54Questions McDaniel Nienberg Palmer Pastor

Topics: Generally Accepted Accounting Principles, Weighted average cost of capital, Asset Pages: 12 (2000 words) Published: April 17, 2015
Questions
1.a.Discuss the specific items of capital that should be included in the WACC. Because WACC is used for making long term capital investment decisions, the WACC should include long term debt, preferred stock and common stock that helps pay for long term assets. Also include short term sources of capital like accounts payable and accruals dealing with noninterest bearing liabilities and short term interest bearing debt like notes payable

b.The comptroller currently finds the weights for the weighted average cost of capital (WACC) from information from the balance sheet shown in Table 2. Compute the book value weights that the comp­trol­ler currently uses for the company’s capital structure.

ItemAmountWeight
Long term bonds40000 / 129297 or 30.9%
Preferred stock10000 / 129297 or 7.7%
Total Comm. Equity79297 / 129297 or 61.3%
c.Based on the suggestion that the focus should be on market values, compute the weights of debt, preferred stock, and common stock. Market value of debt =120.90*1,000/100 per bond
=1,209
Total market value of debt in capital structure
= 1209*40,000,000/1000
= 48,360,000
Market value of Preferred stock (closing price)
=105*10,000,000/100
= 10,500,000
Market value of common stock
=30.50*6.2261 million
= 189,896,000

ItemAmountWeightPercent
Long term debt48360 / 24876019.4%
Preferred stock10500 / 2487604.2%
Common Equity189900 / 24876076.3%
d.Are book value or market value weights better for calculating the firm’s weighted average cost of capital? Market value weights are preferred over book value when calculating the firms WACC because market value shows the measure of each type of capital at the market value. The book value shows the proportion of the capital in the financial structure of the firm.

2.a.Critique Ace Repair’s current method of estimating its before-tax cost of debt. Because stockholders only really care about cash flows that they can use in the form of paying dividends or reinvesting, Ace should calculate on an after tax basis because the dividends and reinvestment come from after tax dollars.

b.Is the earnings yield (E/P) an appropriate measure of the firm’s cost of equity? No because the earnings yield is lower than the WACC, and the cost of equity should be based off the dividends yield and capital gain. EPS is 2.30 and a share price is 30.50 making the E/P 7.5%

3.a.What is the best estimate of Ace’s cost of debt?
b.Should flotation costs be included in the component cost of debt calculation? Explain.
c.Should the nominal cost of debt or the effective annual rate be used? Explain.
d.How valid is an estimate of the cost of debt based on the yield to maturity of Ace’s debt (ignore the call provision in 3 years) if the firm plans to issue 20-year long-term debt?
e.What other methods could be used to estimate the cost of debt if, for example, Ace’s outstanding debt had not been traded recently?
4.a.What is Ace’s cost of preferred stock?
b.Ace’s preferred stock is more risky to investors than its debt, yet the before-tax yield on its preferred is lower than the yield on A-rated debt issues. Why does this occur?
c.What if Ace’s preferred stock required the establishment of a sinking fund that calls for the retiring 5 percent of the initial issue of preferred stock each year at par? How would the cost of preferred stock change and be handled in the WACC calculation?

5.a.Why is there a cost associated with retained earnings? The cost that is associated with the retained earnings is called an opportunity cost. Since the investor would have been paid the costs of the opportunity to reinvest that money back into the investment

b.What is Ace’s cost of retained earnings, based on the CAPM approach and the analysts’ long run forecast rate of growth?

The cost of retained earnings for Ace is 14.37% using the CAPM approach rs = rRF + (rM - rRF)*b = rRF +...
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