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Cost of Capital
D1 $2.14
10-10 a. rs = +g= + 7% = 9.3% + 7% = 16.3%.
P0 $23
0.5($30,000,000) = $15,000,000.
After-Tax
Percent Cost = Product
Debt 0.50 4.8%* 2.4%
Common equity 0.50 12.0 6.0
WACC = 8.4%
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Corporate Finance Spring 2013 Part 2
Additional Problems
(The following information applies to the next six problems.)
Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20
percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid
semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par,
$100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent
would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk
premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells
for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk
premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs.
The firm's marginal tax rate is 40 percent.
1. What is Rollins' component cost of debt?
a. 10.0%
b. 9.1%
c. 8.6%
d. 8.0%
e. 7.2%
a. 10.0%
b. 11.0%
c. 12.0%
d. 12.6%
e. 13.2%
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Corporate Finance Spring 2013 Part 2
3. What is Rollins' cost of common stock (rs) using the CAPM approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
4. What is the firm's cost of common stock (rs) using the DCF approach?
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
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Corporate Finance Spring 2013 Part 2
1. Cost of debt
Time line:
0 /2?
1 2 3 4 40 6-month
rd
├───────────┼─────┼────────┼─────────┼───∙∙∙───────┤
Periods
PMT = 60 60 60 60 60
VB = 1,000 FV = 1,000
Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are equal.
Thus, the before-tax cost of debt to Rollins is 12 percent. The after-tax cost of debt
equals:
rd,After-tax = 12.0%(1 - 0.40) = 7.2%.
6. WACC
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Corporate Finance Spring 2013 Part 2
Capital Budgeting
11-8 Truck:
Financial calculator: Input the appropriate cash flows into the cash flow register, input I
= 14, and then solve for NPV = $409.
Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 14.99% ≈ 15%.
FV Inflows:
PV FV
0 14% 1 2 3 4 5
| | | | | |
5,100 5,100 5,100 5,100 5,100
5,814
6,628
7,556
8,614
17,100 MIRR = 14.54% (Accept) 33,712
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Corporate Finance Spring 2013 Part 2
Pulley:
Financial calculator: Input the appropriate cash flows into the cash flow register, input I
= 14, and then solve for NPV = $3,318.
Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 20%.
FV Inflows:
PV FV
0 14% 1 2 3 4 5
| | | | | |
7,500 7,500 7,500 7,500 7,500
8,550
9,747
11,112
12,667
22,430 MIRR = 17.19% (Accept) 49,576
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Corporate Finance Spring 2013 Part 2
11-21 a. Payback A (cash flows in thousands):
Annual
Period Cash Flows Cumulative
0 ($25,000) ($25,000)
1 5,000 (20,000)
2 10,000 (10,000)
3 15,000 5,000
4 20,000 25,000
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Corporate Finance Spring 2013 Part 2
b. Discounted payback A (cash flows in thousands):
At a discount rate of 5%, Project A has the higher NPV; consequently, it should be
accepted.
At a discount rate of 15%, Project B has the higher NPV; consequently, it should be
accepted.
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Corporate Finance Spring 2013 Part 2
f. Project ∆ =
Year CFA - CFB
0 $ 0
1 (15)
2 0
3 7
4 14
Step 1: Calculate the NPV of the uneven cash flow stream, so its FV can then be
calculated. With a financial calculator, enter the cash flow stream into the
cash flow registers, then enter I = 10, and solve for NPV = $37,739,908.
Step 1: Calculate the NPV of the uneven cash flow stream, so its FV can then be
calculated. With a financial calculator, enter the cash flow stream into the
cash flow registers, then enter I = 10, and solve for NPV = $36,554,880.
According to the MIRR approach, if the 2 projects were mutually exclusive, Project
A would be chosen because it has the higher MIRR. This is consistent with the NPV
approach.
Additional Problems
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Corporate Finance Spring 2013 Part 2
Additional Problems
1. Your company is considering two mutually exclusive projects, X and Y, whose costs and
cash flows are shown below:
Project X Project Y
Year Cash Flow Cash Flow
0 -$2,000 -$2,000
1 200 2,000
2 600 200
3 800 100
4 1,400 75
The projects are equally risky, and the firm's cost of capital is 12 percent. You must
make a recommendation, and you must base it on the modified IRR (MIRR). What is the
MIRR of the better project?
a. 12.00%
b. 11.46%
c. 13.59%
d. 12.89%
e. 15.73%
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Corporate Finance Spring 2013 Part 2
Time line:
Project Y
r = 12%
0 1 2 3 4 Years
MIRR = ?
Project X Inputs: CF0 = 0; CF1 = 200; CF2 = 600; CF3 = 800; CF4 = 1,400;
I = 12.
Output: NFVX = $3,329.63; NPVX = $2,116.04.
Inputs: N = 4; PV = -2,000; FV = 3,329.63.
Output: IRRX = 13.59% = MIRRX.
Project Y Inputs: CF0 = 0; CF1 = 2,000; CF2 = 200; CF3 = 100; CF4 = 75;
I = 12.
Output: NFVY = $3,247.74; NPVY = $2,063.99.
Inputs: N = 4; PV = -2,000; FV = 3,247.74.
Output: IRRY = 12.885% 12.89% = MIRRY.
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Corporate Finance Spring 2013 Part 2
NPV
2. As the director of capital budgeting for Denver Corporation, you are evaluating two
mutually exclusive projects with the following net cash flows:
Project X Project Z
Year Cash Flow Cash Flow
0 -$100,000 -$100,000
1 50,000 10,000
2 40,000 30,000
3 30,000 40,000
4 10,000 60,000
a. Neither project.
b. Project X, since it has the higher IRR.
c. Project Z, since it has the higher NPV.
d. Project X, since it has the higher NPV.
e. Project Z, since it has the higher IRR.
2. NPV
Time line: Project X (In thousands)
0 1 2 3 4 Years
r = 15%
At a cost of capital of 15%, both projects have negative NPVs and, thus, both would be
rejected.
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Corporate Finance Spring 2013 Part 2
Numerical solution: (In thousands)
Corporate Valuation
15-10 a. NOPAT2008 = $108.6(1-0.4) = $65.16
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Corporate Finance Spring 2013 Part 2
Capital Structure
V = D + S = 0 + ($15)(200,000) = $3,000,000.
b. Using its target capital structure of 30% debt, the company must have debt of:
D = wd V = 0.30($3,348,214.286) = $1,004,464.286.
S = V – D = $2,343,750.
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Corporate Finance Spring 2013 Part 2
c. The number of shares repurchased, X, is:
Initial position:
EPS = [($500,000 – 0)(1-0.40)] / 200,000 = $1.50.
EBIT EBIT
d. 30% debt: TIE = = .
I $70,312.5
Probability TIE
0.10 ( 1.42)
0.20 2.84
0.40 7.11
0.20 11.38
0.10 15.64
The interest payment is not covered when TIE < 1.0. The probability of this
occurring is 0.10, or 10 percent.
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Corporate Finance Spring 2013 Part 2
70 percent debt:
30 percent debt:
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Corporate Finance Spring 2013 Part 2
Additional Problems
1. A consultant has collected the following information regarding Young Publishing:
The company has no growth opportunities (g = 0), so the company pays out all of its
earnings as dividends (EPS = DPS). The consultant believes that if the company moves to
a capital structure financed with 20 percent debt and 80 percent equity (based on market
values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt
will be 10 percent. If the company makes this change, what would be the total market
value of the firm? (The answers are in millions.)
a. $3,200
b. $3,600
c. $4,000
d. $4,200
e. $4,800
2. Dabney Electronics currently has no debt. Its operating income is $20 million and its tax
rate is 40 percent. It pays out all of its net income as dividends and has a zero growth
rate. The current stock price is $40 per share, and it has 2.5 million shares of stock
outstanding. If it moves to a capital structure that has 40 percent debt and 60 percent
equity (based on market values), its investment bankers believe its weighted average cost
of capital would be 10 percent. What would its stock price be if it changes to the new
capital structure?
a. $40
b. $48
c. $52
d. $54
e. $60
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Corporate Finance Spring 2013 Part 2
3. Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon
has a capital structure that consists of 20 percent debt and 80 percent equity, based on
market values. (Its D/S ratio is 0.25.) The risk-free rate is 6 percent and the market risk
premium, rM – rRF, is 5 percent. Currently the company’s cost of equity, which is based
on the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon’s
estimated cost of equity if it were to change its capital structure to 50 percent debt and 50
percent equity?
a. 14.35%
b. 30.00%
c. 14.72%
d. 15.60%
e. 13.64%
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Corporate Finance Spring 2013 Part 2
1. Capital structure and value of the firm
Step 1: Find the new WACC:
WACC = wers + wd(1-T)rd = (0.8(0.11)) + (0.2(1-0.4)0.10) = 0.10.
Step 2: Find the free cash flow. Because there is no growth, there is no
investment in capital, hence FCF is equal to NOPAT:
FCF = NOPAT – Investment in capital = EBIT(1-T) –0 = $800(1-.4)
= $480 million.
Step 3: Find the new value of the firm:
V = FCF/(WACC-g) = $480/0.10 = $4,800 million.
Step 2. Find the new value of equity and debt after the recapitalization:
S = we V = 0.6($120) = $72 million.
D = wd V = 0.4($120) = $48 million.
Step 3. Find the new price per share after the recapitalization:
P = [S + (D-D0)]/n0 = [$72 + ($48 – 0)]/2.5 = $48.
Facts given: rs = 12%; D/E = 0.25; rRF = 6%; RPM = 5%; T = 40%.
Step 1: Find the firm’s current levered beta using the CAPM:
rs = rRF + RPM(b)
12% = 6% + 5%(b)
b = 1.2.
Step 2: Find the firm’s unlevered beta using the Hamada equation:
b = bU[1 + (1 - T)(D/E)]
1.2 = bU[1 + (0.6)(0.25)]
1.2 = 1.15bU
1.0435 = bU.
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Corporate Finance Spring 2013 Part 2
Step 3: Find the new levered beta given the new capital structure using
the Hamada equation:
b = bU[1 + (1 - T)(D/E)]
b = 1.0435[1 + (0.6)(1)]
b = 1.6696.
Step 4: Find the firm’s new cost of equity given its new beta and the CAPM:
rs = rRF + RPM(b)
rs = 6% + 5%(1.6696)
rs = 14.35%.
Good Luck
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