# The cost of capital and the basics of capital budgeting: evaluating

The Cost of Capital And The Basics of Capital Budgeting: Evaluating Cash Flows

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Problem 1

You are employed by ABC Inc. Your boss has asked you to estimate the weighted average cost of capital

for the company. Following are balance sheets and some information about CGT.

Assets

Current assets \$30,000,000

Net plant, property, and equipment \$100,000,000

Total Assets \$130,000,000

Liabilities and Equity

Accounts payable \$10,000,000

Accruals \$10,000,000

Current liabilities \$20,000,000

Long term debt (40,000 bonds, \$1,000 face value) \$40,000,000

Total liabilities \$60,000,000

Preferred Stock (100,000 shares, \$100 face value) \$10,000,000

Common Stock (10,000,000 shares) \$30,000,000

Retained Earnings \$30,000,000

Total shareholders equity \$70,000,000

Total liabilities and shareholders equity \$130,000,000

You check The Wall Street Journal and see that ABC stock is currently selling for \$10.00 per share and that

ABC bonds are selling for \$1100.0 per bond. These bonds have a 7 percent coupon rate, with semi-annual

payments. The bonds mature in twelve years. The preferred stock has an unlimited life and pays an 5

percent annual coupon. The preferred stock sells for \$95. The beta for your company is approximately

equal to 2. The yield on a 20-year Treasury bond is 4.0 percent. The expected return on the stock market is

8.0 percent. ABC is in the 40 percent tax bracket.

2. Davis Corporation is faced with two independent investment opportunities. The

corporation has an investment policy which requires acceptable projects to

recover all costs within 3 years. The cost of capital is 10 percent. The cash flows

for the two projects are:

Project A Project B

Year Cash Flow Cash Flow

0 -\$120,000 -\$90,000

1 42,000 30,000

2 43,000 30,000

3 44,000 30,000

4 45,000 30,000

5 46,000 30,000

Which investment project(s) does the company invest in using the:

1)Payback period rule

2)Discounted payback period rule

3)NPV

4)IRR

3. XYZ Corporation is faced with two mutually exclusive investment opportunities.

The cost of capital is 12 percent. The cash flows for the two projects are:

Project A Project B

Year Cash Flow Cash Flow

0 -\$140,000 -\$100,000

1 60,000 30,000

2 60,000 30,000

3 60,000 30,000

4 30,000

5 30,000

6 30,000

Which investment project should the company invest in using the:

1.Equivalent annual annuity approach

2.The replacement approach

Assignment 6 first_name last_name.doc

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