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Scenario Steps to Completion
6. Calculate the company' weighted average cost of capital (WACC) under the following
assumptions provided by Sue.
The company' long-term bonds currently offer yield to maturity of percent.
The company's stock price is $50 per share (PO $50).
The company recently paid dividend of $2 per share (DO $2.00).
The dividend is expected to grow at constant rate of 6percent year (g 6%).
The company' target capital structure is 75 percent equity and 25 percent debt
The company's tax rate is 40 percent.
How do we compute the WACC in this circumstance? Why do we need to be concerned with
the WACC?
Concept Check
The weighted average cost of capital is the weighted average of the cost of equity and the after-
tax cost of debt. Another way of looking at this is computing the effect of the capital structure on
expected returns by investors
WACC (E/V) re- (D/V): Rd (1-Tc)
Helpful Hint: One thing to bring up here is WACC is needed to determine risk on several levels.
To determine risk we need toremember the following items:
1. Risk is deviation from expectations.
3. Wc need to set expectations for our investments in relation torisk and return. Higher risk
higher return.
4.
Capital is obtained from the marketplace in two forms; equity and debt This is the capital
structure of corporation and impacts the profits of company depending on how this is
managed
5. We use our cost of capital to discount any cash flows from nev investments (NPV and
IRR analysis).
6.
If cost of capital of the projects we undertake to increase sales rises then our risk rises
and the return to our investors is reduced.
7. If debt rises then our obligation to make payments on interest increases and profits can
decrease if sales do not increase rapidly enough.
8.
If risk increases or returns decrease our beta will increase to show the increase in risk this
will increase our required rate of return to stockholders (CAPM) and thus increase our
required rate of return.
Meanwhile, colleague of yours from IT needs help justifying the purchase of software for your
department and asks for your help in justifying the investment. You agree to help because you
know that this particular software will help you generate the information you need in your board
presentation.
Scenario Steps to Completion
7. The company can purchase new planning software for $3,600. The software (asset) has two-
year life, will produce savings of $600 in the first year and $4,200 in the second year.
The discount rate is 15%. Calculate the project's payback and discounted payback period
assuming steady cash flows Also calculate the project's NPV and IRR. Should the project be
funded?
In light of the previous information provided, is the 15% discount rate justified. Explain your
answer.
Concept Check: Payback analysis is the first step in project evaluation. The calculation enables
you to understand if you can simply cover the investment within certain time period When
doing Discounted Payback analysis NPV analysis, discounting rate is used to reduce future
cash flows to present value. The discount rate can be determined in many ways; existing cost of
capital, projected cost of capital, desired return rate, etc as long as you justify what you wish to
use for discounting cash flows and are consistent in your application evaluation will be easier.
Helpful Hint: IRR is discovered when you calculate an NPV where the result is zero (or as close
to zero as you can get); this an iterative process of adjusting the discount rate until you arrive
at zero for an NPV The best thing to do is first calculate NPV and see how far away from zero
you are you can then increase or decrease the discount rate until your NPV zero.
Sue has another vexing problem she has been encountering with regard to capital investments
She has competing investments and has looked at them from several different perspectives and
would like your input.
Scenario Steps to Completion
8. Two of the company' projects A and B have the same expected lives and initial cash
outflows. However, one project' cash flows are larger in the early years while the other project
has larger cash flows in the later years. The two NPV profiles are given below:
NPV
A
B
r
Which of the following statements is most correct?
1. Project A has the smaller cash flows in the later years.
2. Project A has the larger cash flows in the later years.
3. We require information on the cost of capital in order to determine which project has
larger early cash flows
4. The NPV profile graph is inconsistent with the statement made in the problem.
5. None of the statements above is correct.
Explain and support your position.
Concept Check: NPV profile is the result of mapping the relationship between an investment 's
NPV and various discount rates. We begin at the of zero on the axis.
Helpful Hint: It may help to place some numbers on the lines beginning with known variables.

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Given that

Current yield to maturity of the bonds 8%

Tax rate 40%

Current stock price $50

Dividend paid last (D0) $2

Growth rate 6%

The first step is to calculate the cost of equity.

The dividend growth model is used to compute the same.

As per this model, Cost of equity = [D0 * (1 + Growth rate)/Current price] + Growth rate

Cost of equity 10.24%

The WACC computation has been shown below...