Reference no: EM132274272

Basic Problems

I. In March 2010, Hertz Pain Relievers bought a massage machine that provided a return of 8 percent. It was financed by debt costing 7 percent.

n August, Mr. Hertz came up with a heating compound that would have a return of 14 percent. The chief financial officer, Mr. Smith, told him it was impractical because it would require the issuance of common stock at a cost of 16 percent to finance the pur¬chase. Is the company following a logical approach to using its cost of capital?

2. Speedy Delivery Systems can buy a piece of equipment that is anticipated to pro¬vide an 11 percent return and can be financed at 6 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 9 percent return but would cost 15 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firm's capital structure.

a. Compute the weighted average cost of capital.

b. Which project(s) should be accepted?

3. A brilliant young scientist is killed in a plane crash. It is anticipated that he could have earned $240,000 a year for the next 50 years. The attorney for the plaintiff's estate argues that the lost income should be discounted back to the present at 4 percent. The lawyer for the defendant's insurance company argues for a discount rate of 8 percent. What is the difference between the present value of the settle¬ment at 4 percent and 8 percent? Compute each one separately.