Lee College Unit 3 Financial Management Problems Paper This is an open book and open note quiz.The quiz consists of 10 short-answer problems. Be sure to do

Lee College Unit 3 Financial Management Problems Paper This is an open book and open note quiz.The quiz consists of 10 short-answer problems. Be sure to document your procedure in obtaining the answer in addition to clearly indicating your final answer. You must type your answers in a Word document.. Please ensure that your responses are neat and well organized. BUSN-538 Assignment 3.5a
FINANCIAL MANAGEMENT
1
Quiz 3
1. Bartlett Company’s target capital structure is 40% debt, 15% preferred, and 45% common
equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of
common using reinvested earnings is 12.75%. The firm will not be issuing any new stock.
You were hired as a consultant to help determine their cost of capital. What is its WACC?
2. Kenny Electric Company’s noncallable bonds were issued several years ago and now have 20
years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a
price of $1,075, and has a par value of $1,000. If the firm’s tax rate is 40%, what is the
component cost of debt for use in the WACC calculation?
3. To estimate the company’s WACC, Marshall Inc. recently hired you as a consultant. You
have obtained the following information. (1) The firm’s noncallable bonds mature in 20
years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00.
(2) The company’s tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium
is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure consists of 35% debt
and the balance is common equity. The firm uses the CAPM to estimate the cost of common
stock, and it does not expect to issue any new shares. What is its WACC?
4. Patterson Co. is considering a project that has the following cash flows. It’s WACC is 10%.
Year
Cash
flows
a.
b.
c.
d.
0
-$950
1
$500
2
$400
3
$300
What is the project’s payback period?
What is the project’s NPV?
What is the project’s IRR?
What is the project’s discounted payback period?
5. Taylor Inc., the company you work for, is considering a new project whose data are shown
below. What is the project’s Year 1 cash flow?
Sales revenues, each year
Depreciation
Other operating costs
Interest expense
Tax rate
$62,500
$8,000
$25,000
$8,000
35.0%
BUSN-538 Assignment 3.5a
FINANCIAL MANAGEMENT
2
6. Kasper Film Co. is selling off some old equipment it no longer needs because its associated
project has come to an end. The equipment originally cost $22,500, of which 75% has been
depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%.
What is the equipment’s after-tax salvage value for use in a capital budgeting analysis? Note
that if the equipment’s final market value is less than its book value, the firm will receive a
tax credit as a result of the sale.
7. Weston Clothing Company is considering manufacturing a new style of shirt, whose data are
shown below. The equipment to be used would be depreciated by the straight-line method
over its 3-year life and would have a zero salvage value, and no new working capital would
be required. Revenues and other operating costs are expected to be constant over the project’s
3-year life. However, this project would compete with other Weston’s products and would
reduce their pre-tax annual cash flows. What is the project’s NPV? (Hint: Cash flows are
constant in Years 1-3.)
WACC
Pre-tax cash flow reduction for other products
(cannibalization)
Investment cost (depreciable basis)
Straight-line deprec. rate
Sales revenues, each year for 3 years
Annual operating costs (excl. deprec.)
Tax rate
10.0%
$5,000
$80,000
33.333%
$67,500
$25,000
35.0%
CHAPTER
9
The Cost of Capital
© Adalberto Rios Szalay/Sexto Sol/Getty Images
W
hen companies consider investing in new projects, the cost of capital
plays a major role. Sunny Delight Beverage Co. is making big investments to upgrade its juice factories, but would this happen if low
interest rates had not driven down the cost of capital? According to CEO Billy Cyr,
“When the cost of capital goes up, it is harder to justify an equipment purchase.”
The opposite is true when the cost of capital goes down.
Among its businesses, Phoenix Stamping Group LLC produces components for
equipment used in agriculture and transportation. After modernizing two factories,
Phoenix President Brandyn Chapman said, “The cost of capital certainly helps that
decision.”
For these and many other companies, the historically low cost of capital is
making possible major investments in machinery, equipment, and technology.
Many of these investments are designed to increase productivity, which will lead
to lower prices for consumers and higher cash flows for shareholders. On the other
hand, productivity gains mean not as many employees are needed to run the
business.
Think about these issues as you read this chapter.
Source: Adapted from Timothy Aeppel, “Man vs. Machine, a Jobless Recovery—Companies
Are Spending to Upgrade Factories but Hiring Lags; Robots Pump Out Sunny Delight,”
The Wall Street Journal, January 17, 2012, B1.
357
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
358
Part 4
Projects and Their Valuation
Corporate Valuation and
the Cost of Capital
In Chapter 1, we told you that managers should strive to
make their firms more valuable and that the value of a firm
is determined by the size, timing, and risk of its free cash
flows (FCF). Indeed, a firm’s intrinsic value is estimated as
the present value of its FCFs, discounted at the weighted
© Rob Webb/Getty Images
average cost of capital (WACC). In previous chapters, we
examined the major sources of financing (stocks, bonds,
and preferred stock) and the costs of those instruments. In
this chapter, we put those pieces together and estimate
the WACC that is used to determine intrinsic value.
Net operating
profit after taxes
Free cash flow
(FCF)
Value =
Required investments
in operating capital
?
FCF1
(1 + WACC)1
+
FCF2
(1 + WACC)2
=
+…+
FCF?
(1 + WACC)?
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
Cost of debt
Cost of equity
Firm’s debt/equity mix
Firm’s business risk
© Cengage Learning 2014
resource
The textbook’s Web site
contains an Excel file that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch09
Tool Kit.xls, and we
encourage you to open the
file and follow along as you
read the chapter.
Businesses require capital to develop new products, build factories and distribution
centers, install information technology, expand internationally, and acquire other
companies. For each of these actions, a company must estimate the total investment
required and then decide whether the expected rate of return exceeds the cost of the
capital. The cost of capital is also a factor in compensation plans, with bonuses
dependent on whether the company’s return on invested capital exceeds the cost of
that capital. This cost is also a key factor in choosing the firm’s mixture of debt and
equity and in decisions to lease rather than buy assets. As these examples illustrate,
the cost of capital is a critical element in many business decisions.1
1
The cost of capital is also an important factor in the regulation of electric, gas, and water companies. These
utilities are natural monopolies in the sense that one firm can supply service at a lower cost than could two or
more firms. Because it has a monopoly, an unregulated electric or water company could exploit its customers.
Therefore, regulators (1) determine the cost of the capital investors have provided the utility and then (2) set
rates designed to permit the company to earn its cost of capital, no more and no less.
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Chapter 9
The Cost of Capital
359
9-1 The Weighted Average Cost of Capital
The value of a company’s operations is the present value of the expected free cash flows
(FCF) discounted at the weighted average cost of capital (WACC):
?
Vop ¼
? ð1 þFCF
WACCÞ
1
t¼1
t
(9-1)
We defined free cash flows (FCF) in Chapter 2, explained how to find present values in
Chapter 4, and used the valuation equation in Chapter 7. Now we define the weighted
average cost of capital (WACC):
WACC ¼ wd rd ð1 ? TÞ þ wstd rstd ð1 ? TÞ þ wps rps þ ws rs
(9-2)
Some of these variables should be familiar to you from previous chapters, but some are
new. All are defined as follows:
rd = Coupon rate on new long-term debt being issued by the firm. Recall from
Chapter 5 that rd is the required return on a bond; for previously issued
bonds, rd, is equal to the bond’s yield to maturity.
T = The firm’s effective marginal tax rate.
rstd = Interest rate on short-term debt, such as notes payable.
rps = Required return on preferred stock, as defined in Chapter 7.
rs = Required return on common stock, as defined in Chapter 7.
w = wd, wstd, wps, and ws, = weights of long-term debt, short-term debt,
preferred stock, and common stock in the firm’s target capital structure.
The weights are the percentages of the different sources of capital the firm
plans to use on a regular basis, with the percentages based on the market
values of those sources of capital in the target capital structure.
In the following sections we explain how to estimate the WACC of a specific company,
MicroDrive, Inc., but let’s begin with a few general concepts. First, companies are financed
by several sources of investor-supplied capital, which are called capital components. We
have included short-term debt and preferred stock because some companies use them as
sources of funding, but most companies only use two major sources of investor-supplied
capital, long-term debt, and common stock.
Second, investors providing the capital components require rates of return (rd, rstd, rps,
and rs) commensurate with the risks of the components in order to induce them to make
the investments. Previous chapters defined those required returns from an investor’s view,
but those returns are costs from a company’s viewpoint. This is why we call the WACC a
cost of capital.
Third, recall that FCF is the cash flow available for distribution to all investors.
Therefore, the free cash flows must provide an overall rate of return sufficient to
compensate investors for their exposure to risk. Intuitively, it makes sense that this
overall return should be a weighted average of the capital components’required returns.
This intuition is confirmed by applying algebra to the definitions of required returns,
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
360
Part 4
Projects and Their Valuation
free cash flow, and the value of operations: The discount rate used in Equation 9-1 is
equal to the WACC as defined in Equation 9-2. In other words, the correct rate for
estimating the present value of a company’s (or project’s) cash flows is the weighted average
cost of capital.
SELF-TEST
Identify a firm’s major capital structure components and give the symbols for their
respective costs and weights.
What is a component cost?
9-2 Choosing Weights for the Weighted
Average Cost of Capital
Figure 9-1 selected data for MicroDrive, Inc., including: (1) liabilities and equity (L&E)
from the balance sheets; (2) percentages of total L&E comprised by each liability or equity
account; (3) book values (as reported on the balance sheets) and percentages of financing
from investor-supplied capital; (4) current market values and percentages of financing
from investor-supplied capital; and (5) target capital structure weights.
Notice that we exclude accounts payable and accruals from capital structure weights.
Capital is provided by investors—interest-bearing debt, preferred stock, and common
equity. Accounts payable and accruals arise from operating decisions, not from financing decisions. Recall that the impact of payables and accruals is incorporated into a
firm’s free cash flows and a project’s cash flows rather than into the cost of capital.
Therefore, we consider only investor-supplied capital when discussing capital structure
weights.
Figure 9-1 reports percentages of financing based on book values, market values, and
target weights. Book values are a record of the cumulative amounts of capital supplied by
investors over the life of the company. For equity, stockholders have supplied capital
directly when MicroDrive issued stock, but they have also supplied capital indirectly when
MicroDrive retained earnings instead of paying bigger dividends. The WACC is used to
find the present value of future cash flows, so it would be inconsistent to use weights based
on the past history of the company.
Stock prices are volatile, so current market values of total common equity often change
dramatically from day to day. Companies certainly don’t try to maintain the weights in
their capital structures daily by issuing stock, repurchasing stock, issuing debt, or repaying
debt in response to changes in their stock price. Therefore, the capital structure weights
based on the current market values might not be a good estimate of the capital structure
that the company will have on average during the future.
The target capital structure is defined as the average capital structure weights (based on
market values) that a company will have during the future. MicroDrive has chosen a target
capital structure composed of 2% short-term debt, 28% long-term debt, 3% preferred stock,
and 67% common equity. MicroDrive presently has more debt in its actual capital structure
(using either book values or market values), but it intends to move towards its target capital
structure in the near future. We explain how firms choose their capital structures in Chapter
15, but for now just accept the given target weights for MicroDrive.
The following sections explain how to estimate the required returns for the capital
structure components.
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Chapter 9
The Cost of Capital
361
FIGURE 9-1
MicroDrive, Inc.: Selected Capital Structure Data (Millions of Dollars, December 31, 2013)
Notes:
1. The market value of the notes payable is equal to the book value. Some of the long-term bonds sell at a discount and some sell at a premium, but their
aggregate market value is approximately equal to their aggregate book value.
2. The common stock price is $25 per share. There are 50 million shares outstanding, for a total market value of equity of $25(50) = $1,250 million.
3. The preferred stock price is $100 per share. There are 1 million shares outstanding, for a total market value of preferred stock of $100(1) = $100 million.
SELF-TEST
What is a target capital structure?
9-3 After-Tax Cost of Debt: rd(1 ? T)
and rstd(1 ? T)
The first step in estimating the cost of debt is to determine the rate of return lenders require.
9-3a The Before-Tax Cost of Short-Term Debt: rstd
Short-term debt should be included in the capital structure only if it is a permanent source
of financing in the sense that the company plans to continually repay and refinance the
short-term debt. This is the case for MicroDrive, whose bankers charge 10% on notes
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
362
Part 4
Projects and Their Valuation
payable. Therefore, MicroDrive’s short-term lenders have a required return of rstd = 10%,
which is MicroDrive’s before-tax cost of short-term debt.
Some large companies use commercial paper as a source of short-term financing.
We discuss this in Chapter 16.
9-3b The Before-Tax Cost of Long-Term Debt: rd
For long-term debt, estimating rd is conceptually straightforward, but some problems
arise in practice. Companies use both fixed- and floating-rate debt, both straight and
convertible debt, both long- and short-term debt, as well as debt with and without sinking
funds. Each type of debt may have a somewhat different cost.
It is unlikely that the financial manager will know at the beginning of a planning
period the exact types and amounts of debt that will be used during the period. The type
or types used will depend on the specific assets to be financed and on capital market
conditions as they develop over time. Even so, the financial manager does know what
types of debt are typical for his firm. For example, MicroDrive typically issues 15-year
bonds to raise long-term debt used to help finance its capital budgeting projects. Because
the WACC is used primarily in capital budgeting, MicroDrive’s treasurer uses the cost of
15-year bonds in her WACC estimate.
Assume that it is January 2014 and that MicroDrive’s treasurer is estimating the
WACC for the coming year. How should she calculate the component cost of debt? Most
financial managers begin by discussing current and prospective interest rates with their
investment bankers. Assume MicroDrive’s bankers believe that a new, 15-year, noncallable, straight bond issue would require a 9% coupon rate with semiannual payments. It
can be offered to the public at its $1,000 par value. Therefore, their estimate of rd is 9%.2
Note that 9% is the cost of new, or marginal, debt, and it will probably not be the same
as the average rate on MicroDrive’s previously issued debt, which is called the historical,
or embedded, rate. The embedded cost is important for some decisions but not for others.
For example, the average cost of all the capital raised in the past and still outstanding is
used by regulators when they determine the rate of return that a public utility should be
allowed to earn. However, in financial management the WACC is used primarily to make
investment decisions, and these decisions hinge on projects’ expected future returns
versus the cost of the new, or marginal, capital that will be used to finance those projects.
Thus, for our purposes, the relevant cost is the marginal cost of new debt to be raised during
the planning period.
MicroDrive has issued debt in the past and the bonds are publicly traded. The financial
staff can use the market price of the bonds to find the yield to maturity (or yield to call, if
the bonds sell at a premium and are likely to be called). This yield is the rate of return that
current bondholders expect to …
Purchase answer to see full
attachment