# Cost of Capital Problem

Current Balance Sheet

Assets $100 Debt $10

Equity $90

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% ?

What is the firm's weighted-average cost of capital at various combinations of debt and

equity, given the above information?

cost of capita (k) = (weight) (cost of dept) + (weight) (cost of equity)

k = (0) .08 + (0) .12 = 0 IS THIS CORRECT

Construct a pro forma balance sheet that indicated the firms 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 $ ?

As a firm initially substitues debt for equity what happens to the cost of capital, and why?

If a firm uses too much debt financing, why does the cost of capital rise?

How would I go about this problem?

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#### Solution Preview

Current Balance Sheet

Assets $100 Debt $10

Equity $90

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

0% 8% 12% 12%

10% 8% 12% 11.60%

20% 8% 12% 11.20%

30% 8% 13% 11.50%

40% 9% 14% 12%

50% 10% 15% 12.50%

60% 12% 16% 13.60%

What is the firm's weighted-average cost of capital at various combinations of debt and

equity, given the above information?

cost of capita (k) = (weight) (cost of debt) + (weight) (cost of equity)

First, we need to know that ASSET = DEBT + EQUITY. Therefore, when Debt/Assets ...

#### Solution Summary

This solution is comprised of a detailed explanation to answer the request of the assignment in excel file.

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:

________________________________________

A B

________________________________________

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:

________________________________________

Cash Inflows

A B C

________________________________________

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:

________________________________________

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:

________________________________________

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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