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(continued )

The T-bill rate is 5 percent, and the expected return on the market is 12 percent.

a. Which projects have a higher expected return than the firm's 12 percent cost of capital?

b. Which projects should be accepted?

c. Which projects would be incorrectly accepted or rejected if the firm's overall cost of capital were used as a hurdle rate?

18. Calculating Flotation Costs Suppose your company needs $6 million to build a new assembly line. Your target debt-equity ratio is 1.0. The flotation cost for new equity is 15 percent, but the flotation cost for debt is only 4 percent. Your boss has decided to fund the project by borrowing money, because the flotation costs are lower and the needed funds are relatively small.

a. What do you think about the rationale behind borrowing the entire amount?

b. What is your company's weighted average flotation cost?

c. What is the true cost of building the new assembly line after taking flotation costs into account? Does it matter in this case that the entire amount is being raised from debt?

19. Calculating Flotation Costs Western Alliance Company needs to raise $12 million to start a new project and will raise the money by selling new bonds. The company has a target capital structure of 60 percent common stock, 10 percent preferred stock, and 30 percent debt. Flotation costs for issuing new common stock are 12 percent, for new preferred stock, 6 percent, and for new debt, 4 percent. What is the true initial cost figure Western should use when evaluating its project?

20. WACC and NPV Sallinger, Inc., is considering a project that will result in initial aftertax cash savings of $4 million at the end of the first year, and these savings will grow at a rate of 5 percent per year indefinitely. The firm has a target debt-equity ratio of .75, a cost of equity of 16 percent, and an aftertax cost of debt of 6 percent. The cost-saving proposal is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and

Intermediate

(Questions 20-21)

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

15. Cost of Capital

© The McGraw-Hill Companies, 2002

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