kim226

The before-tax cost of debt for Hardcastle Industries, Inc. is currently 8.0%, but it will increase to 8.25% when debt levels reach $600 million. The debt-to-total assets ratio for Hardcastle is 40% and its capital structure is composed of debt and common equity only. If Hardcastle changes its target capital structure to 50% debt / 50% equity, which of the following describes the effect on the level of new investment at which the cost of debt will increase? The level will:

A) decrease.

B) change, but can either increase or decrease.

C) increase.

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A break point refers to a level of new investment at which a component’s cost of capital changes. The formula for break point is:

As indicated, as the weight of a capital component in the capital structure increases, the break point at which a change in the component’s cost will decline. No computation is necessary, but when Hardcastle has 40% debt, the breakpoint is $600,000,000 / 0.4 = $1.5 billion. If Hardcastle’s debt increases to 50%, the breakpoint will decline to $600,000,000 / 0.5 = $1.2 billion.

kim226

Which of the following is used to illustrate a firm’s weighted average cost of capital (WACC) at different levels of capital?

A) Schedule of marginal capital break points.

B) Cost of capital component schedule.

C) Marginal cost of capital schedule.

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The marginal cost of capital schedule shows the WACC at different levels of capital investment. It is usually upward sloping and is a function of a firm’s capital structure and its cost of capital at different levels of total capital investment.

kim226

The most accurate way to account for flotation costs when issuing new equity to finance a project is to:

A) increase the cost of equity capital by dividing it by (1 – flotation cost).

B) adjust cash flows in the computation of the project NPV by the dollar amount of the flotation costs.

C) increase the cost of equity capital by multiplying it by (1 + flotation cost).

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Adjusting the cost of equity for flotation costs is incorrect because doing so entails adjusting the present value of cash flows by a fixed percentage over the life of the project. In reality, flotation costs are a cash outflow that occurs at the initiation of a project. Therefore, the correct way to account for flotation costs is to adjust the cash flows in the computation of project NPV, not the cost of equity. The dollar amount of the flotation cost should be considered an additional cash outflow at initiation of the project.

kim226

Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects.  Project 1 has an initial cost of $200,000 and is expected to produce cash flows of $55,000 per year for the next eight years.  Project 2 has an initial cost of $100,000 and is expected to produce cash flows of $40,000 per year for the next four years.  Both projects should be financed at Torch’s weighted average cost of capital.  Torch’s current stock price is $40 per share, and next year’s expected dividend is $1.80.  The firm’s growth rate is 5%, the current tax rate is 30%, and the pre-tax cost of debt is 8%.  Torch has a target capital structure of 50% equity and 50% debt.  If Torch takes on either project, it will need to be financed with externally generated equity which has flotation costs of 4%.  
Suresh is aware that there are two common methods for accounting for flotation costs.  The first method, commonly used in textbooks, is to incorporate flotation costs directly into the cost of equity.  The second, and more correct approach, is to subtract the dollar value of the flotation costs from the project NPV. If Suresh uses the cost of equity adjustment approach to account for flotation costs rather than the correct cash flow adjustment approach, will the NPV for each project be overstated or understated?

Project 1 NPV

Project 2 NPV

A) Understated Overstated

B) Understated Understated

C) Overstated Overstated

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The incorrect method of accounting for flotation costs spreads the flotation cost out over the life of the project by a fixed percentage that does not necessarily reflect the present value of the flotation costs. The impact on project evaluation depends on the length of the project and magnitude of the flotation costs, however, for most projects that are shorter, the incorrect method will overstate NPV, and that is exactly what we see in this problem.
Correct method of accounting for flotation costs:

After-tax cost of debt = 8.0% (1-0.30) = 5.60%
Cost of equity = ($1.80 / $40.00) + 0.05 = 0.045 + 0.05 = 9.50%
WACC = 0.50(5.60%) + 0.50(9.50%) = 7.55%
Flotation costs Project 1 = $200,000 × 0.5 × 0.04 = $4,000
Flotation costs Project 2 = $100,000 × 0.5 × 0.04 = $2,000

NPV Project 1 = -$200,000 - $4,000 + (N = 8, I = 7.55%, PMT = $55,000, FV = 0 →CPT PV = $321,535) = $117,535
NPV Project 2 = -$100,000 - $2,000 + (N = 4, I = 7.55%, PMT = $40,000, FV = 0 →CPT PV = $133,823) = $31,823

Incorrect Adjustment for cost of equity method for accounting for flotation costs:

After-tax cost of debt = 8.0% (1-0.30) = 5.60%
Cost of equity = [$1.80 / $40.00(1-0.04)] + 0.05 = 0.0469 + 0.05 = 9.69%
WACC = 0.50(5.60%) + 0.50(9.69%) = 7.65%

NPV Project 1 = -$200,000 + (N = 8, I = 7.65%, PMT = $55,000, FV = 0 →CPT PV = $320,327) = $120,327
NPV Project 2 = -$100,000+ (N = 4, I = 7.65%, PMT = $40,000, FV = 0 →CPT PV = $133,523) = $33,523

kim226

Cullen Casket Company is considering a project that requires a $175,000 cash outlay and is expected to produce cash flows of $65,000 per year for the next four years. Cullen’s tax rate is 40% and the before-tax cost of debt is 9%. The current share price for Cullen stock is $32 per share and the expected dividend next year is $1.50 per share. Cullen’s expected growth rate is 5%. Cullen finances the project with 70% newly issued equity and 30% debt, and the flotation costs for equity are 4.5%. What is the dollar amount of the flotation costs attributable to the project, and that is the NPV for the project, assuming that flotation costs are accounted for correctly?

Dollar amount of floatation costs

NPV of project

A) $7,875 $30,510

B) $5,513 $32,872

C) $5,513 $30,510

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In order to determine the discount rate, we need to calculate the WACC.
After-tax cost of debt = 9.0% (1 – 0.40) = 5.40%
Cost of equity = ($1.50 / $32.00) + 0.05 = 0.0469 + 0.05 = 0.0969, or 9.69%
WACC = 0.70(9.69%) + 0.30(5.40%) = 8.40%
Since the project is financed with 70% newly issued equity, the amount of equity capital raised is 0.70 × $175,000 = $122,500Flotation costs are 4.5 percent, which equates to a dollar flotation cost of $122,500 × 0.045 = $5,512.50.

kim226

Nippon Post Corporation (NPC), a Japanese software development firm, has a capital structure that is comprised of 60% common equity and 40% debt. In order to finance several capital projects, NPC will raise USD1.6 million by issuing common equity and debt in proportion to its current capital structure. The debt will be issued at par with a 9% coupon and flotation costs on the equity issue will be 3.5%. NPC’s common stock is currently selling for USD21.40 per share, and its last dividend was USD1.80 and is expected to grow at 7% forever. The company’s tax rate is 40%. NPC’s WACC based on the cost of new capital is closest to:

A) 9.6%.

B) 13.1%.

C) 11.8%.

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kd = 0.09(1 – 0.4) = 0.054 = 5.4%
kce = [(1.80 × 1.07) / 21.40] + 0.07 = 0.16 = 16.0%
WACC = 0.6(16.0%) + 0.4(5.4%) = 11.76%
Flotation costs, treated correctly, have no effect on the cost of equity component of the WACC.

terpsichorefan

thanks for sharing