Question

1. Suppose a firm’s after-tax cost of debt is 12%, cost of preferred stock is 8%, and cost of equity is 5%. If the optimal structure is 35% debt and 65% equity, what is the firm’s WACC?

1. 9.22%
2. 8.41%
3. 7.45%
4. 7.20%
5. None of the above

2. Vance Refrigeration just paid a dividend of $1.05 per share and can support dividend growth of 3% per year forever. Assume a required return of 8%. The stock is actively trading at $21.38. Would a value investor purchase the stock today?

            a.   Yes

            b.   No

            c.   Need more information to solve

            d.   A value investor does not purchase stocks

3. A new piece of equipment will produce cash flows of $1,000 in Year 1 and $1,500 in Years 2, 3, 4, and 5. The machine costs $2,500. What is the payback period?

            a.   1 year

2. 2 years

c.   3 years

            d.   4 years

            e.   Not enough information

Answer 1

1

Weight of equity = 1-D/A

Weight of equity = 1-0.35

W(E)=0.65

Weight of debt = D/A

Weight of debt = 0.35

W(D)=0.35

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 12*(1-0)

= 12

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=12*0.35+5*0.65

WACC =7.45%

2

As per DDM

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

Price = 1.05 * (1+0.03) / (0.08 - 0.03)

Price = 21.63

Buy stock as CMP of 21.38 is less than intrinsic value

3

Project
Year	Cash flow stream	Cumulative cash flow
0	-2500	-2500
1	1000	-1500
2	1500	0
3	1500	1500
4	1500	3000
5	1500	4500

Payback period is the time by which undiscounted cashflow cover the intial investment outlay

this is happening at the end of year 2

therefore payback period is:

2 Years