Chapter 10 Questions and Answers

1
Chapter 10 Questions and Answers

• Q1. Pennsylvania Clean Coal Company (PCCC)
  generates electricity for both industrial
  customers as well as consumer households. An
  investment analyst with a private equity fund
  which owns some of PCCCs stock needs to estimate
  the companys weighted average cost of capital.
  PCCCs chief financial officer told the
  investment analyst that PCCC will not invest in
  any project which cannot earn at least a 15
  Return on Assets. The company has 3.5 million
  shares of stock outstanding and these shares are
  valued at 24.55 per share. The company has a
  stock beta that is estimated to be 1.84x. Assume
  the current average expected stock market return
  is 16.00 and the current U.S. Treasury Bond
  interest rate in the market is 4.80. The company
  also has some bonds outstanding which are trading
  at 975 per bond, and the company has 195,000 of
  these bonds outstanding. The bonds have an
  effective yield to maturity of 8.50. The company
  has a marginal income tax rate of 30. Given
  this information, what is PCCCs weighted average
  cost of capital? Calculate everything to 4
  decimal places only.
•  
•  

2
Chapter 10 Questions and Answers

• Q1. Pennsylvania Clean Coal Company (PCCC)
  generates electricity for both industrial
  customers as well as consumer households. An
  investment analyst with a private equity fund
  which owns some of PCCCs stock needs to estimate
  the companys weighted average cost of capital.
  PCCCs chief financial officer told the
  investment analyst that PCCC will not invest in
  any project which cannot earn at least a 15
  Return on Assets. The company has 3.5 million
  shares of stock outstanding and these shares are
  valued at 24.55 per share. The company has a
  stock beta that is estimated to be 1.84x. Assume
  the current average expected stock market return
  is 16.00 and the current U.S. Treasury Bond
  interest rate in the market is 4.80. The company
  also has some bonds outstanding which are trading
  at 975 per bond, and the company has 195,000 of
  these bonds outstanding. The bonds have an
  effective yield to maturity of 8.50. The company
  has a marginal income tax rate of 30. Given
  this information, what is PCCCs weighted average
  cost of capital? Calculate everything to 4
  decimal places only.
• Answer
• Debt outstanding 195,000 bonds x 975 per bond
  190,125,000 0.6887
• Common Equity outstanding 3.5 million shares x
  24.55 per share 85,925,000 0.3113
• Total Capital 276,050,000
  1.0000
•  
•  
•  
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•  

3
Chapter 10 Questions and Answers

• Q1. Pennsylvania Clean Coal Company (PCCC)
  generates electricity for both industrial
  customers as well as consumer households. An
  investment analyst with a private equity fund
  which owns some of PCCCs stock needs to estimate
  the companys weighted average cost of capital.
  PCCCs chief financial officer told the
  investment analyst that PCCC will not invest in
  any project which cannot earn at least a 15
  Return on Assets. The company has 3.5 million
  shares of stock outstanding and these shares are
  valued at 24.55 per share. The company has a
  stock beta that is estimated to be 1.84x. Assume
  the current average expected stock market return
  is 16.00 and the current U.S. Treasury Bond
  interest rate in the market is 4.80. The company
  also has some bonds outstanding which are trading
  at 975 per bond, and the company has 195,000 of
  these bonds outstanding. The bonds have an
  effective yield to maturity of 8.50. The company
  has a marginal income tax rate of 30. Given
  this information, what is PCCCs weighted average
  cost of capital? Calculate everything to 4
  decimal places only.
• Answer
• Debt outstanding 195,000 bonds x 975 per bond
  190,125,000 0.6887
• Common Equity outstanding 3.5 million shares x
  24.55 per share 85,925,000 0.3113
• Total Capital 276,050,000
  1.0000
•  
• Cost of Debt Capital 8.50
• Cost of Equity Capital
• R Risk Free Return Beta x (Market
  Return less Risk Free Return)
• R 4.80 1.84 x (16.00 less 4.80)
  
• R 4.80 1.84 x (11.20)
• R 4.80 20.6080 25.4080
•  

4
Chapter 10 Questions and Answers

• Q1. Pennsylvania Clean Coal Company (PCCC)
  generates electricity for both industrial
  customers as well as consumer households. An
  investment analyst with a private equity fund
  which owns some of PCCCs stock needs to estimate
  the companys weighted average cost of capital.
  PCCCs chief financial officer told the
  investment analyst that PCCC will not invest in
  any project which cannot earn at least a 15
  Return on Assets. The company has 3.5 million
  shares of stock outstanding and these shares are
  valued at 24.55 per share. The company has a
  stock beta that is estimated to be 1.84x. Assume
  the current average expected stock market return
  is 16.00 and the current U.S. Treasury Bond
  interest rate in the market is 4.80. The company
  also has some bonds outstanding which are trading
  at 975 per bond, and the company has 195,000 of
  these bonds outstanding. The bonds have an
  effective yield to maturity of 8.50. The company
  has a marginal income tax rate of 30. Given
  this information, what is PCCCs weighted average
  cost of capital? Calculate everything to 4
  decimal places only.
• Answer
• Debt outstanding 195,000 bonds x 975 per bond
  190,125,000 0.6887
• Common Equity outstanding 3.5 million shares x
  24.55 per share 85,925,000 0.3113
• Total Capital 276,050,000
  1.0000
•  
• Cost of Debt Capital 8.50
• Cost of Equity Capital
• R Risk Free Return Beta x (Market
  Return less Risk Free Return)
• R 4.80 1.84 x (16.00 less 4.80)
  
• R 4.80 1.84 x (11.20)
• R 4.80 20.6080 25.4080
•  
• WACC 0.3113 x 25.4080 0.6887 x
  8.5000 x (1 less tax rate of 30)
• WACC 7.9095 4.0978
• WACC 12.0073
•  

5
Chapter 10 Questions and Answers
Q2. Craftmaker Tools Company sells a wide
assortment of tools for plumbers and painters
through 8 retail stores located in Illinois.
Because of net losses in the past few years, the
company has not been an income tax payer. It
currently has 20 million of Debt outstanding and
15 million of Equity capital outstanding in its
capital structure. Its Cost of Debt currently
is 8.75 and it has a Cost of Equity of 30.
What would be the change in its weighted average
cost of capital (WACC) if it becomes an income
tax payer and its marginal income tax rate
increases to 39? Calculate to 4 decimal places.
6
Chapter 10 Questions and Answers
Q2. Craftmaker Tools Company sells a wide
assortment of tools for plumbers and painters
through 8 retail stores located in Illinois.
Because of net losses in the past few years, the
company has not been an income tax payer. It
currently has 20 million of Debt outstanding and
15 million of Equity capital outstanding in its
capital structure. Its Cost of Debt currently
is 8.75 and it has a Cost of Equity of 30.
What would be the change in its weighted average
cost of capital (WACC) if it becomes an income
tax payer and its marginal income tax rate
increases to 39? Calculate to 4 decimal
places. Answer WACC-Without Taxes (
20/35) x 8.75 (15/35) x 30
5.0000 12.8571
17.8571  
7
Chapter 10 Questions and Answers
Q2. Craftmaker Tools Company sells a wide
assortment of tools for plumbers and painters
through 8 retail stores located in Illinois.
Because of net losses in the past few years, the
company has not been an income tax payer. It
currently has 20 million of Debt outstanding and
15 million of Equity capital outstanding in its
capital structure. Its Cost of Debt currently
is 8.75 and it has a Cost of Equity of 30.
What would be the change in its weighted average
cost of capital (WACC) if it becomes an income
tax payer and its marginal income tax rate
increases to 39? Calculate to 4 decimal
places. Answer WACC-Without Taxes (
20/35) x 8.75 (15/35) x 30
5.0000 12.8571
17.8571   WACC-With Taxes (20/35) x
8.75 x (1 less 39) (15/35 )
x 30 3.0500 12.8571 15.9071
8
Chapter 10 Questions and Answers
Q3. Magic Pan Restaurant Inc.s average interest
rate for all of its Debt outstanding is 7.86.
Its marginal income tax rate is 35. What is the
after- tax cost of its Debt? Q4. Farkington
Arms Corp. common stock is trading for 55.00 per
share, and it expects to pay a dividend this
year of 3.60 per share. Management expects it
can grow the dividend by 4.00 per year for the
foreseeable future. If the company sells any new
shares of stock, the underwriters commission
would average 3.85 per share. What is the
expected cost to the company for its common
stock on a newly-issued basis?   Q5. What
are the two basic reasons why the Weighted
Average Cost of Capital is an important
measurement for management to know?
9
Chapter 10 Questions and Answers
Q3. Magic Pan Restaurant Inc.s average interest
rate for all of its Debt outstanding is 7.86.
Its marginal income tax rate is 35. What is the
after- tax cost of its Debt? A3. After-Tax Cost
of Debt 7.86 x (1 less 0.35) 7.86 x 0.65
5.1090 Q4. Farkington Arms Corp. common
stock is trading for 55.00 per share, and it
expects to pay a dividend this year of 3.60 per
share. Management expects it can grow the
dividend by 4.00 per year for the foreseeable
future. If the company sells any new shares of
stock, the underwriters commission would
average 3.85 per share. What is the expected
cost to the company for its common stock on a
newly-issued basis?   Q5. What are the two
basic reasons why the Weighted Average Cost of
Capital is an important measurement for
management to know?
10
Chapter 10 Questions and Answers
Q3. Magic Pan Restaurant Inc.s average interest
rate for all of its Debt outstanding is 7.86.
Its marginal income tax rate is 35. What is the
after- tax cost of its Debt? A3. After-Tax Cost
of Debt 7.86 x (1 less 0.35) 7.86 x 0.65
5.1090 Q4. Farkington Arms Corp. common
stock is trading for 55.00 per share, and it
expects to pay a dividend this year of 3.60 per
share. Management expects it can grow the
dividend by 4.00 per year for the foreseeable
future. If the company sells any new shares of
stock, the underwriters commission would
average 3.85 per share. What is the expected
cost to the company for its common stock on a
newly-issued basis? A4. ReturnFACNew
3.60 0.040000 0.070381
0.040000 (55.00 - 3.85)
0.110381 11.0381   Q5. What are the
two basic reasons why the Weighted Average Cost
of Capital is an important measurement for
management to know?
11
Chapter 10 Questions and Answers
Q3. Magic Pan Restaurant Inc.s average interest
rate for all of its Debt outstanding is 7.86.
Its marginal income tax rate is 35. What is the
after- tax cost of its Debt? A3. After-Tax Cost
of Debt 7.86 x (1 less 0.35) 7.86 x 0.65
5.1090 Q4. Farkington Arms Corp. common
stock is trading for 55.00 per share, and it
expects to pay a dividend this year of 3.60 per
share. Management expects it can grow the
dividend by 4.00 per year for the foreseeable
future. If the company sells any new shares of
stock, the underwriters commission would
average 3.85 per share. What is the expected
cost to the company for its common stock on a
newly-issued basis? A4. ReturnFACNew
3.60 0.040000 0.070381
0.040000 (55.00 - 3.85)
0.110381 11.0381   Q5. What are the
two basic reasons why the Weighted Average Cost
of Capital is an important measurement for
management to know? A5. (1) To define a
companys Minimum Required Free Cash Flow Return
on Assets (2) To define the Minimum
Required Starting Point Return for New Proposed
Business Investment Projects.
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Chapter 10 Questions and Answers
Q6. What factors affect the WACC in terms of (1)
factors that management has no control over and
(2) factors that management has some control
over?
13
Chapter 10 Questions and Answers
Q6. What factors affect the WACC in terms of (1)
factors that management has no control over and
(2) factors that management has some control
over? A6. (1) Management has no control over
interest rates in the economy, the general level
of stock prices, and income tax
rates.
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Chapter 10 Questions and Answers
Q6. What factors affect the WACC in terms of (1)
factors that management has no control over and
(2) factors that management has some control
over? A6. (1) Management has no control over
interest rates in the economy, the general level
of stock prices, and income tax
rates. (2) Management has some control
over the companys capital structure
(proportional mix of Debt versus
Equity Capital), dividend payout ratio, and the
riskiness of companys existing and
new business investment projects.