Chapter 21 1. HBM, Inc. has the following capital structure:Assets $400,000 Debt $140,000 Preferred stock 20,000 Common stock240,000 The common stock is currently selling for $15 a share, paysa cash dividend of $0.75 per share, and is growing annually at 6percent. The preferred stock pays a $9 cash dividend and currentlysells for $91 a share. The debt pays interest of 8.5 percentannually, and the firm is in the 30 percent marginal tax bracket.a. What is the after-tax cost of debt? b. What is the cost ofpreferred stock? c. What is the cost of common stock? d. What isthe firm’s weighted-average cost of capital? 2. Sun Instrumentsexpects to issue new stock at $34 a share with estimated flotationcosts of 7 percent of the market price. The company currently paysa $2.10 cash dividend and has a 6 percent growth rate. What are thecosts of retained earnings and new common stock? 3. A firm’scurrent balance sheet is as follows: Assets $100 Debt $10 Equity$90 a. What is the firm’s weighted-average cost of capital atvarious combinations of debt and equity, given the followinginformation? Debt/Assets After-Tax Cost of Debt Cost of Equity Costof Capital 0% 8% 12% ? 10 8 12 ? 20 8 12 ? 30 8 13 ? 40 9 14 ? 5010 15 ? 60 12 16 ? b. Construct a pro forma balance sheet thatindicates the firm’s optimal capital structure. Compare thisbalance sheet with the firm’s current balance sheet. What course ofaction should the firm take? Assets $100 Debt $? Equity $? c. As afirm initially substitutes debt for equity financing, what happensto the cost of capital, and why? d. If a firm uses too much debtfinancing, why does the cost of capital rise? Chapter 22 1. Youpurchase machinery for $23,958 that generates cash flow of $6,000for five years. What is the internal rate of return on theinvestment? 2. The cost of capital for a firm is 10 percent. Thefirm has two possible investments with the following cash inflows:A B Year 1 $300 $200 2 200 200 3 100 200 a. Each investment costs$480. What investment(s) should the firm make according to netpresent value? b. What is the internal rate of return for the twoinvestments? Which investment(s) should the firm make? Is this thesame answer you obtained in part a? c. If the cost of capital risesto 14 percent, which investment(s) should the firm make? 3. A firmhas the following investment alternatives: Cash Inflows A B C Year1 $1,100 $3,600 — 2 1,100 — — 3 1,100 — $4,562 Each investmentcosts $3,000; investments B and C are mutually exclusive, and thefirm’s cost of capital is 8 percent. a. What is the net presentvalue of each investment? b. According to the net present values,which investment(s) should the firm make? Why? c. What is theinternal rate of return on each investment? d. According to theinternal rates of return, which investment(s) should the firm make?Why? e. According to both the net present values and internal ratesof return, which investments should the firm make? f. If the firmcould reinvest the $3,600 earned in year one from investment B at10 percent, what effect would that information have on your answerto part e? Would the answer be different if the rate were 14percent? g. If the firm’s cost of capital had been 10 percent, whatwould be investment A’s internal rate of return? h. The paybackmethod of capital budgeting selects which investment? Why? 4. Thechief financial officer has asked you to calculate the net presentvalues and internal rates of return of two $50,000 mutuallyexclusive investments with the following cash flows: Project A CashFlow Project B Cash Flow Year 1 $10,000 $ 0 2 25,000 22,000 330,000 48,000 If the firm’s cost of capital is 9 percent, whichinvestment(s) would you recommend? Would your answer be differentif the cost of capital were 14 percent? 7. An investment with totalcosts of $10,000 will generate total revenues of $11,000 for oneyear. Management thinks that since the investment is profitable, itshould be made. Do you agree? What additional information would youwant? If funds cost 12 percent, what would be your advice tomanagement? Would your answer be different if the cost of capitalis 8 percent? 10. The financial manager has determined thefollowing schedules for the cost of funds: Cost of Debt Ratio Costof Debt Equity 0% 5% 13% 10 5 13 20 5 13 30 5 13 40 5 14 50 6 15 608 16 a. Determine the firm’s optimal capital structure. b.Construct a simple pro forma balance sheet that shows the firm’soptimal combination of debt and equity for its current level ofassets. Assets $500 Debt — Equity — $500 c. An investment costs$400 and offers annual cash inflows of $133 for five years. Shouldthe firm make the investment? d. If the firm makes this additionalinvestment, how should its balance sheet appear? Asset — Debt —Equity — e. If the firm is operating with its optimal capitalstructure and a $400 asset yields 20.0 percent, what return willthe stockholders earn on their investment in the asset? 11.Investments Quick and Slow cost $1,000 each, are mutuallyexclusive, and have the following cash flows. The firm’s cost ofcapital is 10 percent. Cash Inflows Q S Year 1 $1,300 $386 2 — 3863 — 386 4 — 386 a. According to the net present value method ofcapital budgeting, which investment(s) should the firm make? b.According to the internal rate of return method of capitalbudgeting, which investment(s) should the firm make? c. If Q ischosen, the $1,300 can be reinvested and earn 12 percent. Does thisinformation alter your conclusions concerning investing in Q and S?To answer, assume that S’s cash flows can be reinvested at itsinternal rate of return. Would your answer be different if S’s cashflows were reinvested at the cost of capital (10 percent)?
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