The Cost of Capital And The Basics of Capital Budgeting: Evaluating Cash Flows
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PLEASE USE EXCEL TO SOLVE ALL PROBLEMS
Problem 1
You are employed by ABC Inc. Your boss has asked you to estimate the weighted average cost of capital
for the company. Following are balance sheets and some information about CGT.
Assets
Current assets $30,000,000
Net plant, property, and equipment $100,000,000
Total Assets $130,000,000
Liabilities and Equity
Accounts payable $10,000,000
Accruals $10,000,000
Current liabilities $20,000,000
Long term debt (40,000 bonds, $1,000 face value) $40,000,000
Total liabilities $60,000,000
Preferred Stock (100,000 shares, $100 face value) $10,000,000
Common Stock (10,000,000 shares) $30,000,000
Retained Earnings $30,000,000
Total shareholders equity $70,000,000
Total liabilities and shareholders equity $130,000,000
You check The Wall Street Journal and see that ABC stock is currently selling for $10.00 per share and that
ABC bonds are selling for $1100.0 per bond. These bonds have a 7 percent coupon rate, with semi-annual
payments. The bonds mature in twelve years. The preferred stock has an unlimited life and pays an 5
percent annual coupon. The preferred stock sells for $95. The beta for your company is approximately
equal to 2. The yield on a 20-year Treasury bond is 4.0 percent. The expected return on the stock market is
8.0 percent. ABC is in the 40 percent tax bracket.
2. Davis Corporation is faced with two independent investment opportunities. The
corporation has an investment policy which requires acceptable projects to
recover all costs within 3 years. The cost of capital is 10 percent. The cash flows
for the two projects are:
Project A Project B
Year Cash Flow Cash Flow
0 -$120,000 -$90,000
1 42,000 30,000
2 43,000 30,000
3 44,000 30,000
4 45,000 30,000
5 46,000 30,000
Which investment project(s) does the company invest in using the:
1)Payback period rule
2)Discounted payback period rule
3)NPV
4)IRR
3. XYZ Corporation is faced with two mutually exclusive investment opportunities.
The cost of capital is 12 percent. The cash flows for the two projects are:
Project A Project B
Year Cash Flow Cash Flow
0 -$140,000 -$100,000
1 60,000 30,000
2 60,000 30,000
3 60,000 30,000
4 30,000
5 30,000
6 30,000
Which investment project should the company invest in using the:
1.Equivalent annual annuity approach
2.The replacement approach
Please name this file as:
Assignment 6 first_name last_name.doc
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