managerial finance ch 10 & 11
To calculate the after-tax cost of debt, multiply the before-tax cost of debt by___________
(1-T)
The point at which the NPV profile intersects the horizontal axis represents the ________
IRR
Suppose Cold Goose Metal Works Inc. is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of $400,000. The project is expected to generate the following net cash flows: year - cash flow: year 1 - 350000 year 2 - 400000 year 3 - 450000 year 4 - 500000 Cold Goose Metal Works Inc.'s weighted average cost of capital is 7%, and project Alpha has the same risk as the firm's average project. Based on the cash flows, what is project Alpha's net present value (NPV)?
-400000 + (350000/1.07) + (400000/1.07^2) + (450000/1.07^3) + (500000/1.07^4) = 1025260
Green Caterpillar Garden Supplies Inc. is a small firm, and several of its managers are worried about how soon the firm will be able to recover its initial investment from Project Alpha's expected future cash flows. To answer this question, Green Caterpillar's CFO has asked that you compute the project's payback period using the following expected net cash flows and assuming that the cash flows are received evenly throughout each year. year 0 - year 1 - year 2 - year 3 expected cash flow: -4500000 - 1800000 - 3825000 - 1575000 cumulative cash flow: -4500000 - -2700000 - 1125000 - 2700000
-4500000 + 1800000 = -2700000 + 3825000 = 1125000 + 157500 = 2700000 conventional payback period: 1 + (2700000/3825000) = 1.71 years
Companies often use several methods to evaluate the project's cash flows and each of them has its benefits and disadvantages. Based on your understanding of the capital budgeting evaluation methods, which of the following conclusions about capital budgeting are valid? Check all that apply.
-For most firms, the reinvestment rate assumption in the MIRR is more realistic than the assumption in the IRR. -The discounted payback period improves on the regular payback period by accounting for the time value of money.
Which of the following statements indicate a disadvantage of using the regular payback period (not the discounted payback period) for capital budgeting decisions? Check all that apply.
-The payback period does not take the time value of money into account. -The payback period does not take the project's entire life into account. NOT: the payback period is calculated using net income instead of cash flows
The Harrison Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company's cost of internal equity. Harrison's bonds yield 11.52%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 4.95%. Based on the bond-yield-plus-risk-premium approach, Harrison's cost of internal equity is:
16.47% 11.52 + 4.95 = 16.47
Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%. If its current tax rate is 25%, how much higher will Turnbull's weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings? (Note: Round your intermediate calculations to two decimal places.)
.76% 0.58(11.1%)(1-0.25)+0.06(12.2%)+0.36(14.7%) = 10.85% .58(11.1%)(1-.25)+.06(12.2%)+.36(16.8%) = 11.61% 11.61% - 10.85% = 0.76%
Wyle Co. has $3.9 million of debt, $1.5 million of preferred stock, and $1.8 million of common equity. What would be its weight on debt?
0.54 wd = debt / (debt + preferred stock + common equity) wd= 3.9 million / (3.9 million + 1.5 million + 1.8 million) = 0.54
Western Gas & Electric Company (WGC) can borrow funds at an interest rate of 10.20% for a period of eight years. Its marginal federal-plus-state tax rate is 25%. WGC's after-tax cost of debt is _____________ (rounded to two decimal places).
10.20 x (1-.25) 7.65%
) is 4.23% while the market risk premium is 6.63%. The Monroe Company has a beta of 0.92. Using the capital asset pricing model (CAPM) approach, Monroe's cost of equity is ___________
10.33% 4.23 + (.92 x 6.63) = 10.33
At the present time, Ferro Enterprises does not have any preferred stock outstanding but is looking to include preferred stock in its capital structure in the future. Ferro has found some institutional investors that are willing to purchase its preferred stock issue provided that it pays a perpetual dividend of $14 per share. If the investors pay $134.26 per share for their investment, then Ferro's cost of preferred stock (rounded to four decimal places) will be _____________.
10.4275% rp = dp / pp rp = 14 / 134.26 = 10.4275%
Last Tuesday, Green Caterpillar Garden Supplies Inc. lost a portion of its planning and financial data when both its main and its backup servers crashed. The company's CFO remembers that the internal rate of return (IRR) of Project Gamma is 13.2%, but he can't recall how much Green Caterpillar originally invested in the project nor the project's net present value (NPV). However, he found a note that detailed the annual net cash flows expected to be generated by Project Gamma. They are: year - cash flow: year 1 - 2400000 year 2 - 4500000 year 3 - 4500000 year 4 - 4500000 The level of risk exhibited by Project Gamma is the same as that exhibited by the company's average project, which means that Project Gamma's net cash flows can be discounted using Green Caterpillar's 9% WACC. Given the data and hints, Project Gamma's initial investment is __________ and its NPV is ___________ (rounded to the nearest whole dollar).
11,474,565 initial investment = (2,400,000/1.132^1) + (4,500,000/1.132^2) +(4,500,000/1.132^3) +(4,500,000/1.132^4) = 2120141.343 + 3511718.213 + 3102224.57 + 2740481.069 = 11,474,565 1,177,569 NPV = -11474565 + (2400000/1.09^1) + (4500000/1.09^2) + 4500000/1.09^3) + (4500000/1.09^4) = 1177569
Grant Enterprises's stock is currently selling for $32.45 per share, and the firm expects its per-share dividend to be $1.38 in one year. Analysts project the firm's growth rate to be constant at 7.27%. Estimating the cost of equity using the discounted cash flow (or dividend growth) approach, what is Grant's cost of internal equity?
11.52% (1.38 / 32.45) + .0727 = 11.52%
Turnbull Co. is considering a project that requires an initial investment of $270,000. The firm will raise the $270,000 in the capital by issuing $100,000 of debt at a before-tax cost of 11.1%, $30,000 of preferred stock at a cost of 12.2%, and $140,000 of equity at a cost of 14.7%. The firm faces a tax rate of 25%. What will be the WACC for this project? ___________ (Note: Round your intermediate calculations to three decimal places.)
12.06% wd= 100,000/270,000 = 0.370 wp= 30,000/270,000 = 0.111 wc= 140,000/270,000 = 0.519 WACC = .370(11.1%)(1-.25)+.111(12.2%)+.519(14.7%) = 12.06%
Alpha Moose Transporters is considering investing in a one-year project that requires an initial investment of $475,000. To do so, it will have to issue new common stock and will incur a flotation cost of 2.00%. At the end of the year, the project is expected to produce a cash inflow of $550,000. The rate of return that Alpha Moose expects to earn on its project (net of its flotation costs) is _________ (rounded to two decimal places).
13.52% flotation cost = 475000 x 0.02 = 9500 expected rate of return = cash inflow / (initial investment + floation cost) - 1 550,000 / (475000 + 9500) - 1 = 13.52
How much value in this example does the discounted payback period method fail to recognize due to this theoretical deficiency?
1586991
Falcon Freight is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $850,000. Falcon Freight has been basing capital budgeting decisions on a project's NPV; however, its new CFO wants to start using the IRR method for capital budgeting decisions. The CFO says that the IRR is a better method because returns in percentage form are easier to understand and compare to required returns. Falcon Freight's WACC is 8%, and project Sigma has the same risk as the firm's average project. year - cash flow: year 1 - 300000 year 2 - 425000 year 3 - 400000 year 4- 425000 Which of the following is the correct calculation of project Sigma's IRR?
27.53% excel: =IRR(-850000, 300000, 425000, 400000, 425000, 0)
Suppose you are evaluating a project with the expected future cash inflows shown in the following table. Your boss has asked you to calculate the project's net present value (NPV). You don't know the project's initial cost, but you do know the project's regular, or conventional, payback period is 2.50 years. year - cash flow year 1 - 300000 year 2 - 500000 year 3 - 475000 year 4 - 425000 If the project's weighted average cost of capital (WACC) is 8%, the project's NPV (rounded to the nearest dollar) is:
358405 300000 + 500000 + (475000 / 2) = 1037500 -1037500 + (300000/1.08^1) + (500000/1.08^2) + (475000/1.08^3) + (425000/1.08^4) = 358405
Suppose Grant is currently distributing 75% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 20%. Grant's estimated growth rate is _______
5% g= ROE x retention ratio 20% x .2500 = 5
At the present time, Water and Power Company (WPC) has 5-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,050.76 per bond, carry a coupon rate of 10%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 25%. If WPC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? (Note: Round your YTM rate to two decimal place.)
6.53% annual coupon = bonds face value x annual coupon rate =1000 x .10 = 100 per year Financial calculator to find the bonds YTM (I) P/y = 1 n=5 pv= -1050.76 pmt= 100 fv= 1000 Find I = 8.70 after-tax cost of debt = rd x (1-T) =8.70% x (1-0.25) =6.53%
Water and Power Company (WPC) can borrow funds at an interest rate of 11.10% for a period of five years. Its marginal federal-plus-state tax rate is 25%. WPC's after-tax cost of debt is ____________
8.32% after-tax cost of debt= interest rate on new debt - tax savings = rd - (rd x T) =rd x (1-T) =11.10% x (1- 0.25) =11.10 x .75 =8.32%
Sunny Day Manufacturing Company has a current stock price of $33.35 per share, and is expected to pay a per-share dividend of $1.36 at the end of the year. The company's earnings' and dividends' growth rate are expected to grow at the constant rate of 5.20% into the foreseeable future. If Sunny Day expects to incur flotation costs of 6.50% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock (rounded to two decimal places) should be _______
9.56% re = 1.36 / 33.35x(1- .0650) + .052 (1.36 / 31.18225) + 0.52 .0436145564 + .052 = .0956
Kuhn Co. is considering a new project that will require an initial investment of $4 million. It has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. Kuhn has noncallable bonds outstanding that mature in five years with a face value of $1,000, an annual coupon rate of 10%, and a market price of $1,050.76. The yield on the company's current bonds is a good approximation of the yield on any new bonds that it issues. The company can sell shares of preferred stock that pay an annual dividend of $8 at a price of $92.25 per share. Kuhn does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $33.35 per share, and it is expected to pay a dividend of $1.36 at the end of next year. Flotation costs will represent 8% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 8.7%, and they face a tax rate of 25%. What will be the WACC for this project? ___________ (Note: Round your intermediate calculations to two decimal places.)
9.98% annual coupon = 1000x.10 = 100 financial calculator for I : p/y = 1 n= 5 pv = -1050.76 pmt = 100 fv= 1000 i = 8.70 8/92.25 = 8.67% 1.36/[33.35(1-.08)] + .087 = 13.13% .45(8.70%)(1-.25)+0.04(8.67%) + .51(13.13%) = 9.98%
On what grounds do you base your accept-reject decision?
Division H's project should be rejected since its return is less than the risk-based cost of capital for the division.
On what grounds do you base your accept-reject decision?
Division L's project should be accepted since its return is greater than the risk-based cost of capital for the division.
Alpha Moose Transporters Co.'s addition to earnings for this year is expected to be $745,000. Its target capital structure consists of 40% debt, 5% preferred, and 55% equity. Determine Alpha Moose Transporters's retained earnings breakpoint:
RE breakpoint = addition to retained earnings for the year/equity fraction of target capital structure 745000 /.55 = 1354545
Which of the following statements about the relationship between the IRR and the MIRR is correct?
a typical firm's IRR will be greater than its MIRR
Cold Goose Metal Works Inc.'s decision to accept or reject project Alpha is independent of its decisions on other projects. If the firm follows the NPV method, it should ___________ project Alpha.
accept
If this is an independent project, the IRR method states that the firm should ______________
accept project sigma
Which of the following statements best describes the difference between the IRR method and the MIRR method?
The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital.
A project's IRR will ___________ if the project's cash inflows increase, and everything else is unaffected.
increase
Which version of a project's payback period should the CFO use when evaluating Project Alpha, given its theoretical superiority?
the discounted payback period
Which of the following statements best explains what it means when a project has an NPV of $0?
When a project has an NPV of $0, the project is earning a rate of return equal to the project's weighted average cost of capital. It's OK to accept a project with an NPV of $0, because the project is earning the required minimum rate of return.
Wellington Industries has two divisions, L and H. Division L is the company's low-risk division and would have a weighted average cost of capital of 8% if it was operated as an independent company. Division H is the company's high-risk division and would have a weighted average cost of capital of 14% if it was operated as an independent company. Because the two divisions are the same size, the company has a composite weighted average cost of capital of 11%. Division L is considering a project with an expected return of 9.5%. should wellington industries accept or reject the project
accept the project
At the present time, Western Gas & Electric Company (WGC) has 5-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,229.24 per bond, carry a coupon rate of 10%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 25%. If WGC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? (Note: Round your YTM rate to two decimal place.)
annual coupon = 1000x.10 = 100 p/y = 1 n = 5 pv = -1229.24 pmt = 100 fv = 1000 find I = 4.74 4.74 x (1-.25) = 3.56%
The ____________ is the interest rate that a firm pays on any new debt financing.
before-tax cost of debt
For which capital component must you make a tax adjustment when calculating a firm's weighted average cost of capital (WACC)?
debt
Preferred stock is a hybrid security, because it has some characteristics typical of debt and others typical of equity. The following table lists various characteristics of preferred stock. Determine which of these characteristics is consistent with debt and which is consistent with equity. has a par, or face, value :
debt
A project's IRR will _________ if the project's cash inflows decrease, and everything else is unaffected.
decrease
The conventional payback period ignores the time value of money, and this concerns Green Caterpillar's CFO. He has now asked you to compute Alpha's discounted payback period, assuming the company has a 9% cost of capital. Complete the following table and perform any necessary calculations. Round the discounted cash flow values to the nearest whole dollar, and the discounted payback period to two decimal places. For full credit, complete the entire table. (Note: If your answer is negative, be sure to use a minus sign in your answer.) year 0 - year 1 - year 2 - year 3 cash flow: -4500000 - 1800000 - 3825000 - 1575000 discounted cash flow: -4500000 - 1651376 - 3219426 - 1216189 cumulative discounted cash flow: -4500000 - -2848624 - 370802 - 1586991
discounted payback period: 1 + (2848624/3219426) = 1.88 years
Preferred stock is a hybrid security because it has some characteristics typical of debt and others typical of equity. The following table lists various characteristics of preferred stock. Determine which of these characteristics is consistent with debt and which is consistent with equity. no tax adjustments are made when calculating the cost of preferred stock
equity
True or False: Sophisticated firms use only the NPV method in capital budgeting decisions.
false
True or False: The following statement accurately describes how firms make decisions related to issuing new common stock. taking flotation costs into account will reduce the cost of new common stock
false: flotation costs are additional cost associated with raising new common stock
If a firm cannot invest retained earnings to earn a rate of return ______________ the required rate of return on retained earnings, it should return those funds to its stockholders.
greater than or equal to
Each of the following factors affects the weighted average cost of capital (WACC) equation. Which of the following factors are outside a firm's control? Check all that apply.
interest rates in the economy the performance of index finds, such as the S&P 500 NOT: the firms dividend payout ratio
before tax cost of debt =
rd
______________ is the symbol that represents the cost of raising capital by issuing new stock in the weighted average cost of capital (WACC) equation.
re
cost of common equity raised by issuing new stock =
re
National Petroleum Refiners Corporation (NPR) has two divisions, L and H. Division L is the company's low-risk division and would have a weighted average cost of capital of 8% if it was operated as an independent company. Division H is the company's high-risk division and would have a weighted average cost of capital of 14% if it was operated as an independent company. Because the two divisions are the same size, the company has a composite weighted average cost of capital of 11%. Division H is considering a project with an expected return of 12%. Should National Petroleum Refiners Corporation (NPR) accept or reject the project?
reject the project
cost of preferred stock =
rp
cost of common equity raised by retaining earnings =
rs
Each of the following factors affects the weighted average cost of capital (WACC) equation. Which of the following factors are outside a firm's control? Check all that apply.
tax rate the inflation rate NOT: the firm's capital budgeting decision rules
If the project's cost of capital were to increase, how would that affect the IRR?
the IRR would not change
Each of the following factors affects the weighted average cost of capital (WACC) equation. Which of the following factors are outside a firm's control? Check all that apply.
the general level of stock prices the effect of the tax rate on the cost of debt in the weighted average cost of capital equation NOT: the firms capital structure
True or False: The following statement accurately describes how firms make decisions related to issuing new common stock. If a firm needs additional capital from equity sources once its retained earnings breakpoint is reached, it will have to raise the capital by issuing new common stock.
true: firms will raise all the equity they can from retained earnings before issuing new common stock, because capital from retained earnings are cheaper than capital raised from issuing new common stock
