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

The total taxes are 35+ 4.7 = 39.7%

The After tax cost of long ternm debt = 5.50*(1-0.397) = 3.3165%

The after tax cost of short term debt = 8.2*(1-0.397) = 4.9446%

WACC = 0.08* 4.9446% + 0.21* 3.3165% + 0.35*19.50% + 0.36*22.5% = 16.02%

b. The ROR are calculated using the =irr(cash flows) formula in excel and the results are tabulated as follows:

Hence you accept projects: 1,2,4 and 7.

Project First Cost Annual Benefit Life (years) ROR 1 $250,000 $50,000 15 18.42% Accept 2 $300,000 $70,000 10 19.36% Accept 3 $125,000 $38,000 5 15.80% Reject 4 $50,000 $12,500 10 21.41% Accept 5 $375,000 $107,500 5 13.34% Reject 6 $200,000 $32,000 20 15.03% Reject 7 $500,000 $155,000 5 16.64% Accept

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