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Review problems

Review problems. Example 1. A not for profit organization such as a ballet company or museum, usually carries no debt. Also, since there are no shareholders, there is no equity outstanding.

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Review problems

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  1. Review problems

  2. Example 1 • A not for profit organization such as a ballet company or museum, usually carries no debt. Also, since there are no shareholders, there is no equity outstanding. • How would you go about determining the appropriate weighted average cost of capital for not for profit organizations?

  3. Answer 1 • This focuses on the fact that the firm’s cost of capital is an opportunity cost relative to the riskiness of the firm’s assets. In a world without taxes use the weights of the assets and liabilities of the company. • With taxes it is difficult to determine a correct answer. • Donations to such organizations are tax deductible so does this lower the cost?

  4. Example 2 • According to US law companies do not pay tax on 80% of dividends received from shares held in other firms. Only 20% is taxable. • How much must the price of the share fall on the ex dividend date in order to prevent the holder making arbitrage profits? • Assume the CG and statutory tax rates are both 0.50.

  5. Answer 2 • The arbitrage is buy the day before ex div and sell day after.

  6. Problem 3 • The Azzurri company has a current market value of €1 million. Half of which is debt. Its current weighted cost of capital is 9%. The tax rate is 40%. • The treasurer proposes a new project costing €500.000 financed completely with debt. • It will earn 8,5% on its levered after tax cash flows. • The treasurer argues the project is desirable because it earns more than 5% which is the before tax cost of debt to the firm. • What do you think?

  7. Answer 3 • Need to know the appropriate WACC for project. Should suspect 100% debt financing is unrealistic! • Better to calculate new WACC for firm as a whole with the project included. • Find cost of equity as 15%. • Then reapply • WACC = 0,15*0,33 + 0,05(1-0,4)*0,67 = 6.96% • Project should be accepted as earns more than the new WACC.

  8. 3 continued • The reasoning of the treasurer is suspect. • 1. No project has 100% debt capacity. • 2. If the project has same risk as the firm but more debt (and can use all tax shields) then reasonable that the WACC is lower. • However, note we used the same cost of equity in both. What is the impact of increased debt on cost of equity! • Should we instead calculate new cost of equity with stable WACC! • On this analysis the project is not sufficient.

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