EBK CONTEMPORARY FINANCIAL MANAGEMENT
14th Edition
ISBN: 9781337514835
Author: MOYER
Publisher: CENGAGE LEARNING - CONSIGNMENT
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A company puts together a set of cash flow projections and calculates an IRR of 25% for the project. The firm's cost of capital is about 10%. The CEO maintains that the favorability of the calculated IRR relative to the cost of capital makes the project an easy choice for acceptance and urges management to move forward immediately.
i. Should this project be evaluated using different standards?
ii. How does the possibility of bankruptcy as a result of the project affect the analysis?
iii. Are capital budgeting rules still appropriate?
An analyst at a company notes that its cost of debt is far below that of equity. He concludes that it is important for the firm to maintain the ability to increase its borrowing because if it cannot borrow, it will be forced to use more expensive equity to finance some projects. This might lead it to reject some projects that would have seemed attractive if evaluated at the lower cost of debt.
How do you balance the amount of equity and debt? Explain the significance of maintaining the ability to increase borrowing capacity for a company with a lower cost of debt compared to equity. How does this impact project evaluation and investment decisions, and what role does the concept of cost of capital play in such considerations?
Diol Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much its debt would cost at different debt levels, the company’s treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:
Structure
Market Debt-to-Value Ratio (Wd)
Market Equity-to-Value Ratio (Ws)
Bond Rating
Pre-tax Cost of Debt (rd)
A
0.0
1.0
AA
9.0%
B
0.2
0.8
BBB
10.5%
C
0.5
0.5
BB
11.6%
D
0.6
0.4
C
12.7%
E
0.75
0.25
D
14.0%
Diol uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free rate is 7%; the market risk is 13%, and the company’s tax rate is 20%. Diol estimates that if it had no debt, its “unlevered” beta, bU, would be 1.3.
What is the…
Chapter 14 Solutions
EBK CONTEMPORARY FINANCIAL MANAGEMENT
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