Investment Decision Rules

1. MV Corporation has debt with market value of $100 million, common equity with a book value of $100 million, and preferred stock with $20 million outstanding. Its common equity trades at $50 per share, and the firm has 6 million shares outstanding. What weights should MV Corporation use in its WACC?

2. Avicorp has a $10 million debt issue outstanding, with a 6% coupon rate. The debt has semi-annual coupons, the next coupon is due in six months, and the debt matures in five years. It is currently priced at 95% of par value.

1. What is Avicorp's pre-tax cost of debt?

2. If Avicorp faces a 40% tax rate, what is its after tax cost of debt?

3. Dewyco has preferred stock trading at $50 per share. The next preferred dividend of $4 is due in one year. What is Dewyco's cost of capital for preferred stock?

4. Steady Company's stock has a beta of 0.20. If the risk-free rate is 6% and the market risk premium is 7%, what is an estimate of Steady Company's cost of equity?

5. HighGrowth Company has a stock price of $20. The firm will pay a dividend next year of $1, and its dividend is expected to grow at a rate of 4% per year thereafter. What is your estimate of HighGrowth's cost of equity capital?

6. Mackenzie Company has a price of $36 and will issue a dividend of $2 next year. It has a beta of 1.2, the risk-free rate is 5.5%, and the market risk premium is estimated to be 5%

1. Estimate the equity cost of capital for Mackenzie.

2. Under the CGDM, at what rate do you need to expect Mackenzie's dividends to grow to get the same equity cost of capital as in part (a)?

7. Growth Company's current share price is $20 and is expected to pay a $1 dividend per share next year. After that, the firm's dividends are expected to grow at a rate of 4% per year.

1. What is an estimate of Growth Company's cost of equity?

2. Growth Company also has preferred stock outstanding that pays a $2 share fixed dividend. If this stock is currently priced at $28, what is Growth Company's cost of preferred stock?

3. Growth Company has existing debt issued three years ago with a coupon rate of 6%. The firm just issued a new debt at par with coupon rate of 6.5%. What is Growth Company's pre-tax cost of debt?

4. Growth Company has 5 million common shares outstanding and 1 million preferred shares outstanding, and its equity has a total book value of $50 million. Its liabilities have a market value of $20 million. If Growth Company's common and preferred shares are priced at $20 and $28, respectively, what is the market value of Growth Company's assets?

5. Growth Company faces a 35% tax rate. Given the information in parts (a) and (d), and your answers to those problems, what is Growth Company's WACC?

8. Fabulous Fabricators needs to decide how to allocate space in its production facility this year. It is considering the following contracts:

	NPV	Use of facility
A	$2 million	100%
B	$1 million	60%
C	$1.5 million	40%

1. What are the profitability indexes of the projects?

2. What should Fabulous Fabricators do?

9. You are choosing between two projects, but can only take one. The cash flows for the projects are given in the following table:

	0	1	2	3	4
A	-$50	25	20	20	15
B	-$100	20	40	50	60

1. What are the IRRs of the two projects?

2. If your discount rate is 5%, what are the NPVs of the two projects?

3. Why do IRR and NPV rank the two projects differently?

10. You are considering making a movie. The movie is expected to cost $10 million up front and take a year to make. After that, it is expected to make $5 million in the year it is released and $2 million for the following four years. What is the pay pack period of this investment? If you require a payback of two years, will you make the movie? Does the movie have positive NPV if the cost of capital is 10%?

11. You own a coal mining company and are considering opening a new mine. The mine itself will cost $120 million to open. If this money is spent immediately, the mine will generate $20 million every year for the next 10 years. After that, the coal will run out and the site must be cleaned and maintained as environmental standards. The cleaning and maintenance are expected to cost $2 million per year on perpetuity. What does the IRR rule say about whether you should accept this opportunity? If the cost of capital is 8%, what does the NPV rule say?

12. You are considering the following two projects and can only take one.  Your cost of capital is 11%.

	0	1	2	3	4
A	-100	25	30	40	50
B	-100	50	40	30	20

1. What is the NPV of each project at your cost of capital?

2. What is the IRR of each project?

3. At what cost of capital do you become indifferent about which project to choose? This is the crossover rate.

4. What should you do?