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Chapter 10
Project Financing and Non-economic Attributes
10.1 Risk The higher the risk, the higher the MARR
Investment Opportunity MARR may be lowered for pet projects or for company to
expand into target areas.
Government Intervention May result in higher or lower MARRs, depending on the how
the intervention affects the companys competitiveness
Tax structure Higher taxes induce companies to raise the MARR and vice versa
Limited capital Limited availability of capital results in increased MARRs as companies
attempt to deploy the capital most effectively
Market rates higher interest rates increase the cost of capital, requiring a higher MARR
10.2
(a) Equity
(b) Equity
(c) Debt
(d) Debt
(e) Equity
10.6 ROR measure: Select projects A and E to total $13 million. Opportunity cost is ROR =
20.4% for project C
PW measure: Select projects A and C to total $16 million. Opportunity cost is ROR =
26.0% for project E
1
(25%)
(a) Determine the after-tax cost of debt capital, Equation [10.4], and WACC
After-tax cost of debt capital = 10(1 - 0.36) = 6.4%
After-tax WACC = 0.35(6.4%) + 0.65(14.5%) = 11.665%
3
10.18 The lowest WACC value of 6.7% occurs at the debt fraction of 0.3 or $30,000 in loans.
This translates into funding $70,000 from their own funds.
10.19 (a) Compute and plot WACC for each D-E mix. See plot in problem 10.20 below.
D-E mix
100-0
70-30
65-35
50-50
35-65
20-80
0 - 100
WACC
14.50%
11.44
10.53
9.70
9.84
12.48
12.50
10.20 (a) The spreadsheet shows a 50% - 50% mix to have the lowest WACC at 9.70%.
(b) Multiply the debt rate (column C) by 1.1 to add the 10% (column D) and observe the
new plot. Now debt of 35% (D-E of 35-65) has the lowest WACC = 10.18%.
10.21 (a)
(RATE function)
(spreadsheet)
(spreadsheet)
(spreadsheet)
(RATE function)
Bond issue
Annual bond dividend = 800,000(0.06) = $48,000
Tax saving = 48,000(0.40) = $19,200
Effective bond dividend = 48,000 19,200 = $28,800
The AW-based i* relation is:
0 = 800,000(A/P,i*,10) - 28,800 - 800,000(A/F,i*,10)
i* = 3.60%
By Equation [10.7]
Re = 0.92/23 + 0.032
= 0.072 (7.2%)
10.28 The two tax rates are the same for equity financing because stock dividends paid to
stockholders and owners are not tax deductible like interest is for corporate debt.
10.29
Re = 0.032 + 1.41(0.038)
= 0.0856 (8.56%)
Re = DV1/P + g
= 0.93/18.80 + 0.015
= 0.0644
(6.44%)
A large D-E mix over time is not healthy financially because this indicates that the
person owns too small of a percentage of his or her own assets (equity ownership) and is
risky for creditors and lenders. When the economy is in a tight money situation
additional cash and debt capital (loans, credit cards, etc.) will be hard to obtain and very
expensive in terms of the interest rate charged.
10.35 If the D-E mix of the purchaser is too high after the buyout and large interest
payments (debt service) are required, the new companys credit rating may be degraded.
In the event that additional borrowed funds are needed, it may not be possible to obtain
them. Available equity funds may have to be depleted to stay afloat or grow as
competition challenges the combined companies. Such events may significantly weaken
the economic standing of the company.
9
10.36 (a) First find cost of equity capital using CAPM, which is the MARR
Re = 3.0 + 0.95(5.0) = 7.75%
Find i* on equity investment of $250,000 and NCF of $48,000
0 = -250,000 + 48,000(P/A, i*,7)
i* = 8.0% > 7.75%
The venture is acceptable
(b) For 50% equity financing at 7.75% and 50% debt financing at 8%
WACC = MARR = 0.50(7.75%) + 0.50(8%)
= 7.875%
The venture is acceptable because 8.0% > 7.875%
10.37 100% equity financing
MARR = 7.5% is known. Determine PW at the MARR
PW = -250,000 + 30,000(P/A,7.5%,15)
= -250,000 + 30,000(8.82712)
= -250,000 + 264,814
= $14,814
Since PW > 0, 100% equity financing meets the MARR requirement
60%-40% D-E financing
Loan principal = 250,000(0.60) = $150,000
Loan payment = 150,000(A/P,7%,15)
= 150,000(0.10979)
= $16,469 per year
Cost of 60% debt capital is 7% for the loan.
WACC = 0.4(7.5%) + 0.6(7%) = 7.2%
MARR = 7.2%
Annual NCF = project NCF - loan payment
= $30,000 16,469 = $13,531
Amount of equity invested = 250,000 - 150,000 = $100,000
10
(RATE on spreadsheet)
x2 = 10.33%
Debt capital cost would have to decrease from 10.5% to 10.33%
10.40 Two independent, revenue projects with different lives. Fastest solution is to find AW at
MARR for each project. Select all those with AW > 0. Find WACC first.
Equity capital is 40% at a cost of 7.5% per year
Debt capital is 5% per year, compounded quarterly. Effective rate after taxes is
After-tax debt i* = [(1 + 0.05/4)4 - 1] (1- 0.3) (100%)
= 5.095(0.7) = 3.566% per year
WACC = 0.4(7.5%) + 0.6(3.566%) = 5.14% per year
MARR = WACC = 5.14%
12
(Sum is 1.00)
S = 1 + 2 + 3 + + 10 = 10(11)/2 = 55
(a) WC = 3/55 = 0.055
(b) WJ = 10/55 = 0.182
Importance Score
100
35
50
70
255
13
Weighting, Wi = Score/255
Attribute
F
S
U
R
Wi
0.39
0.14
0.20
0.27
1.00
Importance
9
1
3
6
10
4.8
33.8
Weighting, Wi = Score/33.8
Attribute
1
2
3
4
5
6
Wi______
9/33.8 = 0.27
1/33.8 = 0.03
3/33.8 = 0.09
6/33.8 = 0.18
10/33.8 = 0.30
4.8/33.8 = 0.14
14
Importance
score
20
80
100
Sum = 200
Wi
0.10
0.40
0.50
1
5
40
50
95
Vij values____
2
3__
7
10
24
12
20
25
51
47 = Rj values
Importance
score
100
80
20
Sum = 200
Vij values____
1
2
3
25
35
50
40
24
12
10
4
5
75
63
67 = Rj values
Wi
0.50
0.40
0.10
Importance
by manager
80
35
30
20
165
Therefore, select B
15
Wi
0.48
0.21
0.18
0.12
Rj_______
A
B__
0.48 0.43
0.07 0.21
0.18 0.16
0.03 0.12
0.76 0.92
Importance
(by trainer)
80
80
100
50
310
Wi
0.26
0.26
0.32
0.16
Rj______
A
B__
0.26 0.23
0.09 0.26
0.32 0.29
0.04 0.16
0.71 0.94
Select B
Conclusion: 2 methods indicate B and 1, the PW method, indicates A
10.49 Answer is (c)
10.50 Answer is (b)
10.51 Answer is (a)
10.52 Answer is (b)
10.53 Equity = 41/71 = 57.7%
Debt = 30/71 = 42.3%
Answer is (d)
10.54 WACC = 5/10(13.7) + 2/10(8.9) + 3/10(7.8)
= 10.97%
Answer is (c)
10.55 Before-tax ROR = after-tax ROR/(1- Te)
= 11.2%/(1-0.39)
= 18.4%
Answer is (c)
10.56 Historical WACC = 0.5(11%) + 0.5(9%) = 10%
Let x = cost of equity capital
WACC = equity fraction(cost of equity) + fraction of debt(cost of debt)
10% = 0.25(x) + 0.75[9%(1.2)]
16
17
(RATE function)
(RATE function)
(RATE function)
19