CHAPTER 6: PROBLEMS

1. Ampex common stock has a beta of 1.4. If the risk-free rate is 8 percent, the expected market
return is 16 percent, and Ampex has $20 million of 8 percent debt with 10 years until
maturity. It has a yield to maturity of 12 percent and a marginal tax rate of 50 %. D/E for the
company is 2.0. What is the weighted average cost of capital for Ampex?
2. Calvin Inc. earned $2.00 per share during the past year and has just paid a dividend of $.40
per share. Investors forecast that Calvin will continue to retain 80 percent of its earnings for
the next 4 years and that earnings will grow at 25 percent per year through year 5. The
dividend payout ratio is expected to be raised in year 5 to 50 percent, reducing the dividend
growth rate to 8 percent thereafter. If Calvins equity is .9, the risk-free rate is 8.5 percent,
and the market risk premium is 8 percent, what should its price be today?
Answer: With an estimated 25% annual growth rate, Calvins forecast earnings for the next
5 years are $2.50, $3.13, $3.91, $4.88, $6.10. With a 20% dividend payout rate for the first 4
years and a 50% payout rate thereafter, this earnings stream yields dividends of $0.50, $0.63,
$0.78, $0.98, $3.05. Note that the last term in the series is just $6.10 * 0.50. In year 6, the
forecast dividend is $6.10 * 1.08 * 0.50 = $3.29. This dividend is projected to grow at the
rate of 8% annually.
It is important in answering this question to consider the fact that the dividend payout rate
changed in year 5 to 50%, from 20%. Hence, just taking the initial 40 dividend and
multiplying it by (1.25)5 will not give you the correct answer.
To determine Calvins price today based on these expectations, we must next estimate
Calvins cost of equity capital. Using the CAPM, this figure is
ke = rf + e(rm - rf) = 8.5% + 0.9 * 8% = 15.7%
The present value at 15.7% of the first 5 dividend payments is $3.42. The present value as of the
end of year 5 of the dividend flows from year 6 on can be found using the dividend growth
model, Po = DIV1/(ke - g). Substituting in the numbers previously calculated, we get
Po = DIV1/(ke - g) = $3.29/(0.157 - 0.08) = $42.73
The present value of this number of today is $42.73/(1.157)5 = $20.61. Adding the value of the
two cash flows gives a price for Calvins stock today of $24.03.
Remember that you must discount the price as of the beginning of year 6 by (1.157)5 instead of
(1.157)6. The former is correct because you are discounting it back 5 years, not 6 years.
6. Westcon is considering building a facility to tap thermal energy using wind power. Part of the
projects cost, $750,000, can be financed with a loan from the Federal Energy Commission at
the below-market rate of 5 percent. The remainder, $250,000, can be financed with an
industrial revenue bond at 10 percent. No debt is being displaced. Current debt rates for
Westcon are 15 percent. The project should generate before tax cash flows of $1,500,000 per
year for ten years. Westcon has a 40 percent tax rate, and the D/E ratio is .50. Westcon
estimates that the project beta is 1.50 and forecasts a risk-free rate of 10 percent for the life of
the project. The return on the market is estimated to be 20 percent.

a. Should Westcon undertake the project?

b. Assuming the project is of the same risk as Westcon itself, would the project be
acceptable without the subsidies? Explain.
Answer: This is a very difficult problem. Two sets of answers appear below. The first
answer takes a simple approach to problem solution when annual cash flows are $1.5M and
the tax rate is 40%. The first answer assumes that no debt is displaced.
The second answer analyzes the problem when cash flows are $300,000 per year, and the
tax rate is 50%. The second solution assumes that debt is displaced, and demonstrates the
equivalence of the WACC and the APV approach in decision-making.

Version 1
We assume there is no investment tax credit and no depreciation. In the absence of
favorable financing terms, cash flows include an initial outlay of $1M, and annual after-tax
cashflows of $1.5M(1 0.40) = $0.9M. Since the project beta is 1.5, the required rate of
return is rp = rf + p(rm rf) = 10 + 1.5(10) = 25%. The present value of these cash flows is
$3.213M 1M = $2.213M.
a. We now add debt to the analysis. We assume debt is risk-free. From equation 9.11, we
need to find the adjusted net present value (APV), which takes into account the present
value of tax shields and favorable financing terms. Note that since the 15% debt rate
applies to the company as a whole, we cannot use it in this project analysis.
Assume that both loans (250K and 750K) will make annual interest payments and
repay principal following the ten year project life. Tax savings in each year will then
be: 250,000(0.10)(0.40) + 750,000(0.05)(0.40) = $25,000.
The present value of the tax savings (assuming these savings are risk-free) is
$25,000[PVIFA(r=10%,10 yrs)] = $153,614.18 = $0.154M.
The FEC loan subsidy amounts to a subsidy of (0.10 0.05)(750,000) = $37,500 per
year for 10 years. If this is risk-free, the present value is $230,421.27 = $0.230M.

APV = $2.213M + 0.154M + 0.230M = $2.597M.

Westcon should undertake the project (APV>0).
b. If the project were the same risk as Westcon itself, it should likely be accepted. The exact
weighted average cost of capital of Westcon cannot be determined from the given
information. However, as long as WACC<89.85%, the project should be accepted.

Version 2
Assume that annual operating cash flows are $300,000, and the marginal tax rate is 50%.
Ignore depreciation. These changes are reflected in some printings and not in others.
There are two basic approaches that you can take to solve this problem and they both give
similar answers. One approach is to use the adjusted present value (APV) and value the
project on an all-equity basis and then separately value the tax advantages of debt and the

interest subsidy. The other approach is to use a weighted average cost of capital (WACC)
ignoring the subsidized financing but taking into account the tax deductibility of debt and
then separately value the interest subsidy.

APV Approach
APV = NPV of project if all-equity financed
NPV of financing side-effects caused by project acceptance
APV = I0 + S CFi/(1 + k*)i + S Ti/(1 + r)i + S Si/(1 + r)i
where k* = the all-equity cost of capital
CFi = the after-tax operating cash flow
Ti = tax savings in period i resulting from the specific financing package
Si = before-tax dollar value of interest subsidies in period i resulting from project-specific
financing
r = before-tax cost of unsubsidized debt
The latter two terms in the equation above are discounted at the before-tax cost of debt to
reflect the relatively certain value of the cash flows resulting from interest tax shields and
interest savings.
To apply the APV, we first have to calculate the all-equity cost of capital. This figure is k* =
rf + a(rm rf), where a is the asset beta for the project. Substituting in the numbers given
in the problem yields k* = 25%.
The after-tax operating cash flows (we are ignoring depreciation in this problem) are
$300,000 (1 0.50) = $150,000.
The debt capacity of the new project is $333,333, given Westcons target debt:equity ratio
of 0.50. However, Westcon is adding $1 million in debt. This means that the new debt is
displacing $666,667 in 15% debt elsewhere in Westcons capital structure.
The tax savings on the added debt equal the value of the interest write-off in the $1 million
in new debt minus the lost tax shield on the $666,667 in 15% debt that is displaced by the
new debt. That is, the interest tax shield is worth 0.5[750,000 0.05 + 250,000 0.10 0.15
666,667] = $18,750. The negative figure means that the tax shield on the displaced debt
exceeds the tax shield on the low interest debt. This should not be surprising: consider
what the tax shield would be on debt that carried a zero interest rate. Clearly, the benefits
of the interest subsidy dont show up in the form of a tax write-off; but they do show up in
the interest subsidy figure.
The before-tax value of the interest subsidy is 750,000(0.15 0.05) + 250,000(0.15 0.10) =
$87,500. Hence, the total value of the specific financing package, taking into account both
the tax benefits of debt and the interest subsidy that Westcon receives, is $87,500 $18,750
= $68,750.
Now we can calculate the APV:
APV = $1,000,000 + S 150,000/(1.25)i + S 68,750/(1.15)i

= $1,000,000 + 535,575 + 345,040 = $119,385.

The project is not acceptable, even with the financing subsidy.
WACC Approach
In this approach, we first value the project ignoring the financing subsidy. To do this, we
must calculate the WACC ignoring the interest subsidy, which we use to discount the aftertax operating cash flows of $150,000 annually. Then, we estimate the value of the interest
subsidy and subtract this figure from the project NPV.
To calculate the WACC, we must estimate the levered cost of equity capital, which requires
that we calculate the levered equity beta. We can calculate the levered equity beta using
the formula
e = a[1 + (1 t)D/E]
Assuming that the projects debt capacity is the same as Westcons debt capacity, because
the risks are assumed to be the same, we can substitute in the figures given in the problem
and get
e = 1.5[1 + 0.50 0.50] = 1.875.
The resulting cost of equity capital, given a debt:equity ratio of 0.50 is 28.75% (10% +
1.875 10%).
The WACC, ignoring the interest subsidy (which we will calculate separately) is
2/3 28.75% + 1/3 15.00% 0.50 = 21.67%
The project NPV, discounted at the 21.67% WACC, equals
NPV = $1,000,000 + S 150,000/(1.2167)i = $405,163.
The NPV of the interest subsidy can be calculated using the following reasoning. Westcon
must pay $62,500 in interest annually for the next ten years and then repay $1 million
principal at the end of ten years. In return, Westcon receives $1,000,000 today. Given
these cash inflows and outflows, we can calculate the loans NPV just as we would for any
project analysis. Note, however, that unlike the typical capital budgeting problem we
examined, the cash inflow occurs immediately, and the cash outflows later. The principle is
the same, however. We now need to know the required return on this project and
Westcons marginal tax rate.
The required return is based on the opportunity cost of the funds provided: the 15% rate
that Westcon would have to pay to borrow $1M in the capital market. We are told that
Westcons marginal tax rate is 50%. The after-tax required return will be 7.5% and the
after-tax interest payments will be $37,500. Now we can calculate the NPV of Westcons
financing bargain:
NPV = $1,000,000 S $37,500/(1.075)i $1,000,000/(1.075)10
= $1,000,000 699,696 = $300,304.
Alternatively, you could just calculate the present value of the ten-year annuity consisting
of the annual after-tax interest savings of 0.50 $87,500 = $43,750. This annuity,

discounted at the 7.5% after-tax cost of debt financing, equals $300,304.

Adding together the project NPV with the financing NPV yields a total project value of
$405,163 + $300,304 = $104,859. The WACC approach gives the same answer as the
APV approach: the project is not acceptable.
Although in theory the two approaches should yield identical quantitative results, they
dont in practice. The difference stems from the slightly different effects of adjusting the
numerator in one case for taxes and the denominator in the other case.