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MGMT E-2900B

MGMT E-2900B. PROBLEM SOLVING SESSION FEBRUARY 2, 2010. CAPITAL BUDGETING. NPV Profiles. This question can be addressed by creating a graphical expression of the two cash flows We know that at a WACC of 10% the NPV’s are identical

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MGMT E-2900B

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  1. MGMT E-2900B PROBLEM SOLVING SESSION FEBRUARY 2, 2010

  2. CAPITAL BUDGETING

  3. NPV Profiles This question can be addressed by creating a graphical expression of the two cash flows We know that at a WACC of 10% the NPV’s are identical We know that Project S has an undiscounted cash flow of $20,000 (the same as saying that the WACC is 0%), and we know that Project L has an undiscounted cash flow of $30,000 We can use this information to plot points on a graph to answer the question

  4. NPV Profiles Again, this problem can be addressed graphically IRR is the point on the graph where NPV = 0 We know the IRR’s for each project and we know the WACC where the NPV’s are equal

  5. COST OF CAPITAL

  6. After Tax Cost of Debt A company has $8 million in debt outstanding with a coupon rate of 10%. Currently, the yield to maturity (YTM) is 12%. If the firm’s tax rate is 35%, what is the company’s after-tax cost of debt? a. 6.5% b. 7.8% c. 12.0%

  7. After-Tax Cost of Debt The primary question is which cost to use, the coupon rate or the yield to maturity (YTM). The argument for coupon rate is that is the current cash outflow for the company debt The argument for yield to maturity is that it represents the rate at which a firm can issue new debt. The yield to maturity is the stronger argument because it reflects current market and current firm conditions The after-tax cost of debt is kd(1 – t) where t = tax rate

  8. After-Tax Cost of Debt A company has $8 million in debt outstanding with a coupon rate of 10%. Currently, the yield to maturity (YTM) is 12%. If the firm’s tax rate is 35%, what is the company’s after-tax cost of debt? a. 6.5% b. 7.8% c. 12.0%

  9. Marginal Cost of Capital A company is planning a $20 million expansion. The expansion is to be financed by selling $8 million in new debt and $12 million in new common stock. The before-tax required return on debt is 10% and 15% for equity. If the company is in the 30% tax bracket, the company’s marginal cost of capital is closest to: • 13.0% • 8.2% • 11.8%

  10. Marginal Cost of Capital This problem requires the calculation of the cost of capital of the new financing The equation is the same as for the cost of capital = (wd x kd(1-t)) + (we x ke) Wd = 40% ($8 million/$20 million) Kd = 10%(1 – 30%) = 7% We = 60% ($12 million/$20 million) Ke = 15%

  11. Marginal Cost of Capital A company is planning a $20 million expansion. The expansion is to be financed by selling $8 million in new debt and $12 million in new common stock. The before-tax required return on debt is 10% and 15% for equity. If the company is in the 30% tax bracket, the company’s marginal cost of capital is closest to: • 13.0% • 8.2% • 11.8%

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