Weighted average cost of capital


Weighted average cost of capital
Page 366
19. Global Technology’s capital structure is as follows:

Debt 35%
Preferred stock 15
Common equity 50

The aftertax cost of debt is 6.5 percent; the cost of preferred stock is 10 percent; and the cost of common equity (in the form of retained earnings) is 13.5 percent. Calculate Global Technology’s weighted average cost of capital in a manner similar to Table 11-1.
Weighted average cost of capital
20. Evans Technology has the following capital structure:

Debt 40%
Common equity 60

The aftertax cost of debt is 6 percent, and the cost of common equity (in the form of retained earnings) is 13 percent.
a. What is the firm’s weighted average cost of capital?
b. An outside consultant has suggested that because debt is cheaper than equity, the firm should switch to a capital structure that is 50 percent debt and 50 percent equity. Under this new and more debt-oriented arrangement, the aftertax cost of debt is 7 percent, and the cost of common equity (in the form of retained earnings) is 15 percent. Recalculate the firm’s weighted average cost of capital.
c. Which plan is optimal in terms of minimizing the weighted average cost of capital?
Weighted average cost of capital
21. Sauer Milk Inc. wants to determine the minimum cost of capital point for the firm. Assume it is considering the following financial plans:

Cost (Aftertax) Weights
Plan A
Debt 4.0% 30%
Preferred stock 8.0 15
Common equity 12.0 55
Plan B
Debt 4.5% 40%
Preferred stock 8.5 15
Common equity 13.0 45
Plan C
Debt 5.0% 45%
Preferred stock 18.7 15
Common equity 12.8 40
Plan D
Debt 12.0% 50%
Preferred stock 19.2 15
Common equity 14.5 35

Page 367
a. Which of the four plans has the lowest weighted average cost of capital? (Round to two places to the right of the decimal point.)
b. Briefly discuss the results from Plan C and Plan D, and why one is better than the other.

Chapter 12

#6 Assume a $250,000 investment and the following cash flows for two products:

Year Product X Product Y
1 $90,000 $50,000
2 90,000 80,000
3 60,000 60,000
4 20,000 70,000

Which alternatives would you select under the payback method?

#12. King’s Department Store is contemplating the purchase of a new machine at a cost of $22,802. The machine will provide $3,500 per year in cash flow for nine years. King’s has a cost of capital of 10 percent. Using the internal rate of return method, evaluate this project and indicate whether it should be undertaken

#15.The Horizon Company will invest $60,000 in a temporary project that will generate the following cash inflows for the next three years.

Year Cash Flow
1 $15,000
2 25,000
3 40,000

The firm will also be required to spend $10,000 to close down the project at the end of the three years. If the cost of capital is 10 percent, should the investment be undertaken?

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