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Problem 1:
You are given the following data for a company: Cost of debt = 8%, cost of retained earnings =
12%, cost of new common equity = 14%, tax rate = 35% and retained earnings = $1000. The
firms target capital structure is 40% debt and 60% common equity. Compute the following:
A. Retained earnings break point
= Retained earnings/Equity % of target capital
= 1000/60% = $1666.6 or approx. to 1667
Higher WACC means funds raised above the breakpoint.
B. WACC below the RE break point: = Cost of Debt*(1-Tax Rate) *Weight of Debt + Cost of
Retained Earnings*Weight of Equity =
CD WD CRE WACC
8x(1-.35) x .40 +12 x.60 =9.28%.
C. WACC above the RE break point: = Cost of Debt*(1-Tax Rate) *Weight of Debt + Cost of
External Equity*Weight of Equity =
CD WD CEE WACC
8x (1-.35) x .45 + 14 x.60 =10.74%.
Problem 2:
The cost of debt for firm XYZ is 6%. Its tax rate is 40%. The cost of retained earnings is 12%
and the cost of external common equity is 14%. Retained earnings is $5000. The target capital
structure calls for 45% debt and 55% equity. Compute the following:
A. Retained earnings break point.
= Retained earnings/Equity % of target capital
= 5000/55% = $9090.90 or approx. to 9091.
B. WACC below the RE break point: = Cost of Debt*(1-Tax Rate) *Weight of Debt + Cost of
Retained Earnings*Weight of Equity =

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CD WD CRE WACC
0.06 x (1- 0.40) x 0.45 +0.12 x 0.55 =0.0822 or 8.22%.
C. WACC above the RE break point: = Cost of Debt*(1-Tax Rate) *Weight of Debt + Cost of
External Equity*Weight of Equity =
CD WD CEE WACC
0.06 x (1- 0.40) x 0.45 +0.55 x 0.14 =0.0932 or 9.32%.
Problem 3:
The firm referred to in problem 2 has 3 projects available: One with a cost of $4000 and an IRR
of 18%; one with a cost of $3000 and an IRR of 20%; and one with a cost of $6000 and an IRR
of 6%. Do the following:
Compute the optimal capital budget. In other words, how much capital must the firm raise in
order to invest in all projects whose IRR exceeds the WACC?
What projects should be accepted?
WACC = 6%*45%*(1-40%) + 14%*55%= 9.32%
Projects IRR exceed WACC are One with a cost of $4000 and an IRR of 18%; one with a cost of
$3000 and an IRR of 20%
Optimal capital budget = 4000+3000 = $7000.
Accepted projects: One with a cost of $4000 and an IRR of 18%; one with a cost of $3000 and
an IRR of 20%
Problem 4:
A potential CB project has the following cash flows: CF0 = -$500, CF1 = $300, CF2 = $200,
CF3 = $150. WACC = 6%. Compute the following:
A. Payback Period The payback period is = 2 years. Initial cash flow 500= (300+200) is
generated in 2 years.
B. NPV= -500 + 300/1.06 + 200/1.06^2 + 150/1.06^3 = 86.968.
C. IRR => 16.46% is the rate at which NPV is zero.
=> -500 + 300/(1+IRR) + 200/(1+IRR) ^2 + 150/(1+IRR) ^3 = 0

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Problem 1: You are given the following data for a company: Cost of debt = 8%, cost of retained earnings = 12%, cost of new common equity = 14%, tax rate = 35% and retained earnings = $1000. The firms target capital structure is 40% debt and 60% common equity. Compute the following: A. Retained earnings break point = Retained earnings/Equity % of target capital = 1000/60% = $1666.6 or approx. to 1667 Higher WACC means funds raised above the breakpoint. B. WACC below the RE break point: = Cost of Debt*(1-Tax Rate) *Weight of Debt + Cost of Retained Earnings*Weight of Equity = CD WD CRE WACC 8x(1-.35) x .40 +12 x.60 =9.28%. C. WACC above the RE break point: = Cost of Debt*(1-Tax Rate) *Weight of Debt + Cost of External Equity*Weight of Equity = CD 8x (1-.35) WD x CEE WACC .45 + 14 x.60 =10.74%. Problem 2: The cost of debt for firm XYZ is 6%. Its tax rate is 40%. The cost of retained earnings is 12% and the cost of external common equity is 14%. Retained earnings is $5000. The target capital structure calls for 45% debt and 55% equity. Compute the following: A. Retained earnings break point. = Retained earnings/Equity % of target capital = 5000/55% = $9090.90 or appr ...
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