Question

Chapters 7, 9

& 10 Exam

2.

The weighted average cost of capital

A)

typically involves a proportionate weighting of the return on equity and the return on debt.

B)

reflects a discount rate that implies the use of all debt for financing.

C)

is used to value the equity of the firm.

D)

never changes once it is determined.

Chapter 9

Problems:

1.

Umpqua Energy Holdings is financed forty percent with debt and sixty percent with equity. Umpqua’s

expected return on equity is 11 percent and its expected return on debt is 5 percent. Umpqua has a

corporate tax rate of 35 percent.

Calculate Umpqua’s weighted average cost of capital.

2.

Amazon recently reported it has $8.2 billion in debt and $14.8 billion of equity. What fraction of the

firm’s value is financed with debt? With equity?

Answer 1

1)

typically involves a proportionate weighting of the return on equity and the return on debt.

Weighted average cost of capital is the weighted average cost of equity and debt. WACC can change as per the risk of the project and can also change depending upon the future capital structure of the firm.

2)

WACC = Weight of equity*cost of equity + weight of debt*after tax cost of debt

WACC = 0.6*0.11 + 0.4*0.05*(1 - 0.35)

WACC = 0.066 + 0.013

WACC = 0.079 or 7.9%

3)

Total market value of capital structure = 8.2 + 14.8 = 23 billion

Fraction of debt = (8.2 / 23) = 0.3565 or 35.65%

Fraction of equity = (14.8 / 23) = 0.6435 or 64.35%