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QUESTIONS :
7. Brite Lighting Corporation wants to investigate the effect on its cost of capital based on the rate at which the company is taxed. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% common stock. The cost of financing with retained earnings is 14% (i.e., rs = 14%), the cost of preferred stock financing is 9% (rps = 9%), and the before-tax cost of debt is 11% (rd = 11%). Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts (a) to (c) below.
(a) Tax rate = 40%.
(b) Tax rate = 35%.
(c) Tax rate = 25%.
8. Westerly Manufacturing has compiled the information shown in the following table:
|
Source of Capital |
Book Value |
Market Value |
After-tax Cost |
|
Long-Term Debt |
$4,000,000 |
$3,840,000 |
6.0% |
|
Preferred Stock |
$40,000 |
$60,000 |
13.0% |
|
Common Stock Equity |
$1,060,000 |
$3,000,000 |
17.0% |
|
Totals |
$5,100,000 |
$6,900,000 |
(a) Calculate the firm’s weighted average cost of capital (WACC) using book value weights.
(b) Calculate the firm’s weighted average cost of capital (WACC) using market value weights.
(c) Compare your answers found in parts (a) and (b) and briefly explain the differences. Other things equal, would you recommend that Westerly Manufacturing rely on its book value weights or market value weights in determining its WACC?
| 9. To help finance a major expansion, Delano Development Company sold a noncallable bond several years ago that now has 15 years to maturity. This bond has a 10.25% annual coupon, paid semiannually, it sells at a price of $1,025, and it has a par value of $1,000. If Delano’s tax rate is 40%, what component cost of debt should be used in the WACC calculation? |
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10. Roxie Epoxy’s balance sheet shows a total of $50 million long-term debt with a coupon rate of 8.00% and a yield to maturity of 7.00%. This debt currently has a market value of $55 million. The balance sheet also shows that that the company has 20 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $8.25 per share; stockholders’ required return, rs, is 10.00%; and the firm’s tax rate is 40%. Based on market value weights, and assuming the firm is currently at its target capital structure, what WACC should Roxie use to evaluate capital budgeting projects? |
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11. Bruner Breakfast Foods’ (BBF) balance sheet shows a total of $20 million long-term debt with a coupon rate of 8.00% (assume each bond to have a maturity value, M, of $1,000). The yield to maturity on this debt is 10.00%, and the debt has a total current market value of $18 million. The balance sheet also shows that that the company has 10 million shares of stock, and total of common equity (common stock plus retained earnings) is $30 million. The current stock price is $4.50 per share, and stockholders’ required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 50% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on target, book, and market value capital structures (Note: I am asking for three (3) separate WACC values here). |
