Question 1 (Time Value of Money and WACC)
(a) You need to pay off a car loan within the next two years.
The payment will be $4,000 every
month. Today you have made a single deposit into a
return-guaranteed investment account
that will allow you to cope with all the monthly payments.
This account earns an effective
annual interest rate of 12.68250301%. The first payment will
be made in one month.
(i) Calculate the corresponding monthly rate for the
investment account.
(ii) “You need to have at least $96,000 at your account today
in order to make all the
payments on the car loan in the next two years.” True or
false? Briefly explain without
doing any time value of money related (i.e. PVA or FVA)
calculations.
(iii) What is the amount of the single deposit made
today?
(iv) If your mother is going to make the first year’s
repayments for you (as a birthday gift)
and thus you don’t need to withdraw the $4,000 every month
from the investment
account, how much more money will you have in your bank
account two years from
now?
(b) The Chief financial officer of Kurdishy Oil has given you
the assignment of estimating the
firm’s cost of capital. The present capital structure, which
is considered optimal, is as follows:
Market Value
Debt $40 million
Preferred stock 5 million
Common equity 55 million
The anticipated financing opportunities are:
1) Debt can be issued with a 15 percent before-tax cost.
2) Preferred stock will be $100 par, carry a dividend of 13
percent, and can be sold at $96
per share.
3) Common equity has a beta of 1.20, rM = 17% and rf =
12%.
Kurdishy’s tax rate is 40%.
(i) Calculate the after-tax cost of debt, cost of preferred
stock and cost of equity of Galaxy
Oil.
(ii) What is the cost of capital of Kurdishy Oil?
(iii) The CEO of Kurdishy asks you about the company’s capital
structure. She wants to
know why the company doesn't use more preferred stock
financing as it costs less than
debt. What would you tell the president? [Note: Confine your
answer to no more a
couple of lines.]