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inance Basics

QUESTIONS

- a. Discuss the specific items of capital that should be included in the WACC.

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.

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

d. Are book value or market value weights better for calculating the firm’s weighted aver- age cost of capital?

- a. Critique Ace Repair’s current method of estimating its before-tax cost of debt.

b. Is the earnings yield (E/P) an appropriate measure of the firm’s cost of equity?

- 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 out- standing debt had not been traded recently?

- 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?

- 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 worse measure of its future market risk than the his- torical beta for a portfolio would be for the portfolio’s future market risk? Explain.

e. What are some alternative ways to obtain a market risk premium for use in a CAPM cost- of-equity calculation? Discuss both the possibility of obtaining estimates from outside organizations and also ways which Ace could calculate a market risk premium itself.

- a. What is Ace’s discounted cash flow (DCF) cost of retained earnings?

b. Suppose Ace, over the last few years, has had an 18 percent average return on equity (ROE) and has paid out 20 percent of its net income as dividends. Under what conditions could this information be used to help estimate the firm’s expected future growth rate, g? Estimate ks using this procedure for determining g.

c. What was the firm’s historical dividend growth rate using the point-to-point method? Using the linear regression method?

- Use the bond-yield-plus-risk-premium method to estimate Ace’s cost of retained earnings.
Based on all the information available, what is your best estimate for ks? Explain how you decided what weight to give to each estimating technique.

What is your estimate of Ace’s cost of new common stock, ke? What are some potential weaknesses in the procedures used to obtain this estimate?

a. Compute Ace’s WACC’s based on the company’s target capital structure and construct the marginal cost of capital (MCC) schedule. How large could the company’s capital budget be before it is forced to sell new common stock? Ignore depreciation at this point.

b. Would the MCC schedule remain constant beyond the retained earnings break point, no matter how much new capital it raised? Explain. Again, ignore depreciation.

c. How does depreciation affect the MCC schedule? If depreciation were simply ignored, would this affect the acceptability of proposed capital projects? Explain.

- Should the corporate cost of capital as developed above be used for all projects? If not, what type of adjustments should be made?

**Attachment:-** case15.docx