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Chapter 4: Q7BP (page 364)

The Goodsmith Charitable Foundation, which is tax-exempt, issued debt last year at 9 percent to help finance a new playground facility in Los Angeles. This year the cost of debt is 25 percent higher; that is, firms that paid 11 percent for debt last year will be paying 13.75 percent this year.

a. If the Goodsmith Charitable Foundation borrowed money this year, what would the aftertax cost of debt be, based on their cost last year and the 25 percent increase?

b. If the receipts of the foundation were found to be taxable by the IRS (at a rate of 34 percent because of involvement in political activities), what would the aftertax cost of debt be?

Short Answer

Expert verified
  1. The after tax cost of debt is 11.25%
  2. The after tax cost of debt is 7.425%.

Step by step solution

01

Step 1:

Debt cost this year (9*1.25) (a)

11.25%

  1. Tax rate (b)

1

After tax cost of debt (a*b)

11.25%

02

Step 2:

Debt cost this year (9*1.25) (a)

11.25%

  1. Tax rate (b)

0.66

After tax cost of debt (a*b)

7.425%

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Most popular questions from this chapter

What are the three factors that influence the required rate of return by investors?

Hooper Chemical Company, a major chemical firm that uses such raw materials as carbon and petroleum as part of its production process, is examining a plastics firm to add to its operations. Before the acquisition, the normal expected outcomes for the firm were as follows:

Outcomes (\( millions) Probability

Recession .............................. \)20 0.30

Normal economy ................... 40 0.40

Strong economy .................... 60 0.30

After the acquisition, the expected outcomes for the firm would be:

Outcomes (\( millions) Probability

Recession .............................. \) 10 0.3

Normal economy ................... 40 0.4

Strong economy .................... 80 0.3

a. Compute the expected value, standard deviation, and coefficient of variation before the acquisition.

b. After the acquisition, these values are as follows:

Expected value .............................................. 43.0 (\( millions)

Standard deviation ........................................ 27.2 (\) millions)

Coefficient of variation ................................... 0.633

Comment on whether this acquisition appears desirable to you.

c. Do you think the firm鈥檚 stock price is likely to go up as a result of this acquisition?

d. If the firm were interested in reducing its risk exposure, which of the following three industries would you advise it to consider for an acquisition?

Briefly comment on your answer.

(1) Chemical company

(2) Oil company

(3) Computer company


Question:Ecology Labs Inc. will pay a dividend of \(6.40 per share in the next 12 months (D1). The required rate of return (Ke) is 14 percent and the constant growth rate is 5 percent.

a. Compute P0. (For parts b, c, and d in this problem, all variables remain the same except the one specifically changed. Each question is independent of the others.)

b. Assume Ke, the required rate of return, goes up to 18 percent. What will be the new value of P0?

c. Assume the growth rate (g) goes up to 9 percent. What will be the new value of P0? Ke goes back to its original value of 14 percent.

d. Assume D1 is \)7.00. What will be the new value of P0? Assume Ke is at its original value of 14 percent and g goes back to its original value of 5 percent.

Sheila Goodman recently received her MBA from the Harvard Business School. She has joined the family business, Goodman Software Products Inc., as vice president of finance.

She believes in adjusting projects for risk . Her father is somewhat skeptical but agrees to go along with her. Her approach is somewhat different than the risk-adjusted discount rate approach, but achieves the same objective.

She suggests that the inflows for each year of a project be adjusted downward for lack of certainty and then be discounted back at a risk-free rate. The theory is that the adjustment penalty makes the inflows the equivalent of riskless inflows, and therefore a risk-free rate is justified.

A table showing the possible coefficient of variation for an inflow and the associated adjustment factor is shown next:

Coefficient of Variation Adjustment Factor

0鈥�0.25 0.90

0.26鈥�0.50 0.80

0.51鈥�0.75 0.70

0.76鈥�1.00 0.60

1.01鈥�1.25 0.50

Assume a \(184,000 project provides the following inflows with the associated coefficients of variation for each year:

Year Inflow Coefficient of Variation

1 \)32,200 0.12

2 59,500 0.28

3 79,900 0.45

4 59,200 0.79

  1. 65,600 1.15

A Fill in the following table:

Year Inflow Coefficient of Variation Adjustment Factor Adjusted Inflow

1 \(32,200 0.12

2 59,500 0.28

3 79,900 0.45

4 59,200 0.79

5 65,600 1.15

b. If the risk-free rate is 5 percent, should this \)184,000 project be accepted? Compute the net present value of the adjusted inflows

Five investment alternatives have the following returns and standard deviations of returns:

Alternatives

Returns:

Expected Value

Standard Deviation

A ....................... \( 5,000 \)1,200

B ....................... 4,000 600

C ....................... 4,000 800

D ....................... 8,000 3,200

E ....................... 10,000 900

Using the coefficient of variation, rank the five alternatives from the lowest risk to the highest risk
See all solutions

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