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?

5

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

1) WACC = cost of equity * market value equity /MArket value firm + cost of debt * market value debt /MArket value firm

= 8.2% *.08 +5.5*.21 (1- (35% + 4.7%)) + 19.5% *.35 + 22.5* .36

= 1.09% + 14.92%

WACC = 16%

2) It is shown in the table:

Hence the project 2 should be selected

3) The firm's Minimum rate of return = sum of all the projects present value = total cash outflow

Hence the NPV all the project is positive = $51056 hence the minimum rate of return has to be more than 16%.

Project First Cost Annual Benefit Life (years) PVIFA 16% Present value NEt present value 1 $250,000 $50,000 15 5.5755 $278,775 $28,775 2 $300,000 $70,000 10 4.833 $338,310 $38,310 3 $125,000 $38,000 5 3.274 $124,412 -$588 4 $50,000 $12,500 10 4.833 $60,413 $10,413 5 $375,000 $107,500 5 3.274 $351,955 -$23,045 6 $200,000 $32,000 20 5.9288 $189,722 -$10,278 7 $500,000 $155,000 5 3.274 $507,470 $7,470

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