Question_Lasher_12Dec_2nd
Question # 00005381
Posted By:
Updated on: 12/14/2013 05:43 PM Due on: 12/31/2013
1. You're the newly hired CFO of a small construction company. The privately held firm is
capitalized with $2 million in owner's equity and $3 million in variable rate bank loans. The
construction business is quite risky, so returns of 20% to 25% are normally demanded on equity
investments. The bank is currently charging 14% on the firm's loans, but interest rates are expected to
rise in the near future. Your boss, the owner, started his career as a carpenter and has an excellent grasp
of day-to-day operations. However, he knows little about finance. Business has been good lately, and
several expansion projects are under consideration. A cash flow projection has been made for each.
You're satisfied that these estimates are reasonable.
The owner has called you in and confessed to being confused about the projects. He instinctively
feels that some are financially marginal and may not be beneficial to the company, but he doesn't know
how to demonstrate this or to choose among the projects that are financially viable.
Assuming the owner understands the concept of return on investment, write a brief memo explaining
the ideas of IRR and cost of capital and how they can solve his problem. Don't get into the detailed
mechanics of the calculations, but do use the figures given above to make a rough estimate of the
company's cost of capital, and use the result in your memo.
line.
2. You're the CFO of a small company that is considering a new venture. The president and
several other members of management are very excited about the idea for reasons related to engineering
and marketing rather than profitability. You've analyzed the proposal by using capital budgeting
techniques, and found that it fails both IRR and NPV tests using a cost of capital based on market
returns. The problem is that interest rates have risen steeply in the last year, so the cost of capital seems
unusually high.
You've presented your results to the management team, who are very disappointed. In fact, they'd
like to find a way to discredit your analysis, so they can justify going ahead with the project. You've
explained your analysis, and everything seems well understood except for one point. The group insists
that the use of returns currently available to investors as a basis for the cost of capital components
doesn't make sense. The vice president of marketing put his objection as follows. "Two years ago
Chapter 13
we borrowed $1 million at 10%. We haven't paid it back, and we're still making interest payments of
$100,000 every year. Clearly, our cost of debt is 10% and not the 14% you want to use. If you'd use
our "real" cost of debt, as well as of equity and preferred stock, the project would easily qualify
financially." How do you respond?
(The appropriate response is relatively short. It's worth noting that this kind of thing happens all the
time in corporations. Marketing and engineering people often get carried away with "neat" projects that
don't make sense financially. The CFO has to watch the bottom line and it's not unusual to be seen as a
wet blanket who wants to spoil the others' fun!)
3. The engineering department at Digitech Inc. wants to buy a new, state-of-the-art computer. The
proposed machine is faster than the one now being used, but whether the extra speed is worth the
expense is questionable, given the nature of the firm's applications. The Chief Engineer (who has an
MBA and a reasonable understanding of financial principles) has put together an enormously detailed
capital budgeting proposal for the acquisition of the new machine. The proposal concludes that it's a
great deal.
You're a financial analyst for the firm, and have been assigned to review the engineering proposal.
Your review has highlighted two problems. First, the cost savings projected as a result of using the new
machine seem rather optimistic. Second, the analysis uses an unrealistically low cost of capital.
With respect to the second point, the engineering proposal contains the following exhibit
documenting the development of the cost of capital used:
Digitech's capital structure is 60% debt and 40% equity
The manufacturer is offering financing at 8% as a sales incentive
Cost of capital = 8% × .6 = 4.8%
After tax this is 4.8% (1?T) = 4.8%(.6) = 2.9%
You've checked the market and found that Digitech's bonds are currently selling to yield 14%
and the stock is returning about 20%. How would you proceed? That is, explain the chief engineer's
error(s) and indicate the correct calculations.
4. Whitefish Inc. operates a fleet of 15 fishing boats in the North Atlantic Ocean. Fishing has been
good in the last few years, as has the market for product, so the firm can sell all the fish it can catch.
Charlie Bass, the vice president for operations, has worked up a capital budgeting proposal for the
acquisition of new boats. Each boat is viewed as an individual project identical to the others, and shows
an IRR of 22%. The firm's cost of capital has been correctly calculated at 14% before the retained
earnings break and 15% after that point. Charlie argues that the capital budgeting figures show that the
firm should acquire as many new boats as it possibly can, financing them with whatever means it finds
available. You are Whitefish's CFO. Support or criticize Charlie's position. How should the
appropriate number of new boats be determined? Does acquiring a large number of new boats present
any problems or risks that aren’t immediately apparent from the financial figures?
PROBLEMS
The Cost of Capital
WACC Calculations: Example 13-1 (page 561)
1. Blazingame Inc.'s capital components have the following market values:
Debt $35,180,000
Preferred Stock $17,500,000
Common Equity $48,350,000
Calculate the firm's capital structure and show the weights that would be used for a weighted average
cost of capital (WACC) computation.
2. The Aztec Corporation has the following capital components and costs. Calculate Aztec's
WACC.
Component Value Cost
Debt $23,625 12.0%
Preferred Stock $ 4,350 13.5%
Common Equity $52,275 19.2%
3. Willerton Industries Inc. has the following balances in its capital accounts as of 12/31/x3:
Long Term Debt $65,000,000
Preferred Stock $15,000,000
Common Stock $40,000,000
Paid in Excess $15,000,000
Retained Earnings $37,500,000
Calculate Willerton’s capital structure based on book values.
Market Value Based Capital Structure: Example 13-2 (page 564)
4. Referring to Willerton Industries of the previous problem, the company’s long term debt is
comprised of 20-year $1,000 face value bonds issued seven years ago at an 8% coupon rate.
The bonds are now selling to yield 6%. Willerton’s preferred is from a single issue of $100 par
value, 9% preferred stock that is now selling to yield 8%. Willerton has four million shares of
common stock outstanding at a current market price of $31. Calculate Willerton’s market value
based capital structure.
5. Again referring to Willerton of the two previous problems, assume the firm’s cost of retained
earnings is 11% and its marginal tax rate is 40%, calculate its WACC using its book value
based capital structure ignoring floatation costs. Make the same calculation using the market
value based capital structure. How significant is the difference?
Chapter 13
6. A relatively young firm has capital components valued at book and market and market
component costs as follows. No new securities have been issued since the firm was originally
capitalized.
Values Market
Component Market Book Cost
Debt $42,830 $40,000 8.5%
Preferred Stock $10,650 $10,000 10.6%
Common Equity $65,740 $32,000 25.3%
a. Calculate the firm's capital structures and WACCs based on both book and market values, and
compare the two.
b. What appears to have happened to interest rates since the company was started?
c. Does the firm seem to be successful? Why?
d. What would be the implication of using a WACC based on book as opposed to market values? In
other words, what kinds of mistakes might management make by using the book values?
7. Five years ago Hemingway Inc. issued 6,000 thirty-year bonds with par values of $1,000 at a
coupon rate of 8%. The bonds are now selling to yield 5%. The company also has 15,000 shares of
preferred stock outstanding that pay a dividend of $6.50 per share. These are currently selling to yield
10%. Its common stock is selling at $21, and 200,000 shares are outstanding. Calculate Hemingway’s
market value based capital structure.
capitalized with $2 million in owner's equity and $3 million in variable rate bank loans. The
construction business is quite risky, so returns of 20% to 25% are normally demanded on equity
investments. The bank is currently charging 14% on the firm's loans, but interest rates are expected to
rise in the near future. Your boss, the owner, started his career as a carpenter and has an excellent grasp
of day-to-day operations. However, he knows little about finance. Business has been good lately, and
several expansion projects are under consideration. A cash flow projection has been made for each.
You're satisfied that these estimates are reasonable.
The owner has called you in and confessed to being confused about the projects. He instinctively
feels that some are financially marginal and may not be beneficial to the company, but he doesn't know
how to demonstrate this or to choose among the projects that are financially viable.
Assuming the owner understands the concept of return on investment, write a brief memo explaining
the ideas of IRR and cost of capital and how they can solve his problem. Don't get into the detailed
mechanics of the calculations, but do use the figures given above to make a rough estimate of the
company's cost of capital, and use the result in your memo.
line.
2. You're the CFO of a small company that is considering a new venture. The president and
several other members of management are very excited about the idea for reasons related to engineering
and marketing rather than profitability. You've analyzed the proposal by using capital budgeting
techniques, and found that it fails both IRR and NPV tests using a cost of capital based on market
returns. The problem is that interest rates have risen steeply in the last year, so the cost of capital seems
unusually high.
You've presented your results to the management team, who are very disappointed. In fact, they'd
like to find a way to discredit your analysis, so they can justify going ahead with the project. You've
explained your analysis, and everything seems well understood except for one point. The group insists
that the use of returns currently available to investors as a basis for the cost of capital components
doesn't make sense. The vice president of marketing put his objection as follows. "Two years ago
Chapter 13
we borrowed $1 million at 10%. We haven't paid it back, and we're still making interest payments of
$100,000 every year. Clearly, our cost of debt is 10% and not the 14% you want to use. If you'd use
our "real" cost of debt, as well as of equity and preferred stock, the project would easily qualify
financially." How do you respond?
(The appropriate response is relatively short. It's worth noting that this kind of thing happens all the
time in corporations. Marketing and engineering people often get carried away with "neat" projects that
don't make sense financially. The CFO has to watch the bottom line and it's not unusual to be seen as a
wet blanket who wants to spoil the others' fun!)
3. The engineering department at Digitech Inc. wants to buy a new, state-of-the-art computer. The
proposed machine is faster than the one now being used, but whether the extra speed is worth the
expense is questionable, given the nature of the firm's applications. The Chief Engineer (who has an
MBA and a reasonable understanding of financial principles) has put together an enormously detailed
capital budgeting proposal for the acquisition of the new machine. The proposal concludes that it's a
great deal.
You're a financial analyst for the firm, and have been assigned to review the engineering proposal.
Your review has highlighted two problems. First, the cost savings projected as a result of using the new
machine seem rather optimistic. Second, the analysis uses an unrealistically low cost of capital.
With respect to the second point, the engineering proposal contains the following exhibit
documenting the development of the cost of capital used:
Digitech's capital structure is 60% debt and 40% equity
The manufacturer is offering financing at 8% as a sales incentive
Cost of capital = 8% × .6 = 4.8%
After tax this is 4.8% (1?T) = 4.8%(.6) = 2.9%
You've checked the market and found that Digitech's bonds are currently selling to yield 14%
and the stock is returning about 20%. How would you proceed? That is, explain the chief engineer's
error(s) and indicate the correct calculations.
4. Whitefish Inc. operates a fleet of 15 fishing boats in the North Atlantic Ocean. Fishing has been
good in the last few years, as has the market for product, so the firm can sell all the fish it can catch.
Charlie Bass, the vice president for operations, has worked up a capital budgeting proposal for the
acquisition of new boats. Each boat is viewed as an individual project identical to the others, and shows
an IRR of 22%. The firm's cost of capital has been correctly calculated at 14% before the retained
earnings break and 15% after that point. Charlie argues that the capital budgeting figures show that the
firm should acquire as many new boats as it possibly can, financing them with whatever means it finds
available. You are Whitefish's CFO. Support or criticize Charlie's position. How should the
appropriate number of new boats be determined? Does acquiring a large number of new boats present
any problems or risks that aren’t immediately apparent from the financial figures?
PROBLEMS
The Cost of Capital
WACC Calculations: Example 13-1 (page 561)
1. Blazingame Inc.'s capital components have the following market values:
Debt $35,180,000
Preferred Stock $17,500,000
Common Equity $48,350,000
Calculate the firm's capital structure and show the weights that would be used for a weighted average
cost of capital (WACC) computation.
2. The Aztec Corporation has the following capital components and costs. Calculate Aztec's
WACC.
Component Value Cost
Debt $23,625 12.0%
Preferred Stock $ 4,350 13.5%
Common Equity $52,275 19.2%
3. Willerton Industries Inc. has the following balances in its capital accounts as of 12/31/x3:
Long Term Debt $65,000,000
Preferred Stock $15,000,000
Common Stock $40,000,000
Paid in Excess $15,000,000
Retained Earnings $37,500,000
Calculate Willerton’s capital structure based on book values.
Market Value Based Capital Structure: Example 13-2 (page 564)
4. Referring to Willerton Industries of the previous problem, the company’s long term debt is
comprised of 20-year $1,000 face value bonds issued seven years ago at an 8% coupon rate.
The bonds are now selling to yield 6%. Willerton’s preferred is from a single issue of $100 par
value, 9% preferred stock that is now selling to yield 8%. Willerton has four million shares of
common stock outstanding at a current market price of $31. Calculate Willerton’s market value
based capital structure.
5. Again referring to Willerton of the two previous problems, assume the firm’s cost of retained
earnings is 11% and its marginal tax rate is 40%, calculate its WACC using its book value
based capital structure ignoring floatation costs. Make the same calculation using the market
value based capital structure. How significant is the difference?
Chapter 13
6. A relatively young firm has capital components valued at book and market and market
component costs as follows. No new securities have been issued since the firm was originally
capitalized.
Values Market
Component Market Book Cost
Debt $42,830 $40,000 8.5%
Preferred Stock $10,650 $10,000 10.6%
Common Equity $65,740 $32,000 25.3%
a. Calculate the firm's capital structures and WACCs based on both book and market values, and
compare the two.
b. What appears to have happened to interest rates since the company was started?
c. Does the firm seem to be successful? Why?
d. What would be the implication of using a WACC based on book as opposed to market values? In
other words, what kinds of mistakes might management make by using the book values?
7. Five years ago Hemingway Inc. issued 6,000 thirty-year bonds with par values of $1,000 at a
coupon rate of 8%. The bonds are now selling to yield 5%. The company also has 15,000 shares of
preferred stock outstanding that pay a dividend of $6.50 per share. These are currently selling to yield
10%. Its common stock is selling at $21, and 200,000 shares are outstanding. Calculate Hemingway’s
market value based capital structure.
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Solution: Question_Lasher_12Dec_2nd - Answer