Week 13 Questions

Chapter 19
14. WACC Table 19.4 shows a simplified balance sheet for Rensselaer
Felt. Calculate this companys weighted-average cost of capital. The debt
has just been refinanced at an interest rate of 6% (short term) and 8%
(long term). The expected rate of return on the companys shares is 15%.
There are 7.46 million shares outstanding, and the shares are trading at
$46. The tax rate is 35%.

15. WACC How will Rensselaer Felts WACC and cost of equity change
if it issues $50 million in new equity and uses the proceeds to retire longterm debt? Assume the companys borrowing rates are unchanged. Use
the three-step procedure from Section 19-3.
17. APV Consider another perpetual project like the crusher described
in Section 19-1. Its initial investment is $1,000,000, and the expected
cash inflow is $95,000 a year in perpetuity. The opportunity cost of
capital with all-equity financing is 10%, and the project allows the firm to
borrow at 7%. The tax rate is 35%. Use APV to calculate this projects
value.
a. Assume first that the project will be partly financed with $400,000 of
debt and that the debt amount is to be fixed and perpetual.
b. Then assume that the initial borrowing will be increased or reduced in
proportion to changes in the market value of this project.
Explain the difference between your answers to (a) and (b).
18. Opportunity cost of capital Suppose the project described in
Problem 17 is to be undertaken by a university. Funds for the project will
be withdrawn from the universitys endowment, which is invested in a
widely diversified portfolio of stocks and bonds. However, the university
can also borrow at 7%. The university is tax exempt.

The university treasurer proposes to finance the project by issuing

$400,000 of perpetual bonds at 7% and by selling $600,000 worth of
common stocks from the endowment. The expected return on the
common stocks is 10%. He therefore proposes to evaluate the project by
discounting at a weighted-average cost of capital, calculated as:

Whats right or wrong with the treasurers approach? Should the

university invest? Should it borrow? Would the projects value to the
university change if the treasurer financed the project entirely by selling
common stocks from the endowment?
21. Issue cost and APV The Bunsen Chemical Company is currently at
its target debt ratio of 40%. It is contemplating a $1 million expansion of
its existing business. This expansion is expected to produce a cash inflow
of $130,000 a year in perpetuity.
The company is uncertain whether to undertake this expansion and how
to finance it. The two options are a $1 million issue of common stock or a
$1 million issue of 20-year debt. The flotation costs of a stock issue would
be around 5% of the amount raised, and the flotation costs of a debt issue
would be around 1%.
Bunsens financial manager, Ms. Polly Ethylene, estimates that the
required return on the companys equity is 14%, but she argues that the
flotation costs increase the cost of new equity to 19%. On this basis, the
project does not appear viable.
On the other hand, she points out that the company can raise new debt
on a 7% yield, which would make the cost of new debt 8%. She
therefore recommends that Bunsen should go ahead with the project and
finance it with an issue of long-term debt. Is Ms. Ethylene right? How
would you evaluate the project?