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) E/V * Re + D/V * Rd * (1 – Tc)

Tc = corporate tax rate

2)

It can accept projects 1, 2, 3, 4, 7.

Re = cost of equity Rd = cost of debt E = market value of the firm’s equity D = market value of the firm’s debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt

Tc = corporate tax rate

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 $100,000,000.00 0.081 0.00656 0.65 0.35 WACC 9%

2)

Project First Cost Annual Benefit Life (years) ROI 1 $250,000 $50,000 15 33% 2 $300,000 $70,000 10 19% 3 $125,000 $38,000 5 16% 4 $50,000 $12,500 10 21% 5 $375,000 $107,500 5 13% 6 $200,000 $32,000 20 10% 7 $500,000 $155,000 5 17%

It can accept projects 1, 2, 3, 4, 7.

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