The Saunders Investment Bank has the following financing outstanding. 

Debt: 130,000 bonds with a coupon rate of 9 percent and a current price quote of 112; the bonds have 20 years to maturity. 300,000 zero coupon bonds with a price quote of 17 and 30 years until maturity. Both bonds have a par value of $1,000. Assume semiannual compounding.

   Preferred stock:

220,000 shares of 7 percent preferred stock with a current price of $69, and a par value of $100.

   Common stock:

3,300,000 shares of common stock; the current price is $55, and the beta of the stock is 1.0.

   Market: The corporate tax rate is 35 percent, the market risk

premium is 6 percent, and the risk-free rate is 3 percent.

What is the WACC for the company? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) WACC            6.93 ± 1% %ExplanationWe will begin by finding the market value of each type of financing. We will use B1 to represent the coupon bond, and B2 to represent the zero coupon bond. So, the market value of the firm’s financing is: BB1 = 130,000($1,000)(1.120) = $145,600,000BB2 = 300,000($1,000)(.170) = $51,000,000P = 220,000($69) = $15,180,000S = 3,300,000($55) = $181,500,000 And the total market value of the firm is: V = $145,600,000 + 51,000,000 + 15,180,000 + 181,500,000V = $393,280,000 Now, we can find the cost of equity using the CAPM. The cost of equity is: RS = .03 + 1.00(.06)RS = .0900, or 9.00% The cost of debt is the YTM of the bonds, so: P0 = $1,120 = $45(PVIFAR%,40) + $1,000(PVIFR%,40)

R = 3.902%YTM = 3.902% × 2 = 7.80% And the aftertax cost of debt is: RB1 = (1 – .35)(.0780)RB1 = .0507, or 5.07% And the aftertax cost of the zero coupon bonds is: P0 = $170 = $1,000(PVIFR%,60)R = 2.997%YTM = 2.997% × 2 = 5.99%RB2 = (1 – .35)(.0599)RB2 = .0390, or 3.90% Even though the zero coupon bonds make no payments, the calculation for the YTM (or price) still assumes semiannual compounding, consistent with a coupon bond. Also remember that, even though the company does not make interest payments, the accrued interest is still tax deductible for the company. To find the required return on preferred stock, we can use the preferred stock pricing equation, which is the level perpetuity equation, so the required return on the company’s preferred stock is: RP = D1/P0RP = $7/$69RP = .1014, or 10.14% Occasionally, the required return on the preferred stock may be lower than the required return on the bonds. This result is not consistent with the risk levels of the two instruments, but is a common occurrence. There is a practical reason for this: Assume Company A owns stock in Company B. The tax code allows Company A to exclude at least 70 percent of the dividends received from Company B, meaning Company A does not pay taxes on this amount. In practice, much of the outstanding preferred stock is owned by other companies, who are willing to take the lower return since much of the return is effectively tax exempt for the investing company. Now we have all of the components to calculate the WACC. The WACC is: RWACC = .0507($145,600,000/$393,280,000) + .0390($51,000,000/$393,280,000) + .0900($181,500,000/$393,280,000) + .1014($15,180,000/$393,280,000)RWACC = .0693, or 6.93%

You are given the following information for Cleen Power Co. Assume the company’s tax rate is 35 percent. 

Debt: 6,000 7.3 percent coupon bonds outstanding, $1,000 par value, 15 years to maturity, selling for 109 percent of par; the bonds make semiannual payments.

   Common stock:

450,000 shares outstanding, selling for $63 per share; the beta is 1.06.

   Market: 12 percent market risk premium and 5.3 percent risk-free

rate. What is the company's WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) WACC            15.42 ± 1%  %ExplanationWe will begin by finding the market value of each type of financing. We find: B = 6,000($1,000)(1.09)B = $6,540,000 S = 450,000($63)S = $28,350,000 And the total market value of the firm is: V = $6,540,000 + 28,350,000V = $34,890,000 Now, we can find the cost of equity using the CAPM. The cost of equity is: RS = .053 + 1.06(.12)RS = .1802, or 18.02% The cost of debt is the YTM of the bonds, so: P0 = $1,090 = $36.50(PVIFAR%,30) + $1,000(PVIFR%,30)R = 3.180%YTM = 3.180% × 2 = 6.36% And the aftertax cost of debt is: RB = (1 – .35)(.0636)RB = .0413, or 4.13% Now we have all of the components to calculate the WACC. The WACC is: RWACC = .0413($6,540,000/$34,890,000) + .1802($28,350,000/$34,890,000)RWACC = .1542, or 15.42% 

Notice that we didn’t include the (1 – tC) term in the WACC equation. We used the aftertax cost of debt in the equation, so the term is not needed here.

Suspect Corp. issued a bond with a maturity of 30 years and a semiannual coupon rate of 6 percent 4 years ago. The bond currently sells for 95 percent of its face value. The company’s tax rate is 35 percent. a. What is the pretax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Pretax cost of debt            6.40 ± 1% % b. What is the aftertax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Aftertax cost of debt            4.16 ± 1% % c. Which is more relevant, the pretax or the aftertax cost of debt? 

Aftertax cost of debtCorrect

Pretax cost of debt

rev: 05_03_2017_QC_CS-88557Explanationa. The pretax cost of debt is the YTM of the company’s bonds, so: P0 = $950 = $30(PVIFAR%,52) + $1,000(PVIFR%,52)R = 3.199%YTM = 2 × 3.199% = 6.40% b. 

The aftertax cost of debt is: RD = .0640(1 – .35)RD = .0416, or 4.16% c. The aftertax rate is more relevant because that is the actual cost to the company.The Hudson Corporation’s common stock has a beta of 1.4. If the risk-free rate is 5.4 percent and the expected return on the market is 12 percent, what is the company’s cost of equity capital? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Cost of equity capital            14.64 ± 1% %ExplanationHere we have information to calculate the cost of equity using the CAPM. The cost of equity is: RE = .054 + 1.4(.12 – .054)RE = .1464, or 14.64%

1. Calculate the pretax cost and the aftertax cost of debt.=Yield(D5,D6,D8,D7,100,D9)

=D16*(1-D10)

Suppose your company needs $12 million to build a new assembly line. Your target debt−equity ratio is .5. The flotation cost for new equity is 12 percent, but the flotation cost for debt is only 9 percent. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small.  a. What is your company’s weighted average flotation cost, assuming all equity is raised externally? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)  Weighed average flotation cost            11.00 ± 1% %  b. What is the true cost of building the new assembly line after taking flotation costs into account? (Enter your answer in dollars, not millions of dollars. Do not round intermediate calculations and round your answer to the nearest whole dollar, e.g. 1,234,567.)  True cost           $ 13,483,146 ± 0.01%Explanationa. The weighted average flotation cost is the weighted average of the flotation costs for debt and equity, so: fT = .09(.50/1.5) + .12(1/1.5)fT = .1100, or 11.00% b. The total cost of the equipment including flotation costs is: Amount raised(1 – .1100) = $12,000,000Amount raised = $12,000,000/(1 – .1100)Amount raised = $13,483,146 Even if the specific funds are actually being raised completely from debt, the flotation costs, and hence true investment cost, should be valued as if the firm’s target capital structure is used.The Saunders Investment Bank has the following financing outstanding. 

Debt: 10,000 bonds with a coupon rate of 11 percent and a current price quote of 109.5; the bonds have 20 years to maturity. 180,000 zero coupon bonds with a price quote of 20 and 30 years until maturity. Both bonds have a par value of $1,000. Assume semiannual compounding.

   Preferred stock:

100,000 shares of 9 percent preferred stock with a current price of $84, and a par value of $100.

   Common stock: 2,100,000 shares of common stock; the current price is $70, and

the beta of the stock is 1.4.   

Market: The corporate tax rate is 35 percent, the market risk premium is 6 percent, and the risk-free rate is 3 percent.

What is the WACC for the company? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) WACC            9.70 ± 1% %ExplanationWe will begin by finding the market value of each type of financing. We will use B1 to represent the coupon bond, and B2 to represent the zero coupon bond. So, the market value of the firm’s financing is: BB1 = 10,000($1,000)(1.095) = $10,950,000BB2 = 180,000($1,000)(.200) = $36,000,000P = 100,000($84) = $8,400,000S = 2,100,000($70) = $147,000,000 And the total market value of the firm is: V = $10,950,000 + 36,000,000 + 8,400,000 + 147,000,000V = $202,350,000 Now, we can find the cost of equity using the CAPM. The cost of equity is: RS = .03 + 1.40(.06)RS = .1140, or 11.40% The cost of debt is the YTM of the bonds, so: P0 = $1,095 = $55(PVIFAR%,40) + $1,000(PVIFR%,40)

R = 4.950%YTM = 4.950% × 2 = 9.90% And the aftertax cost of debt is: RB1 = (1 – .35)(.0990)RB1 = .0644, or 6.44% And the aftertax cost of the zero coupon bonds is: P0 = $200 = $1,000(PVIFR%,60)R = 2.719%YTM = 2.719% × 2 = 5.44%RB2 = (1 – .35)(.0544)RB2 = .0353, or 3.53% Even though the zero coupon bonds make no payments, the calculation for the YTM (or price) still assumes semiannual compounding, consistent with a coupon bond. Also remember that, even though the company does not make interest payments, the accrued interest is still tax deductible for the company. To find the required return on preferred stock, we can use the preferred stock pricing equation, which is the level perpetuity equation, so the required return on the company’s preferred stock is: RP = D1/P0RP = $9/$84RP = .1071, or 10.71% Occasionally, the required return on the preferred stock may be lower than the required return on the bonds. This result is not consistent with the risk levels of the two instruments, but is a common occurrence. There is a practical reason for this: Assume Company A owns stock in Company B. The tax code allows Company A to exclude at least 70 percent of the dividends received from Company B, meaning Company A does not pay taxes on this amount. In practice, much of the outstanding preferred stock is owned by other companies, who are willing to take the lower return since much of the return is effectively tax exempt for the investing company. Now we have all of the components to calculate the WACC. The WACC is: RWACC = .0644($10,950,000/$202,350,000) + .0353($36,000,000/$202,350,000) + .1140($147,000,000/$202,350,000) + .1071($8,400,000/$202,350,000)RWACC = .0970, or 9.70%

Matroyshka, Inc., has a target debt−equity ratio of 1.80. Its WACC is 8.7 percent, and the tax rate is 40 percent. a. If the company’s cost of equity is 15 percent, what is its pretax cost of debt? (Do not round intermediate calculations. Enter

your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Pretax cost of debt            8.67 ± 1% % b. If instead you know that the aftertax cost of debt is 7.1 percent, what is the cost of equity? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Cost of equity            11.58 ± 1% %Explanationa. Using the equation to calculate WACC, we find: RWACC = .087 = (1/2.80)(.15) + (1.80/2.80)(1 – .40)RD

RB = .0867, or 8.67% b. Using the equation to calculate WACC, we find: RWACC = .087 = (1/2.80)RE + (1.80/2.80)(.071)RS = .1158, or 11.58%

You are given the following information for Cleen Power Co. Assume the company’s tax rate is 40 percent. 

Debt: 8,000 6.3 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 106 percent of par; the bonds make semiannual payments.

   Common stock:

350,000 shares outstanding, selling for $53 per share; the beta is 1.09.

   Market: 10 percent market risk premium and 4.3 percent risk-free rate.

 What is the company's WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

 WACC            11.52 ± 1%  %ExplanationWe will begin by finding the market value of each type of financing. We find: B = 8,000($1,000)(1.06)B = $8,480,000 S = 350,000($53)S = $18,550,000 And the total market value of the firm is: V = $8,480,000 + 18,550,000V = $27,030,000 Now, we can find the cost of equity using the CAPM. The cost of equity is: RS = .043 + 1.09(.10)RS = .1520, or 15.20% The cost of debt is the YTM of the bonds, so: P0 = $1,060 = $31.50(PVIFAR%,40) + $1,000(PVIFR%,40)R = 2.895%YTM = 2.895% × 2 = 5.79% And the aftertax cost of debt is: RB = (1 – .40)(.0579)RB = .0347, or 3.47% Now we have all of the components to calculate the WACC. The WACC is: RWACC = .0347($8,480,000/$27,030,000) + .1520($18,550,000/$27,030,000)RWACC = .1152, or 11.52% Notice that we didn’t include the (1 – tC) term in the WACC equation. We used the aftertax cost of debt in the equation, so the term is not needed here.

1. Calculate the market value capital structure and WACC.=D6*D12(D11/100)

=D15*D17

=D20*D22

=SUM(D35:D37

=D35/D38

=D36/D38

=D37/D38

=Yield(D7,D8,D9,D11,100,D10)

=D46*(1-D28)

=D27+(D16*D26)

+(D21*D23)/D22

The Saunders Investment Bank has the following financing outstanding. 

Debt: 120,000 bonds with a coupon rate of 8 percent and a current price quote of 110; the bonds have 20 years to maturity. 290,000 zero coupon bonds with a price quote of 17.5 and 30 years until maturity. Both bonds have a par value of $1,000. Assume semiannual compounding.

   Preferred stock:

210,000 shares of 6 percent preferred stock with a current price of $70, and a par value of $100.

   Common stock: 3,200,000 shares of common stock; the current price is $56, and

the beta of the stock is 1.05.   

Market: The corporate tax rate is 40 percent, the market risk premium is 7 percent, and the risk-free rate is 4 percent.

What is the WACC for the company? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) WACC            7.70 ± 1% %ExplanationWe will begin by finding the market value of each type of financing. We will use B1 to represent the coupon bond, and B2 to represent the zero coupon bond. So, the market value of the firm’s financing is: BB1 = 120,000($1,000)(1.100) = $132,000,000BB2 = 290,000($1,000)(.175) = $50,750,000P = 210,000($70) = $14,700,000

S = 3,200,000($56) = $179,200,000 And the total market value of the firm is: V = $132,000,000 + 50,750,000 + 14,700,000 + 179,200,000V = $376,650,000 Now, we can find the cost of equity using the CAPM. The cost of equity is: RS = .04 + 1.05(.07)RS = .1135, or 11.35% The cost of debt is the YTM of the bonds, so: P0 = $1,100 = $40(PVIFAR%,40) + $1,000(PVIFR%,40)R = 3.530%YTM = 3.530% × 2 = 7.06% And the aftertax cost of debt is: RB1 = (1 – .40)(.0706)RB1 = .0424, or 4.24% And the aftertax cost of the zero coupon bonds is: P0 = $175 = $1,000(PVIFR%,60)R = 2.948%YTM = 2.948% × 2 = 5.90%RB2 = (1 – .40)(.0590)RB2 = .0354, or 3.54% Even though the zero coupon bonds make no payments, the calculation for the YTM (or price) still assumes semiannual compounding, consistent with a coupon bond. Also remember that, even though the company does not make interest payments, the accrued interest is still tax deductible for the company. To find the required return on preferred stock, we can use the preferred stock pricing equation, which is the level perpetuity equation, so the required return on the company’s preferred stock is: RP = D1/P0RP = $6/$70RP = .0857, or 8.57% Occasionally, the required return on the preferred stock may be lower than the required return on the bonds. This result is not consistent with the risk levels of the two instruments, but is a common occurrence. There is a practical reason for this: Assume Company A owns stock in Company B. The tax code allows Company A to exclude at least 70 percent of the dividends received from Company B, meaning Company A does not pay taxes on this amount. In practice, much of the outstanding preferred stock is owned by other companies, who are willing to take the lower return since much of the return is effectively tax exempt for the investing company.

 Now we have all of the components to calculate the WACC. The WACC is: RWACC = .0424($132,000,000/$376,650,000) + .0354($50,750,000/$376,650,000) + .1135($179,200,000/$376,650,000) + .0857($14,700,000/$376,650,000)RWACC = .0770, or 7.70%Suspect Corp. issued a bond with a maturity of 30 years and a semiannual coupon rate of 8 percent 3 years ago. The bond currently sells for 93 percent of its face value. The company’s tax rate is 35 percent. a. What is the pretax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Pretax cost of debt            8.68 ± 1% % b. What is the aftertax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Aftertax cost of debt            5.64 ± 1% % c. Which is more relevant, the pretax or the aftertax cost of debt? 

Aftertax cost of debtCorrect

Pretax cost of debt

rev: 05_03_2017_QC_CS-88557Explanationa. The pretax cost of debt is the YTM of the company’s bonds, so: P0 = $930 = $40(PVIFAR%,54) + $1,000(PVIFR%,54)R = 4.338%YTM = 2 × 4.338% = 8.68% b. 

The aftertax cost of debt is: RD = .0868(1 – .35)RD = .0564, or 5.64% c. The aftertax rate is more relevant because that is the actual cost to the company.

Matroyshka, Inc., has a target debt−equity ratio of 1.30. Its WACC is 8.4 percent, and the tax rate is 40 percent. a. If the company’s cost of equity is 13 percent, what is its pretax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Pretax cost of debt            8.10 ± 1% % b. If instead you know that the aftertax cost of debt is 3.7 percent, what is the cost of equity? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Cost of equity            14.51 ± 1% %Explanationa. Using the equation to calculate WACC, we find: RWACC = .084 = (1/2.30)(.13) + (1.30/2.30)(1 – .40)RD

RB = .0810, or 8.10% b. Using the equation to calculate WACC, we find: RWACC = .084 = (1/2.30)RE + (1.30/2.30)(.037)RS = .1451, or 14.51%

Floyd Industries stock has a beta of 1.3. The company just paid a dividend of $.30, and the dividends are expected to grow at 4 percent per year. The expected return on the market is 13 percent,

and Treasury bills are yielding 5.7 percent. The current price of the company's stock is $74. a. Calculate the cost of equity using the DDM method. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) DDM method            4.42 ± 1% % b. Calculate the cost of equity using the SML method. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) SML method            15.19 ± 1% %Explanationa. Using the dividend growth model, the cost of equity is: RS = [($.30)(1.04)/$74] + .04RS = .0442, or 4.42% b. Using the CAPM, the cost of equity is: RS = .057 + 1.30(.13 – .057)RS = .1519, or 15.19% When using the dividend growth model or the CAPM, you must remember that both are estimates for the cost of equity. Additionally, and perhaps more importantly, each method of estimating the cost of equity depends upon different assumptions.

1. Calculate the pretax cost and the aftertax cost of debt.=Yield(D5,D6,D8,D7,100,D9)

=D16*(1-D10)

Suppose you have been hired as a financial consultant to Defense Electronics, Inc. (DEI), a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. This will be a five-year project. The company bought some land three years ago for $3.8 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $4.6 million. In five years, the aftertax value of the land will be $5 million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $31.44 million to build. The following market data on DEI’s securities is current: 

Debt: 223,000 7 percent coupon bonds outstanding, 25 years to maturity, selling for 107 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

   Common stock:

8,100,000 shares outstanding, selling for $70.30 per share; the beta is 1.3.

   

Preferred stock:

443,000 shares of 4 percent preferred stock outstanding, selling for $80.30 per share and and having a par value of $100.

   Market: 6 percent expected market risk premium; 4 percent risk-free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 7 percent on new common stock issues, 5 percent on new preferred stock issues, and 3 percent on new debt issues. Wharton has included all direct and indirect issuance costs (along with its profit) in setting these spreads. Wharton has recommended to DEI that it raise the funds needed to build the plant by issuing new shares of common stock. DEI’s tax rate is 40 percent. The project requires $1,125,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally. a. Calculate the project’s initial Time 0 cash flow, taking into account all side effects. Assume that the net working capital will not require flotation costs. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.) Cash flow           $  -39,095,232 ± 0.01%  b. The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +1 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI’s project. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Discount rate            10.27 ± 1% % c. The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (that is, the end of Year 5), the plant and equipment can be scrapped for $3.8 million. What is the aftertax salvage value of this plant and

equipment? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.) Aftertax salvage value           $ 6,996,000 ± 0.01%  d. The company will incur $6,100,000 in annual fixed costs. The plan is to manufacture 13,500 RDSs per year and sell them at $10,450 per machine; the variable production costs are $9,050 per RDS. What is the annual operating cash flow (OCF) from this project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.) Operating cash flow           $ 9,252,000 ± 0.01%  e. DEI’s comptroller is primarily interested in the impact of DEI’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this project? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) Break-even quantity            7,164 ± 0.1% units f. Finally, DEI’s president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS project’s internal rate of return (IRR) and net present value (NPV) are. Assume that the net working capital will not require flotation costs. (Enter your NPV answer in dollars, not millions of dollars, e.g., 1,234,567. Enter your IRR answer as a percent. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)    

IRR 13.52 ± 1%  %

NPV

$ 3,788,536.05 ± 0.01%

ExplanationThe $3.8 million cost of the land three years ago is a sunk cost and irrelevant; the $4.6 million appraised value of the land is an opportunity cost and is relevant. The $5 million land value in five years is a relevant cash flow as well. The fact that the company is keeping the land rather than selling it is unimportant. The land is an opportunity cost in five years and is a relevant cash flow for this project. The market value capitalization weights are: B = 223,000($1,000)(1.07) = $238,610,000S = 8,100,000($70.30) = $569,430,000P = 443,000($80.30) = $35,572,900 The total market value of the company is: V = $238,610,000 + 569,430,000 + 35,572,900 = $843,612,900 The weight of each form of financing in the company’s capital structure is: XB = $238,610,000/$843,612,900 = .2828XS = $569,430,000/$843,612,900 = .6750XP   = $35,572,900/$843,612,900 = .0422 Next we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so: Rs = .04 + 1.3(.06)Rs = .1180, or 11.80% The cost of debt is the YTM of the company’s outstanding bonds, so: P0 = $1,070 = $35(PVIFAR%,50) + $1,000(PVIFR%,50)R = 3.217%YTM = 3.217% × 2 = 6.43% And the aftertax cost of debt is: RB = (1 – .40)(.0643)RB = .0386, or 3.86% The cost of preferred stock is: RP = $4/$80.30RP = .0498, or 4.98% a. The weighted average flotation cost is the sum of the weight of each source of funds in the capital structure of the company times the flotation costs, so: 

fT = (.6750)(.07) + (.0422)(.05) + (.2828)(.03)fT = .0578, or 5.78% The initial cash outflow for the project needs to be adjusted for the flotation costs. To account for the flotation costs: Amount raised(1 – .0578) = $31,440,000Amount raised = $31,440,000/(1 – .0578)Amount raised = $33,370,232.12 So the cash flow at Time 0 will be: CF0 = –$4,600,000 – 33,370,232.12 – 1,125,000CF0 = –$39,095,232 There is an important caveat to this solution. This solution assumes that the increase in net working capital does not require the company to raise outside funds; therefore the flotation costs are not included. However, this is an assumption and the company could need to raise outside funds for the NWC. If this is true, the initial cash outlay includes these flotation costs, so: Total cost of NWC including flotation costs: $1,125,000/(1 – .0578) = $1,194,068 This would make the total initial cash flow: CF0 = –$4,600,000 – 33,370,232.12 – 1,194,068CF0 = –$39,164,301 b. To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is: WACC = [(.6750)(.1180) + (.0422)(.0498) + (.2828)(.0386)]WACC = .0927, or 9.27% The company wants to use the subjective approach to this project because it is located overseas. The adjustment factor is +1 percent, so the required return on this project is: Project required return = .0927 + .01Project required return = .1027, or 10.27% c. The annual depreciation for the equipment will be: $31,440,000/8 = $3,930,000 So, the book value of the equipment at the end of five years will be: 

BV5 = $31,440,000 – 5($3,930,000)BV5 = $11,790,000 So, the aftertax salvage value will be: Aftertax salvage value = $3,800,000 + .40($11,790,000 – 3,800,000)Aftertax salvage value = $6,996,000 d. Using the tax shield approach, the OCF for this project is: OCF = [(P – v)Q – FC](1 – tc) + tcDOCF = [($10,450 – 9,050)(13,500) – 6,100,000](1 – .40) + .40($31,440,000/8)OCF = $9,252,000 e. The accounting break-even sales figure for this project is: QA = (FC + D)/(P – v)QA = ($6,100,000 + 3,930,000)/($10,450 – 9,050)QA = 7,164 units f. We have calculated all cash flows of the project. We just need to make sure that in Year 5 we add back the aftertax salvage value and the recovery of the initial NWC. The cash flows for the project are: Year   Cash Flow  

0   –$ 39,095,232 

1     9,252,000 

2     9,252,000 

3     9,252,000 

4     9,252,000 

5     22,373,000 

Using the required return of 10.27 percent, the NPV of the project is: NPV = –$39,095,232 + $9,252,000(PVIFA10.27%,4) + $22,373,000/1.10275

NPV = $3,788,536.05 And the IRR is: NPV = 0 = –$39,095,232 + $9,252,000(PVIFAIRR%,4) + $22,373,000/(1 + IRR)5

IRR = 13.52% If the initial NWC is assumed to be financed from outside sources, the cash flows are: Year   Cash Flow  

0   –$ 39,164,301 

1     9,252,000 

2     9,252,000 

3     9,252,000 

4     9,252,000 

5     22,373,000 

With this assumption, and the required return of 10.27 percent, the NPV of the project is: NPV = –$39,164,301 + $9,252,000(PVIFA10.27%,4) + $22,373,000/1.10275

NPV = $3,719,467.63 And the IRR is: IRR = 0 = –$39,164,301 + $9,252,000(PVIFAIRR%,4) + $22,373,000/(1 + IRR)5

IRR = 13.45%

You are given the following information for Cleen Power Co. Assume the company’s tax rate is 30 percent. 

Debt: 6,000 7.9 percent coupon bonds outstanding, $1,000 par

value, 25 years to maturity, selling for 108 percent of par; the bonds make semiannual payments.

   Common stock:

510,000 shares outstanding, selling for $69 per share; the beta is 1.12.

   Market: 10 percent market risk premium and 5.9 percent risk-free rate.

 What is the company's WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) WACC            15.23 ± 1%  %ExplanationWe will begin by finding the market value of each type of financing. We find: B = 6,000($1,000)(1.08)B = $6,480,000 S = 510,000($69)S = $35,190,000 And the total market value of the firm is: V = $6,480,000 + 35,190,000V = $41,670,000 Now, we can find the cost of equity using the CAPM. The cost of equity is: RS = .059 + 1.12(.10)RS = .1710, or 17.10% The cost of debt is the YTM of the bonds, so: P0 = $1,080 = $39.50(PVIFAR%,50) + $1,000(PVIFR%,50)R = 3.603%YTM = 3.603% × 2 = 7.21% And the aftertax cost of debt is: RB = (1 – .30)(.0721)RB = .0504, or 5.04% Now we have all of the components to calculate the WACC. The WACC is: RWACC = .0504($6,480,000/$41,670,000) + .1710($35,190,000/$41,670,000)

RWACC = .1523, or 15.23% Notice that we didn’t include the (1 – tC) term in the WACC equation. We used the aftertax cost of debt in the equation, so the term is not needed here.

Suppose your company needs $17 million to build a new assembly line. Your target debt−equity ratio is .75. The flotation cost for new equity is 10 percent, but the flotation cost for debt is only 7 percent. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small.  a. What is your company’s weighted average flotation cost, assuming all equity is raised externally? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)  Weighed average flotation cost            8.71 ± 1% %  b. What is the true cost of building the new assembly line after taking flotation costs into account? (Enter your answer in dollars, not millions of dollars. Do not round intermediate calculations and round your answer to the nearest whole dollar, e.g. 1,234,567.)  True cost           $ 18,622,848 ± 0.01%Explanationa. The weighted average flotation cost is the weighted average of the flotation costs for debt and equity, so: fT = .07(.75/1.75) + .10(1/1.75)fT = .0871, or 8.71% b. The total cost of the equipment including flotation costs is: Amount raised(1 – .0871) = $17,000,000Amount raised = $17,000,000/(1 – .0871)Amount raised = $18,622,848 Even if the specific funds are actually being raised completely from debt, the flotation

costs, and hence true investment cost, should be valued as if the firm’s target capital structure is used.

Suspect Corp. issued a bond with a maturity of 10 years and a semiannual coupon rate of 8 percent 3 years ago. The bond currently sells for 96 percent of its face value. The company’s tax rate is 35 percent. a. What is the pretax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Pretax cost of debt            8.78 ± 1% % b. What is the aftertax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Aftertax cost of debt            5.70 ± 1% % c. Which is more relevant, the pretax or the aftertax cost of debt? 

Aftertax cost of debtCorrect

Pretax cost of debt

rev: 05_03_2017_QC_CS-88557Explanationa. The pretax cost of debt is the YTM of the company’s bonds, so: P0 = $960 = $40(PVIFAR%,14) + $1,000(PVIFR%,14)R = 4.388%YTM = 2 × 4.388% = 8.78% b. The aftertax cost of debt is: 

RD = .0878(1 – .35)RD = .0570, or 5.70% c. The aftertax rate is more relevant because that is the actual cost to the company.1