Part 1: A firm has the current liabilities and equity financing on its balance s

Question

Part 1: A firm has the current liabilities and equity financing on its balance sheet shown below. The firm has taxable income that puts it in a 35% federal tax bracket, and the state in which it operates levies a 4.7% income tax. Compute the firm’s weighted average cost of capital.

Part 2: The same firm is considering the following projects to improve its production process. If the firm has a capital budget of $1,250,000, which projects should be accepted by the rate of return criteria? What is the firm’s opportunity cost of capital?

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Part 3: From your estimates of the WACC in part 1 and the opportunity cost of capital in part 2, what do you estimate the firm’s true MARR to be?

Source Amount Interest / RoR Proportion Short-term loan $8,000,000 8.20% 0.08 Long-term loan $21,000,000 5.50% 0.21 Retained Earnings $35,000,000 19.50% 0.35 Common stock $36,000,000 22.50% 0.36

Explanation / Answer

Answer:

Part 1:

Source Amount Interest / RoR After tax Proportion WACC Short-term loan $8,000,000 8.20% 4.94% 0.08 0.40% Long-term loan $21,000,000 5.50% 3.32% 0.21 0.70% Retained Earnings $35,000,000 19.50% 19.50% 0.35 6.83% Common stock $36,000,000 22.50% 22.50% 0.36 8.10% 16.02%

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