kim226

Simcox Financial is considering raising additional capital to finance a takeover of one of the firm’s major competitors. Reuben Mellum, an analyst with Simcox, has put together the following schedule of costs related to raising new capital:

Amount of New Debt (in millions)	After-tax Cost of Debt	Amount of New Equity (in millions)	Cost of Equity
$0 to $149	4.2%	$0 to $399	7.5%
$150 to $349	5.0%	$400 to $799	8.5%

Assuming that Simcox has a target debt to equity ratio of 65% equity and 35% debt, what are the marginal cost of capital schedule breakpoints for raising additional debt capital and equity capital, respectively?

Breakpoint for new debt capital

Breakpoint for new equity capital

A) $428.6 million $533.3 million

B) $428.6 million $615.4 million

C) $375.0 million $615.4 million

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A breakpoint is calculated as the amount of capital where component cost changes / weight of component in the WACC. The breakpoint for raising new debt capital occurs at ($150 / 0.35) = $428.6 million, and the breakpoint for raising new equity capital occurs at ($400 / 0.65) = $615.4 million.

kim226

Stolzenbach Technologies has a target capital structure of 60% equity and 40% debt. The schedule of financing costs for the Stolzenbach is shown in the table below:

Amount of New Debt (in millions)	After-tax Cost of Debt	Amount of New Equity (in millions)	Cost of Equity
$0 to $199	4.5%	$0 to $299	7.5%
$200 to $399	5.0%	$300 to $699	8.5%
$400 to $599	5.5%	$700 to $999	9.5%

Stolzenbach Technologies has breakpoints for raising additional financing at both:

A) $500 million and $700 million.

B) $400 million and $700 million.

C) $500 million and $1,000 million.

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Stolzenbach will have a break point each time a component cost of capital changes, for a total of three marginal cost of capital schedule breakpoints.
Break pointDebt > $200mm = ($200 million ÷ 0.4) = $500 million
Break pointDebt > $400mm = ($400 million ÷ 0.4) = $1,000 million
Break pointEquity > $300mm = ($300 million ÷ 0.6) = $500 million
Break pointEquity > $700mm = ($700 million ÷ 0.6) = $1,167 million

kim226

In order to more accurately estimate the cost of equity for a company situated in a developing market, an analyst should:

A) use the yield on the sovereign debt of the developing country instead of the risk free rate when using the capital asset pricing model (CAPM).

B) add a country risk premium to the market risk premium when using the capital asset pricing model (CAPM).

C) add a country risk premium to the risk-free rate when using the capital asset pricing model (CAPM).

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In order to reflect the increased risk when investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.

kim226

Jeffery Marian, an analyst with Arlington Machinery, is estimating a country risk premium to include in his estimate of the cost of equity for a project Arlington is starting in India. Marian has compiled the following information for his analysis:  

• Indian 10-year government bond yield = 7.20%
• 10-year U.S. Treasury bond yield = 4.60%
• Annualized standard deviation of the Bombay Sensex stock index = 40%.
• Annualized standard deviation of Indian dollar denominated 10-year government bond = 24%
• Annualized standard deviation of the S&P 500 Index = 18%.

The estimated country risk premium for India based on Marian’s research is closest to:

A) 2.6%.

B) 4.3%.

C) 5.8%.

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CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard deviation of sovereign bond market in terms of the developed market currency)

= (0.072 – 0.046)(0.40/0.24) = 0.043, or 4.3%.

kim226

Jamal Winfield is an analyst with Stolzenbach Technologies, a major computer services company based in the U.S. Stolzenbach’s management team is considering opening new stores in Mexico, and wants to estimate the cost of equity capital for Stolzenbach’s investment in Mexico. Winfield has researched bond yields in Mexico and found that the yield on a Mexican government 10-year bond is 7.7%. A similar maturity U.S. Treasury bond has a yield of 4.6%. In the most recent year, the standard deviation of Mexico's All Share Index stock index and the S&P 500 index was 38% and 20% respectively. The annualized standard deviation of the Mexican dollar-denominated 10-year government bond over the last year was 26%. Winfield has also determined that the appropriate beta to use for the project is 1.25, and the market risk premium is 6%. The risk free interest rate is 4.2%. What is the appropriate country risk premium for Mexico and what is the cost of equity that Winfield should use in his analysis?

Country Risk Premium for Mexico

Cost of Equity for Project

A) 4.53% 17.36%

B) 5.89% 17.36%

C) 4.53% 19.06%

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CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard deviation of sovereign bond market in terms of the developed market currency)

= (0.077 – 0.046)(0.38 ÷ 0.26) = 0.0453, or 4.53%

Cost of equity = RF + β[E(RMKT) – RF + CRP] = 0.042 + 1.25[0.06 + 0.0453] = 0.1736 = 17.36% Note that you are given the market risk premium, which equals E(RMKT) – RF.

kim226

Tony Costa, operations manager of BioChem Inc., is exploring a proposed product line expansion. Costa explains that he estimates the beta for the project by seeking out a publicly traded firm that is engaged exclusively in the same business as the proposed BioChem product line expansion. The beta of the proposed project is estimated from the beta of that firm after appropriate adjustments for capital structure differences. The method that Costa uses is known as the:

A) build-up method.

B) pure-play method.

C) accounting method.

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The method used by Costa is known as the pure-play method. The method entails selection of the pure-play equity beta, unlevering it using the pure-play company’s capital structure, and re-levering using the subject company’s capital structure.

kim226

Affluence Inc. is considering whether to expand its recreational sports division by embarking on a new project. Affluence’s capital structure consists of 75% debt and 25% equity and its marginal tax rate is 30%. Aspire Brands is a publicly traded firm that specializes in recreational sports products. Aspire has a debt-to-equity ratio of 1.7, a beta of 0.8, and a marginal tax rate of 35%. Using the pure-play method with Aspire as the comparable firm, the project beta Affluence should use to calculate the cost of equity capital for this project is closest to:

A) 0.38.

B) 0.58.

C) 1.18.

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The unlevered asset beta is:

Affluence’s debt-to-equity ratio = 0.75/0.25 = 3. To calculate the project beta, re-lever the asset beta using Affluence’s debt-to-equity ratio and marginal tax rate:

kim226

A publicly traded company has a beta of 1.2, a debt/equity ratio of 1.5, ROE of 8.1%, and a marginal tax rate of 40%. The unlevered beta for this company is closest to:

A) 1.071.

B) 0.832.

C) 0.632.

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The unlevered beta for this company is calculated as:

kim226

Utilitarian Co. is looking to expand its appliances division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc. is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of 3, a marginal tax rate of 40%, and its debt is currently yielding 6.8%. The risk-free rate is currently 5% and the expected return on the market portfolio is 9%. Using this data, calculate Utilitarian’s weighted average cost of capital for this potential expansion.

A) 5.7%.

B) 4.2%.

C) 7.1%.

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kim226

Degen Company is considering a project in the commercial printing business. Its debt currently has a yield of 12%. Degen has a leverage ratio of 2.3 and a marginal tax rate of 30%. Hodgkins Inc., a publicly traded firm that operates only in the commercial printing business, has a marginal tax rate of 25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. The risk-free rate is 3% and the expected return on the market portfolio is 9%. The appropriate WACC to use in evaluating Degen’s project is closest to:

A) 8.9%.

B) 8.6%.

C) 9.2%.

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Hodgkins’ asset beta:

We are given Degen’s leverage ratio (assets-to-equity) as equal to 2.3. If we assign the value of 1 to equity (A/E = 2.3/1), then debt (and the debt-to-equity ratio) must be 2.3 − 1 = 1.3.
Equity beta for the project:
βPROJECT = 0.52[1 + (1 − 0.3)(1.3)] = 0.9932
Project cost of equity = 3% + 0.9932(9% − 3%) = 8.96%
Degen’s capital structure weight for debt is 1.3/2.3 = 56.5%, and its weight for equity is 1/2.3 = 43.5%.
The appropriate WACC for the project is therefore:
0.565(12%)(1 − 0.3) + 0.435(8.96%) = 8.64%.