Chapter 14 - Cost of Capital
74. The Bakery is considering a new project it considers to be a little riskier than its current operations. Thus, management has decided to add an additional 1.5 percent to the company's overall cost of capital when evaluating this project. The project has an initial cash outlay of $62,000 and projected cash inflows of $17,000 in year one, $28,000 in year two, and $30,000 in year three. The firm uses 25 percent debt and 75 percent common stock as its capital structure. The company's cost of equity is 15.5 percent while the aftertax cost of debt for the firm is 6.1 percent. What is the projected net present value of the new project? A. -$6,208 B. -$5,964 C. -$2,308 D. $1,427 E. $1,573
WACCFirm = (0.75 ? 0.155) + (0.25 ? 0.061) = 0.1315 WACCProject = 0.1315 + 0.015 = 0.1465
NPV = -$62,000 + ($17,000/1.1465) + ($28,000/1.14652) + ($30,000/1.14653) = -$5,964
AACSB: Analytic Bloom's: Analysis Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Project NPV
75. The Oil Derrick has an overall cost of equity of 13.6 percent and a beta of 1.28. The firm is financed solely with common stock. The risk-free rate of return is 3.4 percent. What is an appropriate cost of capital for a division within the firm that has an estimated beta of 1.18? A. 12.37 percent B. 12.41 percent C. 12.54 percent D. 12.67 percent E. 12.80 percent
0.136 = 0.034 + 1.28mrp; mrp = 0.0796875
ReDivision = 0.034 + 1.18(0.0796875) = 12.80 percent
AACSB: Analytic Bloom's: Analysis Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Divisional cost of capital
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Chapter 14 - Cost of Capital
76. Miller Sisters has an overall beta of 0.64 and a cost of equity of 11.2 percent for the firm overall. The firm is 100 percent financed with common stock. Division A within the firm has an estimated beta of 1.08 and is the riskiest of all of the firm's operations. What is an appropriate cost of capital for division A if the market risk premium is 9.5 percent? A. 15.12 percent B. 15.38 percent C. 15.63 percent D. 15.77 percent E. 16.01 percent
0.112 = rf + 0.64(0.095); rf = 0.0512
ReDivision = 0.0512 + 1.08(0.095) = 15.38 percent
AACSB: Analytic Bloom's: Analysis Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Divisional cost of capital
14-42
Chapter 14 - Cost of Capital
77. Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project. Deep Mining is in the actual mining business and has an aftertax cost of capital of 12.8 percent. Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 10.6 percent. The project under consideration has initial costs of $575,000 and anticipated annual cash inflows of $102,000 a year for ten years. Which firm(s), if either, should accept this project? A. Company A only B. Company B only
C. both Company A and Company B D. neither Company A or Company B
E. cannot be determined without further information
Neither company should accept this project as the applicable discount rate for both firms is 12.8 percent and the NPV is negative at this discount rate.
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-5 Section: 14.5 Topic: Pure Play
14-43
Chapter 14 - Cost of Capital
78. Sister Pools sells outdoor swimming pools and currently has an aftertax cost of capital of 11.6 percent. Al's Construction builds and sells water features and fountains and has an aftertax cost of capital of 10.8 percent. Sister Pools is considering building and selling its own water features and fountains. The sales manager of Sister Pools estimates that the water features and fountains would produce 20 percent of the firm's future total sales. The initial cash outlay for this project would be $85,000. The expected net cash inflows are $16,000 a year for 7 years. What is the net present value of the Sister Pools project? A. -$11,044 B. -$9,115 C. -$7,262 D. -$4,508 E. $1,219
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-5 Section: 14.5 Topic: Pure Play
79. Decker's is a chain of furniture retail stores. Furniture Fashions is a furniture maker and a supplier to Decker's. Decker's has a beta of 1.38 as compared to Furniture Fashion's beta of 1.12. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Decker's use if it considers a project that involves the manufacturing of furniture?
A. 12.46 percent B. 12.92 percent C. 13.50 percent D. 14.08 percent E. 14.54 percent
Re = 0.035 + 1.12(0.08) = 12.46 percent
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-5 Section: 14.5 Topic: Pure Play
14-44
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