Fin-6

Business Finance Assignment 6

NOTE: For the problems below, you must show your calculations to receive credit.

NOTE: For the discussion questions below, your answers should be in your own words, not

shared from another student or copied from any other source. I do not expect a lengthy response, but I do expect your answer for each question will be about a paragraph with approximately

50-100 words.

Chapter 11

1. Adams Waste Management can buy a piece of equipment that is anticipated to provide an 8 percent

return and can be financed at 5 percent with debt. Later in the year, the firm turns down an

opportunity to buy a new machine that would yield a 15 percent return but would cost 17 percent

to finance through common equity. Assume debt and common equity each represent 50 percent of

the firm’s capital structure.

a. Compute the weighted average cost of capital.

b. Which project(s) should be accepted?

2. Calculate the aftertax cost of debt under each of the following conditions.

Yield Corporate Tax Rate

a. 8.0% 25%

b. 11.4 35

c. 7.5 0

3. The Adcock Corporation issued $100 par value preferred stock 10 years ago. The stock provided a 7

percent yield at the time of issue. The preferred stock is now selling for $84. What is the current

yield or cost of the preferred stock? (Disregard flotation costs.)

4. AgriProducts, Inc. wants to determine the minimum cost of capital point for the company. Assume it

is considering the following financial plans:

Cost (aftertax)

Weights

Plan A

Debt ....................................... 5.0% 20%

Preferred stock ...................... 7.0 10

Common equity ..................... 14.0 70

Plan B

Debt ....................................... 5.5% 30%

Preferred stock ...................... 8.0 10

Common equity ..................... 15.0 60

Plan C

Debt ....................................... 6.0% 40%

Preferred stock ...................... 9.0 10

Common equity ..................... 15.8 50

Plan D

Debt ....................................... 8.0% 50%

Preferred stock ...................... 10.0 10

Common equity ..................... 17.5 40

a. Which of the four plans has the lowest weighted average cost of capital? (Round to two

places to the right of decimal point.)

b. Briefly discuss the results from Plan C and Plan D, and why one is better than

the other.

Chapter 12

5. Arkansas Airways Corporation has earnings before depreciation and taxes of $100,000, depreciation

of $50,000, and that it has a 35 percent tax bracket.

a. Compute its cash flow using the format below.

Earnings before depreciation and taxes _____

Depreciation _____

Earnings before taxes _____

Taxes @ 30% _____

Earnings after taxes _____

Depreciation _____

Cash Flow _____

b. How much would cash flow be if there were only $10,000 in depreciation? All other factors

are the same.

c. How much cash flow is lost due to the reduced depreciation between a & b?

6. Aaron’s is considering a $50,000 investment and the following cash flows for two alternatives.

Year Investment A Investment B 1 ................ $10,000 $20,000

2 ................ 11,000 25,000

3 ................ 13,000 10,000

4 ................ 16,000 —

5 ................ 30,000 —

a. Which alternative would you select under the payback method?

b. If the inflow in the fifth year for Investment A were $100,000 instead of $30,000, would your

answer change under the payback method?

7. Agape Corp. will invest $90,000 in a temporary project that will generate the following cash inflows

for the next three years (inflows at the end of the year).

Year Cash Flow 1 ............ $23,000

2 ............ 38,000

3 ............ 61,000

The firm will be required to spend $17,500 to close down the project at the end of the three years.

If the cost of capital is 10 percent, should the investment be undertaken? Use the net present value

method.

Chapter 13

8. Abbie’s Dance Studio is considering the purchase of new sound equipment that will enhance the

popularity of its aerobics dancing. The equipment will cost $25,000. The owner is not sure how

many members the new equipment will attract, but she estimates that her increased annual cash

flows for each of the next five years will have the following probability distribution. Her cost of

capital is 11 percent.

Cash Flow Probability $3,600 .............. .2

5,000 .............. .3

7,400 .............. .4

9,000 .............. .1

a. What is the expected value of the cash flow? The value you compute will apply to each of the

five years.

b. What is the expected net present value?

c. Should she buy the new equipment?

Chapter 14

9. What is the key tax characteristic for investors associated with state and local (municipal) securities?

10. How would you define efficient security markets?

11. The efficient market hypothesis is interpreted in a weak form, a semistrong form, and a strong form.

How can we differentiate its various forms?

12. What was the primary purpose of the Securities Act of 1933?

Chapter 15

13. What are the benefits accruing to a company that is traded in the public securities markets?

14. What are the disadvantages to being public?

15. How does a leveraged buyout work? What does the debt structure of the firm normally look like

after a leveraged buyout? What might be done to reduce the debt?