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# WACC and Capital Gains Tax

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12-12A (Weighted average cost of capital). The target capital structure for QM Industries is 40 percent common stock, 10 percent preferred stock, and 50 percent debt. If the cost of equity for the firm is 18 percent, the cost of preferred stock is 10 percent, the before-tax cost of debt is 8 percent, and the firm's tax rate is 35 percent, what is QM's weighted average cost of capital?

10-1B: (Capital gains tax). The R. T. Kleinman Corporation is considering selling one of its old assembly machines. The machine, purchased for \$40,000 five years ago, had an expected life of 10 years and an expected salvage value of zero. Assume Kleinman uses simplified straight-line depreciation, creating depreciation of \$4,000 per year,and could sell this old machine for \$45,000. Also assume a 34 percent marginal tax rate.

A) What would be the taxes associated with this sale?
B) If the old machine were sold for \$40,000, what would be the taxes associated with this sale?
C) If the old machine were sold for \$20,000, what would be the taxes associated with this sale?
D) If the old machine were sold for \$17,000, what would be the taxes associated with this sale?

https://brainmass.com/economics/personal-finance-savings/222560

#### Solution Preview

12-12A
(Weighted average cost of capital) The target capital structure for QM Industries is 40 percent common stock, 10 percent preferred stock, and 50 percent debt. If the cost of equity for the firm is 18 percent, the cost of preferred stock is 10 percent, the before-tax cost of debt is 8 percent, and the firm's tax rate is 35 percent, what is QM's weighted average cost of capital?

Step 1: Calculate the after tax cost of debt

Marginal Tax rate T = 35% (Corporate Tax Rate)
Pre tax cost of debt= kd= 8.00%
After tax cost of debt= kd(1-T)= 5.200% =(100% -35.%)*8.%

Step 2: Calculate the weighted average cost of capital

WACC=proportion of debt x after tax cost of debt + proportion of common stock x cost of common stock + proportion of ...

#### Solution Summary

Calculates WACC and capital gains tax.

\$2.19

## Capital Budgeting - NPV IRR MIRR Payback WACC

Look at a potential new product; a fertilizer that your company's R&D people developed for use on lawns. Your company's marketing manager thinks you can sell 22.500 bags in the first year and that volume will increase by 10% in each year thereafter for the next 3 years after which time the product will become obsolete when replaced by newer cheaper products. The selling price for each 10 lb bag will be 25.95. The required equipment cost is \$165,000, plus another \$30,000 for shipping and installation. Current assets (receivables and inventories) would increase by \$20,000, while current liabilities (accounts payable and accruals) would rise by \$14,000. Variable costs would be 75 percent of sales revenues, fixed costs (exclusive of depreciation) would be \$92,000 per year, and the fixed assets would be depreciated under MACRS with a 5-year life. When production ceases after 4 years, the equipment should have a market value of \$10,000. GroGreen's tax rate is 42 percent, and it uses a 11 percent WACC for average-risk projects.

a. Find the required Year 0 investment, the annual after-tax operating cash flows, and the terminal year cash flow, and then calculate the project's NPV, IRR, MIRR, and payback. Assume at this point that the project is of average risk.

b. Suppose you now learn that R&D costs for the new product were \$30,000, and those costs were incurred and expensed for tax purposes last year. How would this affect your estimate of NPV and other profitability measures?

c. If the new project would reduce cash flows from your company's other fertilizer lines how would those factors affect the project's NPV?

d.Your company currently has an empty building it owns that could house the manufacturing for this production, alternatively they could sell that building if they chose to, and how would those factors affect the project's NPV?

e. The CEO expressed concern that some of the base-case inputs might be too optimistic or too pessimistic, and he wants to know how the NPV would be affected if these 6 variables were all 20% better or 20% worse than the base-case level: unit sales, sales price, variable costs, fixed costs, WACC, and equipment cost. Hold other things constant when you consider each variable, and construct a sensitivity graph to illustrate your results.

f. From the analysis above discuss the sensitivity of the given variables and how they may impact any decisions on this project.

g. Using the guidelines provided in this outline is it wise to proceed with the project? Discuss the outcome of each valuation? What are the risks and potential benefits?

h. Consider what would happen if the credit markets were to falter again suddenly, similar to what happened in the fall of 07, and say that your company now had a cost of capital of 15% as opposed to 11%. Does the decision on the project change, and if so why? Now consider that even given these economic conditions the firm wanted to move forward, how could real options be employed to help improve the financial outlook of this project?

i. Step forward and imagine that the original proposal had been completed and was under review by other department mangers. What if during this process when manufacturing reviewed the initial proposal they felt it may be possible to actually lower the variable cost below 75% to make the fertilizer. They estimated they could lower the VC to 65% through the installation of solar equipment that could be used on the drying lines to make the fertilizer that would speed the process. They estimated additional investment required would be 250,000 for solar equipment and installation, none of which could be recovered in salvage value at the end of the project. Also when marketing reviewed this possibility they estimated that by adding this additional Green's component of solar, base sales in the initial year would be 10% higher than originally estimated. Given these possibilities how could the use of solar on the drying lines impact the analysis? Is it worthwhile to go this Greene's route or is the original proposal better? Explain. Also, are there other considerations your company's managers should be making in regard to this revised proposal?

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