# Chapter 10 Questions and Answers

## Chapter 10 Questions and Answers

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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 PCCC’s stock needs to estimate the company’s weighted average cost of capital. PCCC’s 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 PCCC’s 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 PCCC’s stock needs to estimate the company’s weighted average cost of capital. PCCC’s 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 PCCC’s 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

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 PCCC’s stock needs to estimate the company’s weighted average cost of capital. PCCC’s 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 PCCC’s 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 PCCC’s stock needs to estimate the company’s weighted average cost of capital. PCCC’s 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 PCCC’s 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. 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. It’s 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. Chapter 10 Questions and Answers

6. 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. It’s 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% Chapter 10 Questions and Answers

7. 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. It’s 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% Chapter 10 Questions and Answers

8. Q3. Magic Pan Restaurant Inc.’s average interest rate for all of its Debt outstanding is 7.86%. It’s 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? Chapter 10 Questions and Answers

9. Q3. Magic Pan Restaurant Inc.’s average interest rate for all of its Debt outstanding is 7.86%. It’s 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? Chapter 10 Questions and Answers

10. Q3. Magic Pan Restaurant Inc.’s average interest rate for all of its Debt outstanding is 7.86%. It’s 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? Chapter 10 Questions and Answers

11. Q3. Magic Pan Restaurant Inc.’s average interest rate for all of its Debt outstanding is 7.86%. It’s 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 company’s Minimum Required Free Cash Flow Return on Assets; (2) To define the Minimum Required Starting Point Return for New Proposed Business Investment Projects. Chapter 10 Questions and Answers

12. 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? Chapter 10 Questions and Answers

13. 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. Chapter 10 Questions and Answers

14. 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 company’s capital structure (proportional mix of Debt versus Equity Capital), dividend payout ratio, and the riskiness of company’s existing and new business investment projects. Chapter 10 Questions and Answers