Final Exam Study Fin 301 Ch. 14-15b
Questions with Correct Answers
Two main measures for Cost of Debt Capital for entities - Answer-1. Pre-tax - does not
include effect in Income Statement (Does not include Tax Shield effect)
2. (Real world) Post-tax - includes effect on Income Statement. (Includes Tax Shield
effect)
rD, Post-tax - Answer-(1-Trate)*rD, pretax
trate= Taxrate
Due to the tax shield effect
CAPM Assumptions - Answer-- Can't beat the market (Perfect Market)
- Riskier projects require higher expected value payoffs (Risk averse investors)
Smallco takes out a 1,000 one-year loan that its bank describes as "a 10% interest
loan." The loan contract states that SmallCo will get 1,000 at EOY 0 and repay repay
100 + 1,000 at EOY 1. The contract also states that Smallco will pay the bank a fee of
50 at EOY zero, for the right to enter into the agreement.
What is Smallco's pre-tax cost of capital for this loan? (Pre-tax cost of capital is the IRR
for this project)
IRR Example - Answer-NPV= summationCFi/(1+IRR)^Ti
for IRR NPV = 0
50 for bank fee
0 = 1000 - 50 - 1100/(1+IRR)^1
IRR = 1100/950 - 1 = .158
MedCo's weighted average, pre-tax cost of debt capital is 10%. The firm has $2MM in
outstanding debt. Its tax rate is 30%. What is the firm's weighted average post-tax cost
of capital?
Post-Tax rD Example - Answer-Pre-tax rD = (Interest Expense in period)/(Total
DebtBOP)
Post-tax rD = (1-Trate)*Pre-taxrD
,(1-.3)*.1 = .07
7%
rE ex. using FV=PV*(1+r)^T equation
Your friend is selling 100K shares at $1 each in his new company, OppCo. This
represents 100% of OppCo's shares. OppCo will invest the paid in capital for ***one
year***, with the expectation (hope) that it will be able to return shareholders $1.25 per
share after one year, when the firm will be closed down.
What is OppCo's cost of equity capital, rE? Round your answer to two decimal places. -
Answer-FV = PV*(1+r)^T
1.25 = 1.00*(1+rE)^1
rE = FV/PV-1
rE=1.25/1.00-1
rE=.25
Consider OppCo, described in the previous question.
Bankruptcy aside, are equity investors in OppCo guaranteed to earn rE? - Answer-
Equity (unlike bond and loan contracts) does not carry guarantees. It represents
ownership in an entity.
Stocks are not contracts
NI ex w Debt
For year 20X1, Zero Motorcycles earns $30MM of EBIT. If the firm's tax rate is 30% and
it pays 10% interest on $100MM of debt, what is its NI for 20X1? Assume the firm's
Taxable Income is equal to its EBT. - Answer-EBIT 30MM
10% int on 100MM
= 10MM interest
30-10
= 20 EBT
Tax Rate = 30%
20*.3 = 6
EBT 20
, -
Tax rate 6
NI = 14
Pre-tax rD
What is this company's pre-tax rD in year 2?
Balance sheet
yr 1 y2
Total Assets. 21,000. 24,200
Liab
AP 5250 5500
Total Debt 3150 4400
etc
Income statement
Rev 945 990
SGA 141.8 148.5
Interest 52.5 110.0
EBT 750.8 731.5
Etc
Pre-tax rD = Interest/(Total Debt, BOP) - Answer-Pre-tax rD = Interest/(Total Debt,
BOP)
110/3150 = .035
Trial and Error IRR
Zero Motorcycles takes out a $10MM loan, agreeing to pay 0.6MM interest at EOY 1
and at EOY 2, when it will repay the principal. The bank also charges Zero a fee of 5%
"points" for this loan, payable at EOY 0 (at loan signing). 5% "points" means 5% of the
principal amount of the loan. What is zero's pre-tax cost of debt capital (rD) for this
loan?
Hints: 1. rD is the IRR of the loan, with all the loan's cash flows, including the fee. 2.
Write the appropriate equation and try these values: 7.35%, 8.84%, and 10.21%. -
Answer-Takes out loan so positive initial CF
5% fee of principal
10*.05 = .5
NPV = summation CFi/(1+IRR)^Ti
Questions with Correct Answers
Two main measures for Cost of Debt Capital for entities - Answer-1. Pre-tax - does not
include effect in Income Statement (Does not include Tax Shield effect)
2. (Real world) Post-tax - includes effect on Income Statement. (Includes Tax Shield
effect)
rD, Post-tax - Answer-(1-Trate)*rD, pretax
trate= Taxrate
Due to the tax shield effect
CAPM Assumptions - Answer-- Can't beat the market (Perfect Market)
- Riskier projects require higher expected value payoffs (Risk averse investors)
Smallco takes out a 1,000 one-year loan that its bank describes as "a 10% interest
loan." The loan contract states that SmallCo will get 1,000 at EOY 0 and repay repay
100 + 1,000 at EOY 1. The contract also states that Smallco will pay the bank a fee of
50 at EOY zero, for the right to enter into the agreement.
What is Smallco's pre-tax cost of capital for this loan? (Pre-tax cost of capital is the IRR
for this project)
IRR Example - Answer-NPV= summationCFi/(1+IRR)^Ti
for IRR NPV = 0
50 for bank fee
0 = 1000 - 50 - 1100/(1+IRR)^1
IRR = 1100/950 - 1 = .158
MedCo's weighted average, pre-tax cost of debt capital is 10%. The firm has $2MM in
outstanding debt. Its tax rate is 30%. What is the firm's weighted average post-tax cost
of capital?
Post-Tax rD Example - Answer-Pre-tax rD = (Interest Expense in period)/(Total
DebtBOP)
Post-tax rD = (1-Trate)*Pre-taxrD
,(1-.3)*.1 = .07
7%
rE ex. using FV=PV*(1+r)^T equation
Your friend is selling 100K shares at $1 each in his new company, OppCo. This
represents 100% of OppCo's shares. OppCo will invest the paid in capital for ***one
year***, with the expectation (hope) that it will be able to return shareholders $1.25 per
share after one year, when the firm will be closed down.
What is OppCo's cost of equity capital, rE? Round your answer to two decimal places. -
Answer-FV = PV*(1+r)^T
1.25 = 1.00*(1+rE)^1
rE = FV/PV-1
rE=1.25/1.00-1
rE=.25
Consider OppCo, described in the previous question.
Bankruptcy aside, are equity investors in OppCo guaranteed to earn rE? - Answer-
Equity (unlike bond and loan contracts) does not carry guarantees. It represents
ownership in an entity.
Stocks are not contracts
NI ex w Debt
For year 20X1, Zero Motorcycles earns $30MM of EBIT. If the firm's tax rate is 30% and
it pays 10% interest on $100MM of debt, what is its NI for 20X1? Assume the firm's
Taxable Income is equal to its EBT. - Answer-EBIT 30MM
10% int on 100MM
= 10MM interest
30-10
= 20 EBT
Tax Rate = 30%
20*.3 = 6
EBT 20
, -
Tax rate 6
NI = 14
Pre-tax rD
What is this company's pre-tax rD in year 2?
Balance sheet
yr 1 y2
Total Assets. 21,000. 24,200
Liab
AP 5250 5500
Total Debt 3150 4400
etc
Income statement
Rev 945 990
SGA 141.8 148.5
Interest 52.5 110.0
EBT 750.8 731.5
Etc
Pre-tax rD = Interest/(Total Debt, BOP) - Answer-Pre-tax rD = Interest/(Total Debt,
BOP)
110/3150 = .035
Trial and Error IRR
Zero Motorcycles takes out a $10MM loan, agreeing to pay 0.6MM interest at EOY 1
and at EOY 2, when it will repay the principal. The bank also charges Zero a fee of 5%
"points" for this loan, payable at EOY 0 (at loan signing). 5% "points" means 5% of the
principal amount of the loan. What is zero's pre-tax cost of debt capital (rD) for this
loan?
Hints: 1. rD is the IRR of the loan, with all the loan's cash flows, including the fee. 2.
Write the appropriate equation and try these values: 7.35%, 8.84%, and 10.21%. -
Answer-Takes out loan so positive initial CF
5% fee of principal
10*.05 = .5
NPV = summation CFi/(1+IRR)^Ti
