CORPORATE FINANCIAL MANAGEMENT, Fourth Edition

Solutions Manual, Chapter 8

Chapter 8
Questions
1.

The financing decision refers to how a firm will pay for its assets, with debt or equity. The investment decision is which
assets a firm chooses to invest in. The other side of the financing decision consists of equity holders and debtholders.
The other side of the investing decision is made up of the entities that have sold assets to the firm.

2.

If the IRR of a project exactly equals the cost of capital, the NPV will be zero.

3.

Present value depends on the amount of the future cash flows and the cost of capital.

4.

Operating leverage is the mix of fixed and variable costs required to produce a product or service. Financial leverage is
the mix of debt and equity used in financing an asset.

5.

A firm may be able to raise the expected future cash flows of a project by switching to a heavily automated process with
a higher operating leverage than the current process. The new process would be more risky and the present value of the
cash flows could be exactly the same given the raise in the cost of capital.

6.

The firm is selecting projects that have an IRR greater than the single discount rate. The projects with higher IRRs are
riskier projects. If the firm is only selecting these projects, it will become riskier over time.

7.

Operating risk is the risk associated with a firms choice between fixed and variable production costs. It is different from
financial risk in that it is unique for each of the firms investments and affects both the diversifiable and nondiversifiable
risk of the firm. It therefore affects a projects beta and its cost of capital. Sometimes a firm has little choice in choosing
its operating leverage, thus making operating risk very difficult to manage.

8.

In order to compute the NPV of a project, it is first necessary to compute the required return for the project. The required
return can be found by looking at firms with operations similar to the project. The stock betas of these firms should be
adjusted to asset betas and averaged. The required return can then be found using the average asset beta and the project
market line. Finally, the NPV is calculated by discounting the projects future cash flows by the required return.

Challenging Questions
9.

Even though the expected return is less than the weighted average cost of capital, the project does not have a negative
NPV. In fact, this purely financial investment would have a zero NPV because of the principle of capital market
efficiency. The problem is that the projects cost of capital must be adjusted for the risk of the project. It should not be
based on the weighted average cost of capital of the entire firm unless the projects risk is similar to the risk of the firm
as a whole. In this case, the WACC is irrelevant.

10. The firm should go ahead with the investment. The firms current cost of capital (based on a beta of 1.85) is not relevant
because the new investment is not like the firms current operations. The cost of capital to be used when evaluating the
investment is 15% because the investment has the same risk as the market, r = r f + (rm -rf) = 10% + 1.0(15% - 10%) =
15%. Since the IRR is 20%, the project has a positive NPV.
11. A corporate raider could take advantage of the situation by buying all the debt and equity of the firm for $8.5 million and
selling the assets to other firms for $10 million. The transaction would result in a $1.5 million profit. Another set of
transactions that could result in a profit to the shareholders would be for the firm to sell its assets and use the proceeds to
pay down its debt and a liquidating dividend to the shareholders.

Copyright 2011 by Wohl Publishing, Inc. All rights reserved.

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CORPORATE FINANCIAL MANAGEMENT, Fourth Edition

Solutions Manual, Chapter 8

12. The chairman is WRONG! The cost of debt is always lower than the cost of equitybecause of the risk return tradeoff,
debt is bearing less risk than equity, so it has a lower required return. In fact, the firms cost of capital will not change
whether the firm issues equity or the cheaper debt. The reason is that the cost of capital is determined primarily by the
risk of the investmentnot the mix of financing. Besides, a change in financial risk will occur when the firm issues new
securities in a different proportion from the current financing mix. If the firm issues a large level of debt, the debtholders
will require a higher yield to offset the increase in risk as will the equityholders too, and the firms weighted average cost
of capital will remain unchanged.

Problem Set A
A1.

a. r = rf + (rm - rf)
rA = 9% + 1.00(15% - 9)% = 15.00%
N=12 r=15 PV=? PMT=310 FV=0 PV=-1680.3919
NPVA = -$1,500 + $1,680.3919 = $180.3919
rB = 9% + 2.25(15% - 9)% = 22.50%
N=8 r=22.5 PV=? PMT=310 FV=0 PV=-1783.9956
NPVB = -$1,500 + $1,783.9956 = $283.9956
rC= 9% + 2.22(15% - 9)% = 22.32%
N=7 r=22.32 PV=? PMT=435 FV=0 PV=-1473.2471
NPVC = -$1,500 + $1,473.2471 = -$26.7529
rD = 9% + 0.65(15% - 9)% = 12.90%
N=11 r=12.9 PV=? PMT=270 FV=0 PV=-1542.0371
NPVD = -$1,500 + $1,542.0371 = $42.0371
rE = 9% + 1.37(15% - 9)% = 17.22%
N=10 r=17.22 PV=? PMT=385 FV=0 PV=-1779.3043
NPVE = -$1,500 + $1,779.3043 = $279.3043
rF = 9% + 2.36(15% - 9)% = 23.16%
N=9 r=23.16 PV=? PMT=405 FV=0 PV=-1480.4858
NPVF = -$1,500 + $1,480.4858 = -$19.5142
b. Projects A, B, D, and E should be undertaken.

A2.

WACC = (1 - L)re + L(1 - T)rd

WACC = (1 - 0.35) x 14% + 0.35(1 - 0.40) x 8% = 10.78%

A3.

WACC = (1 - L)re + L(1 - T)rd

WACC = (1 - 0.45) x 18% + 0.45(1 - 0.40) x 6% = 11.52%

A4.

L = D / (D + E) = 30% / (30% + 70%) = 0.30

WACC = (1 - L)re + L(1 - T)rd
WACC = (1 - 0.30) x 14% + 0.30(1 - 0.40) x 8% = 11.24%

A5.

L = D / (D + E) = $100 / ($100 + $200) = 0.3333

WACC = (1 - L)re + L(1 - T)rd
WACC = (1 - 0.3333) x 13% + 0.3333(1 - 0.38) x 7.5% = 10.217%

A6.

D = 1,000 x $1,200 = $1,200,000

E = 250,000 x $68 = $17,000,000
Proportion D = L = D / (D + E) = $1,200,000 / ($1,200,000 + $17,000,000) = 0.0659
Proportion E = 1- L = 1 - 0.0659 = 0.9341

A7.

a. A = 0.20 x 1.00 + 0.10 x 2.25 + 0.12 x 2.22 + 0.10 x 0.65 + 0.34 x 1.37 + 0.14 x 2.36 = 1.55
b. = A / (1 - L) = 1.55 / (1 - 0.20) = 1.94

A8.

A = (1 - L) = (1 - 0.43) x 1.32 = 0.75

A9.

Firm Value = $1,000 + $300 + $1,700 = $3,000

Proportion D = $1,000 / $3,000 = 0.3333
Proportion P = $300 / $3,000 = 0.1000
Proportion E = $1,700 / $3,000 = 0.5667
WACC = 0.3333(1 - .30) x 8% + 0.1000 x 9% + 0.5667 x 14% = 10.70%

Copyright 2011 by Wohl Publishing, Inc. All rights reserved.

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CORPORATE FINANCIAL MANAGEMENT, Fourth Edition

Solutions Manual, Chapter 8

Problem Set B
B1.

L = D / (D + E) = $50 / ($50 + $50) = 0.50

WACC = (1 - L)re + L(1 - T)rd
15% = (1 - 0.50) re + 0.50(1 - .40) x 9%
12.3% = 0.50 x re
re = 24.60%

B2.

WACC = (1 - L)re + L(1 - T)rd

10% = (1 - 0.50) re + 0.50 x 5%
7.5% = 0.50 x re
re = 15.0%

B3.

Firm Value = $35 + $15 + $50 = $100

WACC = $35 / $100 x 12% + $15 / $100 x 17% + $50 / $100 x 15% = 14.25%

B4.

WACC = (1 - L)re + L(1 - T)rd

14% = (1 - L)16% + L x 6%
-2% = -10% x L ; so L = 20%
Proportion D = L = 20%
Proportion E = 1 - L = 1 - 0.20 = 80%

B5.

WACC = (1 - L)re + L(1 - T)rd

10% = (1 - L)15% + L(1 - 0.40) x 7.5%
-5% = -10.5% x L ; so L = 47.62%
Proportion D = L = 47.62%
Proportion E = 1 - L = 1 - 0.4762 = 52.38%

B6.

r = rf + (rm - rf)
P0 = D1 / (r - g) = D0(1 + g) / (r - g)
rA = 9% + 1.3(14% - 9%) = 15.5%
PA = $1.20(1 + 0.05) / (0.155 - 0.05) = $12.00
Since the current market price is $15, do not invest.
rB = 9% + 0.9(14% - 9%) = 13.5%
PB = $1.30(1 + 0.10) / (0.135 - 0.10) = $40.86
Since the current market price is $28, invest.
rC = 9% + 1.1(14% - 9%) = 14.5%
PC = $2.40(1 + 0.08) / (0.145 - 0.08) = $39.88
Since the current market price is $31, invest.

B7.

E = 10,000,000 x $23.63 = $236,300,000

D = 100,000 x $835.00 = $83,500,000
L = D / (D + E) = $83,500,000 / ($83,500,000 + $236,300,000) = 0.2611
re = D1 / P0 + g = $1.92 / $23.62 + 0.08 = 16.13%
CALC: n = 42 PV = -835 PMT = 8.5% x $1,000/2 = 42.5 FV = 1,000 r = 5.23%
5.23% semi-annually is 10.73% APY so rd = 10.73%
WACC = (1 - L)re + L(1 - T)rd
WACC = (1 - 0.2611)16.13% + 0.2611(1 - 0.34)10.73% = 13.77%

B8.

Total Dollar Return = 11% x $50,000 + 18% x $50,000 = $14,500

r = $14,500 / $100,000 = 14.5%
or: r = 11% x [$50,000 / ($50,000 + $50,000)] + 18% x [$50,000 / ($50,000 + $50,000)] = 14.5%

B9.

Dollar Profit = 18% x $25,000 = $4,500

Interest Expense = 10% x $10,000 = $1,000
Net Profit = 4,500 1,000 = $3,500
r = $3,500 / $15,000 = 23.33%

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CORPORATE FINANCIAL MANAGEMENT, Fourth Edition

Solutions Manual, Chapter 8

B10. a. CALC: n = 20 PV = -$1,050 PMT = (10% x $1,000)/2 = $50 FV = $1,000 r = 4.6119%

YTM = 2 x r = 9.2238;
After-tax rd = (1 - 0.40)9.22238% = 5.53%
b. re = rf + (rM - rf) = 6% + 1.30(14% - 6%) = 16.40%
c. L = D / (D + E) = 10,000 x $1,050 / (10,000 x $1,050 + 400,000 x $40) = 0.3962
WACC = (1 - L)re + L(1 - T)rd = (1 - 0.3962)16.40% + 0.3962(1 - 0.40)9.21% = 12.09%
B11. Total Dollar Return = 20% x $4,000 + 12% x $6,000 = $1,520; r = $1,520/$10,000 = 15.2%
B12. Dollar Profit = 15% x $70,000 = $10,500
Interest Expense = 9% x $45,000 = $4,050
Net Profit = 10,500 4050 = $6,450; r = $6,450/$25,000 = 25.80%
B13. Note: The wording in the text says the bonds have a 9% annual coupon, meaning that the semi-annual payments total
9% per year. If this were interpreted to instead mean a single 9% payment per year, the bond yield would instead be
7.5404%, and after-tax be 4.5243%. This does not change the WACC, if it is rounded to 2 decimal places.
a. CALC: n = 20 PV = -$1,100 PMT = (9% x $1,000)/2 = $45 FV = $1,000 r = 3.7785%
YTM = 3.7785 x 2 = 7.56%;
After-tax rd = (1 - 0.40)7.56% = 4.53%
b. re = rf + (rM - rf) = 6% + 1.20(14% - 6%) = 15.60%
c. L = D / (D + E) = 100,000 x $1,100 / (100,000 x $1,100 + 5,000,000 x $50) = 0.3056
WACC = (1 - L)re + L(1 - T)rd = (1 - 0.3056)15.60% + 0.3056(1 - 0.40)7.56% = 12.22%
B14. A = Corr(A,M)A / M
A = 0.80 x (0.25 / 0.40) = 0.50
rA = rf + A(rM - rf)
rA = 9% + 0.5(14% - 9%)
rA = 11.50%
NPVA = -$100,000 + $114,000 / (1 + 0.115)1 = $2,242.15
B = Corr(B,M)B / M
B = 0.32 x (0.25 / 0.40) = 0.20
rB = rf + B(rM - rf)
rB = 9% + 0.20(14% - 9%)
rB = 10.0%
NPVB = -$50,000 + $56,000 / (1 + 0.10)1 = $909.09
B15.
re
(1 - T)rd
WACC

Required Returns
0.25

Return

0.20
0.15
0.10
0.05
0.00
0.05

0.20

0.40

0.60

0.80

0.95

L
Project A should be selected because it has a larger positive NPV.
Copyright 2011 by Wohl Publishing, Inc. All rights reserved.

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CORPORATE FINANCIAL MANAGEMENT, Fourth Edition

Solutions Manual, Chapter 8

Problem Set C
C1. a. The investment is in oil and gas, not chemicals, and only four of the companies are useful comparisons. Therefore, we
use the average of the unleveraged betas for the four oil companies as an estimate of the project beta. Approximating
all of the debt betas to be zero, we apply each firms L to compute the unleveraged beta using equation (11.6):
A = (1 - L) / (1 - TL)
Franklin Oil A = (1 - 0.50)1.40 / (1 - 0.34 x 0.50) = 0.84
Oscar Oil A = (1 - 0.50)1.45 / (1 - 0.34 x 0.50) = 0.87
VMB Oil & Gas A = (1 - 0.45)1.30 / (1 - 0.34 x 0.45) = 0.84
Peters Oil & Gas A = (1 - 0.60)1.55 / (1 - 0.34 x 0.60) = 0.78
Average A = ( 0.84 + 0.87 + 0.84 + 0.78) / 4 = 0.835
b. re = rf + (rM - rf)
re = 10% + 0.835(6%) = 15.01% is the unleveraged required return to equity.
c. To find the required return on leveraged equity, we need to find the leveraged beta by rearranging equation (11.6): =
A (1 - TL) / (1 L) = 1.40
So the leveraged required return to equity is re = 10% + 1.4(6%) = 18.4%
Finally WACC = (1 - L)re + L(1 - T)rd
WACC = (1 - 0.50)18.4% + 0.50(1 - 0.34)15.15% = 14.2%
C2. a. A = (1 - L) / (1 - TL) = (1 - 0.40) 1.40 / (1 - 0.34 x 0.40) = 0.97
b. L = D / (D + L) = $25 / ($25 + $50) = 0.3333
Estimating the debt beta to be zero, = (1- TL) A / (1 - L) = (1 - 0.34 x 0.3333) 0.97 / (1 - 0.3333) = 1.29
c. WACC = rf + A(rM - rf) = 6% + 0.97(14% - 6%) = 13.76
re = rf + (rM - rf) = 6% + 1.29(14% - 6%) = 16.32%
C3. Rearranging Equation (8.5), we have A = [L(1-T)d + (1 - L) ] / (1 - TL)
A = [0.65 x 0.60 x 0.39 + (1 - 0.65) 2.8] / (1 - 0.40 x 0.65) = 1.53
C4.
L
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%

Bd
0.00
0.00
0.00
0.02
0.05
0.10
0.20
0.35
0.55
0.80
1.20

Be
1.20
1.33
1.50
1.71
1.97
2.30
2.70
3.18
3.80
4.80
N/A

rd
4.50%
4.50%
4.50%
4.58%
4.70%
4.90%
5.30%
5.90%
6.70%
7.70%
9.30%

re
9.30%
9.83%
10.50%
11.32%
12.37%
13.70%
15.30%
17.23%
19.70%
23.70%
N/A

ra
9.30%
9.30%
9.30%
9.30%
9.30%
9.30%
9.30%
9.30%
9.30%
9.30%
9.30%

Ignoring taxes, A = Ld + (1 - L) = 100% x 1.20 + (1 - 1) = 1.20.

= (A - Ld) / (1 - L) = (1.20 - Ld) / (1 - L)
r = rf + (rM - rf)

Copyright 2011 by Wohl Publishing, Inc. All rights reserved.

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