Ethical Thinking in the Liberal Arts
September 6, 2021
6272
September 6, 2021

Calculate the after-tax cost of debt

1.    Calculate the after-tax cost of debt under each of the following conditions:

 

a.    Interest rate, 8 percent; tax rate, 0 percent. Round your answer to two decimal places.
 %

 

b.   Interest rate, 8 percent; tax rate, 25 percent. Round your answer to two decimal places.
 %

 

c.    Interest rate, 8 percent; tax rate, 30 percent. Round your answer to two decimal places.
 %

 

 

2.    LL Incorporated’s currently outstanding 9% coupon bonds have a yield to maturity of 12%. LL believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 40%, what is LL’s after-tax cost of debt? Round the answer to two decimal places.

 

 %

 

 

3.

 

Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $52.5 a share with an annual dividend of $3.50 a share. Ignoring flotation costs, what is the company’s cost of preferred stock, rps? Round the answer to two decimal places.

 

 %

 

 

4

 

 

 

Summerdahl Resorts’ common stock is currently trading at $30 a share. The stock is expected to pay a dividend of $3.00 a share at the end of the year (D1 = $3.00), and the dividend is expected to grow at a constant rate of 5% a year. What is the cost of common equity? Round your answer to two decimal places.

 

 %

 

 

5.
Booher Book Stores has a beta of 1.2. The yield on a 3-month T-bill is 4.5% and the yield on a 10-year T-bond is 8%. The market risk premium is 4%, and the return on an average stock in the market last years was 8.5%. What is the estimated cost of common equity using the CAPM? Round your answer to two decimal places.

 

 %

 

 

 

 

 

 

 

 

6.

 

Shi Importers’ balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common equity. Shi’s tax rate is 40%, rd = 7%, rps = 5.7%, and rs = 11%. If Shi has a target capital structure of 30% debt, 5% preferred stock, and 65% common stock, what is Shi’s WACC? Round your answer to two decimal places.

 

 %

 

 

7

 

 

 

David Ortiz Motors has a target capital structure of 40% debt and 60% equity. The yield to maturity on the company’s outstanding bonds is 8%, and the company’s tax rate is 40%. Ortiz’s CFO has calculated the company’s WACC as 8.74%. What is the company’s cost of equity capital? Round your answer to two decimal places.

 

 %

 

 

8.On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $25 million in new projects. The firm’s present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt.

 

Debt

 

$30,000,000

 

Common equity

 

30,000,000

 

Total capital

 

$60,000,000

 

New bonds will have an 6% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The stockholders’ required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so $1.20/$30 = 4%.) The marginal corporate tax rate is 40%.

 

a.    In order to maintain the present capital structure, how much of the new investment must be financed by common equity?
$

 

b.   Assuming there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing additional shares of equity, what is its WACC? Round your answer to two decimal places.
 %

 

c.    Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC?
_________________ 
I. rs and the WACC will increase due to the flotation costs of new equity.
II. rs and the WACC will decrease due to the flotation costs of new equity.
III. rs will increase and the WACC will decrease due to the flotation costs of new equity.
IV. rs will decrease and the WACC will increase due to the flotation costs of new equity.
V. rs and the WACC will not be affected by flotation costs of new equity.

 

 

 

 

9.

 

A project has an initial cost of $47,975, expected net cash inflows of $13,000 per year for 9 years, and a cost of capital of 13%. What is the project’s NPV? (Hint: Begin by constructing a time line.) Round your answer to the nearest cent.

 

$ ________

 

 

10.

 

A project has an initial cost of $50,000, expected net cash inflows of $12,000 per year for 8 years, and a cost of capital of 10%. What is the project’s IRR? Round your answer to two decimal places.

 

 %

 

 

11.

 

A project has an initial cost of $54,575, expected net cash inflows of $15,000 per year for 8 years, and a cost of capital of 14%. What is the project’s MIRR? Round your answer to two decimal places.

 

 %

 

 

12.

 

 

 

A project has an initial cost of $58,550, expected net cash inflows of $12,000 per year for 7 years, and a cost of capital of 12%. What is the project’s payback period? Round your answer to two decimal places.

 

years

 

 

13.

 

 

 

 

 

A project has an initial cost of $36,650, expected net cash inflows of $10,000 per year for 9 years, and a cost of capital of 13%. What is the project’s PI? Round your answer to two decimal places.

 

________

 

 

14.

 

A project has an initial cost of $52,125, expected net cash inflows of $12,000 per year for 8 years, and a cost of capital of 12%. What is the project’s discounted payback period? Round your answer to two decimal places.

 

years

 

 

15.

 

Your division is considering two investment projects, each of which requires an up-front expenditure of $17 million. You estimate that the investments will produce the following net cash flows:

 

Year

 

Project A

 

Project B

 

1

 

$ 5,000,000

 

$20,000,000

 

2

 

10,000,000

 

10,000,000

 

3

 

20,000,000

 

6,000,000

 

a.    What are the two projects’ net present values, assuming the cost of capital is 5%? Round your answers to the nearest dollar. 
Project A $ __________ 
Project B $ __________ 

What are the two projects’ net present values, assuming the cost of capital is 10%? Round your answers to the nearest dollar. 
Project A $ __________ 
Project B $ __________ 

What are the two projects’ net present values, assuming the cost of capital is 15%? Round your answers to the nearest dollar. 
Project A $ __________ 
Project B $ __________

 

b.   What are the two projects’ IRRs at these same costs of capital? Round your answers to two decimal places.
Project A % 
Project B %

 

 

 

 

16.

 

 

 

Davis Industries must choose between a gas-powered and an electric-powered forklift truck for moving materials in its factory. Since both forklifts perform the same function, the firm will choose only one. (They are mutually exclusive investments.) The electric-powered truck will cost more, but it will be less expensive to operate; it will cost $21,500, whereas the gas-powered truck will cost $17,960. The cost of capital that applies to both investments is 13%. The life for both types of truck is estimated to be 6 years, during which time the net cash flows for the electric-powered truck will be $6,860 per year and those for the gas-powered truck will be $4,600 per year. Annual net cash flows include depreciation expenses.

 

Calculate the NPV for each type of truck. Round your answers to the nearest dollar.

 

Electric-powered truck

 

$ ________

 

Gas-powered truck

 

$ ________

 

Calculate the IRR for each type of truck. Round your answers to two decimal places.

 

Electric-powered truck

 

________ %

 

Gas-powered truck

 

________ %

 

Which type of the truck should the firm purchase?
_________________

 

 

17.

 

After discovering a new gold vein in the Colorado mountains, CTC Mining Corporation must decide whether to mine the deposit. The most cost-effective method of mining gold is sulfuric acid extraction, a process that results in environmental damage. Before proceeding with the extraction, CTC must spend $900,000 for new mining equipment and pay $165,000 for its installation. The gold mined will net the firm an estimated $350,000 each year over the 5-year life of the vein. CTC’s cost of capital is 17%. For the purposes of this problem, assume that the cash inflows occur at the end of the year.

 

a.    What is the project’s NPV? Round your answer to the nearest dollar. 
$ ________ 
What is the project’s IRR? Round your answer to two decimal places. 
 %

 

b.   Should this project be undertaken if environmental impacts were not a consideration?
_________________

 

 

c.    How should environmental effects be considered when evaluating this, or any other, project?
_________________ 
I. Environmental effects should be ignored since they would have no effect on the project’s profitability.
II. Environmental effects should be treated as sunk costs.
III. Environmental effects could be added by estimating penalties or any other cash outflows that might be imposed on the firm to help return the land to its previous state (if possible).

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