What is the after-tax cost of debt

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Reference no: EM132214872

Part A -

Problem 1 - HBM, Inc. has the following capital structure: Assets $400,000 Debt $140,000 Preferred stock 20,000 Common stock 240,000. The common stock is currently selling for $15 a share, pays a cash dividend of $0.75 per share, and is growing annually at 6 percent. The preferred stock pays a $9 cash dividend and currently sells for $91 a share. The debt pays interest of 8.5 percent annually, and the firm is in the 30 percent marginal tax bracket.

a. What is the after-tax cost of debt?

b. What is the cost of preferred stock?

c. What is the cost of common stock?

d. What is the firm's weighted-average cost of capital?

Problem 2 - Sun Instruments expects to issue new stock at $34 a share with estimated flotation costs of 7 percent of the market price. The company currently pays a $2.10 cash dividend and has a 6 percent growth rate. What are the costs of retained earnings and new common stock?

Problem 3 - A firm's current balance sheet is as follows:

Assets $100

Debt $10

Equity $90

a. What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?

Debt/Assets

After-Tax Cost of Debt

Cost of Equity

Cost of Capital

0%

8%

12%

?

10

8

12

?

20

8

12

?

30

8

13

?

40

9

14

?

50

10

15

?

60

12

16

?

b. Construct a pro forma balance sheet that indicates the firm's optimal capital structure. Compare this balance sheet with the firm's current balance sheet. What course of action should the firm take?

Assets $100

Debt ?

Equity ?

c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?

d. If a firm uses too much debt financing, why does the cost of capital rise?

Part B -

Problem 1 - An investment costs $23,958 and will generate cash flow of $6,000 annually for five years. The firm's cost of capital is 10 percent.

a. What is the investment's internal rate of return? Based on the internal rate of return, should the firm make the investment?

b. What is the investment's net present value? Based on the net present value, should the firm make the investment?

Problem 2 - A firm has two possible investments with the following cash inflows. Each investment costs $480, and the cost of capital is ten percent.

Year

Cash Inflows

A

B

1

$300

$200

2

200

200

a. Based only on visual inspection, which investment is to be preferred and why?

b. Based on each investment's net present value, which investment(s) should the firm make?

c. Based on each investment's internal rate of return, which investment(s) should the firm make? Is this the same answer you obtained in part b?

d. If the cost of capital were to increase to 14 percent, which investment(s) should the firm make?

Problem 3 - A firm has the following investment alternatives:

Year

Cash Inflows

A

B

C

1

$1,100

$3,600

-

2

1,100

-

-

3

1,100

-

$4,562

Each investment costs $3,000; investments B and C are mutually exclusive, and the firm's cost of capital is 8 percent.

a. What is the net present value of each investment?

b. According to the net present values, which investment(s) should the firm make? Why?

c. What is the internal rate of return on each investment?

d. According to the internal rates of return, which investment(s) should the firm make? Why?

e. According to both the net present values and internal rates of return, which investments should the firm make?

f. If the firm could reinvest the $3,600 earned in year 1 from investment B at 10 percent, what effect would that information have on your answer to part e? Would the answer be different if the rate were 14 percent?

g. If the firm's cost of capital had been 10 percent, what would be investment A's internal rate of return?

h. The payback method of capital budgeting selects which investment? Why? (Review Chapter 19, if necessary.)

Problem 4 - A firm's cost of capital is 12 percent. The firm has three investments to choose among; the cash flows of each are as follows:

Year

Cash Inflows

A

B

C

1

$395

-

$1,241

2

395

-

-

3

395

-

-

4

-

$1,749

-

Each investment requires a $1,000 cash outlay, and investments B and C are mutually exclusive.

a. Which investment(s) should the firm make according to the net present values? Why?

b. Which investment(s) should the firm make according to the internal rates of return? Why?

c. If all funds are reinvested at 15 percent, which investment(s) should the firm make? Would your answer be different if the reinvestment rate were 12 percent?

Problem 5 - An investment with total costs of $10,000 will generate total revenues of $11,000 for one year. Management thinks that since the investment is profitable, it should be made. Do you agree?

What additional information would you want?

If funds cost 12 percent, what would be your advice to management?

Would your answer be different if the cost of capital is 8 percent?

Problem 6 - The financial manager has determined the following schedules for the cost of funds:

Cost of Debt Ratio

Cost of Debt

Equity

0%

5%

13%

10

5

13

20

5

13

30

5

13

40

5

14

50

6

15

60

8

16

a. Determine the firm's optimal capital structure.

b. Construct a simple pro forma balance sheet that shows the firm's optimal combination of debt and equity for its current level of assets.

Assets

$500

Debt

-

 

 

Equity

-

 

 

 

$500

c. An investment costs $400 and offers annual cash inflows of $133 for five years. Should the firm make the investment?

d. If the firm makes this additional investment, how should its balance sheet appear?

Assets

-

Debt

-

 

 

Equity

-

e. If the firm is operating with its optimal capital structure and a $400 asset yields 20.0 percent, what return will the stockholders earn on their investment in the asset?

Problem 7 - Investments Quick and Slow cost $1,000 each, are mutually exclusive, and have the following cash flows. The firm's cost of capital is 10 percent.

Year

Cash Inflows

Q

S

1

$1,300

$386

2

-

386

3

-

386

4

-

386

a. According to the net present value method of capital budgeting, which investment(s) should the firm make?

b. According to the internal rate of return method of capital budgeting, which investment(s) should the firm make?

c. If Q is chosen, the $1,300 can be reinvested and earn 12 percent. Does this information alter your conclusions concerning investing in Q and S? To answer, assume that S's cash flows can be reinvested at its internal rate of return. Would your answer be different if S's cash flows were reinvested at the cost of capital (10 percent)?

Problem 8 - a. What is the EOQ for a firm that sells 5,000 units when the cost of placing an order is $5 and the carrying costs are $3.50 per unit?

b. How long will the EOQ last? How many orders are placed annually?

c. As a result of lower interest rates, the financial manager determines the carrying costs are now $1.80 per unit. What are the new EOQ and annual number of objects?

Problem 9 - Given the following information:

Annual sales in units

30,000

Cost of placing an order

$60.00

Per-unit carrying costs

$1.50

Existing units of safety stock

300

a. What is the EOQ?

b. What is the average inventory based on the EOQ and the existing safety stock?

c. What is the maximum level of inventory?

d. How many orders are placed each year?

Problem 10 - What is the effective, compound rate of interest you earn if you enter into a repurchase agreement in which you buy a Treasury bill for $76,789 and agree to sell it after a month (30 days) for $77,345?

What is the compound rate of interest you pay if you sell a Treasury bill for $76,789 and repurchase it after 30 days for $77,345?

Problem 11 - Tinker, Inc. finances its seasonal working capital need with short-term bank loans. Management plans to borrow $65,000 for a year. The bank has offered the company a 3.5 percent discounted loan with a 1.5 percent origination fee.

What are the interest payment and the origination fee required by the loan?

What is the rate of interest charged by the bank?

Problem 12 - Bank A offers the following terms for a $10 million loan:

  • interest rate: 8 percent for one year on funds borrowed
  • fees: 0.5 percent of the unused balance for the unused term of the loan

Bank B offers the following terms for a $10 million loan:

  • interest rate: 6.6 percent for one year on funds borrowed
  • fees: 2 percent origination fee

a. Which terms are better if the firm intends to borrow the $10 million for the entire year?

b. If the firm plans to use the funds for only three months, which terms are better?

Problem 13 - Which of the following terms of trade credit is the more expensive?

a. A 3 percent cash discount if paid on the 15th day with bill due on the 45th day (3/15, net 45)

b. A 2 percent cash discount if paid on the 10th day with the bill due on the 30th day (2/10, net 30)

Problem 14 - An individual wishes to borrow $10,000 for a year and is offered the fol lowing alternatives:

a. A 10 percent loan discounted in advance

b. An 11 percent straight loan (i.e., interest paid at maturity). Which loan is more expensive?

Problem 15 - If $1 million face amount of commercial paper (270-day paper) is sold for $982,500, what is the simple rate of interest being paid?

What is the compound annual rate?

Reference no: EM132214872

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