Case 54 Questions

Topics: Weighted average cost of capital, Corporate finance, Finance Pages: 10 (1477 words) Published: July 26, 2014
Questions
1.a.Discuss the specific items of capital that should be included in the WACC.
The WACC calculation should include all the sources of capital like common stock, preferred stock, bonds and any other long-term debt.
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.

(In Millions)

c.Based on the suggestion that the focus should be on market values, compute the weights of debt, preferred stock, and common stock.
(In Millions)

MV $
MV %
LT Debt
48.36
19.5%
Preferred
10.00
4.0%
Common
189.90
76.5%

Total
248.26
100%

d.Are book value or market value weights better for calculating the firm’s weighted average cost of capital?
Market value weights are better for calculating the firms weighted average cost of capital because they are forward-looking and based on what the asset is expected to produce in the future. Book values reflect historical costs.

2.a.Critique Ace Repair’s current method of estimating its before-tax cost of debt.
Ace Repairs current method of estimating its before-tax cost of debt is using its coupon rate of the most recent LT bond. This rate is not a good estimate

b.Is the earnings yield (E/P) an appropriate measure of the firm’s cost of equity?
Earnings yield is not an appropriate measure of the firms cost of equity because it only shows the current year’s earnings and the current share price. The future growth isn’t considered in the earnings yield.

3.a.What is the best estimate of Ace’s cost of debt?
The best estimate of Ace’s Cost of Debt is 8.3%, the yield on Ace’s current debt.
b.Should flotation costs be included in the component cost of debt calculation? Explain.
Flotation costs will impact the calculation of the cost of debt but in such a small amount that it’s not influential enough be included.
c.Should the nominal cost of debt or the effective annual rate be used? Explain.
The nominal cost of debt should be used because capital budgeting cash flows occur at year-end. Using the nominal rate makes the cash flow and discount rate consistent.
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?
Ace’s cost of preferred stock is $100.
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?
This occurs because preferred stock are generally owned by corporations, and 70% of preferred stock dividends are non-taxable to corporations. Debt may have a higher pre-tax yield but after taxes are taken out the preferred stock will have a higher yield. This matches with the theory of “high risk, high return”.

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?
b.What is Ace’s cost of retained earnings, based on the CAPM approach and the analysts’ long run forecast rate of growth?
c.Why might one consider the T-bond rate to be a better estimate of the risk-free rate than the T-bill rate? Why might one argue for the use of the T-bill rate?
d.How do historical betas, adjusted historical betas, and fundamental betas differ? Would Ace’s historical beta be a better or a...
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