Problem 9IntroApollo Learnings needs $39 million to build a new campus. The company has a target debt-equity ratio of 1.The flotation cost for new equity is 9% and the flotation cost for new debt is 4%.Part 1What are the weighted average flotation costs as a fraction of the amount invested?4+ decimalsSubmitPart 2What is the true cost of building the new campus (in $ million)?1+ decimalsSubmit

Flotation cost refers to the cost which is incurred while new securities are being issued such as…

Answered: Intro Apollo Learnings needs $39…

EBK CFIN

6th Edition

ISBN:9781337671743

Author:BESLEY

Publisher:BESLEY

Chapter11: The Cost Of Capital

Section: Chapter Questions

Problem 20PROB

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CAMPUS DELI INC. OPTIMAL CAPITAL STRUCTURE Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales were 1,100,000 last year, variable costs were 60% of sales, and fixed costs were 40,000. Therefore, EBIT totaled 400,000. Because the university's enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, CD distributes all earnings as dividends. Invested capital is 2 million, and 80,000 shares are outstanding. The management group owns about 50% of the stock, which is traded in the over-the-counter market. CD currently has no debtit is an all-equity firmand its 80,000 shares outstanding sell at a price of 25 per share, which is also the book value. The firm's federal-plus-state tax rate is 40%. On the basis of statements made in your finance text, you believe that CD's shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea but to provide support for the suggestion. In today's market, the risk-free rate, rRF, is 6%, and the market risk premium, RPM, is 6%. CD's unlevered beta, bU, is 1.0. CD currently has no debt, so its cost of equity (and WACC) is 12%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to CD. You plan to complete your report by asking and then answering the following questions. a. 1. What is business risk? What factors influence a firm's business risk? 2. What is operating leverage, and how does it affect a firm's business risk? 3. What is the firm's return on invested capital (ROIC)? b. 1. What do the terms financial leverage and financial risk mean? 2. How does financial risk differ from business risk? c. To develop an example that can be presented to CD's management as an illustration, consider two hypothetical firms: Firm U with zero debt financing and Firm L with 10,000 of 12% debt. Both firms have 20,000 in invested capital and a 40% federal-plus-state tax rate, they have the following EBIT probability distribution for next year: Probability EBIT 0.25 2,000 0.50 3,000 0.25 4,000 d. After speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars): Now consider the optimal capital structure for CD. 1. To begin, define the terms optimal capital structure and target capital structure. 2. Why does CD's bond rating and cost of debt depend on the amount of money borrowed? 3. Assume that shapes could be repurchased at the current market price of 25 per share. Calculate CD's expected EPS and TIE at debt levels of 0, 250,000, 500,000, 750,000, and 1,000,000. How many shares would remain after recapitalization under each scenario? 4. Using the Hamada equation, what is the cost of equity if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? 5. Considering only the levels of debt discussed, what is the capital structure that minimizes CD's WACC? 6. What would be the new stock price if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? Recall that the payout ratio is 100%, so g = 0. 7. Is EPS maximized at the debt level that maximizes share price? Why or why not? 8. Considering only the levels of debt discussed, what is CD's optimal capital structure? 9. What is the WACC at the optimal capital structure? e. Suppose you discovered that CD had more business risk than you originally estimated. Describe how this would affect the analysis. How would the analysis be affected if the firm had less business risk than originally estimated? Income Statements and Ratios TABLE IC 13.1 f. What are some factors a manager should consider when establishing his or her firm's target capital structure? g. Put labels on Figure IC 13.1 and then discuss the graph as you might use it to explain to your boss why CD might want to use some debt. h. How does the existence of asymmetric information and signaling affect capital structure? FIGURE IC 13.1 Relationship between Capital Structure and Stock Price
OPTIMAL CAPITAL STRUCTURE Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales were 1,100,000 last year, variable costs were 60% of sales, and fixed costs were 40,000. Therefore, EBIT totaled 400,000. Because the universitys enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, CD distributes all earnings as dividends. Invested capital is 2 million, and 80,000 shares are outstanding. The management group owns about 50% of the stock, which is traded in the over-the counter market. CD currently has no debtit is an all-equity firmand its 80,000 shares outstanding sell at a price of 25 per share, which is also the book value. The firms federal-plus-state tax rate is 40%. On the basis of statements made in your finance text, you believe that CDs shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea but to provide support for the suggestion. In todays market, the risk-free rate, rRF, is 6%, and the market risk premium, RPM, is 6%. CDs unlevered beta, bU, is 1 0. CD currently has no debt, so its cost of equity (and WACC) is 12%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to CD. You plan to complete your report by asking and then answering the following questions. a. 1. What is business risk? What factors influence a firms business risk? 2. What is operating leverage, and how does it affect a firms business risk? 3. What is the firms return on invested capital (ROIC)? b. 1. What do the terms financial leverage and financial risk mean? 2. How does financial risk differ from business risk? c. To develop an example that can be presented to CDs management as an illustration, consider two hypothetical firms: Firm U with zero debt financing and Firm L with , of 12% debt. Both firms have 20,000 in invested capital and a 40% federal-plus-state tax rate, and they have the following EBIT probability distribution for next year: Probability EBIT 025 2,000 0.50 3,000 025 4,000 1. Complete the partial income statements and the firms ratios in Table IC 14.1. 2. Be prepared to discuss each entry in the table and to explain how this example illustrates the effect of financial leverage on expected rate of return and risk. d. After speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars): Amount Borrowed Debt/Capital Ratio D/E Ratio Bond Rating rj 0 0 0 250 0.125 0.1429 AA 8.0% 500 0.250 03333 A 9.0 750 0375 0.6000 BBB 113 1,000 0.500 1.0000 BB 14.0 Now consider the optimal capital structure for CD. 1. To begin, define the terms optimal capital structure and target capital structure. 2. Why does CDs bond rating and cost of debt depend on the amount of money borrowed? 3. Assume that shares could be repurchased at the current market price of 25 per share. Calculate CDs expected EPS and TIE at debt levels of 0, 250,000, 500,000, 750,000, and 1,000,000. How many shares would remain after recapitalization under each scenario? 4. Using the Hamada equation, what is the cost of equity if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? 5. Considering only the levels of debt discussed, what is the capital structure that minimizes CDs WACC? 6. What would be the new stock price if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? Recall that the payout ratio is 100%, so g 0. 7. Is EPS maximized at the debt level that maximizes share price? Why or why not? 8. Considering only the levels of debt discussed, what is CDs optimal capital structure? 9. What is the WACC at the optimal capital structure? d. Suppose you discovered that CD had more business risk than you originally estimated. Describe how this would affect the analysis. How would the analysis be affected if the firm had less business risk than originally estimated? e. What are some factors a manager should consider when establishing his or her firms target capital structure? f. Put labels on Figure IC 14.1 and then discuss the graph as you might use it to explain to your boss why CD might want to use some debt. g. How does the existence of asymmetric information and signaling affect capital structure?
TOPIC 3: LEVERAGE & CAPITAL STRUCTURE FANSA manufactures high quality zippers for designer handbags and luggage. The wholesale price of each zip is $5.00, the operating cost per zip is $2.80, while total fixed operating costs are $40,000 per year. FANSA pays $10,400 interest and preferred dividends of $6,000 per year. The company currently sells 35,000 zippers per year and is taxed at a rate of 30%. a. Calculate FANSA’s operating breakeven point. b. On the basis of the firm’s current sales of 35,000 units per year and its interest and preferred dividend costs, calculate its Earnings Before Interest and Taxes (EBIT) and Earnings Available for Common Stockholders (EACS).
son.5 Dirty Dogs Grooming's optimal capital structure calls for 40 percent debt and 60 percent common equity. The company's weighted average cost of capital (WACC) is 11 percent if the amount of retained earnings generated during the year is sufficient to fund the equity portion of its capital budgeting requirements, whereas its WACC is 14 percent if new common stock must be issued. Dirty Dogs has the following independent investment opportunities: Project A: Cost = $684,000; IRR = 16% Project B: Cost = $630,000; IRR = 13% Project C: Cost = $660,000; IRR = 10% If Dirty Dogs expects to generate net income of $720,000 and it pays dividends according to the residual policy, what will its dividend payout ratio be? Round your answer to two decimal places. %
aa.4 Consider the following investment: capital cost is $250 million, all of which can be depreciated in equal amounts for tax over ten years working capital of $65 million tax rate of 30% net revenue of $45 million in the first year growing at 3% PA. The investor can borrow unlimited funds at 6% PA and their discount rate for similar investments is 15 percent. Calculate the net present value of the investment.
Aa.14 Allegience Insurance Company’s management is considering an advertising program that would require an initial expenditure of $177,085 and bring in additional sales over the next five years. The projected additional sales revenue in year 1 is $82,000, with associated expenses of $28,500. The additional sales revenue and expenses from the advertising program are projected to increase by 10 percent each year. Allegience’s tax rate is 30 percent. (Hint: The $177,085 advertising cost is an expense.)Required:1. Compute the payback period for the advertising program.2. Calculate the advertising program’s net present value, assuming an after-tax hurdle rate of 10 percent. (Round your intermediate calculations and final answer to the nearest whole dollar.)
Q No. 1 Assume that you are given assignment to evaluate the capital budgeting projects of the company which is considering investing in two Solar Energy projects, “Jamper Solar Project” and “Sajawal Solar Project”. The initial cost of each project is Rs. 10000 Million. Company discount all projects based on WACC. Further, all the projects are equally risky projects, and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at interest rate of rd 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. The dividend for current period is Rs 7.36, its expected that the dividend will grow at the constant growth rate of 8%, and the company’s common stock sells for 80. The tax rate is 50%. The cash flows of both the projects are given in table below: Time Jamper Solar Project Cashflows (amount in Rs. Millions) Sajawal Solar Project Cashflows (amount in Rs. Millions) 0…
Q No. 1 Assume that you are given assignment to evaluate the capital budgeting projects of the company which is considering investing in two Solar Energy projects, “Jamper Solar Project” and “Sajawal Solar Project”. The initial cost of each project is Rs. 10000 Million. Company discount all projects based on WACC. Further, all the projects are equally risky projects, and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at interest rate of rd 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. The dividend for current period is Rs 7.36, its expected that the dividend will grow at the constant growth rate of 8%, and the company’s common stock sells for 80. The tax rate is 50%. The cash flows of both the projects are given in table below: Time Jamper Solar Project Cashflows (amount in Rs. Millions) Sajawal Solar Project Cashflows (amount in Rs. Millions) 0…
Q No. 1 Assume that you are given assignment to evaluate the capital budgeting projects of the company which is considering investing in two Solar Energy projects, “Jamper Solar Project” and “Sajawal Solar Project”. The initial cost of each project is Rs. 10000 Million. Company discount all projects based on WACC. Further, all the projects are equally risky projects, and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at interest rate of rd 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. The dividend for current period is Rs 7.36, its expected that the dividend will grow at the constant growth rate of 8%, and the company’s common stock sells for 80. The tax rate is 50%. The cash flows of both the projects are given in table below: Time Jamper Solar Project Cashflows (amount in Rs. Millions) Sajawal Solar Project Cashflows (amount in Rs. Millions) 0…
Q No. 1 Assume that you are given assignment to evaluate the capital budgeting projects of the company which is considering investing in two Solar Energy projects, “Jamper Solar Project” and “Sajawal Solar Project”. The initial cost of each project is Rs. 10000 Million. Company discount all projects based on WACC. Further, all the projects are equally risky projects, and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at interest rate of rd 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. The dividend for current period is Rs 7.36, its expected that the dividend will grow at the constant growth rate of 8%, and the company’s common stock sells for 80. The tax rate is 50%. The cash flows of both the projects are given in table below: Time Jamper Solar Project Cashflows (amount in Rs. Millions) Sajawal Solar Project Cashflows (amount in Rs. Millions) 0…
QUESTION 35 Advanced Products is considering the purchase of a computer-aided manufacturing system that requires an initial investment of $1,750,000 and is expected to provide an increase in net income of $200,000 and average annual cash benefits and savings of $250,000 each year for the next 10 years. Their current cost of capital is 10%. Following are selected factors from tables for 10 years at 10%: FV of $1 FVOA PV of $1 PVOA 2.59374 15.93742 0.38554 6.14457 Required: Compute the payback period of the investment 8 years 10 years 7 years 9 years
Week 4Giant Equipment Ltd. is considering two projects to invest next year. Both projects have the same start-up costs. Project A will produce annual cash flows of $42,000 at the beginning of each year for eight years. Project B will produce cash flows of $48,000 at the end of each year for seven years. Thecompany requires a 12% return.Required:a) Which project should the company select and why? b) Which project should the company select if the interest rate is 14% at the cash flows in Project B is also at the beginning of each year?

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Intro Apollo Learnings needs $39 million to build a new campus. The company has a target debt-equity ratio of 1. The flotation cost for new equity is 9% and the flotation cost for new debt is 4%. Part 1 What are the weighted average flotation costs as a fraction of the amount invested?