Innovations Corporation
is preparing its statement of cash flows for the past year. The company has
gathered the following information about the past year just ended on December
31.
An investment project provides cash inflows of $660 per year for eight years.
What is the project payback period if the initial cost is $1,525? (Enter 0 if the project never pays back. Round your answer to 2 decimal places, e.g., 32.16.)
Payback period
years
What is the project payback period if the initial cost is $3,350? (Enter 0 if the project never pays back. Round your answer to 2 decimal places, e.g., 32.16.)
Payback period
years
What is the project payback period if the initial cost is $5,500? (Enter 0 if the project never pays back. Round your answer to 2 decimal places, e.g., 32.16.)
Payback period
years
Explanation:
To calculate the payback period, we need to find the time that the project has recovered its initial investment. The cash flows in this problem are an annuity, so the calculation is simpler. If the initial cost is $1,525, the payback period is:
Payback = 2 + ($205 / $660) = 2.31 years
There is a shortcut to calculate the payback period when the future cash flows are an annuity. Just divide the initial cost by the annual cash flow. For the $3,350 cost, the payback period is:
Payback = $3,350 / $660 = 5.08 years
The payback period for an initial cost of $5,500 is a little trickier. Notice that the total cash inflows after eight years will be:
Total cash inflows = 8($660) = $5,280
If the initial cost is $5,500, the project never pays back. Notice that if you use the shortcut for annuity cash flows, you get:
Payback = $5,500 / $660 = 8.33 years
This answer does not make sense since the cash flows stop after eight years, so again, we must conclude the payback period is never.
Problem 9-7 Calculating IRR [LO5]
A firm evaluates all of its projects by applying the IRR rule. A project under consideration has the following cash flows:
Year
Cash Flow
0
–$
27,200
1
11,200
2
14,200
3
10,200
If the required return is 16 percent, what is the IRR for this project? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
IRR
%
Should the firm accept the project?
No
Explanation:
The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that defines the IRR for this project is:
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 14.96%
Since the IRR is less than the required return, we would reject the project.
Calculator Solution:
Note: Intermediate answers are shown below as rounded, but the full answer was used to complete the calculation.
CFo
–$27,200
C01
$11,200
F01
1
C02
$14,200
F02
1
C03
$10,200
F03
1
IRR CPT
14.96%
Problem 9-8 Calculating NPV [LO1]
A firm evaluates all of its projects by applying the NPV decision rule. A project under consideration has the following cash flows:
Year
Cash Flow
0
–$
28,600
1
12,600
2
15,600
3
11,600
What is the NPV for the project if the required return is 11 percent? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
NPV
$
At a required return of 11 percent, should the firm accept this project?
Yes
What is the NPV for the project if the required return is 25 percent? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
NPV
$
At a required return of 25 percent, should the firm accept this project?
No
Explanation:
The NPV of a project is the PV of the inflows minus the PV of the outflows. The equation for the NPV of this project at an 11 percent required return is:
At a required return of 25 percent, the NPV is negative, so we would reject the project.
Calculator Solution:
Note: Intermediate answers are shown below as rounded, but the full answer was used to complete the calculation.
CFo
–$28,600
CFo
–$28,600
C01
$12,600
C01
$12,600
F01
1
F01
1
C02
$15,600
C02
$15,600
F02
1
F02
1
C03
$11,600
C03
$11,600
F03
1
F03
1
I = 11%
I = 25%
NPV CPT
NPV CPT
$3,894.48
–$2,596.80
Problem 9-12 NPV versus IRR [LO1, 5]
Garage, Inc., has identified the following two mutually exclusive projects:
Year
Cash Flow (A)
Cash Flow (B)
0
–$
28,500
–$
28,500
1
13,900
4,050
2
11,800
9,550
3
8,950
14,700
4
4,850
16,300
a-1
What is the IRR for each of these projects? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
IRR
Project A
%
Project B
%
a-2
Using the IRR decision rule, which project should the company accept?
Project A
a-3
Is this decision necessarily correct?
No
b-1
If the required return is 11 percent, what is the NPV for each of these projects? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
NPV
Project A
$
Project B
$
b-2
Which project will the company choose if it applies the NPV decision rule?
Project B
c.
At what discount rate would the company be indifferent between these two projects? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Discount rate
%
Explanation:
a.
The IRR is the interest rate that makes the NPV of the project equal to zero. The equation for the IRR of Project A is:
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 16.73%
Examining the IRRs of the projects, we see that the IRRA is greater than the IRRB, so IRR decision rule implies accepting Project A. This may not be a correct decision; however, because the IRR criterion has a ranking problem for mutually exclusive projects. To see if the IRR decision rule is correct or not, we need to evaluate the project NPVs.
The NPVB is greater than the NPVA, so we should accept Project B.
c.
To find the crossover rate, we subtract the cash flows from one project from the cash flows of the other project. Here, we will subtract the cash flows for Project B from the cash flows of Project A. Once we find these differential cash flows, we find the IRR. The equation for the crossover rate is:
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
R = 15.28%
At discount rates above 15.28 percent choose Project A; for discount rates below 15.28 percent choose Project B; indifferent between A and B at a discount rate of 15.28 percent.
Calculator Solution:
Note: Intermediate answers are shown below as rounded, but the full answer was used to complete the calculation.
Project A
CFo
–$28,500
CFo
–$28,500
C01
$13,900
C01
$13,900
F01
1
F01
1
C02
$11,800
C02
$11,800
F02
1
F02
1
C03
$8,950
C03
$8,950
F03
1
F03
1
C04
$4,850
C04
$4,850
F04
1
F04
1
IRR CPT
I = 11%
17.37%
NPV CPT
$3,338.68
Project B
CFo
–$28,500
CFo
–$28,500
C01
$4,050
C01
$4,050
F01
1
F01
1
C02
$9,550
C02
$9,550
F02
1
F02
1
C03
$14,700
C03
$14,700
F03
1
F03
1
C04
$16,300
C04
$16,300
F04
1
F04
1
IRR CPT
I = 11%
16.73%
NPV CPT
$4,385.47
Crossover rate
CFo
$0
C01
$9,850
F01
1
C02
$2,250
F02
1
C03
–$5,750
F03
1
CO4
–$11,450
FO4
1
IRR CPT
15.28%
Problem 10-9 Calculating Project OCF [LO1]
Quad Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.67 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,070,000 in annual sales, with costs of $765,000. If the tax rate is 34 percent, what is the OCF for this project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g. 1,234,567.)
OCF
$
Explanation:
Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get:
Quad Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.79 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,110,000 in annual sales, with costs of $805,000. The tax rate is 35 percent and the required return on the project is 12 percent. What is the project’s NPV? (Enter your answer in dollars, not millions of dollars, e.g. 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
NPV
$
Explanation:
Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get:
Since we have the OCF, we can find the NPV as the initial cash outlay plus the PV of the OCFs, which are an annuity, so the NPV is:
NPV = −$2,790,000 + $1,173,750(PVIFA12%,3)
NPV = $29,149.45
Problem 10-11 Calculating Project Cash Flow from Assets [LO1]
Quad Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.4 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life. The project is estimated to generate $1,980,000 in annual sales, with costs of $675,000. The project requires an initial investment in net working capital of $200,000, and the fixed asset will have a market value of $310,000 at the end of the project. If the tax rate is 34 percent, what is the project’s Year 0 net cash flow? Year 1? Year 2? Year 3? (Do not round intermediate calculations. Enter your answers in dollars, not millions of dollars, e.g. 1,234,567. Negative amounts should be indicated by a minus sign.)
Years
Cash Flow
Year 0
$
Year 1
$
Year 2
$
Year 3
$
If the required return is 18 percent, what is the project's NPV? (Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.)
NPV
$
rev: 11_04_2015_QC_CS-32334
Explanation:
The Year 0 cash flow is:
Year 0 = −$2,400,000 − 200,000 = –$2,600,000
The cash outflow at the beginning of the project will increase because of the spending on NWC. At the end of the project, the company will recover the NWC, so it will be a cash inflow. The sale of the equipment will result in a cash inflow, but we also must account for the taxes that will be paid on this sale. So, the cash flows for each year of the project will be:
In Years 1 and 2, the only cash flow is the OCF. In Year 3, the total cash flow will include the recovery of the NWC and the aftertax salvage value, so:
Problem 12-7 Calculating Returns and Variability [LO1]
Returns
Year
X
Y
1
15
%
22
%
2
29
30
3
10
10
4
–
22
–
27
5
10
21
Using the returns shown above, calculate the arithmetic average returns, the variances, and the standard deviations for X and Y. (Do not round intermediate calculations. Enter your average return and standard deviation as a percent rounded to 2 decimal places, e.g., 32.16, and round the variance to 5 decimal places, e.g., 32.16161.)
X
Y
Average return
%
%
Variance
Standard deviation
%
%
rev: 09_29_2015_QC_CS-27339
Problem 12-8 Risk Premiums [LO2, 3]
Suppose we have the following returns for large-company stocks and Treasury bills over a six year period:
Year
Large Company
US Treasury Bill
1
3.95
6.53
2
14.13
4.38
3
19.07
4.25
4
–14.61
7.30
5
–32.10
4.94
6
37.32
6.14
a.
Calculate the arithmetic average returns for large-company stocks and T-bills over this period. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Average returns
Large company stocks
%
T-bills
%
b.
Calculate the standard deviation of the returns for large-company stocks and T-bills over this period. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Standard deviation
Large company stocks
%
T-bills
%
c-1
Calculate the observed risk premium in each year for the large-company stocks versus the T-bills. What was the average risk premium over this period?(Negative amount should be indicated by a minus sign.Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Average risk premium
%
c-2
Calculate the observed risk premium in each year for the large-company stocks versus the T-bills. What was the standard deviation of the risk premium over this period? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Standard deviation
%
Explanation:
We will calculate the sum of the returns for each asset and the observed risk premium first. Doing so, we get:
Year
Large Co. Stock Return
T-Bill Return
Risk Premium
1
3.95
%
6.53
%
–
2.58
%
2
14.13
4.38
9.75
3
19.07
4.25
14.82
4
–
14.61
7.30
–
21.91
5
–
32.10
4.94
–
37.04
6
37.32
6.14
31.18
27.76
33.54
–
5.78
a.
The average return for large company stocks over this period was:
Large company stocks average return = 27.76% / 6 = 4.63%
And the average return for T-bills over this period was:
T-bills average return = 33.54% / 6 = 5.59%
b.
Using the equation for variance, we find the variance for large company stocks over this period was:
And the standard deviation of the observed risk premium was:
Standard deviation = (.062800)1/2 = .2506, or 25.06%
Problem 12-9 Calculating Returns and Variability [LO1]
You’ve observed the following returns on Crash-n-Burn Computer’s stock over the past five years: 14 percent, –7 percent, 17 percent, 15 percent, and 10 percent.
a.
What was the arithmetic average return on Crash-n-Burn’s stock over this five-year period? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place, e.g., 32.1.)
Average return
%
b-1
What was the variance of Crash-n-Burn’s returns over this period? (Do not round intermediate calculations and round your answer to 5 decimal places, e.g., 32.16161.)
Variance
b-2
What was the standard deviation of Crash-n-Burn’s returns over this period? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Standard deviation
%
Explanation:
a.
To find the average return, we sum all the returns and divide by the number of returns, so:
You’ve observed the following returns on Crash-n-Burn Computer’s stock over the past five years: 18 percent, –14 percent, 20 percent, 22 percent, and 10 percent. Suppose the average inflation rate over this period was 3.1 percent and the average T-bill rate over the period was 4.4 percent.
What was the average real risk-free rate over this time period? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Average real risk-free rate
%
What was the average real risk premium?(Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Average real risk premium
%
Explanation:
We can find the average real risk-free rate using the Fisher equation. The average real risk-free rate was:
(1 + R) = (1 + r)(1 + h)
f = (1.044 / 1.031) – 1
f = .0126, or 1.26%
To find the average return, we sum all the returns and divide by the number of returns, so:
To calculate the average real return, we can use the average return of the asset, and the average inflation in the Fisher equation. Doing so, we find:
(1 + R) = (1 + r)(1 + h)
= (1.112 / 1.031) – 1
= .0786, or 7.86%
And to calculate the average real risk premium, we can subtract the average risk-free rate from the average real return. So, the average real risk premium was:
Average real risk premium = Average real return – Average risk-free rate
Average real risk premium = 7.86% – 1.26%
Average real risk premium = 6.60%
Problem 12-15 Arithmetic and Geometric Returns [LO1]
A stock has had returns of 6 percent, 24 percent, 16 percent, −12 percent, 31 percent, and −6 percent over the last six years.
What are the arithmetic and geometric returns for the stock? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Arithmetic return
%
Geometric return
%
Explanation:
The arithmetic average return is the sum of the known returns divided by the number of returns, so:
Remember, the geometric average return will always be less than the arithmetic average return if the returns have any variation.
Problem 13-7 Calculating Returns and Standard Deviations [LO1]
Consider the following information:
Rate of Return If State Occurs
State of
Probability of
Economy
State of Economy
Stock A
Stock B
Recession
.15
.06
−
.19
Normal
.60
.09
.10
Boom
.25
.14
.27
Calculate the expected return for each stock. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Expected return
Stock A
%
Stock B
%
Calculate the standard deviation for each stock. (Do not round intermediate calculations. Enter your answers as a percentrounded to 2 decimal places, e.g., 32.16.)
Standard deviation
Stock A
%
Stock B
%
Explanation:
The expected return of an asset is the sum of each return times the probability of that return occurring. So, the expected return of each stock asset is:
E(RA) = .15(.06) + .60(.09) + .25(.14)
E(RA) = .0980, or 9.80%
E(RB) = .15(−.19) + .60(.10) + .25(.27)
E(RB) = .0990, or 9.90%
To calculate the standard deviation, we first need to calculate the variance. To find the variance, we find the squared deviations from the expected return. We then multiply each possible squared deviation by its probability, then add all of these up. The result is the variance. So, the variance and standard deviation of each stock is:
You own a portfolio equally invested in a risk-free asset and two stocks. If one of the stocks has a beta of 1.11 and the total portfolio is equally as risky as the market, what must the beta be for the other stock in your portfolio? (Do not round intermediate calculations. Round your answer to 2 decimal places, e.g., 32.16.)
Portfolio beta
Explanation:
The beta of a portfolio is the sum of the weight of each asset times the beta of each asset. If the portfolio is as risky as the market, it must have the same beta as the market. Since the beta of the market is one, we know the beta of our portfolio is one. We also need to remember that the beta of the risk-free asset is zero. It has to be zero since the asset has no risk. Setting up the equation for the beta of our portfolio, we get:
βP = 1.0 = 1/3(0) + 1/3(1.11) + 1/3(βX)
Solving for the beta of Stock X, we get:
βX = 1.89
Problem 13-17 Using the SML [LO4]
Asset W has an expected return of 12.2 percent and a beta of 2.00. If the risk-free rate is 4.1 percent, complete the following table for portfolios of Asset W and a risk-free asset. (Leave no cells blank - be certain to enter "0" wherever required. Do not round intermediate calculations. Enter your expected returns as a percent rounded to 2 decimal places, e.g., 32.16, and your beta answers to 3 decimal places, e.g., 32.161.)
Percentage of Portfolio in Asset W
Portfolio Expected Return
Portfolio Beta
0
%
%
25
%
50
%
75
%
100
%
125
%
150
%
If you plot the relationship between portfolio expected return and portfolio beta, what is the slope of the line that results? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Slope of the line
%
Explanation:
First, we need to find the β of the portfolio. The β of the risk-free asset is zero, and the weight of the risk-free asset is one minus the weight of the stock, so the β of the portfolio is:
βP = wW(2.00) + (1 − wW)(0) = 2.00wW
So, to find the β of the portfolio for any weight of the stock, we simply multiply the weight of the stock times its β.
Even though we are solving for the β and expected return of a portfolio of one stock and the risk-free asset for different portfolio weights, we are really solving for the SML. Any combination of this stock and the risk-free asset will fall on the SML. For that matter, a portfolio of any stock and the risk-free asset, or any portfolio of stocks, will fall on the SML. We know the slope of the SML line is the market risk premium, so using the CAPM and the information concerning this stock, the market risk premium is:
E(RW) = .122 = .041 + MRP(2.00)
MRP = .081 / 2.00
MRP = .0405, or 4.05%
So, now we know the CAPM equation for any stock is:
E(RP) = .041 + .0405βp
The slope of the SML is equal to the market risk premium, which is .0405, or 4.05%
Problem 13-19 Reward-to-Risk Ratios [LO4]
Stock Y has a beta of .9 and an expected return of 11.2 percent. Stock Z has a beta of .5 and an expected return of 7.2 percent.
What would the risk-free rate have to be for the two stocks to be correctly priced? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Risk-free rate
%
Explanation:
We need to set the reward-to-risk ratios of the two assets equal to each other, which is:
(.112 – Rf) / .9 = (.072 – Rf) / .5
We can cross multiply to get:
.5(.112 – Rf) = .9(.072 – Rf)
Solving for the risk-free rate, we find:
.0560 – .5Rf = .0648 – .9Rf
Rf = .0220, or 2.20%
Problem 14-13 Calculating the WACC [LO3]
Dinklage Corp. has 6 million shares of common stock outstanding. The current share price is $85, and the book value per share is $8. The company also has two bond issues outstanding. The first bond issue has a face value of $65 million, a coupon rate of 8 percent, and sells for 95 percent of par. The second issue has a face value of $40 million, a coupon rate of 9 percent, and sells for 108 percent of par. The first issue matures in 23 years, the second in 5 years.
Suppose the most recent dividend was $5.70 and the dividend growth rate is 4 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 38 percent. What is the company’s WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
WACC
%
Explanation:
The market value of equity is the share price times the number of shares, so:
MVE = 6,000,000($85)
MVE = $510,000,000
Using the relationship that the total market value of debt is the price quote times the par value of the bond, we find the market value of debt is:
MVD = .95($65,000,000) + 1.08($40,000,000)
MVD = $104,950,000
This makes the total market value of the company:
V = $510,000,000 + 104,950,000
V = $614,950,000
And the market value weights of equity and debt are:
E/V = $510,000,000 / $614,950,000
E/V = .8293
D/V = 1 – E/V = .1707
Next, we will find the cost of equity for the company. The information provided allows us to solve for the cost of equity using the dividend growth model, so:
RE = [$5.70(1.04) / $85] + .04
RE = .1097, or 10.97%
Next, we need to find the YTM on both bond issues. Doing so, we find:
P1 = $950 = $40(PVIFAR%,46) + $1,000(PVIFR%,46)
R = 4.249%
YTM = 4.249% × 2 = 8.50%
P2 = $1,080 = $45(PVIFAR%,10) + $1,000(PVIFR%,10)
R = 3.536%
YTM = 3.536% × 2 = 7.07%
To find the weighted average aftertax cost of debt, we need the weight of each bond as a percentage of the total debt. We find:
xD1 = .95($65,000,000) / $104,950,000
xD1 = .5884
xD2 = 1.08($40,000,000) / $104,950,000
xD2 = .4116
Now we can multiply the weighted average cost of debt times one minus the tax rate to find the weighted average aftertax cost of debt. This gives us:
RD = (1 – .38)[(.5884)(.0850) + (.4116)(.0707)]
RD = .0491, or 4.91%
Using these costs and the weight of debt we calculated earlier, the WACC is:
WACC = .8293(.1097) + .1707(.0491)
WACC = .0994, or 9.94%
Problem 14-15 Finding the WACC [LO3]
You are given the following information for Watson Power Co. Assume the company’s tax rate is 30 percent.
Debt:
9,000 6.4 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 107 percent of par; the bonds make semiannual payments.
Common stock:
360,000 shares outstanding, selling for $54 per share; the beta is 1.10.
Preferred stock:
14,000 shares of 4 percent preferred stock outstanding, currently selling for $74 per share.
Market:
11 percent market risk premium and 4.4 percent risk-free rate.
What is the company's WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
WACC
%
Explanation:
We will begin by finding the market value of each type of financing. We find:
MVD = 9,000($1,000)(1.07) = $9,630,000
MVE = 360,000($54) = $19,440,000
MVP = 14,000($74) = $1,036,000
And the total market value of the firm is:
V = $9,630,000 + 19,440,000 + 1,036,000
V = $30,106,000
Now, we can find the cost of equity using the CAPM. The cost of equity is:
Notice that we didn’t include the (1 – TC) term in the WACC equation. We used the aftertax cost of debt in the equation, so the term is not needed here.
Problem 14-16 Finding the WACC [LO3]
Titan Mining Corporation has 9.7 million shares of common stock outstanding, 410,000 shares of 4 percent preferred stock outstanding, and 215,000 8.5 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $45 per share and has a beta of 1.35, the preferred stock currently sells for $95 per share, and the bonds have 10 years to maturity and sell for 116 percent of par. The market risk premium is 8.5 percent, T-bills are yielding 5 percent, and the company’s tax rate is 35 percent.
a.
What is the firm’s market value capital structure? (Do not round intermediate calculations. Round your answers to 4 decimal places, e.g., 32.1616.)
Market value weight
Debt
Preferred stock
Equity
b.
If the company is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should the firm use to discount the project’s cash flows? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Discount rate
%
Explanation:
a.
We will begin by finding the market value of each type of financing. We find:
MVD = 215,000($1,000)(1.16) = $249,400,000
MVE = 9,700,000($45) = $436,500,000
MVP = 410,000($95) = $38,950,000
And the total market value of the firm is:
V = $249,400,000 + 436,500,000 + 38,950,000 = $724,850,000
So, the market value weights of the company’s financing are:
D/V = $249,400,000 / $724,850,000 = .3441
P/V = $38,950,000 / $724,850,000 = .0537
E/V = $436,500,000 / $724,850,000 = .6022
b.
For projects equally as risky as the firm itself, the WACC should be used as the discount rate.
First we can find the cost of equity using the CAPM. The cost of equity is:
