Costs of capital

Costs of capital

When the WACC formula is applied to cost of capital the outcome seems to imply that debt is cheaper than equity; this implies that a firm with more debt could use a lower discount rate. Does this make sense? Explain your answer.

Topic 2:

Corporations often consume natural resources in our society. Overuse or mining of such natural resources can lead to problems in the natural world. In addition, our society has been using technology to improve a corporations position, either financially or through improved resource allocation. In this assignment you are to research a real world issue and create a solution to the problem. You should:

  1. Identify a problem in our natural world that is the result of overuse or by over mining of one or more natural resources to advance a corporation.
  2. Prepare a summary that includes the negative effects on the natural world, how technology was used, and the benefit to the corporation.
  3. Add an additional summary to propose a solution using technology to solve the problem. Explain how the proposed solution continues to benefit the corporation financially. Your summary should also show how this solution could create a significant improvement in the natural world.

The goal of this assignment is to use your critical thinking skills to identify a problem and propose a solution that leaves the corporation and the environment in the best shape possible with the help of technology. This discussion will require that you include resources using APA format.

 

Assignment

Legitron Corporation has $280 million of debt outstanding at an interest rate of 8 percent. What is the dollar value of the tax shield on that debt, just for this year, if Legitron is subject to a 36 percent Cmarginal tax rate?

 

Value of tax shield $____________

Marx and Spender currently has a WACC of 18 percent. If the cost of debt capital for the firm is 9 percent and the firm is currently financed with 47 percent debt, then what is the current cost of equity capital for the firm? Assume that the assumptions in Modigliani and Miller’s Proposition 1 hold. (Round answer to 2 decimal places, e.g. 17.54%.)

 

Current cost of equity capital ___________% cost of capital

 

The weighted average cost of capital for a firm (assuming all three Modigliani and Miller assumptions apply) is 17 percent. What is the current cost of equity capital for the firm if its cost of debt is 8 percent and the proportion of debt to total firm value for the firm is 0.5?

Current cost of capital __________%

Backwards Resources has a WACC of 11.9 percent, and it is subject to a 34 percent marginal tax rate. Backwards has $379 million of debt outstanding at an interest rate of 10 percent and $787 million of equity (market value) outstanding. What is the expected return on the equity with this capital structure? (Round answer to 2 decimal places, e.g. 17.54%.)

 

Expected return on equity _____________%

 

Santas Shoes is a retailer that has just begun having financial difficulty. Santas suppliers are aware of the increased possibility of bankruptcy. What might Santas suppliers do based on this information? (essay)

 

Costs of capitalA few years ago, a friend of yours started a small business that develops gaming software. The company is doing well and is valued at $1.5 million based on multiples for comparable public companies after adjustments for their lack of marketability. With 300,000 shares outstanding, each share is estimated to be worth $5.

Your friend, who has been serving as CEO and CTO (chief technology officer), has decided that he lacks sufficient managerial skills to continue to build the company. He wants to sell his 160,000 shares and invest the money in an MBA education. You believe you have the appropriate managerial skills to run the company. Would you pay $5 each for these shares? What are some of the factors you should consider in making this decision? (essay)

 

 

A friend of yours is trying to value the equity of a company and, knowing that you have read this book, has asked for your help. So far she has tried to use the FCFE approach. She estimated the cash flows to equity to be as follows: (essay)

 

Sales $800.0
-CGS -450.0
-Depreciation -80.0
-Interest -24.0
Earnings before taxes (EBT) 246.0
-Taxes (0.35 x EBT) -86.1
= Cash Flow to Equity $159.9

 

She also computed the cost of equity using CAPM as follows:
kE = kF + βE(Risk premium) = 0.06 + (1.25 x 0.084) = 0.165, or 16.5%

where the beta is estimated for a comparable publicly traded company. Using this cost of equity, she estimates the discount rate as

WACC = xDebtkDebt pretax(1 – t) + xcskcs
= [0.20 x 0.06 x (1-0.35)]+(0.80 x 0.165) = 0.14, or 14%

Based on this analysis, she concludes that the value of equity is $159.9 million/0.14 = $1,142 million.

Assuming that the numbers used in this analysis are all correct, what advice would you give your friend regarding her analysis?

 

According to M&M Proposition 2, which of the following conditions would maximize the value of a firm?

 

[removed] If the cost of debt remains unchanged, the value of a firm would be maximized at a very low debt ratio.

 

 

 

[removed] If the cost of debt changes, the value of a firm would be maximized at a high debt ratio.

 

 

 

[removed] If the cost of debt changes, the value of a firm would be maximized with a very low debt ratio.

 

 

 

[removed] If the cost of debt remains unchanged, the value of a firm would be maximized at a high debt ratio.

 

The fraction of a firm’s total financing that is represented by debt is a measure of its

 

[removed] financial security.

 

 

 

[removed] efficiency.

 

 

 

[removed] operating leverage.

 

 

 

[removed] financial leverage.

 

Financial policy matters because

 

[removed] taxes matter.

 

 

 

[removed] transactions costs and information costs exist.

 

 

 

[removed] capital structure choices affect a firm’s real investment strategy.

 

 

 

[removed] All of these.

 

 

 

A firm plans to issue $700,000 worth of debt at a YTM of 7.5%. The debt is trading at par. The firm’s marginal corporate tax rate is 30%. What is the present value of the tax savings in perpetuity?

 

[removed] $210,000

 

 

 

[removed] $490,000

 

 

 

[removed] $280,000

 

 

 

[removed] $ 15,750
 

In a world with taxes, the value of a leveraged firm equals the value of an unleveraged firm plus

[removed] the present value of its debt.

 

[removed] the present value of the tax shield from the interest on its debt.

 

[removed] the present value of its future cash flows.

 

[removed] none of these.

 

Besides providing an interest tax shield, the inclusion of debt in a firm’s capital structure provides it with all of the following advantages, except

[removed] less likelihood of managers wasting shareholders’ money due to better oversight by debt-holders.

 

[removed] lower agency costs.

 

[removed] lower transactions costs.

 

[removed] better focus on the maximization of the firm’s cash flows.

 

Under which of the following forms of business organization are the owners faced with double taxation?

[removed] Limited partnership.

 

[removed] Sole proprietorship.

 

[removed] Limited liability Corporation (LLC.)

 

[removed] C Corporation.

Which of the following factors does not directly affect the value of a business?

[removed] All of these directly affect the value of a business.

 

[removed] The magnitude of the expected cash flows that the business is likely to produce.

 

[removed] The timing of the expected cash flows that the business is likely to produce.

 

[removed] The riskiness of the expected cash flows that the business is likely to produce.

Which of the following factors does not directly affect the value of a business?

[removed] All of these directly affect the value of a business.

 

[removed] The magnitude of the expected cash flows that the business is likely to produce.

 

[removed] The timing of the expected cash flows that the business is likely to produce.

 

[removed] The riskiness of the expected cash flows that the business is likely to produce.

Valuations differ between young and mature companies because of all of the following except:

[removed] Young companies have less certain futures.

 

[removed] Many young companies are not yet profitable.

 

[removed] Young companies must invest a considerable amount and that makes it hard to use a cost approach.

 

[removed] All of these are reasons valuations differ between young and mature companies.

 

 

 

 

 

Assignment Solutions