Basic Problems

LG311-1 Diddy Corp stock has a beta of 1.2, the current risk-free rate is 5 percent, and the expected return on the market is 13.5 percent. What is Diddy’s cost of equity?

Using equation 11-2:

LG311-2 JaiLai Cos. stock has a beta of 1.1, the current risk-free rate is 6.2 percent, and the expected return on the market is 12 percent. What is JaiLai’s cost of equity?

Using equation 11-2:

1

LG311-3 Oberon Inc. has a $20 million (face value) 10-year bond issue selling for 97 percent of par that pays an annual coupon of 8.25 percent. What would be Oberon’s before-tax component cost of debt?

Solving equation 11-5 for iD:

Yields iD = .087115, or 8.7115%

LG311-4 KatyDid Clothes has a $150 million (face value) 20-year bond issue selling for 104 percent of par that carries a coupon rate of 11 percent, paid semiannually. What would be Katydid’s before-tax component cost of debt?

Solving equation 11-5 for iD:

Yields iD = .052586, or 5.2586% on a semiannual basis. Since the cost of debt is normally quoted on a nominal annual basis, we

2

should multiple this semiannual rate by two to get a quoted component cost of 5.2586% × 2 = 10.5172%

LG311-5 ILK has preferred stock selling for 97 percent of par that pays an 8 percent annual coupon. What would be ILK’s component cost of preferred stock?

Using equation 11-4:

LG311-6 Marme Inc. has preferred stock selling for 137 percent of par that pays an 11 percent annual coupon. What would be Marme’s component cost of preferred stock?

Using equation 11-4:

3

LG411-7 FarCry Industries, a maker of telecommunications equipment, has 2 million shares of common stock outstanding, 1 million shares of preferred stock outstanding, and 10 thousand bonds. If the common shares are selling for $27 per share, the preferred share are selling for $14.50 per share, and the bonds are selling for 98 percent of par, what would be the weight used for equity in the computation of FarCry’s WACC?

Using the computation for equity weight given in equation 11-1:

4

LG411-8 OMG Inc. has 4 million shares of common stock outstanding, 3 million shares of preferred stock outstanding, and 5 thousand bonds. If the common shares are selling for $17 per share, the preferred share are selling for $26 per share, and the bonds are selling for 108 percent of par, what would be the weight used for equity in the computation of OMG’s WACC?

Using the computation for equity weight given in equation 11-1:

LG411-9 FarCry Industries, a maker of telecommunications equipment, has 2 million shares of common stock outstanding, 1 million shares of preferred stock outstanding, and 10 thousand bonds. If the common shares are selling for $27 per share, the preferred share are selling for $14.50 per share, and the bonds are selling for 98 percent of par, what weight should you use for debt in the computation of FarCry’s WACC?

Using the computation for equity weight given in equation 11-1:

5

LG411-10 OMG Inc. has 4 million shares of common stock outstanding, 3 million shares of preferred stock outstanding, and 5 thousand bonds. If the common shares are selling for $17 per share, the preferred share are selling for $26 per share, and the bonds are selling for 108 percent of par, what weight should you use for debt in the computation of OMG’s WACC?

Using the computation for equity weight given in equation 11-1:

LG411-11 FarCry Industries, a maker of telecommunications equipment, has 2 million shares of common stock outstanding, 1 million shares of preferred stock outstanding, and 10 thousand bonds. If the common shares sell for $27 per share, the preferred shares sell for $14.50 per share, and the bonds sell for 98

6

percent of par, what weight should you use for preferred stock in the computation of FarCry’s WACC?

Using the computation for equity weight given in equation 11-1:

LG411-12 OMG Inc. has 4 million shares of common stock outstanding, 3 million shares of preferred stock outstanding, and 5 thousand bonds. If the common shares sell for $17 per share, the preferred share sell for $26 per share, and the bonds sell for 108 percent of par, what weight should you use for preferred stock in the computation of OMG’s WACC?

Using the computation for equity weight given in equation 11-1:

Intermediate Problems

LG211-13 Suppose that TapDance, Inc.’s capital structure features 65 percent equity, 35 percent debt, and that its before-tax cost of debt is 8 percent, while its cost of equity is 13 percent. If

7

the appropriate weighted average tax rate is 34 percent, what will be TapDance’s WACC?

Using equation 11-1:

LG211-14 JLP Industries has 6.5 million shares of common stock outstanding with a market price of $14.00 per share. The company also has outstanding preferred stock with a market value of $10 million, and 25,000 bonds outstanding, each with face value $1,000 and selling at 90% of par value. The cost of equity is 14%, the cost of preferred is 10%, and the cost of debt is 7.25%. If JLP's tax rate is 34%, what is the WACC?

Using equation 11-1:

8

LG211-15 Suppose that JB Cos. has a capital structure of 78 percent equity, 22 percent debt, and that its before-tax cost of debt is 11 percent while its cost of equity is 17 percent. If the appropriate weighted average tax rate is 25 percent, what will be JB’s WACC?

Using equation 11-1:

LG211-16 Suppose that B2B, Inc. has a capital structure of 37 percent equity, 17 percent preferred stock, and 46 percent debt. If the before-tax component costs of equity, preferred stock and debt are 14.5 percent, 11 percent and 9.5 percent, respectively, what is B2B’s

9

WACC if the firm faces an average tax rate of 30%?

Using equation 11-1:

LG211-17 Suppose that MNINK Industries’ capital structure features 63 percent equity, 7 percent preferred stock, and 30 percent debt. If the before-tax component costs of equity, preferred stock and debt are 11.60 percent, 9.5 percent and 7 percent, respectively, what is MNINK’s WACC if the firm faces an average tax rate of 34%?

Using equation 11-1:

LG311-18 TAFKAP Industries has 3 million shares of stock outstanding selling at $17 per share and an issue of $20 million in 7.5 percent, annual coupon bonds with a maturity of 15 years, selling at 106 percent of par. If TAFKAP’s weighted average tax rate is 34 percent and its cost of equity is 14.5 percent, what is TAFKAP’s WACC?

First, solve equation 11-5 for iD:

10

Then, using equation 11-1:

LG311-19 Johnny Cake Ltd. has 10 million shares of stock outstanding selling at $23 per share and an issue of $50 million in 9 percent, annual coupon bonds with a maturity of 17 years, selling at 93.5 percent of par. If Johnny Cake’s weighted average tax rate is 34 percent, its next dividend is expected to be $3.00 per share, and all future dividends are expected to grow at 6 percent per year, indefinitely, what is its WACC?

First, solve equation 11-5 for iD:

11

Next, use equation 11-3 to solve for iE:

Then, using equation 11-1, solve for WACC:

Basic Problems

LG3 12-20 Suppose you sell a fixed asset for $109,000 when it’s book value is $129,000. If your company’s marginal tax rate is 39%, what will be the effect on cash flows of this sale (i.e., what will be the after-tax cash flow of this sale)?

Using equation 12-3, the after-tax cash inflow from the sale of the asset will be:

12

LG4 12-21 Your Company is considering a new project that will require $1,000,000 of new equipment at the start of the project. The equipment will have a depreciable life of 10 years and will be depreciated to a book value of $150,000 using straight-line depreciation. The cost of capital is 13%, and the firm’s tax rate is 34%. Estimate the present value of the tax benefits from depreciation.

Using equation 12-2, the depreciation per year will be:

With a 34% tax rate, this depreciation will save you $85,000 × .34 = $28,900 in taxes each year. Across the entire project, these savings will constitute a 10 period annuity, which we can value using equation 5-4:

LG7 12-22 You are trying to pick the least-expensive car for your new delivery service. You have two choices:

13

the Scion xA, which will cost $14,000 to purchase and which will have OCF of -$1,200 annually throughout the vehicle’s expected life of three years as a delivery vehicle; and the Toyota Prius, which will cost $20,000 to purchase and which will have OCF of -$650 annually throughout that vehicles expected four-year life. Both cars will be worthless at the end of their life. If you intend to replace whichever type of car you choose with the same thing when its life runs out, again and again out into the foreseeable future, and if your business has a cost of capital of 12 percent, which one should you choose?

One iteration of each delivery car will consist of the following cash flows:

Year 0 1 2 3 4Scion xA

CFs-

$14,000

-$1,200

-$1,200

-$1,200

Toyota Prius CFs

-$20,000

-$650 -$650 -$650 -$650

The NPV of one Scion xA will be:

Treating this as the present value of a 3-period annuity, setting i to 12 percent, and solving for payment will yield a payment of -$7,028.89, which is the Scion’s EAC.

14

The NPV of one Toyota Prius will be:

Treating this as the present value of a 4-period annuity, setting i to 12 percent, and solving for payment will yield a payment of -$7,234.69, which is the Toyota’s EAC.

Based on the EACs, we should choose the Scion.

LG8 12-23 You are evaluating two different cookie-baking ovens. The Pillsbury 707 costs $57,000, has a five-year life, and has an annual OCF (after tax) of -$10,000 per year. The Keebler CookieMunster costs $90,000, has a seven-year life, and has an annual OCF (after tax) of -$8,000 per year. If your discount rate is 12 percent, what is each machine’s EAC?

One iteration of each oven will consist of the following cash flows:

Year 0 1 2 3 4 5 6 7Pillsb

ury CFs

-$57,000

-$10,000

-$10,000

-$10,000

-$10,000

-$10,000

Keebler CFs

-$90,000

-$8,000

-$8,000

-$8,000

-$8,000

-$8,000

-$8,000

-$8,000

15

The NPV of one Pillsbury 707 will be:

Treating this as the present value of a 5-period annuity, setting i to 12 percent, and solving for payment will yield a payment of -$25,812.35, which is the Pillsbury 707’s EAC.

The NPV of one Keebler CookieMunster will be:

Treating this as the present value of a 7-period annuity, setting i to 12 percent, and solving for payment will yield a payment of -$27,720.60, which is the Keebler CookieMunster’s EAC.

Based on the EACs, we should choose the Pillsbury 707.

LG8 12-24 You are considering the purchase of one of two machines used in your manufacturing plant. Machine A has a life of two years, costs $80 initially, and then $125 per year in maintenance costs. Machine B costs $150 initially, has a life of three years, and requires $100 in annual maintenance costs. Either machine must be replaced at the end of its life with an equivalent machine. Which is the better machine

16

for the firm? The discount rate is 12% and the tax rate is zero.

One iteration of each machine will consist of the following cash flows:

Year 0 1 2 3Machine A CFs -$80 -$125 -$125Machine B CFs -$150 -$100 -$100 -$100

The NPV of one Machine A will be:

Treating this as the present value of a 2-period annuity, setting i to 12 percent, and solving for payment will yield a payment of -$172.34, which is Machine A’s EAC.

The NPV of one Machine B will be:

Treating this as the present value of a 3-period annuity, setting i to 12 percent, and solving for payment will yield a payment of -$162.45, which is the Toyota’s EAC.

Based on the EACs, we should choose Machine B.

17

Intermediate Problems

LG3 12-25 KADS, Inc. has spent $400,000 on research to develop a new computer game. The firm is planning to spend $200,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $50,000. The machine has an expected life of 3 years, a $75,000 estimated resale value, and falls under the MACRS 7-Year class life. Revenue from the new game is expected to be $600,000 per year, with costs of $250,000 per year. The firm has a tax rate of 35 percent, an opportunity cost of capital of 15 percent, and it expects net working capital to increase by $100,000 at the beginning of the project. What will the cash flows for this project be?

LG4 12-26 Your firm needs a computerized machine tool lathe which costs $50,000, and requires $12,000 in maintenance for each year of its 3 year life. After 3 years, this machine will be replaced. The machine falls into the MACRS 3-year class life category. Assume a tax rate of 35% and a discount rate of 12%. Calculate the depreciation tax shield for this project in year 3.

18

Depreciation in year 3 will be 14.81% × $50,000 = $7,400. This will save the firm $7,400 × .35 = $2590 in taxes.

LG4 12-27 If the lathe in the previous problem can be sold for $5,000 at the end of year 3, what is the after tax salvage value?

The lathe will have a remaining book value of 7.41% × $50,000 = $3,705. Using equation 12-3, the after-tax cash flows from the sale of the lathe will be:

19