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Answers are in Red

NOTE: Some functions used in these spreadsheets may require that

the "Analysis ToolPak" or "Solver Add-In" be installed in Excel.

To install these, click on the Office button

then "Excel Options," "Add-Ins" and select

"Go." Check "Analysis ToolPak" and

"Solver Add-In," then click "OK."

2012, The McGraw-Hill Companies

Quiz 1

Micro Spinoffs, Inc., issued 20-year debt a year ago at par value with a coupon

rate of 8%, paid annually. Today, the debt is selling at $1,050. If the firms tax bracket is 35%,

what is its after-tax cost of debt?

Time 20 years

Coupon rate 8%

Sales cost of debt 1,050.00 $

Tax bracket 35%

Solution:

Using a financial calculator:

Interest rate on debt = 7.50%

After-tax cost of debt = 4.88%

2012, The McGraw-Hill Companies

Quiz 2

Micro Spinoffs has preferred stock outstanding. The stock pays a dividend

of $4 per share, and the stock sells for $40. What is the cost of preferred stock?

Dividend 4.00 $

Stock price 40.00 $

Solution:

Cost of preferred stock = 10%

2012, The McGraw-Hill Companies

Quiz 3

Micro Spinoffs, Inc., issued 20-year debt a year ago at par value with a coupon rate

of 8%, paid annually. Today, the debt is selling at $1,050. The firms tax bracket is 35%. Micro

Spinoffs also has preferred stock outstanding. The stock pays a dividend of $4 per share,

and the stock sells for $40. Suppose Micro Spinoffs cost of equity is 12%.

What is its WACC if equity is 50%, preferred stock is 20%, and debt is 30% of total capital?

Time 20.00 years

Coupon rate 8%

Sales cost of debt 1,050.00 $

Tax bracket 35%

Dividend 4.00 $

Stock price 40.00 $

Cost of equity 12%

Equity 50%

Preferred stock 20%

Debt 30%

Solution:

After-tax cost of debt = 4.88%

Cost of preferred stock = 10.00%

Cost of equity = 12.00%

WACC = 9.46%

(

+

(

+

(

=

equity preferred debt

WACC r

V

E

r

V

P

T r

V

D

C

) 1 (

2012, The McGraw-Hill Companies

Quiz 4

Reliable Electric is a regulated public utility, and it is expected to provide steady growth

of dividends of 5% per year for the indefinite future. Its last dividend was $5 per share;

the stock sold for $60 per share just after the dividend was paid.

What is the companys cost of equity?

Growth of dividends 5%

Last dividend 5.00

Stock price 60.00

Solution:

Cost of Equity = 13.75%

2012, The McGraw-Hill Companies

Quiz 5

Reactive Industries has the following capital structure. Its corporate tax rate is 35%.

What is its WACC?

Debt $20 million 6%

Preferred stock 10 million 8%

Common stock 50 million 12%

Tax rate 35%

Solution:

Firm value = $80.00 million

Weights

Debt: = 25.00%

Preferred: = 12.50%

Common: = 62.50%

WACC = 9.475%

Security Market Value Required Rate of Return

(

+

(

+

(

=

equity preferred debt

) 1 ( WACC r

V

E

r

V

P

T r

V

D

C

2012, The McGraw-Hill Companies

Quiz 6

Geothermals WACC is 11.4%. Executive Fruits WACC is 12.3%. Now

Executive Fruit is considering an investment in geothermal power production.

Should it discount project cash flows at 12.3%? Why or why not?

Geothermals WACC 11.40%

Executive Fruits WACC 12.30%

Solution:

The proper discount rate to discount the project cash flows is 11.40% .

Executive Fruit should use the WACC of Geothermal, not its own WACC, when

evaluating an investment in geothermal power production. The risk of the project

determines the discount rate, and in this case Geothermals WACC is more

reflective of the risk of the project in question.

2012, The McGraw-Hill Companies

Quiz 7

Icarus Airlines is proposing to go public, and you have been given the task of estimating

the value of its equity. Management plans to maintain debt at 30% of the companys present

value, and you believe that at this capital structure the companys debtholders will demand

a return of 6% and stockholders will require 11%. The company is forecasting that next

years operating cash flow (depreciation plus profit after tax at 40%) will be $68 million and

that investment expenditures will be $30 million. Thereafter, operating cash flows and

investment expenditures are forecast to grow by 4% a year.

a. What is the total value of Icarus?

b. What is the value of the companys equity?

Debt ratio 30%

Debt cost 6%

Equity cost 11%

Tax rate 40%

Operating cash flow 68.00 $ million

Investment expenditures 30.00 $ million

Growth rate 4%

Solution:

a.

WACC = 8.78%

Total value of Icarus = 795.00 $ million

b. Value of Equity = 556.50 $ million

(

+

(

=

equity debt

) 1 ( WACC r

V

E

T r

V

D

C

2012, The McGraw-Hill Companies

Practice Problem 8

The common stock of Buildwell Conservation & Construction, Inc., has a beta of .90.

The Treasury bill rate is 4%, and the market risk premium is estimated at 8%. BCCIs capital

structure is 30% debt, paying a 5% interest rate, and 70% equity. What is BCCIs cost of equity

capital? Its WACC? Buildwell pays tax at 40%.

Beta 0.90

Treasury bill rate 4%

Market risk premium 8%

Debt 30%

Interest rate 5%

Equity 70%

Tax rate 40%

Solution:

Cost of equity capital = 11.20%

WACC = 8.74%

(

+

(

=

equity debt

) 1 ( WACC r

V

E

T r

V

D

C

2012, The McGraw-Hill Companies

Practice Problem 9

The common stock of Buildwell Conservation & Construction, Inc., has a beta of .90.

The Treasury bill rate is 4%, and the market risk premium is estimated at 8%. BCCIs capital

structure is 30% debt, paying a 5% interest rate, and 70% equity. Buildwell pays tax at 40%.

BCCI is evaluating a project with an internal rate of return of 12%. Should it accept the project?

If the project will generate a cash flow of $100,000 a year for 8 years, what is the most BCCI

should be willing to pay to initiate the project?

Beta 0.90

Treasury bill rate 4%

Market risk premium 8%

Debt 30%

Interest rate 5%

Equity 70%

Tax 40%

Internal rate 12%

Cash flow 100,000.00

Time 8.00 years

Solution:

Cost of equity capital = 11.20%

WACC = 8.74%

Present value cash flows = $558,870.94

(

+

(

=

equity debt

) 1 ( WACC r

V

E

T r

V

D

C

2012, The McGraw-Hill Companies

Practice Problem 10

The common stock of Buildwell Conservation & Construction, Inc., has a beta of .90.

The Treasury bill rate is 4%, and the market risk premium is estimated at 8%. BCCIs capital

structure is 30% debt, paying a 5% interest rate, and 70% equity. What is BCCIs cost of equity

capital? Its WACC? Buildwell pays tax at 40%.

You need to estimate the value of Buildwell Conservation. You have the following

forecasts (in millions of dollars) of Buildwells profits and of its future investments

in new plant and working capital:

1 2 3 4

Earnings before interest, taxes, depreciation,

and amortization (EBITDA) 80 100 115 120

Depreciation 20 30 35 40

Pretax profit 60 70 80 80

Investment 12 15 18 20

From year 5 onward, EBITDA, depreciation, and investment are expected to remain unchanged

at year-4 levels. Estimate the companys total value and the separate values of its debt and

equity.

Beta 0.90

Treasury bill rate 4%

Market risk premium 8%

Debt 30%

Interest Rate 5%

Equity 70%

Tax 40%

Solution:

1 2 3 4

3. EBITDA 80 100 115 120

4. Depreciation 20 30 35 40

5. Profit before tax = 3 4 60 70 80 80

6. Tax at 40% 24 28 32 32

7. Profit after tax = 5 6 36 42 48 48

8. Operating cash flow = 4 + 7 56 72 83 88

9. Investment 12 15 18 20

10. Free cash flow = 8 9 44 57 65 68

WACC 8.74%

Horizon value at year 4 is: 778.03 $ million

The companys total value is: 744.33 $ million

Value of the firms debt 223.30 $ million

Value of the firms equity 521.03 $ million

Year

Year

2012, The McGraw-Hill Companies

Practice Problem 11

Find the WACC of William Tell Computers. The total book value of the firms equity is $10 million;

book value per share is $20. The stock sells for a price of $30 per share, and the cost of equity

is 15%. The firms bonds have a face value of $5 million and sell at a price of 110% of face value.

The yield to maturity on the bonds is 9%, and the firms tax rate is 40%.

Book value firms equity 10.00 $ million

Book value per share 20.00 $

Stock sells for a price of 30.00 $

Cost of equity 15%

Bonds total face value 5.00 $ million

Selling price of bond 110%

Yield to maturity of bonds 9%

Firms tax rate 40%

Bonds face value 1,000.00 $

Solution:

Security Market Value

Debt $5.50 million

Equity 15.00 million

Total $20.50

WACC = 12.42%

(

+

(

=

equity debt

) 1 ( WACC r

V

E

T r

V

D

C

2012, The McGraw-Hill Companies

Practice Problem 12

Nodebt, Inc., is a firm with all-equity financing. Its equity beta is .80. The Treasury bill rate

is 4%, and the market risk premium is expected to be 10%. What is Nodebts asset beta?

What is Nodebts weighted-average cost of capital? The firm is exempt from paying taxes.

Beta 0.80

Treasury bill rate 4%

Market risk premium 10%

Solution:

Since the firm is all-equity financed, asset beta = equity beta = 0.80

The WACC is the same as the cost of equity, which can be calculated using the CAPM:

r

equity

= 12%

) r - (r r r

f m f equity

| + =

2012, The McGraw-Hill Companies

Practice Problem 14

Bunkhouse Electronics is a recently incorporated firm that makes electronic entertainment systems.

Its earnings and dividends have been growing at a rate of 30%, and the current dividend yield is 2%.

Its beta is 1.2, the market risk premium is 8%, and the risk-free rate is 4%.

Growth Rate 30%

Current dividend yield 2%

Beta 1.20

Market risk premium 8%

Risk-free rate 4%

a. Calculate two estimates of the firms cost of equity.

b. Which estimate seems more reasonable to you? Why?

Solution:

a. Using the recent growth rate of 30% and the dividend yield of 2%, one estimate would be: 32%

Another estimate, based on the CAPM, would be:

r

equity

= 13.6%

b. The estimate of 32% seems far less reasonable. It is based on a historic growth rate

that is impossible to sustain. The DIV

1

/P

0

+ g rule requires that the growth rate of dividends

per share must be viewed as highly stable over the foreseeable future. In other words, it

requires the use of the sustainable growth rate.

) r - (r r r

f m f equity

| + =

2012, The McGraw-Hill Companies

Practice Problem 15

Olympic Sports has two issues of debt outstanding. One is a 9% coupon bond with a face value

of $20 million, a maturity of 10 years, and a yield to maturity of 10%. The coupons are paid

annually. The other bond issue has a maturity of 15 years, with coupons also paid annually, and

a coupon rate of 10%. The face value of the issue is $25 million, and the issue sells for 94% of

par value. The firms tax rate is 35%.

Bond 1:

Coupon Rate 9%

Total face Value 20 million

Maturity 10.00 years

Yield to maturity 10%

Bond 2:

Coupon Rate 10%

Total face Value 25 million

Maturity 15.00 years

Issue sells for 94%

Tax rate 35%

Face Value 1,000.00

a. What is the before-tax cost of debt for Olympic?

b. What is Olympics after-tax cost of debt?

Solution:

a. The 9% coupon bond has a yield to maturity of 10% and sells for 93.86% of face value,

as shown below:

Present Value $938.55 or 93.86%

Therefore, the market value of the issue is $18.77 million.

The 10% coupon bond sells for 94% of par value and has a yield to maturity of: 10.83%

The market value of the issue is $23.50 million.

Weighted-average before-tax cost of debt = 10.46%

b. After-tax cost of debt = 6.80%

2012, The McGraw-Hill Companies

Practice Problem 16

Examine the following book-value balance sheet for University Products, Inc. What is the capital

structure of the firm on the basis of market values? The preferred stock currently sells for $15 per share

and the common stock for $20 per share. There are 1 million common shares outstanding.

Liabilities and Net Worth

Cash and short-term securities 1.00 $ Bonds, coupon = 8%, paid annually

(maturity = 10 years, current yield

to maturity = 9%) 10.00 $

Accounts receivable 3.00 Preferred stock (par value $20 per

share) 2.00

Inventories 7.00 Common stock (par value $.10) 0.10

Plant and equipment 21.00 Additional paid-in stockholders

equity 9.90

Retained earnings 10.00

Total 32.00 $ Total 32.00 $

Preferred stock current price 15.00 $

Common stock current price 20.00 $

Bond Coupon 8%

Bond par value 1,000.00 $

Maturity 10.00 years

Current yield to maturity 9%

Preferred stock par value 20.00 $

Common stock par value 0.10 $

Common shares outstanding 1.00 million

Solution:

Capital structure :

Security

Market Value

(in millions) Percent

Bonds 9.36 $ 30.3%

Preferred Stock 1.50 4.9%

Common Stock 20.00 64.8%

Total 30.86 $ 100.0%

BOOK VALUE BALANCE SHEET

(all values in millions)

Assets

2012, The McGraw-Hill Companies

Practice Problem 17

Examine the following book-value balance sheet for University Products, Inc. The preferred stock

currently sells for $15 per share and the common stock for $20 per share.

There are 1 million common shares outstanding.

If the preferred stock pays a dividend of $2 per share, the beta of the common stock is .8,

the market risk premium is 10%, the risk-free rate is 6%, and the firms tax rate is 40%, what

is Universitys weighted-average cost of capital?

Liabilities and Net Worth

Cash and short-term securities 1.00 $ Bonds, coupon = 8%, paid annually

(maturity = 10 years, current yield

to maturity = 9%) 10.00 $

Accounts receivable 3.00 Preferred stock (par value $20 per

share) 2.00

Inventories 7.00 Common stock (par value $.10) 0.10

Plant and equipment 21.00 Additional paid-in stockholders

equity 9.90

Retained earnings 10.00

Total 32.00 $ Total 32.00 $

Preferred stock current price 15.00 $

Common stock current price 20.00 $

Bond Coupon 8%

Bond par value 1,000.00 $

Maturity 10.00 years

Current yield to maturity 9%

Preferred stock par value 20.00 $

Common stock par value 0.10 $

Common shares outstanding 1.00 million

Preferred stock dividend 2.00 $

Common stock beta 0.80

Market risk premium 10%

Risk-free rate 6%

Tax Rate 40%

Solution:

Capital structure :

Security

Market Value

(in millions)

% de

deuda

bancaria

Costo

obligacion

Bonds 9.36 $ 30.3% Deuda 9%

Preferred Stock 1.50 4.9% 13.30%

Common Stock 20.00 64.8% 14.50%

Total 30.86 $ 100.0%

Para el WACC siempre utilizaremos el valor del mercado

BOOK VALUE BALANCE SHEET

(all values in millions)

Assets

(

+

(

+

(

=

equity preferred debt

) 1 ( WACC r

V

E

r

V

P

T r

V

D

C

2012, The McGraw-Hill Companies

WACC = 11.36%

Checar ya que el resultado boto un 11.68%

(

+

(

+

(

=

equity preferred debt

) 1 ( WACC r

V

E

r

V

P

T r

V

D

C

2012, The McGraw-Hill Companies

Practice Problem 18

Following is the book-value balance sheet for University Products, Inc. The preferred stock currently

sells for $15 per share and the common stock for $20 per share. There are 1 million common

shares outstanding. Preferred stock pays a dividend of $2 per share, the beta of the common stock is

.8, the market risk premium is 10%, the risk-free rate is 6%, and the firms tax rate is 40%.

University Products is evaluating a new venture into home computer systems. The internal rate of

return on the new venture is estimated at 13.4%. WACCs of firms in the personal computer industry

tend to average around 14%. Should the new project be pursued? Will University Products make the

correct decision if it discounts cash flows on the proposed venture at the firms WACC?

Cash and short-term securities 1.00 $ Bonds, coupon = 8%, paid annually

(maturity = 10 years, current yield

to maturity = 9%) 10.00 $

Accounts receivable 3.00 Preferred stock (par value $20 per

share) 2.00

Inventories 7.00 Common stock (par value $.10) 0.10

Plant and equipment 21.00 Additional paid-in stockholders

equity 9.90

Retained earnings 10.00

Total 32.00 $ Total 32.00 $

Preferred stock current price 15.00 $

Common stock current price 20.00 $

Bond Coupon 8%

Bond par value 1,000.00 $

Maturity 10.00 years

Current yield to maturity 9%

Preferred stock par value 20.00 $

Common stock par value 0.10 $

Common shares outstanding 1.00 million

Preferred stock dividend 2.00 $

Common stock beta 0.80

Market risk premium 10%

Risk-free rate 6%

Tax Rate 40%

IRR on new venture 13.4%

WACC (industry average) 14%

BOOK VALUE BALANCE SHEET

Assets Liabilities and Net Worth

(all values in millions)

2012, The McGraw-Hill Companies

Solution:

Capital structure :

Security

Market Value

(in millions) Percent

Bonds 9.36 $ 30.3%

Preferred Stock 1.50 4.9%

Common Stock 20.00 64.8%

Total 30.86 $ 100.0%

WACC = 11.36%

The IRR on the computer project is less than the WACC of firms in the computer

industry. Therefore, the project should be rejected. However, the WACC of the firm

(based on its existing mix of projects) is only 11.36% . If the firm uses this figure

as the hurdle rate, it will incorrectly go ahead with the venture in home computers.

(

+

(

+

(

=

equity preferred debt

) 1 ( WACC r

V

E

r

V

P

T r

V

D

C

2012, The McGraw-Hill Companies

Practice Problem 19

The total market value of Okefenokee Real Estate Company is $6 million, and the total value of its

debt is $4 million. The treasurer estimates that the beta of the stock currently is 1.2 and that the

expected risk premium on the market is 10%. The Treasury bill rate is 4%.

a. What is the required rate of return on Okefenokee stock?

b. What is the beta of the companys existing portfolio of assets? The debt is perceived to be

virtually risk-free.

c. Estimate the weighted-average cost of capital assuming a tax rate of 40%.

d. Estimate the discount rate for an expansion of the companys present business.

e. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The

beta of optical manufacturers with no debt outstanding is 1.4. What is the required rate of

return on Okefenokees new venture? (You should assume that the risky project will not

enable the firm to issue any additional debt.)

Total market value 6.00 $ million

Total value of debt 4.00 $ million

Beta 1.20

Expected risk premium 10%

Treasury bill rate 4%

Tax Rate 40%

Beta (e) 1.40

Solution:

a.

Required rate of return = 16%

b. Weighted-average beta = 0.72

c.

WACC = 10.56%

d. If the company plans to expand its present business, then the WACC is a

reasonable estimate of the discount rate since the risk of the proposed project

is similar to the risk of the existing projects. Use a discount rate of 10.56%

e. The WACC of optical projects should be based on the risk of those projects.

Using a beta of 1.4, the discount rate for the new venture is: 18.00%

) r - (r r r

f m f equity

| + =

(

+

(

=

equity debt

) 1 ( WACC r

V

E

T r

V

D

C

2012, The McGraw-Hill Companies

Practice Problem 20

With a tax rate of 35%, Big Oil had a WAAC of 10.5%. Suppose Big Oil is excused from

paying taxes. How would its WACC change? Now suppose Big Oil makes a large stock

issue and uses the proceeds to pay off all its debt. How would the cost of equity change?

Common stock beta 0.85

Risk-free interest rate 6%

Debt Value 385.70

Common stock 1,200.00

Debt interest rates 9%

Cost of equity 12%

Solution:

New WACC = 11.27%

If Big Oil issues new equity and uses the proceeds to pay off all of its debt, the cost

of equity will decrease. There is no longer any leverage, so the equity becomes safer

and therefore commands a lower risk premium. In fact, with all-equity financing, the

cost of equity would be the same as the firms WACC, which is 11.27%. This is less

than the previous value of 12.0%. (We use the WACC derived in the absence of

interest tax shields since, for the all-equity firm, there is no interest tax shield.)

(

+

(

=

equity debt

) 1 ( WACC r

V

E

T r

V

D

C

2012, The McGraw-Hill Companies

Practice Problem 21

With a tax rate of 35%, Big Oil had a WAAC of 10.5%. Suppose Big Oil is excused from

paying taxes.

TABLE 13.3

Security Type

Debt D = 385.7 D/V 0.243 r

debt

9%

Common stock E = 1,200.00 E/V 0.757 r

equity

12%

Total V = 1,585.70

Suppose Big Oil starts from the financing mix in Table 13.3, and then borrows an additional

$200 million from the bank. It then pays out a special $200 million dividend, leaving its assets

and operations unchanged. What happens to Big Oils WACC, still assuming it pays no

taxes? What happens to the cost of equity?

Common stock beta 0.85

Risk-free interest rate 6%

Debt Value 385.70

Common stock 1,200.00

Debt interest rates 9%

Cost of equity 12%

Borrowed 200.00 million

Special Dividend 200.00 million

Solution:

The net effect of Big Oils transaction is to leave the firm with $200 million more

debt (because of the borrowing) and $200 million less equity (because of the

dividend payout). Total assets and business risk are unaffected. The WACC will

remain unchanged because business risk is unchanged. However, the cost of

equity will increase. With the now-higher leverage, the business risk is spread

over a smaller equity base, so each share is now riskier.

New WACC = 11.27%

We solve to find that r

equity

= 12.60%

Required Rate of Return Capital Structure

(

+

(

=

equity debt

) 1 ( WACC r

V

E

T r

V

D

C

2012, The McGraw-Hill Companies

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