can eliminate a significant portion of diversifiable risk or unsystematic risk. (According to portfolio the theory and CAPM.)

T F 3. The greater the risk of expected cash inflows, the lower the discount rate we should use to determine the net present value (NPV).

T F 4. The Modified Internal Rate of Return (MIRR) assumes that a project's cash inflows will be reinvested at the project's internal rate of return.

T F 5. Using the CAPM to estimate the cost of equity capital assumes only systematic risk is relevant in the pricing of risky assets.

T F 6. The greater the beta of a company, the higher its cost of equity capital, if everything else holds equal. (According to portfolio the theory and CAPM.)

T F 7. An increase in perceived risk (i.e. market risk) will cause the price of a risky asset to decline.

T F 8. Earning an economic rate of return that is greater than the cost of capital will create a value.

T F 9. The greater the default risk premium, the greater the required rate of return on debt.

T F 10. The risk (and after-tax cost) to holders or owners of preferred stock is higher or greater than the risk to owners of debt in the same company.

T F 11. An increase in economic or political risk in a country would increase the cost of capital to companies in that country.

T F 12. The weighted average cost of capital falls as the firm increases the debt/equity ratio toward its optimal capital structure because investors value the tax deductibility of interest.

T F 13. The greater the uncertainty about a company's net operating income or EBIT, the greater the variability of its free cash flows.

T F 14. According to maturity-matching principle long-term (permanent) assets should be financed with long-term sources of capital.

T F 15. In ranking good independent projects, we should rank projects from highest to lowest internal rate of return.

T F 16. Equity represented by retained earnings has a lower cost that equity from newly issued stock.

T F 17. An increase in the financial risk of a company would cause its optimal debt/equity ratio to decrease.

T F 18. Equity or stockholders have greater risk than creditors of the same company.

T F 19. An increase in the variable cost per unit will increase the (accounting) break-even point for the company.

T F 20. Speeding up the cash inflows (i.e. getting the cash flows earlier in time) that we receive from a project will increase the project's NPV.

T F 21. The greater the debt/equity ratio, the greater the cost of levered equity, if everything else holds equal (according to the MM theory).

T F 22. An increase in liquidity (i.e., a reduction in trading costs) lowers a firm's cost of capital.

T F 23. The relationship between fixed and variable costs in production results in operating leverage.

T F 24. Retained earnings have a cost that represents an opportunity cost if earnings are reinvested

T F 25. Interest paid by corporation is a tax deduction for the paying corporation, but dividends paid are not deductible.

T F 26. Retained earnings are the cash that has been generated by the firm through its operations which has not been paid out to stockholders as dividends.

T F 27. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.

T F 28. Since capital gains can be deferred, the tax rate on dividends is greater than the effective tax rate on capital gains.

T F 29. On its 1999 balance sheet, Sherman Books showed a balance of retained earnings equal to $510 million. On its 2000 balance sheet, the balance of retained earnings was also equal to $510 million. If the company's net income was $200 million, the dividend paid must have also equaled $200 million.

T F 30. The stand-along risk is the project's risk if it were the firm's only asset.

T F 31. Free cash flow is the amount of cash flow available for distribution to all investors after making all necessary investments (in fixed assets and working capital) to support operations.

T F 32. Net operating working capital (NOWC) is equal to the operating current assets minus the operating current liabilities.

T F 33. Net operating profit after taxes (NOPAT) is the amount of profit a company would have from its operations if it had no interest income or interest expenses.

T F 34. The higher the assets to sales ratio (i.e. the capital intensity ratio) the more additional funds needed to support a growth in sales.

T F 35. An equal percentage increase or decrease in the required market return on a bond will have an unequal dollar change in the market price of the bond.

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