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Group 7:

Members: Xu Jiang Jiali Tang


Jie Zeng Xiaohang Gao
Chaofan Lin Yan Ma

Where Do We Draw The Line


Questions:

1.Why do you think Paul prefers to use the WACC when analyzing product
acquisitions rather than some baseline rate or the rate on the cheapest
capital component?

The reason why Paul prefers to use the WACC rather than some baseline rate or
the rate on the cheapest capital component is that the WACC of a company can
change as the capital structure changes. For example, if this company issues a
large amount of bonds which has a rate of return of 20%, then the WACC will go
up to a level which is more than 15%. At this time a baseline rate of 13% is used
in analyzing products acquisitions will surely make the company lose money.

2.How should Ron go about figuring out the cost of debt? Calculate the
firm’s cost of debt.

Taking the flotation rate into consideration,


N
INT (1- t) M
M (1- F) = å t
+
t=1 [1+ rd (1- t)] [1+ rd (1- t)]N
With a financial calculator, N=38, PV=-925*(1-5%)=-878.75,

PMT=60*(1-38%)=37.2, FV=1000. We find I/Y=4.38%, so rd (1- t) = 8.76%

3.Why is there a cost associated with a firm’s retained earnings?

Net income can either be retained earnings or dividends. The reason why
retained earnings are retained is that this amount of money can gain a better
return than that it is divided and invested by shareholders. The investors
(shareholders) of the company request a rate of return on the investments. That is
the cost associated with a firm’s retained earnings.

4.How can Ron estimate the firm’s cost of retained earnings? Should it be
adjusted for taxes? Please explain.
The cost of retained earnings should be the same as the cost of new issued
common stock if the flotation cost for new stock is not considered. It can be
calculated as follow,
R e = R RF + (RPM )bi
rs = 4%+1.45* 9% =17.05%

5.What are two alternative ways by which flotation costs can be included
in the analysis?

Flotation costs can be included in the analysis in two ways, flotation cost of
debt and equity, which means the company will receive less money from issuing
bonds or stocks with flotation cost.Flotation cost can be stated by two ways,
percentage of market price or actual amount of money( in dollars). In this case, it
is stated by the way of percentage of market price.

6.What is NuChem’s cost of new common stock?

ROE=Net Income/Equity=22.11%
Retention ratio=1-Payout ratio=52%
g=ROE*(Retention ratio)=11.5%
D(1)=1.73*g=1.93
D1
re = +g
P(1- F)
With different flotation costs, the costs of new common stock are as follows:
F Rc
0-50M 10% 23.40%
50M-200M 15% 24.10%
>200M 20% 24.89%

7.Develop an investment opportunity schedule (IOS) for Nuchem.

For ProjectA, IRRa=14.99%


For ProjectB, IRRb=19.45%
For ProjectC, IRRc=17.36%
For ProjectD, IRRd=20.86%
To develop IOS, rank the 4 projects from the highest IRR to the lowest one, and
then put them on a graph with IRR on the y-axis and cumulative capital on the
x-axis.
IOS (‘000s)
PROJECT COST('000) Cumulative cost Highest to Lowest IRR
D 119000 119000 20.86%
B 14000 133000 19.45%
C 150000 283000 17.36%
A 17000 300000 14.99%

8.How many break points will the firm’s marginal cost of capital schedule
(MCC schedule) have? Why?

MCC schedule has two break points, because there are three flotation of equity.
Point1=50,000,000/We=50,000/41.86%=119,458,170
Point2=200,000,000/We=200,000 /41.86%=477,832,700

9.Develop the firm’s MCC schedule. Note: For the cost of new equity, use
the average cost of retained earning duly adjusted for flotation costs.

To develop the MCC schedule, calculate the WACC that corresponds to the
different amounts of capital raised. Put them on a graph with MCC on the y-axis
and cumulative capital on the x-axis.

MCC (‘000s)
Cumulative cost Lowest to highest WACC
119000 17.22%
133000 17.51%
283000 17.51%
300000 17.51%

10.Based upon your results, where should Ron draw the line when it comes
to deciding between the 4 product acquisitions? Why?

Put ICC and IOS lines in the same graph and we find obviously that the IRRs of
project D and B are above the MCC, while the IRRs of Project C and A are
below the MCC. Besides, the sum of the investments of two accepted project is
133,000, which is smaller than the maximum capital investment 275,000. So, the
line is that we accept Project D and B.