Problem_Set__9_Checkpoints

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Southern New Hampshire University *

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401

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Finance

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Jan 9, 2024

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Fin 401 Problem Set #9 Checkpoints Project Cost of Capital Note: These checkpoints are short answers intended to help you check your work as you go along. They are not full solutions, which will be posted on Learning Suite after the problem set is turned in. Remember that to get full credit for problem sets you must show all your work, and the answers listed here are usually not sufficient responses to the questions. 1. Do Higgins, Chapter 8, #1, part (c). Answer in back of book. 2. Do Higgins, Chapter 8, #8. a. IRR=16% b. WACC = 11.6% c. 3. Each year Briggs & Stratton (producer of gasoline engines) estimates its own company- wide WACC. For the most recent year, it based its calculation on the following assumptions (info taken from Keown, et al, Financial Management, p. 394): Risk-free rate comes from the current 30-year government bond yield = 6.1% Market Risk Premium comes from the historical average difference between equity returns and long-term bonds returns = 6% Equity Beta is estimated by a regression of B&S stock returns on S&P 500 returns = 0.83 Cost of debt comes from the yield to maturity on the company’s bonds = 7.5% Capital structure is based on target debt to total market value ratio (D/V) = 23% Tax rate is estimated by the company = 38% a. Based on Briggs & Stratton’s assumptions, you should have found their return on assets to be 10.3% in the previous problem set. What is their WACC? WACC = 9.6% b. Suppose Apple Inc. was considering launching a gasoline engine product line. Since they have tons of cash on their balance sheet, Apple will just use its cash balance to fund the entire project. The cash is sitting in short-term investments yielding 3%

interest. What would be the required return on assets for Apple’s investment in this project? c. Assume that Apple’s marginal tax rate is 15% and their bonds have a YTM of 4%. What would be the WACC that Apple should use to evaluate an investment in a project to develop gasoline engines? WACC = 10.0% d. Suppose this question has piqued your interest in gasoline engines, so you decide that you want to start a new gasoline engine production company when you graduate from college. You have no money and no expertise, so you plan to beg your friends for startup capital. What would be the required return on assets for your startup? 4. DEF is a private company for which we don’t observe stock prices. Find the required return on assets and WACC for DEF Corporation using the information below. Market risk premium = 6% Current long-term treasury rate = 5% Comparable firm #1’s debt ratio (D/V) = 50% Comparable firm #1’s equity (levered) beta = 1.2 Comparable firm #1’s debt beta = 0.3 Comparable firm #2’s debt ratio (D/V) =35% Comparable firm #2’s equity beta = 0.8 Comparable firm #2’s debt beta = 0.25 DEF Corporation’s debt ratio (D/V) = 20% DEF Corporation’s debt beta = 0.2 DEF Corporation’s tax rate = 30% WACC = 8.7% 5. JKL Corporation and MNO Corporation are both bidding for an existing food processing plant located in Shreveport, Louisiana. Both firms are highly profitable and have similar debt ratios and costs of debt, but MNO currently operates in a much more volatile industry than JKL. As JKL and MNO separately prepare their valuations for the plant, what difference would you expect to see in the appropriate WACC each firm will use? (Assume both firms have the same access to correct information, and that both make equally accurate calculations.) 2

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