Finance
Assignment 6
1. HBM,
Inc. has the following capital structure:
Assets $400,000 Debt $140,000
Preferred
stock 20,000
Common
stock 240,000
The common stock is currently
selling for $15 a share, pays a cash dividend of $0.75 per share, and is
growing annually at 6 percent. The
preferred stock pays a $9 cash dividend and currently sells for $91 a
share. The debt pays interest of 8.5
percent annually, and the firm is in the 30 percent marginal tax bracket.
a. What is the after-tax cost of
debt?
b. What is the cost of preferred
stock?
c. What is the cost of common
stock?
d. What is the firm’s
weighted-average cost of capital?
2. Sun
Instruments expects to issue new stock at $34 a share with estimated flotation
costs of 7
percent of the market price. The company
currently pays a $2.10 cash dividend and has a 6 percent growth rate. What are the costs of retained earnings and
new common stock?
A firm’s current balance sheet is
as follows:
Assets $100 Debt $10
Preferred
stock $90
What is the firms
weighted-average cost of capital at various combinations of debt and equity,
given the following information?
Debt/Assets After-Tax
Cost of Debt Cost
of Equity Cost of Capital
0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?
b. Construct a pro forma balance
sheet that indicates the firm’s optimal capital structure. Compare this balance
sheet with the firm’s current balance sheet.
What course of action should the firm take?
Assets $100 Debt $?
Preferred
stock $?
c. As a firm initially
substitutes debt for equity financing, what happens to the cost of capital, and
why?
d. If a firm uses too much debt
financing, why does the cost of capital rise?
1. You
purchase machinery for $23, 958 that generates cash flow of $6,000 for five
years. What is the internal rate of
return on the investment?
2. The
cost of capital for a firm is 10 percent.
The firm has two possible investments with the following cash inflows:
A B
Year 1 $300 $200
Year
2
200 200
Year
3
100 200
a. Each investment costs
$480. What investment(s) should the firm
make according to net present value?
b. What is the internal rate of
return for the two investments? Which
investment(S) should the firm make? Is
this the same answer you obtained in part a?
c. If the cost of capital rises
to 14 percent, which investment(s) should the firm make?
3. A
firm has the following investment alternatives:
Cash Inflows
A B C
Year
1 $1,100 $3,600 -----
Year
2
1,100 ----- -----
Year
3 1,100 ----- $4,562
Each investment costs $3,000;
investments B and C are mutually exclusive, and the firm’s cost of capital is 8
percent.
a. What is the net present value
of each investment
b. According to the net present
values, which investment(s) should the firm make? Why?
c. What is the internal rate of
return on each investment?
d. According to the internal
rates of return, which investment(s) should the firm make? Why?
e. According to both the net
present values and internal rates of return, which investments should the firm
make?
f. If the firm could reinvest the
$3,600 earned in year one from investment B at 10 percent, what effect would
that information have on your answer to part e? Would the answer be different if the rate were 14 percent?
g. If the firm’s cost of capital
had been 10 percent, what would be investment A’s internal rate of return?
h. The payback method of capital
budgeting selects which investment? Why?
4. The
chief financial officer has asked you to calculate the net present values and
internal rates of return of two $50,000 mutually exclusive investments with the
following cash flows:
Project A Project
B
Cashflow Cashflow
Year
1 $10,000 $0
Year
2 25,000 22,000
Year
3 30,000 48,000
If the firms cost of capital is 9
percent, which investment(s) would you recommend? Would you answer be different if the cost of
capital were 14 percent?
7. An investment with total costs of $10,000
will generate total revenues of $11,000 for one year. Management thinks that since the investment
is profitable, it should be made. Do you
agree? What additional information would you
want? If funds cost 12 percent, what
would be your advice to management?
Would your answer be different if the cost of capital is 8 percent?
While the investment offers an
accounting profit of $1,000, that is insufficient information to make the
investment. Alternative uses for the funds and their cost should be considered.
11. The financial manager has determined the
following schedules for the cost of funds:
Cost of debt ratio Cost of debt Equity
0% 5% 13%
10 5 13
20 5 13
30 5 13
40 5 14
50 6 15
60 8 16
a. Determine the firm’s optimal
capital structure
b. Construct a simple pro forma
balance sheet that shows the firm’s optimal combination of debt and equity for
its current level of assets
Assets $500 Debt -------
Equity -------
$500
c. An investment costs $400 and
offers annual inflows of $133 for five years.
Should the firm make the investment?
d. If the firm makes this
additional investment, how should it balance sheet appear?
Assets ------ Debt --------
Equity -------
e. If the firm is operating with
its optimal capital structure and a $400 asset yields 20.0 percent, what return
will the stockholders earn on their investment in the asset?
11. Investments Quick and Slow cost $1,000 each,
are mutually exclusive, and have the following cash flows. The firm’s cost of capital is 10 percent.
Cash
Inflows
Q S
Year
1 $1,300 $386
Year
2 --------- 386
Year
3
-------- 386
Year
4 ---------- 386
a. According to the net present
value method of capital budgeting, which investment(s) should the firm make?
b. According to the internal rate
of return method of capita budgeting, which investment(s) should the firm make?
c. If Q is chosen, the $1,300 can
be reinvested and earn 12 percent. Does
this information alter your conclusions concerning investing in Q and S? To answer that S’s cash flows can be
reinvested at its internal rate of return.
Would your answer be different if S’S cashflows were invested at the
cost of capital (10 percent)?
TUTORIAL PREVIEW
After-tax cost of debt Kd = 8.5%
x (1 - tax rate)
= 8.5 x (1 - .30) = 5.95%
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