Basic Problems

LG311-1Diddy 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
Diddys cost of equity?
Using equation 11-2:
( )
[ ] .05 1.2 .135 .05
.152
E f E M f
i i E i i 1 +
]
+

LG311-2JaiLai 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
JaiLais cost of equity?
Using equation 11-2:
( )
[ ]
.062 1.1 .12 .062
.1258
E f E M f
i i E i i 1 +
]
+

1
LG311-3Oberon 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 Oberons before-tax component cost
of debt?
Solving equation 11-5 for i
D
:
( )
( )
10
10
1
1
1
$1, 000
Solve $970 $82.50 for
1
D
D
D
D
i
i
i
i
1

1
+

1
+
' ;
1
+

1

]

Yields i
D
= .087115, or 8.7115%
LG311-4KatyDid 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 Katydids before-
tax component cost of debt?
Solving equation 11-5 for i
D
:
( )
( )
40
40
1
1
1
$1, 000
Solve $1,040 $55 for
1
D
D
D
D
i
i
i
i
1

1
+

1
+
' ;
1
+

1

]

Yields i
D
= .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%
LG311-5ILK has preferred stock selling for 97 percent of
par that pays an 8 percent annual coupon.
What would be ILKs component cost of
preferred stock?
Using equation 11-4:
1
0
$8
$97
.0825, or 8.25%
P
D
i
P

LG311-6Marme Inc. has preferred stock selling for 137

percent of par that pays an 11 percent annual
coupon. What would be Marmes component
cost of preferred stock?
Using equation 11-4:
3
1
0
$11
$137
.0803, or 8.03%
P
D
i
P

LG411-7FarCry 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
FarCrys WACC?
Using the computation for equity weight given in
equation 11-1:
2, 000, 000 $27
2, 000, 000 $27 1, 000, 000 $14.50 10, 000 .98 $1, 0 00
$54, 000, 000
$78, 300, 000
.6897, or 68.97%
E
E P D

+ + + +

4
LG411-8OMG 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 OMGs WACC?
Using the computation for equity weight given in
equation 11-1:
4, 000, 000 $17
4, 000, 000 $17 3, 000, 000 $26 5, 000 1.08 $1, 000
$68, 000, 000
$151, 400, 000
.4491, or 44.91%
E
E P D

+ + + +

LG411-9FarCry 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
FarCrys WACC?
Using the computation for equity weight given in
equation 11-1:
5
2, 000, 000 $27
2, 000, 000 $27 1, 000, 000 $14.50 10, 000 .98 $1, 0 00
$9, 800, 000
$78, 300, 000
.1252, or 12.52%
E
E P D

+ + + +

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 OMGs WACC?
Using the computation for equity weight given in
equation 11-1:
5, 000 1.08 $1, 000
4, 000, 000 $17 3, 000, 000 $26 5, 000 1.08 $1, 000
$5, 400, 000
$151, 400, 000
.0357, or 3.57%
E
E P D

+ + + +

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 FarCrys
WACC?
Using the computation for equity weight given in
equation 11-1:
2, 000, 000 $27
2, 000, 000 $27 1, 000, 000 $14.50 10, 000 .98 $1, 0 00
$14, 500, 000
$78, 300, 000
.1852, or 18.52%
E
E P D

+ + + +

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 OMGs WACC?
Using the computation for equity weight given in
equation 11-1:
3, 000, 000 $26
4, 000, 000 $17 3, 000, 000 $26 5, 000 1.08 $1, 000
$78, 000, 000
$151, 400, 000
.5152, or 51.52%
E
E P D

+ + + +

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 TapDances WACC?
Using equation 11-1:
( )
( )
WACC 1
.65 13% 0 0% .35 8% 1 .34
10.298%
E P D C
E P D
i i i T
E P D E P D E P D
+ +
+ + + + + +
+ +

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
( ) WACC 1
6, 500, 000 $14
14%
6, 500, 000 $14 $10, 000, 000 25, 000 $1, 000 .9
$10, 000, 000
10%
6, 500, 000 $14 $10, 000, 000 25, 000 $1, 000 .9
25, 000 $1, 000 .9
6, 500, 000 $14 $10, 000, 000 25,
E P D C
E P D
i i i T
E P D E P D E P D
+ +
+ + + + + +

+ +
+
+ +

+
+ +
( )
( )
7.25% 1 .34
000 $1, 000 .9
$91, 000, 000
14%
$91, 000, 000 $10, 000, 000 22, 500, 000
$10, 000, 000
10%
$91, 000, 000 $10, 000, 000 22, 500, 000
22, 500, 000
7.25% 1 .34
$91, 000, 000 $10, 000, 000 22, 500, 000
.7368 14% .0810 1



+ +
+
+ +
+
+ +
+ ( ) 0% .1822 7.25% 1 .34
11.9973%
+

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 JBs WACC?
Using equation 11-1:
( )
( )
WACC 1
.78 17% 0 0% .22 11% 1 .25
15.075%
E P D C
E P D
i i i T
E P D E P D E P D
+ +
+ + + + + +
+ +

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
9.5 percent, respectively, what is B2Bs WACC
if the firm faces an average tax rate of 30%?
Using equation 11-1:
( )
( )
WACC 1
.37 14.5% .17 11% .46 9.5% 1 .30
9.859%
E P D C
E P D
i i i T
E P D E P D E P D
+ +
+ + + + + +
+ +

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 MNINKs
WACC if the firm faces an average tax rate of
34%?
Using equation 11-1:
( )
( )
WACC 1
.63 11.60% .07 9.5% .30 7% 1 .34
9.359%
E P D C
E P D
i i i T
E P D E P D E P D
+ +
+ + + + + +
+ +

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 TAFKAPs
weighted average tax rate is 34 percent and its
cost of equity is 14.5 percent, what is TAFKAPs
WACC?
First, solve equation 11-5 for i
D
:
10
( )
( )
( )
( )
15
15
1
1
1
Solve PV PMT for
1
1
1
1
$1, 000
Solve $1,060 $75 for
1
6.8476%
N
D
D
N
D
D
D
D
D
D
D
i
PV
i
i
i
i
i
i
i
i
1

1
+

1
+
' ;
1
+

1

1
]

1

1
+

1
+
' ;
1
+

1

1
]

Then, using equation 11-1:

( )
( )
( )
WACC 1
3, 000, 000 $17
14.5%
3, 000, 000 $17 $20, 000, 000 1.06
$20, 000, 000 1.06
6.8476% 1 .34
3, 000, 000 $17 $20, 000, 000 1.06
.7064 14.5% .2936 6.8476% 1 .34
11.5694%
E D C
E D
i i T
E P D E P D
+
+ + + +

+
+
+

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 Cakes
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 i
D
:
11
( )
( )
( )
( )
17
17
1
1
1
Solve PV PMT for
1
1
1
1
$1, 000
Solve $935 $90 for
1
9.8003%
N
D
D
N
D
D
D
D
D
D
D
i
PV
i
i
i
i
i
i
i
i
1

1
+

1
+
' ;
1
+

1

1
]

1

1
+

1
+
' ;
1
+

1

1
]

Next, use equation 11-3 to solve for i

E
:
1
0
$3.00
.06
$23
.1904, or 19.04%
E
D
i g
P
+
+

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

( )
( )
( )
WACC 1
10, 000, 000 $23
19.04%
10, 000, 000 $23 $50.000, 000 .935
$50.000, 000 .935
9.8003% 1 .34
10, 000, 000 $23 $50.000, 000 .935
.8311 19.04% .1689 9.8003% 1 .34
16.9163%
E D C
E D
i i T
E P D E P D
+
+ + + +

+
+
+

Basic Problems
LG3 12-20 Suppose you sell a fixed asset for $109,000
when its book value is $129,000. If your companys
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
( ) ( )
( ) ( )
AT CF Book Value Market Value-Book Value 1
$129, 000 $109, 000 $129, 000 1 .39
$116, 800
C
T +
+

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 firms tax rate is 34%.
Estimate the present value of the tax benefits from
depreciation.
Using equation 12-2, the depreciation per year will be:
Ending Book Value - Beginning Book Value
Depreciation
Life of Asset
$1, 000, 000 $150, 000
10
$85, 000

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:
( )
( )
N
10
1
1
1 i
PVA PMT
i
1
1
1 .13
$28, 900
.13
$156, 818.44
N
1

1
+
1

1
1
1
]
1

1
+
1

1
1
1
]

LG7 12-22 You are trying to pick the least-expensive car for
your new delivery service. You have two choices: the
Scion xA, which will cost $14,000 to purchase and
13
which will have OCF of -$1,200 annually throughout
the vehicles 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 4
Scion xA
CFs
-
$14,0
00
-
$1,2
00
-
$1,2
00
-
$1,2
00
Toyota
Prius
CFs
-
$20,0
00
-$650 -$650 -$650 -
$6
50
The NPV of one Scion xA will be:
( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
3
0 3 1 2
0 1 2 3
0
0 1 2 3
1 1 1 1 1
$14, 000 $1, 200 $1, 200 $1, 200
1.12 1.12 1.12 1.12
$16,882.1975
t
t
t
CF CF CF CF CF
i i i i i
+ + +
+ + + + +

+ + +

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 Scions EAC.
The NPV of one Toyota Prius will be:
14
( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
4
0 3 1 2 4
0 1 2 3 4
0
0 1 2 3 4
1 1 1 1 1 1
$20, 000 $650 $650 $650 $650
1.12 1.12 1.12 1.12 1.12
$21, 974.2771
t
t
t
CF CF CF CF CF CF
i i i i i i
+ + + +
+ + + + + +

+ + + +

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 Toyotas 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 machines EAC?
One iteration of each oven will consist of the following
cash flows:
Year 0 1 2 3 4 5 6 7
Pillsb
ury
CF
s
-
$5
7,0
00
-
$1
0,0
00
-
$1
0,0
00
-
$1
0,0
00
-
$1
0,0
00
-
$1
0,0
00
Keebl
er
CF
s
-
$9
0,0
00
-
$8,
00
0
-
$8,
00
0
-
$8,
00
0
-
$8,
00
0
-
$8,
00
0
-
$
8,
0
0
0
-
$8
,0
00
The NPV of one Pillsbury 707 will be:
15
( ) ( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
5
0 3 5 1 2 4
0 1 2 3 4 5
0
0 1 2 3 4 5
1 1 1 1 1 1 1
$57, 000 $10, 000 $10, 000 $10, 000 $10, 000 $10, 0 00
1.12 1.12 1.12 1.12 1.12 1.12
$93, 047.7620
t
t
t
CF CF CF CF CF CF CF
i i i i i i i
+ + + + +
+ + + + + + +

+ + + + +

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 707s EAC.
The NPV of one Keebler CookieMunster will be:
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
7
0 3 5 6 7 1 2 4
0 1 2 3 4 5 6 7
0
0 1 2 3 4 5 6 7
1 1 1 1 1 1 1 1 1
$90, 000 $8, 000 $8, 000 $8, 000 $8, 000 $8, 000 $8, 000 $8, 000
1.12 1.12 1.12 1.12 1.12 1.12 1.12 1.12
$126, 510.0523
t
t
t
CF CF CF CF CF CF CF CF CF
i i i i i i i i i
+ + + + + + +
+ + + + + + + + +

+ + + + + + +

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 CookieMunsters 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 for
the firm? The discount rate is 12% and the tax rate is
zero.
16
One iteration of each machine will consist of the
following cash flows:
Year 0 1 2 3
Machine A CFs -$80 -$125 -$125
Machine B CFs -$150 -$100 -$100 -$100
The NPV of one Machine A will be:
( ) ( ) ( ) ( )
( ) ( ) ( )
2
0 1 2
0 1 2
0
0 1 2
1 1 1 1
$80 $125 $125
1.12 1.12 1.12
$291.2564
t
t
t
CF CF CF CF
i i i i
+ +
+ + + +

+ +

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 As EAC.
The NPV of one Machine B will be:
( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
3
0 3 1 2
0 1 2 3
0
0 1 2 3
1 1 1 1 1
$150 $100 $100 $100
1.12 1.12 1.12 1.12
$390.1831
t
t
t
CF CF CF CF CF
i i i i i
+ + +
+ + + + +

+ + +

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
Toyotas EAC.
Based on the EACs, we should choose Machine B.
Intermediate Problems
17
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.
Depreciation in year 3 will be 14.81% $50,000 =
$7,400. This will save the firm $7,400 .35 = $2590
in taxes.
18
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:
( ) ( )
( ) ( )
AT CF Book Value Market Value-Book Value 1
$3, 705 $5, 000 $3, 705 1 .35
$4, 546.75
C
T +
+

19