1) XYX corporations capital structure calls for 60% debt and 40% common equity.

Question

1) XYX corporations capital structure calls for 60% debt and 40% common equity.  The companys cost of debt is 8%. Retained earnings are estimated to be $160 million. The companys cost of retained earnings is 14% and the cost of external common equity is 16%. The corporate tax rate is 30%. Calculate the WACC below the RE break point.

2)XYZ, Inc. is considering a 5 year, 12% WACC capital budgeting project under three scenarios. If conditions are excellent, the cash flows from this project are expected to be $4,000 per year; under fair conditions, cash flows are projected at $2,500 per year; and under unfavorable conditions, cash flows are projected at ($600) per year. The initial investment outlay is $3,000 and the probabilities of these three conditions are 30%, 50% and 20%, respectively. Assume that XYZ has the option to abandon this project in the second year if conditions are unfavorable. It could do so by selling this project to another company at a price of $1,500 in year 2 and consequently cash flows would be 0 in years 3 and beyond. Calculate the standard deviation given the abandonment option.

Explanation / Answer

Ans 1

Details In Mn Total estimated Retained earning assuming no dividend pay out is expected. 160 Cost of Retained earnings 14% Weight of RE 40% Retained earning Break Point= Retained earnigs/Weight of common equity             400.00 For any additional capital infusion to the tune of 400 WACC of XYZ corporation would be (Cost of Debt * Weight) + (Cost of RE * Weight) (.08*(1-.30)*.60)+(.14*.40) 8.96% This means 400 Mn capital can be raised with a WACC of 8.96% without resorting to more expensive expensive external equity

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