Problem 13-2 Calculating Cost of Debt Advance, Inc., is trying to determine its
ID: 2751466 • Letter: P
Question
Problem 13-2 Calculating Cost of Debt
Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 16 years to maturity that is quoted at 107 percent of face value. The issue makes semiannual payments and has a coupon rate of 10 percent annually.
What is Advance's pretax cost of debt? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16))
If the tax rate is 35 percent, what is the aftertax cost of debt? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16))
Problem 13-16 WACC and NPV
Och, Inc., is considering a project that will result in initial aftertax cash savings of $1.79 million at the end of the first year, and these savings will grow at a rate of 3 percent per year indefinitely. The firm has a target debt–equity ratio of .85, a cost of equity of 11.9 percent, and an aftertax cost of debt of 4.7 percent. The cost-saving proposal is somewhat riskier than the usual projects the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2 per cent to the cost of capital for such risky projects.
What is the maximum initial cost of company would be willing to pay for the project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)
Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 16 years to maturity that is quoted at 107 percent of face value. The issue makes semiannual payments and has a coupon rate of 10 percent annually.
Explanation / Answer
a.Pretax cost of debt =10%
b.Tax rate =35%
Post tax cost of debt =Pretax cost of debt *(1-Tax rate)
Post tax cost of debt =10 % (1-.35)= 65% of 10% =6.5
Post tax cost of debt =6.5%
WACC and NPV
WACC=W1R1 + W2R2
W1,W2 =Weights of individual stocks
R1,R2 =Expected return on individual stocks
Debt equity ratio =.85
Cost of equity =11.9 %
After tax cost of debt =4.7 %
Cost of Equity = (Next Year's dividends per share / Current market value of stock) + Growth rate of dividends
WACC = .85 * 0.119 + .15 * 0.047=10.82 %
Net present value =Present value of cash inflow –Present value of cash outflow
Net present value is calculated by discounting the cash flow by an appropriate discount rate which is the required rate of return on a project.
In the given problem,it is mentioned that the firm applies adjustment factor of 2 % for such projects to arrive a weighted cost of capital.
Discount rate to be used to for calculating NPV =WACC + 2% =12.82%
Annual after tax cash savings =$1.79 m
Growth rate =3 %
Present value of growing annuity till perpetuity= Annual cash flow/r-g
r= required rate of return
g=growth rate
Present value of 1.79 m to be received annually at a growth rate of 3 % =1822810591=18.22m
At 12.82 % discount rate which is the weighted cost of capital ,present value of cash inflows will be equal to present value of cash outflow.
NPV=Present value of cash inflows –Present value of cash outflow
0=18.22m –Initial investment in period 0
Initial investment =18.22 m
Maximum initial outlay company would like to pay =18.22m