Jose is analyzing two mutually exclusive projects of similar size and has prepared the following

data. Both projects have 5 year lives.

Project A Project
$15,090
2.76 years
Required return 8.3%

B Net present value

$14,693 Payback period
2.51 years
8.0%

Jose has been asked for his best recommendation given this information. His recommendation
should be to accept which project?
Jose should accept Project A and reject Project B because Project A has the greater Net present
value.
Given that the net present value (NPV) is generally considered to be the best method of analysis,
why should you still use the other methods? Net present value (NPV) is generally considered to
be the best method of analysis, however there are reasons to use other methods. The payback
method is used because of the ease to calculate. Payback does not require determining an
appropriate discount rate or accounting for all possible cash Flows for an investment. The
discounted payback method is also useful when you can determine the discount rate but can't
determine all possible cash Flows. Both payback methods require establishing a pre-specified cut
off time. The internal rate of return (IRR) is used when you know the cash Flows but instead of
determining a discount rate you set NPV to zero and solve for the IRR. This is useful in ranking
investment decisions that may have different levels of risk (discount rates) and using the IRR to
decide which one to pick. The profitability index is useful when trying to make decisions based
on profit Managers are still required to determine an appropriate discount rate and identify all
subsequent cash Flows after the initial investment, but the PI will tell you whether to accept a
project based on the ratio being greater than or less

2. Quarles Industries had the following operating results for 2015: sales = $27,660; cost of goods
sold = $19,310; depreciation expense = $4,900; interest expense = $2,190; dividends paid =
$1,000. At the beginning of the year, net fixed assets were $16,530, current assets were $5,770,
and current liabilities were $3,270. At the end of the year, net fixed assets were $20,210, current
assets were $7,116, and current liabilities were $3,810. The tax rate for 2015 was 35 percent.
a.
Income Statement
Sales $ 27,660
Cost of goods sold 19,310
Depreciation 4,900

EBIT $ 3,450
Interest 2,190

Taxable income $ 1,260

Taxes (35%) 441

Net income $ 819

b.
OCF = EBIT + Depreciation Taxes
OCF = $3,450 + 4,900 441
OCF = $7,909
c.
Change in NWC = NWCend NWCbeg
Change in NWC = (CAend CLend) (CAbeg CLbeg)
Change in NWC = ($7,116 3,810) ($5,770 3,270)
Change in NWC = $3,306 2,500
Change in NWC = $806
Net capital spending = NFAend NFAbeg + Depreciation
Net capital spending = $20,210 16,530 + 4,900
Net capital spending = $8,580
CFA = OCF Change in NWC Net capital spending
CFA = $7,909 806 8,580
CFA = $1,477
The cash flow from assets can be positive or negative, since it represents whether the firm raised
funds or distributed funds on a net basis. In this problem, even though net income and OCF are
positive, the firm invested heavily in both fixed assets and net working capital; it had to raise a
net $1,477 in funds from its stockholders and creditors to make these investments.
d.
Cash flow to creditors = Interest - Net new LTD
Cash flow to creditors = $2,190 0
Cash flow to creditors = $2,190

Cash flow to stockholders = Cash flow from assets Cash flow to creditors
Cash flow to stockholders = -$1,477 2,190
Cash flow to stockholders = $3,667
We can also calculate the cash flow to stockholders as:
Cash flow to stockholders = Dividends Net new equity
Solving for net new equity, we get:
Net new equity = Dividends Cash flow to stockholders
Net new equity = $1,000 (3,667)
Net new equity = $4,667
The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from
operations. The firm invested $806 in new net working capital and $8,580 in new fixed assets.
The firm had to raise $1,477 from its stakeholders to support this new investment. It
accomplished this by raising $4,667 in the form of new equity. After paying out $1,000 of this in
the form of dividends to shareholders and $2,190 in the form of interest to creditors, $1,477 was
left to meet the firm's cash flow needs for investment.
Prepare a 2015 balance sheet for Cornell Corp. based on the following information: cash =
$145,000; patents and copyrights = $630,000; accounts payable = $222,000; accounts receivable
= $135,000; tangible net fixed assets = $1,665,000; inventory = $302,000; notes payable =
$130,000; accumulated retained earnings = $1,242,000; long-term debt = $863,000.
CORNELL COP.
Balance Sheet
Assets
Cash $ 145,000
Accounts receivable 135,000
Inventory 302,000
Current assets $ 582,000
Tangible net fixed assets 1,665,000
Intangible net fixed assets 630,000
Total assets $ 2,877,000
Liabilities
Accounts payable $ 222,000
Notes payable 130,000
Current liabilities $ 352,000
Long-term debt 863,000
Total liabilities $ 1,215,000

Common stock 420,000

Accumulated retained earnings 1,242,000
Total liabilities & owners' equity $ 2,877,000

Explanation:
Total liabilities and owners' equity is:
TL & OE = CL + LTD + Common stock + Retained earnings
Solving for this equation for common stock gives us:
Common stock = $2,877,000 1,215,000 1,242,000
Common stock = $420,000
Depreciation expense
You are given the following information for Gandolfino Pizza Co.: sales = $51,000; costs =
$22,700; addition to retained earnings = $7,600; dividends paid = $2,800; interest expense =
$5,100; tax rate = 35 percent. Calculate the depreciation expense.
The solution to this question works the income statement backwards. Starting at the bottom:
Net income = Dividends + Addition to retained earnings
Net income = $2,800 + 7,600
Net income = $10,400
Now, looking at the income statement:
EBT EBT Tax rate = Net income
Recognize that EBT Tax rate is simply the calculation for taxes. Solving this for EBT yields:
EBT = NI / (1 Tax rate)
EBT = $10,400 / (1 .35)
EBT = $16,000
Now you can calculate:
EBIT = EBT + Interest
EBIT = $16,000 + 5,100
EBIT = $21,100
The last step is to use:
EBIT = Sales Costs Depreciation

$21,100 = $51,000 22,700 Depreciation

Solving for depreciation, we find that depreciation = $7,200
Operating cash flow
Cash flow to creditors
Cash flow to stockholders
Addition to NWC
Volbeat Corp. shows the following information on its 2015 income statement: sales = $275,000;
costs = $188,000; other expenses = $7,900; depreciation expense = $15,200; interest expense =
$13,600; taxes = $17,605; dividends = $10,500. In addition, you're told that the firm issued
$5,100 in new equity during 2015 and redeemed $3,600 in outstanding long-term debt.
To find the OCF, we first calculate net income.
Income Statement
Sales $ 275,000
Costs 188,000
Other expenses 7,900
Depreciation 15,200
EBIT $ 63,900
Interest 13,600
Taxable income $ 50,300
Taxes 17,605
Net income $ 32,695
Dividends $ 10,500
Additions to RE $ 22,195

a.
OCF = EBIT + Depreciation - Taxes
OCF = $63,900 + 15,200 - 17,605
OCF = $61,495
b.

CFC = Interest - Net new LTD

CFC = $13,600 - (-3,600)
CFC = $17,200
Note that the net new long-term debt is negative because the company repaid part of its longterm debt.
c.
CFS = Dividends - Net new equity
CFS = $10,500 - 5,100
CFS = $5,400
d.
We know that CFA = CFC + CFS, so:
CFA = $17,200 + 5,400
CFA = $22,600
CFA is also equal to OCF - Net capital spending - Change in NWC. We already know OCF. Net
capital spending is equal to:
Net capital spending = Increase in NFA + Depreciation
Net capital spending = $22,000 + 15,200
Net capital spending = $37,200
Now we can use:
CFA = OCF - Net capital spending - Change in NWC
$22,600 = $61,495 - 37,200 - Change in NWC
Change in NWC = $1,695
This means that the company increased its NWC by $1,695.
Book value of total assets
Sum of NWC and market value of fixed assets
Klingon Widgets, Inc., purchased new cloaking machinery three years ago for $12 million. The
machinery can be sold to the Romulans today for $10.8 million. Klingon's current balance sheet
shows net fixed assets of $10 million, current liabilities of $830,000, and net working capital of
$248,000. If all the current assets were liquidated today, the company would receive $1.15
million cash.
To find the book value of current assets, we use: NWC = CA - CL. Rearranging to solve for
current assets, we get:
CA = NWC + CL
CA = $248,000 + 830,000
CA = $1,078,000

The market value of current assets and fixed assets is given, so:
Book value CA $ 1,078,000 NWC $ 1,150,000
Book value NFA 10,000,000 Market value NFA 10,800,000
Book value assets $ 11,078,000 Total $ 11,950,000
Operating cash flow
Ridiculousness, Inc., has sales of $46,000, costs of $20,900, depreciation expense of $1,500, and
interest expense of $1,100.
If the tax rate is 35 percent, what is the operating cash flow, or OCF?
To calculate OCF, we first need the income statement:
Income Statement
Sales $ 46,000
Costs 20,900
Depreciation 1,500
EBIT $ 23,600
Interest 1,100
Taxable income $ 22,500
Taxes (35%) 7,875
Net income $ 14,625
OCF = EBIT + Depreciation - Taxes
OCF = $23,600 + 1,500 - 7,875
OCF = $17,225
Average tax rate
Marginal tax rate
The Dyrdek Co. had $279,000 in 2014 taxable income. Use the tax rates from
The total taxes paid will be:
Taxes = .15($50,000) + .25($25,000) + .34($25,000) + .39($279,000 - 100,000)
Taxes = $92,060
The average tax rate is the total tax paid divided by taxable income, so:
Average tax rate = $92,060 / $279,000

Average tax rate = .3300, or 33.00%

The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate is 39
percent.
Taxes
The Dyrdek Co. had $303,000 in 2014 taxable income. Use the tax rates from Table 2.3.
Calculate the company's 2014 income taxes.
Taxes = .15($50,000) + .25($25,000) + .34($25,000) + .39($303,000 - 100,000)
Taxes = $101,420
Earnings per share
Dividends per share
Billy's Exterminators, Inc., has sales of $652,000, costs of $298,000, depreciation expense of
$50,000, interest expense of $35,000, a tax rate of 35 percent, and paid out $66,000 in cash
dividends. The firm has 100,000 shares of common stock outstanding.
The income statement for the company is:
Income Statement
Sales $ 652,000
Costs 298,000
Depreciation 50,000
EBIT $ 304,000
Interest 35,000
EBT $ 269,000
Taxes (35%) 94,150
Net income $ 174,850
The earnings per share (EPS) are:
EPS = Net income / Shares
EPS = $174,850 / 100,000
EPS = $1.75 per share
And the dividends per share (DPS) are:
DPS = Dividends / Shares
DPS = $66,000 / 100,000
DPS = $.66 per share
Addition to retained earnings

Billy's Exterminators, Inc., has sales of $743,000, costs of $294,000, depreciation expense of
$46,000, interest expense of $33,000, a tax rate of 35 percent, and paid out $68,000 in cash
dividends.
The income statement for the company is:
Income Statement
Sales $ 743,000
Costs 294,000
Depreciation 46,000
EBIT $ 403,000
Interest 33,000
EBT $ 370,000
Taxes (35%) 129,500
Net income $ 240,500
One equation for net income is:
Net income = Dividends + Addition to retained earnings
Rearranging, we get:
Addition to retained earnings = Net income - Dividends
Addition to retained earnings = $240,500 - 68,000
Addition to retained earnings = $172,500
Net income
Billy's Exterminators, Inc., has sales of $740,000, costs of $288,000, depreciation expense of
$40,000, interest expense of $30,000, and a tax rate of 35 percent
The income statement for the company is:
Income Statement
Sales $ 740,000
Costs 288,000
Depreciation 40,000
EBIT $ 412,000
Interest 30,000
EBT $ 382,000
Taxes (35%) 133,700
Net income $ 248,300

Shareholders' equity
Net working capital
KCCO, Inc., has current assets of $5,000, net fixed assets of $23,000, current liabilities of
$3,500, and long-term debt of $7,900
To find owners' equity, we must construct a balance sheet as follows:
Balance Sheet
CA $ 5,000 CL $ 3,500
NFA 23,000 LTD 7,900
OE ??
TA $ 28,000 TL & OE $ 28,000

We know that total liabilities and owners' equity (TL & OE) must equal total assets of $28,000.
We also know that TL & OE is equal to current liabilities plus long-term debt plus owners'
equity, so owners' equity is:
OE = $28,000 - 7,900 - 3,500 = $16,600
And net working capital (NWC) is:
NWC = CA - CL = $5,000 - 3,500 = $1,500

ng Periods Income statement data: Sales $6,100 Cost of goods sold 5,300 Balance sheet data:
Inventory $ 600 Accounts receivable 220 Accounts payable 380 Calculate the accounts
receivable period, accounts payable period, inventory period, and cash conversion cycle for the
above firm: (Use 365 days in a year. Do not round intermediate calculations. Round your
answers to 1 decimal place.) a . Accounts receivable period days b . Accounts payable period
days c. Inventory period days d . Cash conversion cycle days Explanation: Some values below
may show as rounded for display purposes, though unrounded numbers should be used for the
actual calculations. a. Accounts receivable period = 220 = 13.2 days 6,100/365 b. Accounts
payable period = 380 = 26.2 days 5,300/365 c. Inventory period = 600 = 41.3 days 5,300/365 d.
Cash conversion cycle = 13.2 + 41.3 26.2 = 28.3 days 13.2 1% 26.2 1% 41.3 1% 28.3
1%

Income statement data:

Sales $6,100
Cost of goods sold 5,300
Balance sheet data:
Inventory $ 600
Accounts receivable 220
Accounts payable 380
Calculate the accounts receivable period, accounts payable period, inventory period, and cash
conversion cycle for the above firm: (Use 365 days in a year. Do not round intermediate
calculations. Round your answers to 1 decimal place.)
a . Accounts receivable period days
b . Accounts payable period days
c. Inventory period days
d . Cash conversion cycle days
Explanation: Some values below may show as rounded for display purposes, though unrounded
numbers should be used for the actual calculations.
a. Accounts receivable period = 220 /6100/365= 13.2 days
b. Accounts payable period =

380/5,300/365 =26.2 days

c. Inventory period = 600 /5300/365 = 41.3 days

d. Cash conversion cycle = 13.2 + 41.3 26.2 = 28.3 days 13.2 1% 26.2 1% 41.3 1% 28.3
1%
SDJ, Inc., has net working capital of $3,640, current liabilities of $5,430, and inventory of
$4,290.
What is the current ratio?
Using the formula for NWC, we get:
NWC = CA - CL
CA = CL + NWC
CA = $5,430 + 3,640
CA = $9,070
So, the current ratio is:
Current ratio = CA / CL
Current ratio = $9,070 / $5,430
Current ratio = 1.67 times

And the quick ratio is:

Quick ratio = (CA Inventory) / CL
Quick ratio = ($9,070 4,290) / $5,430
Quick ratio = .88 times
Net income
ROA
ROE
Shelton, Inc., has sales of $29 million, total assets of $27.1 million, and total debt of $9.3
million. Assume the profit margin is 11 percent.
We need to find net income first. So:
Profit margin = Net income / Sales
Net income = Profit margin(Sales)
Net income = .11($29,000,000)
Net income = $3,190,000
ROA = Net income / TA
ROA = $3,190,000 / $27,100,000
ROA = .1177, or 11.77%
To find ROE, we need to find total equity. Since TL & OE equals TA:
TA = TD + TE
TE = TA TD
TE = $27,100,000 9,300,000
TE = $17,800,000
ROE = Net income / TE
ROE = $3,190,000 / $17,800,000
ROE = .1792, or 17.92%
Net income
Y3K, Inc., has sales of $6,219, total assets of $2,835, and a debt-equity ratio of 1.50. If its return
on equity is 10 percent, what is its net income?
This is a multistep problem involving several ratios. The ratios given are all part of the DuPont
Identity. The only DuPont Identity ratio not given is the profit margin. If we know the profit
margin, we can find the net income since sales are given. So, we begin with the DuPont Identity:
ROE = .10 = (PM)(TAT)(EM) = (PM)(S / TA)(1 + D/E)
Solving the DuPont Identity for profit margin, we get:
PM = [(ROE)(TA)] / [(1 + D/E)(S)]
PM = [(.10)($2,835)] / [(1 + 1.50)($6,219)]

PM = .0182
Now that we have the profit margin, we can use this number and the given sales figure to solve
for net income:
PM = .0182 = NI / S
NI = .0182($6,219)
NI = $113.40
ROE
If Roten Rooters, Inc., has an equity multiplier of 1.52, total asset turnover of 1.20, and a profit
margin of 6.2 percent, what is its ROE?
ROE = (PM)(TAT)(EM)
ROE = (.062)(1.20)(1.52)
ROE = .1131, or 11.31%
Receivables turnover
Days' sales in receivables
Average collection period
Receivables turnover = Sales / Receivables
Receivables turnover = $4,902,040 / $342,800
Receivables turnover = 14.30 times
Days' sales in receivables = 365 days / Receivables turnover
Days' sales in receivables = 365 / 14.30
Days' sales in receivables = 25.52 days
On average, the company's customers paid off their accounts in 25.52 days
Inventory turnover
Days' sales in inventory
Days on shelf in inventory
The Green Corporation has ending inventory of $482,750, and cost of goods sold for the year
just ended was $4,209,580
Inventory turnover = COGS / Inventory
Inventory turnover = $4,209,580 / $482,750
Inventory turnover = 8.72 times
Days' sales in inventory = 365 days / Inventory turnover
Days' sales in inventory = 365 / 8.72
Days' sales in inventory = 41.86 days
On average, a unit of inventory sat on the shelf 41.86 days before it was sold
Debt-equity ratio
Equity multiplier
Levine, Inc., has a total debt ratio of .36. What is its debt-equity ratio?

Total debt ratio = .36 = TD / TA

Substituting total debt plus total equity for total assets, we get:
.36 = TD / (TD + TE)
Solving this equation yields:
.36(TE) = .64(TD)
Debt-equity ratio = TD / TE
Debt-equity ratio = .36 / .64
Debt-equity ratio = .56
Equity multiplier = 1 + D/E
Equity multiplier = 1.56
Earnings
Dividends
Book value
Market-to-book ratio
Price-sales ratio
Makers Corp. had additions to retained earnings for the year just ended of $248,000. The firm
paid out $187,000 in cash dividends, and it has ending total equity of $4.92 million. The
company currently has 150,000 shares of common stock outstanding
Net income = Addition to RE + Dividends = $248,000 + 187,000 = $435,000
Earnings per share = NI / Shares = $435,000 / 150,000 = $2.90 per share
Dividends per share = Dividends / Shares = $187,000 / 150,000 = $1.25 per share
Book value per share = TE / Shares = $4,920,000 / 150,000 = $32.80 per share
Market-to-book ratio = Share price / BVPS = $80 / $32.80 = 2.44 times
P/E ratio = Share price / EPS = $80 / $2.90 = 27.59 times
Sales per share = Sales / Shares = $4,740,000 / 150,000 = $31.60
P/S ratio = Share price / Sales per share = $80 / $31.60 = 2.53 times
Debt-equity ratio
Zombie Corp. has a profit margin of 4.7 percent, total asset turnover of 2.1, and ROE of 19.24
percent. What is this firm's debt-equity ratio?
This question gives all of the necessary ratios for the DuPont Identity except the equity
multiplier, so, using the DuPont Identity:

ROE = (PM)(TAT)(EM)
ROE = .1924 = (.047)(2.10)(EM)
EM = .1924 / (.047)(2.10)
EM = 1.95
D/E = EM - 1
D/E = 1.95 - 1
D/E = .95

TOPIC 9
COST OF CAPITAL
(Chapter12)
Answers to Concepts Review and Critical Thinking Questions

Q12.1 WACC. On the most basic level, if a firm's WACC is 12 percent, what does this
mean?

It is the minimum rate of return the firm must earn overall on its existing assets. If
it earns more than this, value is created.

Q12.2 Book Values versus Market Values. In calculating the WACC, if you had to use
book values for either debt or equity, which would you choose? Why?

Book values for debt are likely to be much closer to their market values than are
book values for equity.

Q12.3 Project Risk. If you can borrow all the money you need for a project at 6 percent,
doesn't it follow that 6 percent is your cost of capital for the project?

No. The cost of capital depends on the risk of the project, not the source of the
money

Q12.4 WACC and Taxes. Why do we use an aftertax figure for cost of debt but not for
cost of equity?

Interest expense is tax-deductible. There is no difference between pretax and

aftertax equity costs.

Q12.8 Cost of Capital. Suppose Tom O'Bedlam, president of Bedlam Products, Inc., has
hired you to determine the firm's cost of debt and cost of equity capital.
a) The stock currently sells for $50 per share, and the dividend per share will
probably be about $5. Tom argues, It will cost us $5 per share to use the
stockholders' money this year, so the cost of equity is equal to 10 percent ($5/50).
What's wrong with this conclusion?
b) Based on the most recent financial statements, Bedlam Products' total liabilities
are $8 million. Total interest expense for the coming year will be about $1 million.

Tom therefore reasons, We owe $8 million, and we will pay $1 million interest.
Therefore, our cost of debt is obviously $1 million/ 8 million = 12.5%. What's
wrong with this conclusion?
c) Based on his own analysis, Tom is recommending that the company increase its
use of equity financing, because debt costs 12.5 percent, but equity only costs 10
percent; thus equity is cheaper. Ignoring all the other issues, what do you think
about the conclusion that the cost of equity is less than the cost of debt?

a.

This only considers the dividend yield component of the required return on equity.

b. This is the current yield only, not the promised yield to maturity. In addition, it is based
on the book value of the liability, and it ignores taxes.
c. Equity is inherently riskier than debt (except, perhaps, in the unusual case where a
firms assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If
taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity
does exceed the cost of debt.

Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require
multiple steps. Due to space and readability constraints, when these intermediate steps are
included in this solutions manual, rounding may appear to have occurred. However, the final
answer for each problem is found without rounding during any step in the problem.

Q3
Calculating Cost of Equity. Stock in Matta Ltd has a beta of 0.90. The market
risk premium is 7 percent, and T-bills are currently yielding 4 percent. Matta's most
recent dividend was $1.90 per share, and dividends are expected to grow at a 5 percent

annual rate indefinitely. If the stock sells for $40 per share, what is your best estimate of
Matta's cost of equity

We have the information available to calculate the cost of equity, using the CAPM and
the dividend growth model. Using the CAPM, we find:

RE = .04 + 0.90(.07) = .1030 or 10.30%

And using the dividend growth model, the cost of equity is

RE = [$1.90(1.05)/$40] + .05 = .0999 or 9.99%

Both estimates of the cost of equity seem reasonable. If we remember the historical
return on large capitalization stocks, the estimate from the CAPM model is slightly lower
than average, and the estimate from the dividend growth model is about one percent lower
than the historical average, so we cannot definitively say one of the estimates is incorrect.
Given this, we will use the average of the two, so:

RE = (.1030 + .0999)/2 = .1014 or 10.14%

Q6
Calculating Cost of Debt. ICU Window, Inc., is trying to determine its cost of
debt. The firm has a debt issue outstanding with seven years to maturity that is quoted at
108 percent of face value. The issue makes semi-annual payments and has an embedded
cost of 7.4 percent annually. What is ICU's pretax cost of debt? If the tax rate is 39

percent, what is the aftertax cost of debt?

The pretax cost of debt is the YTM of the companys bonds, so:

P0 = $1,080 = $37(PVIFAR%,14) + $1,000(PVIFR%,14)

R = 2.992%
YTM = 2 2.992%
YTM = 5.98%

And the aftertax cost of debt is:

RD = .0598(1 .39)
RD = .0365 or 3.65%

Q9
Calculating WACC. Mullineaux Corporation has a target capital structure of 60
percent common stock, 5 percent preferred stock, and 35 percent debt. Its cost of equity
is 11 percent, the cost of preferred stock is 5.5 percent, and the cost of debt is 7.2 percent.
The relevant tax rate is 35 percent.
a.

What is Mullineaux's WACC?

b. The company president has approached you about Mullineaux's capital structure.
He wants to know why the company doesn't use more preferred stock financing,
since it costs less than debt. What would you tell the president?

a.

Using the equation to calculate the WACC, we find:

WACC = .60(.11) + .05(.055) + .35(.072)(1 .35)

WACC = .0851 or 8.51%

b. Since interest is tax deductible and dividends are not, we must look at the aftertax cost
of debt, which is:

RD = .072(1 .35)
RD = .0468 or 4.68%

Hence, on an aftertax basis, debt is cheaper than the preferred stock.

Q10 Taxes and WACC. Zymaca Mining has a target debt-equity ratio of .55. Its cost
of equity is 14 percent, and its cost of debt is 8 percent. If the tax rate is 35 percent, what
is the company's WACC?

Here, we need to use the debt-equity ratio to calculate the WACC. A debt-equity ratio of
.65 implies a weight of debt of .65/1.65 and an equity weight of 1/1.65. Using this
relationship, we find:

WACC = .14(1/1.55) + .08(.55/1.55)(1 .35)

WACC = .1088 or 10.88%

Q18 Calculating the WACC. You are given the following information concerning
Trivent Furnitures and are to calculate the WACC for the firm:

Debt:

9,000 6.2 percent coupon bonds outstanding, with 20 years to

maturity, and a quoted price of 104. These bonds pay interest
semi-annually

Commo
n stock:

225,000 shares of common stock selling for $64.50 per share.

The stock has a beta of 0.85 and will pay a dividend of $2.70
next year. The dividend is expected to grow by 5 percent per
year indefinitely

Preferre
d stock:

10,000 shares of 5.4 percent preferred stock selling at $94 per

share.

Market:

A 12 percent expected return, a 5 percent risk-free rate, and a

35 percent tax rate.

We will begin by finding the market value of each type of financing. We find:

MVD = 9,000($1,000)(1.04) = $9,360,000

MVE = 225,000($64.50) = $14,512,500
MVP = 10,000($94) = $940,000

And the total market value of the firm is:

V = $9,360,000 + 14,512,500 + 940,000

V = $24,812,500

Now, we can find the cost of equity using the CAPM. The cost of equity is:

RE1 = .05 + .85(.12 .05)

RE1 = .1095 or 10.95%

We can also find the cost of equity, using the dividend discount model. The cost of
equity with the dividend discount model is:

RE2 = ($2.70/$64.50) + .05

RE2 = .0919 or 9.19%

Both estimates for the cost of equity seem reasonable, so we will use the average of the
two. The cost of equity estimate is:

RE = (.1095 + .0919)/2
RE = .1007 or 10.07%

The cost of debt is the YTM of the bonds, so:

P0 = $1,040 = $31(PVIFAR%,40) + $1,000(PVIFR%,40)

R = 2.939%
YTM = 2.939% 2
YTM = 5.86%

And the aftertax cost of debt is:

RD = (1 .35)(.0586)
RD = .0381 or 3.81%

The cost of preferred stock is:

RP = $5.40/$94
RP = .0574 or 5.74%

Now, we have all of the components to calculate the WACC. The WACC is:

WACC = .0381($9,360,000/$24,812,500) + .0574($940,000/$24,812,500)

+ .1007($14,512,500/$24,812,500)

WACC = .0754 or 7.54%

4. Holdup Bank has an issue of preferred stock with a $4.25 stated dividend that just sold for
$92 per share. What is the banks cost of preferred stock? The cost of preferred stock is the
dividend payment divided by the price, so:
R P = $4.25/$92 = .0462, or 4.62%

55. Jiminys Cricket Farm issued a 30-year, 8 percent semiannual bond 3 years ago. The bond
currently sells for 93 percent of its face value. The companys tax rate is 35 percent. 1. What is
the pretax cost of debt? 1. What is the aftertax cost of debt? Which is more relevant, the pretax
or the aftertax cost of debt? Why? a. The pretax cost of debt is the YTM of the companys bonds,
so: P 0 = $930 = $40(PVIFA R %,54 ) + $1,000(PVIF R %,54 ) R = 4.338%
YTM = 2 4.338% = 8.68%
b. The aftertax cost of debt is: R D = .0868(1 .35) = .0564, or 5.64%
c. The aftertax rate is more relevant because that is the actual cost to the company.
56. Mullineaux Corporation has a target capital structure of 60 percent common stock, 5 percent
preferred stock, and 35 percent debt. Its cost of equity is 12 percent, the cost of preferred stock is
5 percent, and the pretax cost of debt is 7 percent. The relevant tax rate is 35 percent. 1. What is
Mullineauxs WACC? The company president has approached you about Mullineauxs capital
structure. He wants to know why the company doesnt use more preferred stock financing
because it costs less than debt. What would you tell the president?
a. Using the equation to calculate the WACC, we find:
WACC = .60(.12) + .05(.05) + .35(.07)(1 .35)
= .0904, or 9.04%
b. Since interest is tax deductible and dividends are not, we must look at the aftertax cost of
debt, which is: .07(1 .35) = .0455, or 4.55%
Hence, on an aftertax basis, debt is cheaper than the preferred stock.
57. Titan Mining Corporation has 8.5 million shares of common stock outstanding, 250,000
shares of 5 percent preferred stock outstanding, and 135,000 7.5 percent semiannual bonds
outstanding, par value $1,000 each. The common stock currently sells for $34 per share and

has a beta of 1.25, the preferred stock currently sells for $91 per share, and the bonds have
15 years

to maturity and sell for 114 percent of par. The market risk premium is 7.5 percent, T-bills are
yielding 4 percent, and Titan Minings tax rate is 35 percent.
1. What is the firms market value capital structure? If Titan Mining is evaluating a new
investment project that has the same risk as the firms typical project, what rate should the firm
use to discount the projects cash flows?
a. We will begin by finding the market value of each type of financing. We find:
MV D = 135,000($1,000)(1.14) = $153,900,000
MV E = 8,500,000($34) = $289,000,000
MV P = 250,000($91) = $22,750,000
And the total market value of the firm is:
V = $153,900,000 + 289,000,000 + 22,750,000 = $465,650,000

EFINITIONS Topic: INCREMENTAL CASH FLOWS 1. The changes in the firm's future
cash flows that are a direct consequence of accepting a project are called: A)
Incremental cash flows. B) Stand-alone cash flows. C) Aftertax cash flows. D) Net
present value cash flows. E) Erosion cash flows.
Answer: A
Topic: STAND-ALONE PRINCIPLE 2. The evaluation of a project based solely on its
incremental cash flows is the basis of the: A) Incremental cash flow method. B)
Stand-alone principle. C) Dividend growth model. D) Aftertax salvage value analysis.
E) Discounted payback method.
Answer: B
Topic: SUNK COSTS 3. A cost that has already been paid, or the liability to pay has
already been incurred, is a(n): A) Salvage value expense. B) Net working capital
expense. C) Sunk cost. D) Opportunity cost. E) Erosion cost.
Answer: C
Topic: OPPORTUNITY COSTS 4. The most valuable investment given up if an
alternative investment is chosen is a(n): A) Salvage value expense. B) Net working

capital expense. C) Sunk cost. D) Opportunity cost. E) Erosion cost.

Answer: D
Topic: EROSION COSTS 5. The cash flows of a new project that come at the expense
of a firm's existing projects are: A) Salvage value expenses. B) Net working capital
expenses. C) Sunk costs. D) Opportunity costs. E) Erosion costs.
Answer: E

Topic: PRO FORMA FINANCIAL STATEMENTS 6. A pro forma financial statement is one
that _____________________. A) projects future years' operations B) is expressed as a
percentage of the total assets of the firm C) is expressed as a percentage of the total sales of the
firm D) is expressed relative to a chosen base year's financial statement E) reflects the past and
current operations of the firm
Answer: A
Topic: MACRS DEPRECIATION 7. The depreciation method currently allowed under US tax
law governing the accelerated write-off of property under various lifetime classifications is
called: A) FIFO depreciation. B) MACRS depreciation. C) Straight-line depreciation. D) Sumof-years digits depreciation. E) Curvilinear depreciation.
Answer: B
Topic: DEPRECIATION TAX SHIELD 8. The cash flow tax savings generated as a result of a
firm's tax-deductible depreciation expense is called (the) ___________________. A) aftertax
depreciation savings B) depreciable basis C) depreciation tax shield D) operating cash flow E)
aftertax salvage value
Answer: C

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Topic: PRO FORMA FINANCIAL STATEMENTS 6. A pro forma financial statement is one
that _____________________. A) projects future years' operations B) is expressed as a
percentage of the total assets of the firm C) is expressed as a percentage of the
total sales of the firm D) is expressed relative to a chosen base year's financial
statement E) reflects the past and current operations of the firm Answer: A
Topic: MACRS DEPRECIATION 7. The depreciation method currently allowed under
US tax law governing the accelerated write-off of property under various lifetime
classifications is called: A) FIFO depreciation. B) MACRS depreciation. C) Straightline depreciation. D) Sum-of-years digits depreciation. E) Curvilinear depreciation.
Answer: B
Topic: DEPRECIATION TAX SHIELD 8. The cash flow tax savings generated as a result
of a firm's tax-deductible depreciation expense is called (the) ___________________. A)
aftertax depreciation savings B) depreciable basis C) depreciation tax shield D)
operating cash flow E) aftertax salvage value Answer: C Topic: CASH FLOW FROM
PROJECTS 9. The cash flow from projects for a company is: A) The net operating
cash flow generated by the project, less any sunk costs and erosion costs. B) The
sum of the incremental operating cash flow and aftertax salvage value of the
project