FIN 326: Intermediate Corporate Finance
(The following information applies to Problems 1-4)
- Please show all work, calculation, or explanation to receive full credit and circle the correct answer.
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm’s weighted average cost of capital. The balance sheet and some other information are provided below.
Current assets$ 38,000,000
Net plant, property, and equipment 101,000,000
Liabilities and Equity
Accounts payable$ 10,000,000
Current liabilities$ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities$ 59,000,000
Common stock (10,000,000 shares)30,000,000
Retained earnings 50,000,000
Total shareholders’ equity 80,000,000
Total liabilities and shareholders’ equity$139,000,000
1.The Collins Group’s bond with $1,000 par value 20-year, 7.25% annual
coupon rate with semiannual coupon payment is selling or $875. What is the best estimate of the after-tax cost of debt if the firm’s tax rate is 40%?
|AnswerCost of debt = [coupon amount + (face value-issue price)/time to maturity]/[(face value + issue price)/2]Cost of debt = [72.5+(1000-875)/20]/[(1000+875)/2]Cost of debt = 78.75/937.5Cost of debt = 8.4%After tax cost of debt = 8.5%*(1-40%) = 5.04%Best estimate for cost of debt = 5.14% (out of the given options)|
2.The stock’s beta is 1.25, and the yield on a 20-year Treasury bond is 5.50%.
The required return on the stock market is 11.50%. Based on the CAPM,
what is the firm’s cost of common stock?
|AnswerAs per CAPM, a firm’s cost of common stock = risk free rate + (return on market-risk free rate)*betafirm’s cost of common stock = 5.5% + [(11.5%-5.5%)*1.25]firm’s cost of common stock = 13.00%|
3.Which of the following is the best estimate for the weight of debt for use in calculating the firm’s WACC? The debt is selling for $875 per bond and the stock is selling or 15.25 per share
|AnswerValue of debt = $875*40,000 = 35,000,000Value of common stocks = $15.25*10,000,000 = 152,500,000Total value = 35,000,000+ 152,500,000 = 187,500,000Weight of debt = 35,000,000/187,500,000 = 18.67%|
4.What is the best estimate of the firm’s WACC?
|AnswerWACC = cost of debt*weight of debt + cost of equity*weight of equity WACC = (5.14%*18.67%)+(13%*81.33%)WACC = 11.53%|
5.Quinlan Enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year end (D1 = $2.50), and the dividend is expected to grow at a constant rate of 5.50% a year. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company’s WACC if all the equity used is from retained earnings?
6.A company’s perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm’s cost of preferred stock?
7.The management of California Fluoride Industries (CFI) is planning next year’s capital budget. The company’s earnings and dividends are growing at a constant rate of 4 percent. The last dividend, D0, was $0.80; and the current equilibrium stock price is $8.73. CFI can raise new debt at a 12 percent beforetax cost. CFI is at its optimal capital structure, which is 35 percent debt and 65 percent equity, and the firm’s marginal tax rate is 40 percent. CFI has the following independent, indivisible, and equally risky investment opportunities:
Project Cost Rate of Return
A$ 18,000 9%
B 16,000 11%
C 13,000 15%
D 23,000 13%
What is CFI’s optimal capital budget?
|AnswerGrowth rate (g) = 4%D0 = $0.80Current price (P0) = $8.73Cost of equity = (D0*(1+g)/P0)+gCost of equity = (0.8*(1+4%)/8.73)+4% = 13.53%Cost of debt (before tax) = 12%Cost of debt (after tax) = 12%*(1-40%) = 7.2%WACC = 13.53%*65% + 7.2%*35% = 11.31%Projects C and D are expected to earn returns higher than the WACC. So, the firm should invest in these two projects. For investing the firm will require a total of $36,000 i.e. $13,000 + $23,000|
8.Radiator Products Company (RPC) is at its optimal capital structure of 75 percent common equity and 25 percent debt. RPC’s WACC is 12.50 percent. RPC has a marginal tax rate of 40 percent. Next year’s dividend is expected to be $2.50 per share, and RPC has a constant growth in earnings and dividends of 5 percent. The cost of common equity used in the WACC is based on retained earnings, while the beforetax cost of debt is 10 percent. What is RPC’s current equilibrium stock price?
|Answerbeforetax cost of debt = 10%tax rate = 40%after tax cost of debt = 10%*(1-40%) = 6%WACC = 12.5%12.5% = (6%*25%) + (cost of equity*75%)Cost of equity*75% = 11%Cost of equity = 14.67%Price of stock = D1/(cost of equity-growth rate)Price of stock = 2.5/(14.67%-5%) = $25.83|
9.Which of the following statements is CORRECT?
a.When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
b.Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
c.If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.
d.Higher flotation costs reduce investors’ expected returns, and that leads to a reduction in a company’s WACC.
e.When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
10.Which of the following statements is CORRECT?
a.WACC calculations should be based on the before-tax costs of all the individual capital components.
b.Flotation costs associated with issuing new common stock normally reduce the WACC.
c.If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.
d.An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
e.A change in a company’s target capital structure cannot affect its WACC.