BSM-410 problem solving activity 8
10-1 AFTER-TAX COST OF DEBT The Holmes Company’s currently outstanding bonds have an 8% coupon and a 10% yield to maturity. Holmes believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 25%, what is Holmes’ aftertax cost of debt? 10-8 COST OF COMMON EQUITY AND WACC Palencia Paints Corporation has a target capital structure of 35% debt and 65% common equity, with no preferred stock. Its before-tax cost of debt is 8%, and its marginal tax rate is 25%. The current stock price is P 0 = $ 22.00 . The last dividend was D 0 = $ 2.25 , and it is expected to grow at a 5% constant rate. What is its cost of common equity and its WACC? 10-21 CALCULATING THE WACC Here is the condensed 2021 balance sheet for Skye Computer Company (in thousands of dollars): 11-1 NPV Project L requires an initial outlay at t = 0 of $65,000, its expected cash inflows are $12,000 per year for 9 years, and its WACC is 9%. What is the project’s NPV? 11-9 CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS An electric utility is considering a new power plant in northern Arizona. Power from the plant would be sold in the Phoenix area, where it is badly needed. Because the firm has received a permit, the plant would be legal, but it would cause some air pollution. The company could spend an additional $40 million at Year 0 to mitigate the environmental problem, but it would not be required to do so. The plant without mitigation would require an initial outlay of $240 million, and the expected cash inflows would be $80 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be $84 million. Unemployment in the area where the plant would be built is high, and the plant would provide about 350 good jobs. The risk-adjusted WACC is 17%. A. Calculate the NPV and IRR with and without mitigation. B. How should the environmental effects be dealt with when evaluating this project? C. Should this project be undertaken? If so, should the firm do the mitigation? Why or why not? 11-23 CAPITAL BUDGETING CRITERIA Your division is considering two projects. Its WACC is 10%, and the projects’ after-tax cash flows (in millions of dollars) would be as follows: A. Calculate the projects’ NPVs, IRRs, MIRRs, regular paybacks, and discounted paybacks. B. If the two projects are independent, which project(s) should be chosen? C. If the two projects are mutually exclusive and the WACC is 10%, which project(s) should be chosen? D. Plot NPV profiles for the two projects. Identify the projects’ IRRs on the graph. E. If the WACC was 5%, would this change your recommendation if the projects were mutually exclusive? If the WACC was 15%, would this change your recommendation? Explain your answers. F. The crossover rate is 13.5252%. Explain what this rate is and how it affects the choice between mutually exclusive projects. G. Is it possible for conflicts to exist between the NPV and the IRR when independent projects are being evaluated? Explain your answer. H. Now look at the regular and discounted paybacks. Which project looks better when judged by the paybacks? I. If the payback was the only method a firm used to accept or reject projects, what payback should it choose as the cutoff point, that is, reject projects if their paybacks are not below the chosen cutoff? Is your selected cutoff based on some economic criteria, or is it more or less arbitrary? Are the cutoff criteria equally arbitrary when firms use the NPV and/or the IRR as the criteria? Explain. J. Define the MIRR. What’s the difference between the IRR and the MIRR, and which generally gives a better idea of the rate of return on the investment in a project? Explain. K. Why do most academics and financial executives regard the NPV as being the single best criterion and better than the IRR? Why do companies still calculate IRRs? Source: Eugene F. Brigham; Joel F. Houston (2022). Fundamentals of Financial Management: Concise (11th Edition). Cengage Learning
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