CHAPTER 6: PROBLEMS

1. Ampex common stock has a beta of 1.4. If the risk-free rate is 8 percent, the expected market
return is 16 percent, and Ampex has $20 million of 8 percent debt, with a yield to maturity of
12 percent and a marginal tax rate of 50 percent, what is the weighted average cost of capital
for Ampex?
Answer:
2. Calvin Inc. earned $2.00 per share during the past year and has just paid a dividend of $.40
per share. Investors forecast that Calvin will continue to retain 80 percent of its earnings for
the next 4 years and that earnings will grow at 25 percent per year through year 5. The
dividend payout ratio is expected to be raised in year 5 to 50 percent, reducing the dividend
growth rate to 8 percent thereafter. If Calvin’s equity β is .9, the risk-free rate is 8.5 percent,
and the market risk premium is 8 percent, what should its price be today?
Answer: With an estimated 25% annual growth rate, Calvin’s forecast earnings for the next
5 years are $2.50, $3.13, $3.91, $4.88, $6.10. With a 20% dividend payout rate for the first 4
years and a 50% payout rate thereafter, this earnings stream yields dividends of $0.50, $0.63,
$0.78, $0.98, $3.05. Note that the last term in the series is just $6.10 * 0.50. In year 6, the
forecast dividend is $6.10 * 1.08 * 0.50 = $3.29. This dividend is projected to grow at the
rate of 8% annually.
It is important in answering this question to consider the fact that the dividend payout rate
changed in year 5 to 50%, from 20%. Hence, just taking the initial 40¢ dividend and
multiplying it by (1.25)5 will not give you the correct answer.
To determine Calvin’s price today based on these expectations, we must next estimate
Calvin’s cost of equity capital. Using the CAPM, this figure is
ke = rf + βe(rm - rf) = 8.5% + 0.9 * 8% = 15.7%
The present value at 15.7% of the first 5 dividend payments is $3.42. The present value as of the
end of year 5 of the dividend flows from year 6 on can be found using the dividend growth
model, Po = DIV1/(ke - g). Substituting in the numbers previously calculated, we get
Po = DIV1/(ke - g) = $3.29/(0.157 - 0.08) = $42.73
The present value of this number of today is $42.73/(1.157)5 = $20.61. Adding the value of the
two cash flows gives a price for Calvin’s stock today of $24.03.
Remember that you must discount the price as of the beginning of year 6 by (1.157)5 instead of
(1.157)6. The former is correct because you are discounting it back 5 years, not 6 years.
3. As a financial analyst for National Engineering, you are required to estimate the cost of
capital the firm should use in evaluating its heavy construction projects. The firm’s balance
sheet data and other information are listed below. Assume the corporate tax rate is 35 percent.
a. What is your estimate? What assumptions must you make to calculate this estimate?
Answer: The balance sheet liabilities (market values) along with the required after-
tax rates of return are shown below:
Item Mkt Value (000’s) Req’d Rate
Accounts Payable $200 0.00%
 10-Year Debt 250 12% ´ (1 ─ 0.65) = 7.80%
15-Year Debt 1000 15% ´ (1 ─ 0.65) = 9.75%
1-Year Debt 250 11% ´ (1 ─ 0.65) = 7.15%
Preferred Stock 450 4.50/22.50 = 20.00%
Common Stock 4725 7% + 10% = 17.00%
Total/Wtd Avg $6875 14.95%

Assumptions:
i. Accounts payable have the same average risk as short-term debt, but no cost (i.e. built
into price).
ii. Average price is a good estimate of current market value.
iii. The riskiness of the firm has not changed substantially; the historical data provide
accurate estimates of future risk and return.

Note: Stock will normally earn a higher average return than preferred.
b. What qualifications to this estimate should you mention in your report when National
applies this rate to its various projects?
Answer: In using this estimate of the WACC, the firm should be careful not to
apply this discount rate to projects whose risks are not comparable with that of the
firm as a whole. Project required return rates depend on the market risk of the
projects, not the overall risk or credit-worthiness of the firm.
Selected Balance Sheet Items Market Data

Market Value Yield

(bonds)

Bonds (see market data) Bonds

Preferred stock $400,000 8%, 10-year $250,000 12%
Common stock $800,000 12%, 15- $1,000,000 15%
Retained earnings $2,000,000 year $250,000 11%
21%, 1-year
Common stock:
Average dividend growth (5 years) = 10%
Current dividend yield = 7%
Price = $47.25
Shares = 100,000
Preferred stock:
$4.50 preferred dividend
Price = $22.50
Shares = 20,000

4. A corporation’s securities have the following betas and market values:

Market
 Beta Value

Debt .1 $100,000
Preferred .4 200,000
Common 1.5 100,000
Calculate the following figures given a riskless interest rate of 10 percent and market risk
premium of 5 percent:
a. discount rates for each security.
Answer: Debt discount rate rD = 10 + 0.1(5) = 10.5%

Preferred discount rate rP = 10 + 0.4(5) = 12.0%

Common discount rate rE = 10 + 1.5(5) = 17.5%
b. the asset beta for the corporation.
Answer: The asset beta is the market-weighted average beta of the assets, which is
equivalent to the market-weighted average beta of the liabilities (ratio terms in
000’s):
ßA = 0.1(100/400) + 0.4(200/400) + 1.5(100/400) = 0.60
c. the weighted average cost of capital.

Answer: WACC = 0.105(0.25) + 0.12(0.50) + 0.175(0.25) = 13.0%

d. the discount rate for the unlevered assets.
Answer: The discount rate for unlevered assets whose business risk is the same as
that of the firm as a whole is exactly equal to the weighted average cost of capital, or
13.0%.
5. As part of its efforts at diversification, the Sherbert theater organization, producer of
Broadway plays, is considering acquiring a movie theater chain. A prime acquisition
candidate is Consolidated Cinemas, currently owned by a conglomerate, Tryon. Although
Tryon has given Sherbert what it feels is an accurate forecast of expected cash flows from the
cinema chain, Sherbert would like to have its own estimate of the required rate of return to
apply to these cash flows. The chief financial officer has acquired the following information
on independently owned movie house chains:

Movie House Beta D/TA*

NCO Theater, Inc. 1.70 .40

Worldwide/Global .50 .10
Screen Rocks 2.50 .50
Ultimate Theater -.10 .75
a. Using a risk-free rate of 7.5 percent and a market risk premium of 8.5 percent, what is
your estimate of the cost of equity capital for Consolidated?
Answer: We assume that the debt is risk-free, and that the betas shown in the table
are equity betas. Then the asset betas can be found with the following equation: ß A
= ßE[E/TA], where TA = total assets = D + E. Asset betas appear below:
NCO Theater, Inc. 1.70(1 ─ 0.40) = 1.020
Worldwide/Global 0.50(1 ─ 0.10) = 0.450
Screen Rocks 2.50(1 ─ 0.50) = 1.250
Ultimate Theater ─0.10(1 ─ 0.75) = ─0.025
The average asset beta is 0.67375, so the required rate of return is 7.5 + 0.67375(8) =
12.89%.
b. What qualifications would you include with your estimate?
Answer: The quality of the estimate is limited by the extent to which these four
companies can serve as proxies for Consolidated Cinemas. The betas seem quite
different, indicating that the assumption may be questionable. A second doubt
concerns the source of the betas. If the betas were derived from historical
relationships, are those relationships still valid? If they were derived from
subjective data, what assumptions were made in the calculations?
6. Westcon is considering building a facility to tap thermal energy using wind power. Part of the
project’s cost, $750,000, can be financed with a loan from the Federal Energy Commission at
the below-market rate of 5 percent. The remainder, $250,000, can be financed with an
industrial revenue bond at 10 percent. Current debt rates for Westcon are 15 percent. The
project should generate pre-tax net profit of $425,000 a year for ten years. Westcon has a 40
percent tax rate, and the D/E ratio is .50. Westcon estimates that the project beta is 1.50 and
forecasts a risk-free rate of 10 percent for the life of the project. The market rate is estimated
to be 20 percent.
a. Should Westcon undertake the project?
b. Assuming the project is of the same risk as Westcon itself, would the project be
acceptable without the subsidies? Explain.
Answer: This is a very difficult problem. Two sets of answers appear below. The first
answer takes a simple approach to problem solution when annual cash flows are $1.5M and
the tax rate is 40%. The first answer assumes that no debt is displaced.
The second answer analyzes the problem when cash flows are $300,000 per year, and the
tax rate is 50%. The second solution assumes that debt is displaced, and demonstrates the
equivalence of the WACC and the APV approach in decision-making.

Version 1
We assume there is no investment tax credit and no depreciation. In the absence of
favorable financing terms, cash flows include an initial outlay of $1M, and annual after-tax
cashflows of $1.5M(1 ─ 0.40) = $0.9M. Since the project beta is 1.5, the required rate of
return is rp = rf + ßp(rm ─ rf) = 10 + 1.5(10) = 25%. The present value of these cash flows is
$3.213M ─ 1M = $2.213M.
a. We now add debt to the analysis. We assume debt is risk-free. From equation 9.11, we
need to find the adjusted net present value (APV), which takes into account the present
value of tax shields and favorable financing terms. Note that since the 15% debt rate
applies to the company as a whole, we cannot use it in this project analysis.
Assume that both loans (250K and 750K) will make annual interest payments and
repay principal following the ten year project life. Tax savings in each year will then
be: 250,000(0.10)(0.40) + 750,000(0.05)(0.40) = $25,000.
 The present value of the tax savings (assuming these savings are risk-free) is
$25,000[PVIFA(r=10%,10 yrs)] = $153,614.18 = $0.154M.
The FEC loan subsidy amounts to a subsidy of (0.10 ─ 0.05)(750,000) = $37,500 per
year for 10 years. If this is risk-free, the present value is $230,421.27 = $0.230M.

APV = $2.213M + 0.154M + 0.230M = $2.597M.

Westcon should undertake the project (APV>0).

b. If the project were the same risk as Westcon itself, it should likely be accepted. The exact
weighted average cost of capital of Westcon cannot be determined from the given
information. However, as long as WACC<89.85%, the project should be accepted.

Version 2
Assume that annual operating cash flows are $300,000, and the marginal tax rate is 50%.
Ignore depreciation. These changes are reflected in some printings and not in others.
There are two basic approaches that you can take to solve this problem and they both give
similar answers. One approach is to use the adjusted present value (APV) and value the
project on an all-equity basis and then separately value the tax advantages of debt and the
interest subsidy. The other approach is to use a weighted average cost of capital (WACC)
ignoring the subsidized financing but taking into account the tax deductibility of debt and
then separately value the interest subsidy.

APV Approach

APV = NPV of project if all-equity financed

 NPV of financing side-effects caused by project acceptance
APV = ─I0 + S CFi/(1 + k*)i + S Ti/(1 + r)i + S Si/(1 + r)i
where k* = the all-equity cost of capital
CFi = the after-tax operating cash flow
Ti = tax savings in period i resulting from the specific financing package
Si = before-tax dollar value of interest subsidies in period i resulting from project-specific
financing
r = before-tax cost of unsubsidized debt
The latter two terms in the equation above are discounted at the before-tax cost of debt to
reflect the relatively certain value of the cash flows resulting from interest tax shields and
interest savings.
To apply the APV, we first have to calculate the all-equity cost of capital. This figure is k* =
rf + ßa(rm ─ rf), where ßa is the asset beta for the project. Substituting in the numbers given
in the problem yields k* = 25%.
The after-tax operating cash flows (we are ignoring depreciation in this problem) are
$300,000 (1 ─ 0.50) = $150,000.
The debt capacity of the new project is $333,333, given Westcon’s target debt:equity ratio
of 0.50. However, Westcon is adding $1 million in debt. This means that the new debt is
displacing $666,667 in 15% debt elsewhere in Westcon’s capital structure.
The tax savings on the added debt equal the value of the interest write-off in the $1 million
in new debt minus the lost tax shield on the $666,667 in 15% debt that is displaced by the
new debt. That is, the interest tax shield is worth 0.5[750,000 ´ 0.05 + 250,000 ´ 0.10 ─ 0.15
´ 666,667] = ─$18,750. The negative figure means that the tax shield on the displaced debt
exceeds the tax shield on the low interest debt. This should not be surprising: consider
what the tax shield would be on debt that carried a zero interest rate. Clearly, the benefits
of the interest subsidy don’t show up in the form of a tax write-off; but they do show up in
the interest subsidy figure.
The before-tax value of the interest subsidy is 750,000(0.15 ─ 0.05) + 250,000(0.15 ─ 0.10) =
$87,500. Hence, the total value of the specific financing package, taking into account both
the tax benefits of debt and the interest subsidy that Westcon receives, is $87,500 ─ $18,750
= $68,750.
Now we can calculate the APV:
APV = ─$1,000,000 + S 150,000/(1.25)i + S 68,750/(1.15)i
= ─$1,000,000 + 535,575 + 345,040 = ─$119,385.
The project is not acceptable, even with the financing subsidy.
WACC Approach
In this approach, we first value the project ignoring the financing subsidy. To do this, we
must calculate the WACC ignoring the interest subsidy, which we use to discount the after-
tax operating cash flows of $150,000 annually. Then, we estimate the value of the interest
subsidy and subtract this figure from the project NPV.
To calculate the WACC, we must estimate the levered cost of equity capital, which requires
that we calculate the levered equity beta. We can calculate the levered equity beta using
the formula
ße = ßa[1 + (1 ─ t)D/E]
Assuming that the project’s debt capacity is the same as Westcon’s debt capacity, because
the risks are assumed to be the same, we can substitute in the figures given in the problem
and get
ße = 1.5[1 + 0.50 ´ 0.50] = 1.875.
The resulting cost of equity capital, given a debt:equity ratio of 0.50 is 28.75% (10% +
1.875 ´ 10%).
The WACC, ignoring the interest subsidy (which we will calculate separately) is
2/3 ´ 28.75% + 1/3 ´ 15.00% ´ 0.50 = 21.67%
The project NPV, discounted at the 21.67% WACC, equals
NPV = ─$1,000,000 + S 150,000/(1.2167)i = ─$405,163.
The NPV of the interest subsidy can be calculated using the following reasoning. Westcon
must pay $62,500 in interest annually for the next ten years and then repay $1 million
principal at the end of ten years. In return, Westcon receives $1,000,000 today. Given
these cash inflows and outflows, we can calculate the loan’s NPV just as we would for any
project analysis. Note, however, that unlike the typical capital budgeting problem we
examined, the cash inflow occurs immediately, and the cash outflows later. The principle is
the same, however. We now need to know the required return on this project and
Westcon’s marginal tax rate.
The required return is based on the opportunity cost of the funds provided: the 15% rate
that Westcon would have to pay to borrow $1M in the capital market. We are told that
Westcon’s marginal tax rate is 50%. The after-tax required return will be 7.5% and the
after-tax interest payments will be $37,500. Now we can calculate the NPV of Westcon’s
financing bargain:
NPV = $1,000,000 ─ S $37,500/(1.075)i ─ $1,000,000/(1.075)10
= $1,000,000 ─ 699,696 = $300,304.
Alternatively, you could just calculate the present value of the ten-year annuity consisting
of the annual after-tax interest savings of 0.50 ´ $87,500 = $43,750. This annuity,
discounted at the 7.5% after-tax cost of debt financing, equals $300,304.
Adding together the project NPV with the financing NPV yields a total project value of
─$405,163 + $300,304 = ─$104,859. The WACC approach gives the same answer as the
APV approach: the project is not acceptable.
Although in theory the two approaches should yield identical quantitative results, they
don’t in practice. The difference stems from the slightly different effects of adjusting the
numerator in one case for taxes and the denominator in the other case.
7. In analyzing the possible placement of their first fast-food fish restaurant overseas, the Gill
Corp. has the following data:

Correlation of Rate of Return United States with

on Common Stock Indexes, Last Ten Years

.44 France
.75 Canada
.75 Japan
.61 United Kingdom
.27
Italy

The CFO for Gill reasons that the beneficial effect of foreign diversification should be included
in the financial analysis, by multiplying the risk of equity capital by this correlation. With a U.S.
beta of 1.15, what would the project’s beta be under this system? Is this a defensible procedure to
use?
Answer: Country Adjusted Beta
France 0.506
Canada 0.863
Japan 0.633
United Kingdom 0.702
Italy 0.311
The procedure is indefensible. While the diversification benefits of foreign investment are
real and should be considered in project analysis, this ad-hoc procedure will not determine
the appropriate project betas for capital budgeting purposes. The procedure seems to
confuse country risk with project risk.
8. Tom Swift Company has a target capital structure of 40 percent debt and 60 percent equity.
Its estimated beta is .9. Tom Swift is evaluating a new project that is unrelated to its existing
lines of business. However, it has identified three proxy firms exclusively engaged in this
line of business. The average beta for these firms is 1.2, and their debt ratios average 50
percent. Tom Swift’s new project has a projected return of 11.9 percent. The risk-free return
is 10 percent and the market risk premium is 5 percent. All firms have a marginal tax rate of
40 percent. Tom Swift’s before-tax cost of debt is 13 percent.
a. What is the unlevered project beta?
Answer: The project’s unlevered beta can be found with the relation:
ßa = ße { E/[(1─t)D + E] } = 1.2 (0.5/0.8) = 0.75.
b. What is the beta of the project if undertaken by Tom Swift, assuming the company
maintains its target capital structure?
Answer: Inverting the relation in (a):
ße = ßa [ 1 + (1─t)D/E ] = 0.75 [1 + (0.60)(0.40)/(0.60)]
= 1.05
c. Should Tom Swift accept the project?
Answer: The required return is 10 + 1.05(5) = 15.25%. WACC = 12.27%. This
exceeds the expected return of 11.9%. The project should be rejected.
9. The following are the beta estimates from Value-Line for several computer firms as well as
the D/TA for the firms. Suppose the risk-free rate of return is 8 percent, the expected market
return is 17 percent, and the tax rate is 35 percent.

Company Beta D/TA

Apple 1.70 0
Amdahl 1.55 .31
Burroughs 1.00 .24
Commodore 1.50 .14
Cray 1.45 .05
Sperry 1.25 .23
Tandem 1.60 .03
a. What risk premium must these companies pay as a result of leverage?

Answer: Recall that ßa = ße { E/[(1─t)D + E] }

ße D/TA ßa k* ke (ke─k*) PCT
Apple 1.70 0 1.70 23.30% 23.30% 0.00% 0.00%
Amdahl 1.55 0.31 1.20 18.76% 21.95% 3.19% 14.54%
Burroughs 1.00 0.24 0.83 15.45% 17.00% 1.55% 9.13%
Commodore 1.50 0.14 1.35 20.19% 21.50% 1.31% 6.09%
Cray 1.45 0.05 1.40 20.61% 21.05% 0.44% 2.08%
Sperry 1.25 0.23 1.04 17.40% 19.25% 1.85% 9.62%
Tandem 1.60 0.03 1.57 22.11% 22.40% 0.29% 1.29%
The returns ra and re are calculated from the CAPM relationship, ri = rf + ß(rm─rf). The
premium due to leverage is reflected by the difference in the last column
b. What proportion of their total equity cost is a result of financing?
Answer: Proportional part of return represented by the leverage premium

PCT
Apple 0.00%
Amdahl 14.54%
Burroughs 9.13%
Commodore 6.09%
Cray 2.08%
Sperry 9.62%
Tandem 1.29%
10. In late 1984, Sonat, the Birmingham, Alabama-based, energy and energy services
company, ordered six drilling rigs that can be partly submerged from Daewoo
Shipbuilding, a South Korean shipyard. Daewoo agreed to finance the $425 million
purchase price with an 8.5-year loan, at an annual interest rate of 9 percent paid
semiannually. The loan principal is repayable in 17 equal semiannual installments
($25 million every six months). At the time the loan was arranged, the market interest
rate on such a loan would have been about 16 percent. If Sonat’s marginal tax rate
(federal plus state corporate taxes) was 50 percent at the time, how much would this
loan be worth to Sonat?
Answer: