Problem 1:
Speedy Delivery Systems can buy a piece of equipment that is anticipated to pro- vide an 11 percent return and can be financed at 6 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 9 percent return but would cost 15 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firm's capital structure.
a. Compute the weighted average cost of capital.
b. Which project(s) should be accepted?
Problem 2:
Airborne Airlines Inc. has a $1,000 par value bond outstanding with 25 years to maturity. The bond carries an annual interest payment of $88 and is cur- rently selling for $950. Airborne is in a 40 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar.
a. Compute the yield to maturity on the old issue and use this as the yield for the new issue.
b. Make the appropriate tax adjustment to determine the aftertax cost of debt
Problem 3
Global Technology's capital structure is as follows:
Debt ............................................ 35%
Preferred stock ...........................
15 Common equity .......................... 50
The aftertax cost of debt is 6.5 percent; the cost of preferred stock is 10 percent; and the cost of common equity (in the form of retained earnings) is 13.5 percent. Calculate Global Technology's weighted average cost of capital in a manner similar to Table 11-1.
Appendix 11A-1
How does the capital asset pricing model help explain changing costs of capital?