1. Your friend is willing to lend you $500 at 7% and your cousin is willing to l

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Question

1. Your friend is willing to lend you $500 at 7% and your cousin is willing to lend you $1,500 at 12%. If your tax rate is 40%, what is your WACC?

2. How do we compute capital structure weights using (a) book values; and (b) market values? Identify where examples of these methods are presented in the text. Which of these do investors and analysts prefer?

3.Fulton has $30 million in equity, $20 million in debt and $5 million in preferred stock. Component costs of capital are 10%, 7%, and 6%, respectively. If Fulton’s tax rate is 40%, what is its WACC?

4. We’ve discussed two ways of adjusting the WACC for the risk of a proposed project. List the steps involved in each of these two methods. Identify where examples of these methods are presented in the text.

9. Use the graph with lines for the overall WACC and the risk-adjusted WACC to label the following situations if the overall WACC is used to evaluate all projects regardless of their degree of risk:

(A) Acceptance of high risk projects that are bad investments

(B) Acceptance of low-risk projects that are good investments

(D) Rejection of high-risk projects that are bad investments

10. An all-equity firm is considering a project that is only 2/3 as risky as average for the firm. If the annual rate on 3-month T-bills is 2%, the expected return on the market is 10%, and the firm’s tax rate is 35%, what is the WACC for this firm?

Explanation / Answer

(1) Before tax WACC = (500/2000)*7% = (1500/2000)*12% = 8.95%

After tax WACC = 8.95% * (1-40%) = 5.37%

(2) Under book value - The book Value of Equity and Debt are used to compute WACC. The book value of Equity (par value) is divided by total capital to find out the equity weight and the book value (par/face value) of debt is divided by total capital to find out the weight of debt in capital structure. On the contrary, the market price of equity and debt is used respectively under the Market Value weight

(3) After-tax cost of debt = 7% * (1-40%) = 4.20%

WACC = (30/55*10%) + (20/55*4.20%) + (5/55*6%) = 7.527%

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1. Your friend is willing to lend you $500 at 7% and your cousin is willing to l

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