The real Chapter 11-13 TEST TEST

A project has an initial outlay of $5,500. It has a single payoff of $11,419 at the end of year 7. What is the internal rate of return for the project? A. 10.00%. B. 11.00%. C. 12.00%. D. 13.00%.

B N 7 I/Y ? PV -5500 FV 11419

Which of these capital investment analysis techniques facilitates comparison of projects with unequal useful lives? A. Internal rate of return B. Equivalent annual annuity C. Net present value D. Modified internal rate of return

B The other responses are capital budgeting calculation methods

A firm's long-term debt is currently selling at a price of 109. The issue matures in 12 years and pays an annual coupon of 7.5%. What is the before-tax cost of debt? A) 5.60% B) 6.40% C) 7.50% D) 8.90% E) 9.30%

B 6.40% N 12 I ? PV -1090 PMT 75 FV 1000

The balance sheet for Stratton Co. shows $400,000 in common equity, $100,000 in preferred stock, and $500,000 in long-term debt. The company has 20,000 common shares outstanding at a market price of $65 per share. The firm's 4,000 shares of preferred stock are currently priced at $50 per share. The firm Has 500 bonds outstanding selling at par value ($1,000). The company's before-tax cost of debt is 6%. The cost of common stock and preferred stock are estimated to be 10% and 7%respectively. If the firm's marginal tax rate is 40%, what is the firm's weighted average cost of capital? A. 6.5% B. 8.7% C. 7.7% D. 8.1%

D The weighted average cost of capital using market value weights and adjusting the cost of debt for taxes: WACC = .65(10) + .10(7) + .25(6)(1-.40) = 8.1%

Grey Brothers, Inc.'s preferred stock pays a 16 percent dividend. The stock is selling for $64.25, and its par value is $50. Issuance costs are 5 percent and the firm's tax rate is 40 percent. What is the cost of this source of financing?

D = (.16)(50) = $8 Flotation costs = (.05)(64.25) = 3.2125 iP = D/(P - F) = 8 / (64.25 - 3.2125) = 13.11 percent

ACME's common stock paid a dividend of $1.32 last year and is expected to grow at 7 percent annually forever. What is the cost of the firm's retained earnings if the current stock price is $35.31?

D1 = D0(1+g) = $1.32 (1+.07) = $1.41 iE = D1 / P0 + g = 1.41 / $35.31 + .07 = 11 percent

When Calculating operating cash flows for a project, one would calculate it as being mathematically equal to ___________

EBIT - Taxes + Depreciation

WhackAmOle has 2 million shares of common stock outstanding, 1.5 million shares of preferred stock outstanding, and 50,000 bonds. Assume the common shares are selling for $60 per share, the preferred shares are selling for $49.00 per share, and the bonds are selling for 103 percent of par. What would be the weights used in the calculation of WhackAmOle's WACC?

Equity 48.98% P. Stock 30.00% Debt 21.02% 120/ 245 = 0.4849 73.5 / 245 = 0.30 51.5 / 245 = 21.02

BetterPie Industries has 6 million shares of common stock outstanding, 4 million shares of preferred stock outstanding, and 15,000 bonds. Assume the common shares are selling for $46 per share, the preferred shares are selling for $23.50 per share, and the bonds are selling for 98 percent of par. What would be the weights used in the calculation of BetterPie's WACC?

Equity weight 71.74% preffered stock weight 24.43% debt weight 3.82% $276m/$384.70m = 0.7174 $94m /$384.70m = 0.24 $14.7m / $384.70m = 0.038

A local bank is contemplating adding a new ATM to their lobby. They will need another phone line to provide communications which has a monthly cost of $50 per month. This is an example of _____________.

Incremental Cash Flow

A local bank is contemplating adding a new ATM to their lobby. They will need another phone line to provide communication which has a monthly cost of $50 per month. This is an example of

Incremental cash flow

A project has a cost of $60,000, and annual cash flows as shown. The discount rate is 10 percent. Calculate NPV, IRR, PB, and DPB for the project.

NPV = $37,735 IRR = 31.43% Payback = 2.58 years Discounted Payback =2.99 years

Which one is better for Cost of Equity? CAPM or Constant Growth Model?

Neither, if we have both, then average answers out.

Compute the discounted payback statistic for Project D if the appropriate cost of capital is 12 percent and the maximum allowable discounted payback is four years. Time 0 1 2 3 4 5 Flow -12.4k 3490 4460 1800 0 1280

O years rejected

An all-equity firm is considering the projects shown below. The T-bill rate is 4 percent and the market risk premium is 8 percent. If the firm uses its current WACC of 13 percent to evaluate these projects, which project(s) will be incorrectly accepted? Project/expected return/beta A:/9%/0.7 B/20%/1.1 C/15%/1.5 D/18%/1.9

Projects C and D

AB Mining Company just commissioned a firm to identify if an unused portion of their mine contains any silver or gold at a cost of $125,000. This is an example of a(n) _______________.

Sunk

If a firm has already paid an expense of is obliged to pay one in the future, regardless of whether a particular project is undertaken, that expense is a(n) ________________

Sunk Cost

What is the theoretical minimum for the weighted average cost of capital?

The after-tax cost of debt

A manufacturing firm is planning on expanding its existing operations. The expansion project is significant and will require the firm to house the expansion in a different location. the firm is considering building on a lot they own across town. the lot is currently vacant and it was paid for nearly 20 years ago. Given this information, which of the following statements is correct?

The lot is an incremental cash flow because it represents an opportunity cost

How do we come up with an estimate of the cost of capital?

WACC (Weighted Average Cost of Capital)

The WACC Formula

Weighted Average Cost of Capital is the average cost per dollar of capital raised W = (% of equity x cost of equity) + (% of preferred stock x cost of preferred stock) + (% of debt x out-of-pocket cost of debt)

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck for $50,000. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in NWC (spare parts inventory) of $2,500. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm's marginal tax rate is 40 percent. What will the free cash flows for this project be?

Yr 0 Cash flow: -$52,500; Yr 1 Cash flow: $18,666; Yr 2 Cash flow: $20,890; Yr 3 Cash flow: $30,944

Weights of WACC formula

based on market values, not book values (Market values reflect investors' assessment of what they would be willing to pay for various types of securities)

A decrease in net working capital (NWC) is treated as a

cash inflow

For which situation below would one need to "smooth out" the variation in each set of cash flows so that each becomes a perpetuity?

choosing between alternative assets with differing lives

If we are calculating WACC for the firm, then equity, preferred stock and debt would be the _______________ source of capital

entire market value

All of the following are incremental cash flows attributable to the project except

financing costs

this is used as a measure of the total amount of available cash flow from a project

free cash flow

If the new project is riskier than the firm's existing projects, then it should be charged a _________ of capital

higher cost

An increase in the risk free rate will _____________ the cost of equity

increase

Accelerated depreciation allows firms to

receive more of the dollars of depreciation earlier in the asset's life

If a firm has already paid an expense or is obliged to pay one in the future, regardless of whether a particular project is undertaken, that expense is a

sunk cost

A proxy beta is

the average beta of firms that are only engaged in the proposed new line of business

The current market price of Fitch Company's common stock is $47.50. The firm expects to pay a dividend of $2.90, and the growth rate is projected to be 9 percent annually. The company is in a 34 percent tax bracket. Flotation costs would be 8 percent if new stock were issued. What is the cost of internal common equity?

• Internal common stock (retained earnings): iE = D1 / P0 + g = $2.90 / $47.50 + .09 = 15.11 percent

Your company is considering a new project that will require $620,000 of new equipment at the start of the project. The equipment will have a depreciable life of 10 years and will be depreciated to the book value of $100,000 using straight-line depreciation. The cost of capital is 11% and the firms tax rate is 34%. Estimate the present value of the tax benefits from depreciation.

$104,122

Suppose you sell a fixed asset for $110,000 when it's book value is $125,000. 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)?

$115,850

KADS, Inc., has spent $500,000 on research to develop a new computer game. The firm is planning to spend $300,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $60,000. Revenue from the new game is expected to be $700,000 per year, with costs of $350,000 per year. The machine has an expected life of three years, a $95,000 estimated resale value, and falls under the MACRS 7-year class life. Expected net working capital will increase by $200,000 at the beginning of the project (and decrease by $200,000 at the end of the project). The firm has a tax rate of 40 percent and an opportunity cost of capital of 11 percent. -What will the after tax cash flow of the company selling this new game machine at the end of the year?

$119,971.20

Your company has spent $200,000 on research to develop a new computer game. The firm is planning to spend $40,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $5,000. The machine has an expected life of 3 years, a $25,000 estimated resale value, and falls under the MACRS 5-Year class life. Revenue from the new game is expected to be $300,000 per year, with costs of $100,000 per year. The firm has a tax rate of 35 percent, an opportunity cost of capital of 14 percent, and it expects net working capital to increase by $50,000 at the beginning of the project. What will be the operating cash flow for year one of this project?

$133,150

You are evaluating the proposed acquisition of a machine that costs $220,000. The machine will result in increased sales of $120,000 per year for 3 years, but costs will increase by $25,000 per year. The machine will be depreciated 3 years MACRS and will be sold for an estimated $50,000 after 3 years. NWC will increase by $75,000 and remain constant for the life of the project. The firm's tax rate is 40 percent and discount rate is 9 percent. Calculate the project's cash flows.

$181,554

KADS, Inc. has spent $400,000 on research to develop a new computer game. The firm is planning to spend $50,000 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 5-Year class life. Revenue from the new game is expected to be $500,000 per year, with costs of $200,000 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 year 2 free cash flow for this project be?

$206,200

Your firm needs a machine which costs $270,000, and requires $42,000 in maintenance for each year of its 7 year life. After 3 years, this machine will be replaced. The machine falls into the MACRS 7-year class life category. Assume a tax rate of 40% and a discount rate of 16%. If this machine can be sold for $27,000 at the end of year 7, what is the after tax salvage value?

$21,016.80

KADS, Inc. has spent $400,000 on research to develop a new computer game. The firm is planning to spend $250,000 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 $500,000 per year, with costs of $200,000 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 year 1 free cash flow for this project be?

$210,004.50

KADS, Inc., has spent $500,000 on research to develop a new computer game. The firm is planning to spend $300,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $60,000. Revenue from the new game is expected to be $700,000 per year, with costs of $350,000 per year. The machine has an expected life of three years, a $95,000 estimated resale value, and falls under the MACRS 7-year class life. Expected net working capital will increase by $200,000 at the beginning of the project (and decrease by $200,000 at the end of the project). The firm has a tax rate of 40 percent and an opportunity cost of capital of 11 percent. -What will the year 1 free cash flow (also operating cash flow in this case) for this project be?

$230,577.60

KADS, Inc., has spent $500,000 on research to develop a new computer game. The firm is planning to spend $300,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $60,000. Revenue from the new game is expected to be $700,000 per year, with costs of $350,000 per year. The machine has an expected life of three years, a $95,000 estimated resale value, and falls under the MACRS 7-year class life. Expected net working capital will increase by $200,000 at the beginning of the project (and decrease by $200,000 at the end of the project). The firm has a tax rate of 40 percent and an opportunity cost of capital of 11 percent. -What will the year 3 operating cash flow for this project be?

$235,185.60

KADS, Inc. has spent $400,000 on research to develop a new computer game. The firm is planning to spend $50,000 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 $10,000 estimated resale value, and falls under the MACRS 5-Year class life. Revenue from the new game is expected to be $500,000 per year, with costs of $200,000 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 $25,000 at the beginning of the project. What will the year 3 free cash flow for this project be?

$243,300

KADS, Inc., has spent $500,000 on research to develop a new computer game. The firm is planning to spend $300,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $60,000. Revenue from the new game is expected to be $700,000 per year, with costs of $350,000 per year. The machine has an expected life of three years, a $95,000 estimated resale value, and falls under the MACRS 7-year class life. Expected net working capital will increase by $200,000 at the beginning of the project (and decrease by $200,000 at the end of the project). The firm has a tax rate of 40 percent and an opportunity cost of capital of 11 perce nt. -What will the year 2 free cash flow (also operating cash flow in this case) for this project be>

$245,265.60

KADS, Inc., has spent $500,000 on research to develop a new computer game. The firm is planning to spend $300,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $60,000. Revenue from the new game is expected to be $700,000 per year, with costs of $350,000 per year. The machine has an expected life of three years, a $95,000 estimated resale value, and falls under the MACRS 7-year class life. Expected net working capital will increase by $200,000 at the beginning of the project (and decrease by $200,000 at the end of the project). The firm has a tax rate of 40 percent and an opportunity cost of capital of 11 percent. -At the beginning of the project, what will be the change in gross fixed assets?

$360,000

A firm purchases a machine for $2,000,000 which has a class life of 3 years MACRS. The firm's cost of capital is 12 percent. When calculating operating cash flows, what is the present value of the tax benefits from depreciation?

$515,003

Compute the NPV for Project M if the appropriate cost of capital is 7 percent. Time 0 1 2 3 4 5 C.Flow -2000 550 680 720 800 300

$519.90 accepted

KADS, Inc., has spent $500,000 on research to develop a new computer game. The firm is planning to spend $300,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $60,000. Revenue from the new game is expected to be $700,000 per year, with costs of $350,000 per year. The machine has an expected life of three years, a $95,000 estimated resale value, and falls under the MACRS 7-year class life. Expected net working capital will increase by $200,000 at the beginning of the project (and decrease by $200,000 at the end of the project). The firm has a tax rate of 40 percent and an opportunity cost of capital of 11 percent. -What will the year 3 free cash flow for this project be?

$555,156.80

Your Company is considering a new project that will require $570,000 of new equipment at the start of the project. The equipment will have a depreciable life of 7 years and will be depreciated to a book value of $241,000 using straight-line depreciation. The cost of capital is 11%, and the firm's tax rate is 30%. Estimate the present value of the tax benefits from depreciation.

$66,442

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck for $290,000. The truck falls into the MACRS 10-year class, and it will be sold after 10 years for $29,000. Use of the truck will require an increase in NWC (spare parts inventory) of $5,900. The truck will have no effect on revenues, but it is expected to save the firm $123,000 per year in before-tax operating costs, mainly labor. The firm's marginal tax rate is 35 percent. What will the cash flows for this project be during year 2?

$98,220

KADS, Inc. has spent $400,000 on research to develop a new computer game. The firm is planning to spend $250,000 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 year 0 free cash flow for this project be?

-$400,000

KADS, Inc., has spent $500,000 on research to develop a new computer game. The firm is planning to spend $300,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $60,000. Revenue from the new game is expected to be $700,000 per year, with costs of $350,000 per year. The machine has an expected life of three years, a $95,000 estimated resale value, and falls under the MACRS 7-year class life. Expected net working capital will increase by $200,000 at the beginning of the project (and decrease by $200,000 at the end of the project). The firm has a tax rate of 40 percent and an opportunity cost of capital of 11 percent. What will the year 0 free cash flow for this project be?

-$560,000

Compute the NPV statistic for Project U if the appropriate cost of capital is 10 percent. Time 0 1 2 3 4 5 Flow -2250 650 2230 -670 600 -250

-64.92 rejected

Compute the NPV for Project K if the appropriate cost of capital is 5 percent. Time: 0 1 2 3 4 5 Flow -12k 6k 7k 7k 6k -15k

-706.32 rejected

Cost of Capital

-the minimum required return on a project -the appropriate discount rate for valuing cash flows associated with a project. -the opportunity cost associated with a project

KADS, Inc., has spent $320,000 on research to develop a new computer game. The firm is planning to spend $120,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $42,000. The machine has an expected life of three years, a $67,000 estimated resale value, and falls under the MACRS 7-year class life. Revenue from the new game is expected to be $520,000 per year, with costs of $170,000 per year. The firm has a tax rate of 35 percent, an opportunity cost of capital of 12 percent, and it expects net working capital to increase by $60,000 at the beginning of the project.

...

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

...

Compute the payback statistic for Project B if the appropriate cost of capital is 13 percent and the maximum allowable payback period is three years Time 0 1 2 3 4 5 Flow -11.5k 3400 4280 1620 0 1100

0 years rejected

JaiLai Cos. stock has a beta of 0.6, the current risk-free rate is 6.5 percent, and the expected return on the market is 13 percent. What is JaiLai's cost of equity?

10.40% 0.065 + 0.6 [0.13 - 0.065] = 0.1040

Compute the IRR for Project F. The appropriate cost of capital is 13 percent Time 0 1 2 3 4 Flow -11.7k 4200 5030 2370 3000

10.45% rejected

TAFKAP Industries has 8 million shares of stock outstanding selling at $17 per share and an issue of $20 million in 7.5%, annual coupon bonds with a maturity of 15 years, selling at 109% of par ($1000). If TAFKAP's weighted average tax rate is 34% and its cost of equity is 12.5%, what is TAFKAP's WACC?

11.37%

ADK Industries common shares sell for $40 per share. ADK expects to set their next annual dividend at $1.75 per share. If ADK expects future dividends to grow at 7% per year, indefinitely, the current risk-free rate is 4%, the expected rate on the market is 11%, and the stock has a beta of 1.2, what should be the best estimate of the firm's cost of equity?

11.89%

B24&Co stock has a beta of 1.57, the current risk-free rate is 3.07%, and the expected return on the market is 10.57%. what is the cost of equity?

14.85%

Suppose that JB Cos. has a capital structure of 80 percent equity, 20 percent debt, and that its before-tax cost of debt is 14 percent while its cost of equity is 18 percent. Assume the appropriate weighted-average tax rate is 25 percent. What will be JB's WACC?

16.5% =0.80 × 18% + 0 × 0% + 0.20 × 14% × (1 - 0.25)

FarCry Industries, a maker of telecommunications equipment, has 2 million shares of common stock outstanding, 1 million shares of preferred stock outstanding, and 10,000 bonds. Suppose the common shares sell for $28 per share, the preferred shares sell for $15.00 per share, and the bonds sell for 98 percent of par. What weight should you use for preferred stock in the computation of FarCry's WACC?

18.56% =15.0m / 80.80m 80.80m = 2m x 28+ 1m x 15+10,000 x 0.98 x 1000

At the conclusion of your project, your company sells a fixed asset for $200,000. The asset's book value is $148,000, and the firm's tax rate is 34 percent. Calculate the after-tax cash flow from this sale

182,320 ATCF = Book Value + (MV - BV) x (1 - T) = 148,000 + (200,000 - 148,000) x (1 - .34) = 182,320

Compute the discounted payback statistic for Project C if the appropriate cost of capital is 9 percent and the maximum allowable discounted payback period is three years. Time 0 1 2 3 4 5 Flow -1200 560 540 580 340 140

2.52 years accepted

Compute the payback statistic for Project A if the appropriate cost of capital is 9 percent and the maximum allowable payback period is four years time 0 1 2 3 4 5 Flow -3k 1150 1080 920 700 500

2.84 years accepted

Team Spors has 5.4 million shares of common stock outstanding, 3.4 million shares of preferred stock outstanding, and 34,000 bonds. If the common shares are selling for $4.40 per share, the preferred share are selling for $16.4 per share, and the bonds are selling for 98.86% of par, what would be the weight used for equity in the computation of Team's WACC?

21.00%

PDQ, Inc., expects EBIT to be approximately $11.1 million per year for the foreseeable future, and it has 40,000 20-year, 10 percent annual coupon bonds outstanding. What would the appropriate tax rate be for use in the calculation of the debt component of PDQ's WACC?

34.28% Tc ⁢ =( $11.1 m⁢ − $10 m$4 m ×35 %)+( $10 m⁢ − $7.1 m$4 m ×34 %)

Compute the NPV statistic for Project Y if the appropriate cost of capital is 10 percent. Time 0 1 2 3 4 C.Flow -8600 3750 4580 1920 700

514.85 accepted

Refer to the previous problem. If the firm's marginal tax rate is 39 percent, what is the after-tax cost of debt?

6.40% x (1 - 0.39)= 3.90%

Suppose that TW, Inc. has a capital structure of 25 percent equity, 15 percent preferred stock, and 60 percent debt. If the before-tax component costs of equity, preferred stock and debt are 13.5 percent, 9.5 percent and 4 percent, respectively, what is TW's WACC if the firm faces an average tax rate of 30%?

6.48%

Compute the IRR static for Project E. The appropriate cost of capital is 7 percent Time 0 1 2 3 4 5 Flow -2800 870 870 780 560 360

8.42% Accepted

TJ Industries has 7 million shares of common stock outstanding with a market price of $20.00 per share. The company also has outstanding preferred stock with a market value of $10 million, and 100,000 bonds outstanding, each with face value $1,000 and selling at 95% of par value. The cost of equity is 12%, the cost of preferred is 10%, and the cost of debt is 6.45%. If TJ's tax rate is 34%, what is the WACC?

8.92%

IVY has a preferred stock selling for 96.3% of par that pays a 8.7% annual coupon. What would be IVY's component cost of preferred stock?

9.03%

KatyDid Clothes has a $130 million (face value) 30-year bond issue selling for 106 percent of par that carries a coupon rate of 10 percent, paid semiannually. What would be KatyDid's before-tax component cost of debt?

9.40%

Suppose that MNINK Industries' capital structure features 63 percent equity, 8 percent preferred stock, and 29 percent debt. Assume the before-tax component costs of equity, preferred stock, and debt are 11.50 percent, 9.40 percent, and 8.00 percent, respectively. What is MNINK's WACC if the firm faces an average tax rate of 34 percent?

9.53% =0.63 × 11.50% + 0.08 × 9.40% + 0.29 × 8.00% × (1 - 0.34)

Suppose the TipsNToes, Inc's capital structure features 40% equity, 60% debt, and that its before-tax cost of debt is 9%, while its cost of equity is 15%. If the appropriate weighted average tax rate is 34%, what will be TipsNToes' WACC?

9.56%

Example: ADK has 1 million shares of 7% preferred stock outstanding which currently trades at $72 per share. What is ADK's cost of preferred equity?

9.72%

Why do we use market-value weights instead of book-value weights

Because we are interested in determining what the cost of financing the firm's assets would be given today's market situation and the component costs the firm currently faces, not what the historical prices would have been

Component Cost of Equity

CAPM and Constant Growth Model

Example: Calculate the cost of equity for ADK Industries given the following information: -ADK common stock: $32.75 -next dividend expected to be $1.54 per share -ADK expects future dividends to grow by 6% per year indefinitely -Risk-free rate is 3% -the expected return on the market is 9% -ADK has a beta of 1.3

CAPM: 10.8% Constant Growth Model: 10.7% Best estimate: 10.75%

Component Cost of Preferred Stock

Calculate with constant-growth model

A decrease in net working capital (NWC) is treated as a

Cash inflow