1. Consider a firm with initial value of $1000 has debt to equity ratio 3.

3. The firm has cost of debt 9 percent and

cost of equity 16 percent. The firm is considering a project with an initial investment requirement of $1000 and
this will be financed from debt only, which will increase the risk profile of the firm and increase the cost of
debt to 10 percent and cost of equity to 20 percent. What will be the minimum cost of capital of the project?

2. ABC Corporation maintains a capital structure of 60 percent debt and 40 percent equity. The components of
cost of capital are as follows:

Items Debt Equity

Cost of existing funds 6 percent 14 percent
Cost of new funds 7 percent 16 percent
The managers anticipate having $50,000 of income available for reinvestment in the business over the next
year. Depreciation, a non-cash expense, of $30,000 will be deducted in computing income. Compute ABC’s
cost of capital for different levels of investment requirements.

3. Refer to problem 2, consider ABC has following investment opportunities:

Investments A B C D
Cost 30,000 60,000 60,000 50,000
IRR 10.7% 10.2% 10% 9.6%
Comment on acceptance of the projects(s).

4. Jake’s Sound Systems has 210,000 shares of common stock outstanding at a market price of $36 a share. Last
month, Jake’s paid an annual dividend in the amount of $1.593 per share. The dividend growth rate is 4
percent. Jake’s also has 6,000 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7
percent coupon, pay interest annually, and mature in 4.89 years. The bonds are selling at 99 percent of face
value. The company’s tax rate is 34 percent. What is Jake’s weighted average cost of capital?

5. Douglass Enterprises has a capital structure, which is based on 40 percent debt, 10 percent preferred stock, and
50 percent common stock. The after-tax cost of debt is 6 percent, the cost of preferred is 7 percent, and the cost
of common stock is 9 percent. The company is considering a project that is equally as risky as the overall firm.
This project has initial costs of $125,000 and cash inflows of $76,000 a year for two years. What is the
projected net present value of this project?