Principles of Managerial Finance (14th Edition) (Pearson Series in Finance)
Principles of Managerial Finance (14th Edition) (Pearson Series in Finance)
14th Edition
ISBN: 9780133507690
Author: Lawrence J. Gitman, Chad J. Zutter
Publisher: PEARSON
Question
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Chapter 9, Problem 9.4P

a.

Summary Introduction

To discuss:

To calculate the before-tax and after –tax cost of debt using approximation formula.

Introduction:

The before -tax cost debt is the rate of return the firm must pay on a new borrowing. The after-tax cost of a debt is the cost after deducting the tax amount.

When after tax cost of the debt is ri and rd is the before-tax cost of a debt, with the tax rate of the firm T, before-tax cost can be converted to after -tax cost by using the following equation,

ri=rd×(1T)

Using the approximation the before-tax cost of the debt is calculated when the annual interest payment in dollars (I), the net proceeds from the sale of a bond (Nd) and term of the bond in years (n) , using the equation,

rd=(I+([($1,000Nd)]n))((Nd+$1,000)2)

b.

Summary Introduction

To discuss:

Comparison between the two approaches.

Introduction:

The before -tax cost debt is the rate of return the firm must pay on a new borrowing. The after-tax cost of a debt is the cost after deducting the tax amount.

When after tax cost of the debt is ri and rd is the before-tax cost of a debt, with the tax rate of the firm T, before-tax cost can be converted to after -tax cost by using the following equation,

ri=rd×(1T)

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Scenario one: Under what circumstances would it be appropriate for a firm to use different cost of capital for its different operating divisions? If the overall firm WACC was used as the hurdle rate for all divisions, would the riskier division or the more conservative divisions tend to get most of the investment projects? Why? If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division’s cost of capital?

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Principles of Managerial Finance (14th Edition) (Pearson Series in Finance)

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