prashantsahni

At a recent Haggerty Semiconductors Board of Directors meeting, Merle Haggerty was asked to discuss the topic of the company’s weighted average cost of capital (WACC).
At the meeting Haggerty made the following statements about the company’s WACC:
Statement 1: A company creates value by producing a higher return on its assets than the cost of financing those assets. As such, the WACC is the cost of financing a firm’s assets and can be viewed as the firm’s opportunity cost of financing its assets.
Statement 2: Since a firm’s WACC reflects the average risk of the projects that make up the firm, it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than-average risk.
Are Statement 1 and Statement 2, as made by Haggerty CORRECT?

Statement 1

Statement 2

A) Correct Incorrect

B) Incorrect Correct

C) Correct Correct

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Each statement that Haggerty has made to the board of directors regarding the weighted average cost of capital is correct. New projects should have a return that is higher than the cost to finance those projects.

prashantsahni

Deighton Industries has 200,000 bonds outstanding. The par value of each corporate bond is $1,000, and the current market price of the bonds is $965. Deighton also has 6 million common shares outstanding, with a book value of $35 per share and a market price of $28 per share. At a recent board of directors meeting, Deighton board members decided not to change the company’s capital structure in a material way for the future. To calculate the weighted average cost of Deighton’s capital, what weights should be assigned to debt and to equity?

Debt

Equity

A) 53.46% 46.54%

B) 48.85% 51.15%

C) 56.55% 43.45%

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In order to calculate the weighted average cost of capital (WACC), market value weights should be used.

For the bonds	=	200,000 × $965	=	$193,000,000
For the stocks	=	6,000,000 × $28	=	$168,000,000
				$361,000,000

The weight of debt would be: 193,000,000 / 361,000,000 = 0.5346 = 53.46%
The weight of common stock would be: 168,000,000 / 361,000,000 = 0.4654 = 46.54%

prashantsahni

Hans Klein, CFA, is responsible for capital projects at Vertex Corporation. Klein and his assistant, Karl Schwartz, were discussing various issues about capital budgeting and Schwartz made a comment that Klein believed to be incorrect. Which of the following is most likely the incorrect statement made by Schwartz?

A) “The weighted average cost of capital (WACC) should be based on market values for the firm’s outstanding securities.”

B) “Net present value (NPV) and internal rate of return (IRR) result in the same rankings of potential capital projects.”

C) “It is not always appropriate to use the firm’s marginal cost of capital when determining the net present value of a capital project.”

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It is possible that the NPV and IRR methods will give different rankings. This often occurs when there is a significant difference in the timing of the cash flows between two projects. A firm’s marginal cost of capital, or WACC, is only appropriate for computing a project’s NPV if the project has the same risk as the firm.

prashantsahni

Carlos Rodriquez, CFA, and Regine Davis, CFA, were recently discussing the relationships between capital structure, capital budgets, and net present value (NPV) analysis. Which of the following comments made by these two individuals is least accurate?

A) “For projects with more risk than the average firm project, NPV computations should be based on the marginal cost of capital instead of the weighted average cost of capital.”

B) “The optimal capital budget is determined by the intersection of a firm’s marginal cost of capital curve and its investment opportunity schedule.”

C) “A break point occurs at a level of capital expenditure where one of the component costs of capital increases.”

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The marginal cost of capital (MCC) and the weighted average cost of capital (WACC) are the same thing. If a firm’s capital structure remains constant, the MCC (WACC) increases as additional capital is raised.

prashantsahni

The marginal cost of capital is:

A) tied solely to the specific source of financing.

B) equal to the firm's weighted cost of funds.

C) the cost of the last dollar raised by the firm.

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The “marginal” cost refers to the last dollar of financing acquired by the firm assuming funds are raised in the same proportion as the target capital structure. It is a percentage value based on both the returns required by the last bondholders and stockholders to provide capital to the firm. Regardless of whether the funding came from bondholders or stockholders, both debt and equity are needed to fund projects.

prashantsahni

Enamel Manufacturing (EM) is considering investing in a new vehicle. EM finances new projects using retained earnings and bank loans. This new vehicle is expected to have the same level of risk as the typical investment made by EM. Which one of the following should the firm use in making its decision?

A) Marginal cost of capital.

B) Cost of retained earnings.

C) After-tax cost of debt.

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The marginal cost of capital represents the cost of raising an additional dollar of capital. The cost of retained earnings would only be appropriate if the company avoided creditor-supplied financing or the issuance of new common or preferred stock (and preferred stock financing). The after-tax cost of debt is never sufficient, because a business, regardless of their size, always has a residual owner, and hence a cost of equity.

prashantsahni

Which of the following statements is least accurate regarding the marginal cost of capital’s role in determining the net present value (NPV) of a project?

A) Projects for which the present value of the after-tax cash inflows is greater than the present value of the after-tax cash outflows should be undertaken by the firm.

B) The NPVs of potential projects of above-average risk should be calculated using the marginal cost of capital for the firm.

C) When using a firm’s marginal cost of capital to evaluate a specific project, there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project.

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The WACC is the appropriate discount rate for projects that have approximately the same level of risk as the firm’s existing projects. This is because the component costs of capital used to calculate the firm’s WACC are based on the existing level of firm risk. To evaluate a project with above (the firm’s) average risk, a discount rate greater than the firm’s existing WACC should be used. Projects with below-average risk should be evaluated using a discount rate less than the firm’s WACC. An additional issue to consider when using a firm’s WACC (marginal cost of capital) to evaluate a specific project is that there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project. These complexities aside, we can still conclude that the NPVs of potential projects of firm-average risk should be calculated using the marginal cost of capital for the firm. Projects for which the present value of the after-tax cash inflows is greater than the present value of the after-tax cash outflows should be undertaken by the firm.

prashantsahni

Which of the following statements about the role of the marginal cost of capital in determining the net present value of a project is most accurate? The marginal cost of capital should be used to discount the cash flows:

A) of all projects the firm is considering.

B) if the firm’s capital structure is expected to change during the project’s life.

C) for potential projects that have a level of risk near that of the firm’s average project.

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Net present values of projects with the average risk for the firm should be determined using the firm’s marginal cost of capital. The discount rate should be adjusted for projects with above-average or below-average risk. Using the marginal cost of capital assumes the firm’s capital structure does not change over the life of the project.

prashantsahni

Which of the following is most accurate regarding the component costs and component weights in a firm’s weighted average cost of capital (WACC)?

A) The appropriate pre-tax cost of a firm’s new debt is the average coupon rate on the firm’s existing debt.

B) The weights in the WACC should be based on the book values of the individual capital components.

C) Taxes reduce the cost of debt for firms in countries in which interest payments are tax deductible.

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The after-tax cost of debt = kd(1 – t) = kd – kd(t), where kd is the pretax cost of debt and t is the effective corporate tax rate. So the tax savings from the tax treatment of debt is kd(t). Capital component weights should be based on market weights, not book values. And, the appropriate pre-tax cost of debt is the yield to maturity on the firm’s existing debt.

prashantsahni

Ferryville Radar Technologies has five-year, 7.5% notes outstanding that trade at a yield to maturity of 6.8%. The company’s marginal tax rate is 35%. Ferryville plans to issue new five-year notes to finance an expansion. Ferryville’s cost of debt capital is closest to:

A) 4.4%.

B) 4.9%.

C) 2.4%.

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Ferryville’s cost of debt capital is kd(1 - t) = 6.8% × (1 - 0.35) = 4.42%. Note that the before-tax cost of debt is the yield to maturity on the company’s outstanding notes, not their coupon rate. If the expected yield on new par debt were known, we would use that. Since it is not, the yield to maturity on existing debt is the best approximation.