Question 1

An investment banking firm has estimated the following after-tax cost of debt and cost of equity for Toronto's Finest Resorts. 
 $\begin{array}{ccc}
  \text {  Proportion of Debt} &  \text {  After-tax Cost of Debt }&  \text {  Cost of Equity }\
\hline  30 \%  & 6.8 \% &13.8 \% \
 40 \% &  7.7 \% &  14.1 \%  \
50 \%  &  8.9 \%  &  14.6 \%  \
\end{array}$

What is the cost of capital for Toronto's optimal capital structure given the above information?

Accepted Answer

The cost of capital is calculated using the weighted average cost of capital (WACC) formula: WACC = (E/V * Re) + ((D/V * Rd) * (1-T)), where E is the market value of the equity, D is the market value of the debt, V is the total value (E + D), Re is the cost of equity, Rd is the after-tax cost of debt, and T is the tax rate. However, since the tax rate and specific market values are not provided, we simplify the calculation by directly applying the proportions and costs given. The optimal structure is not explicitly stated, but we can calculate the WACC for each scenario and infer the optimal one is the one with the lowest WACC, as it minimizes the firm's cost of financing. Calculating for each given structure:- For 30% debt: WACC = (0.30 * 6.8%) + (0.70 * 13.8%) = 2.04% + 9.66% = 11.70%- For 40% debt: WACC = (0.40 * 7.7%) + (0.60 * 14.1%) = 3.08% + 8.46% = 11.54%- For 50% debt: WACC = (0.50 * 8.9%) + (0.50 * 14.6%) = 4.45% + 7.30% = 11.75%The lowest WACC is 11.54%, indicating the optimal capital structure is with 40% debt.

Question 2

Vancouver's Famous Barbeque has estimated the following cost of debt (before-tax) and cost of equity.

$\begin{array}{ccc}
  \text {  Proportion of Debt} &  \text {  After-tax Cost of Debt }&  \text {  Cost of Equity }\
\hline  30 \%  &7.0 \% &11.1\% \
 40 \% &  7.3 \% &  11.9\%  \
50 \%  &  8.4 \%  &  13.7\%  \
\end{array}$
 What is the cost of capital for Vancouver's optimal capital structure given the above information and a 40% effective tax rate?

Accepted Answer

The optimal cost of capital is calculated using the Weighted Average Cost of Capital (WACC) formula: $$WACC = (E/V) \times Re + (D/V) \times Rd \times (1 - Tc)$$ where E is the market value of the equity, D is the market value of the debt, V is the total market value of the firm (E + D), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. Without explicit proportions for debt and equity at the optimal capital structure, we use the given proportions and their respective costs. The optimal structure is not directly stated, but we can calculate the WACC for each given structure and infer the lowest as the optimal. For the 40% debt structure: $$WACC = 0.6 \times 11.9\% + 0.4 \times 7.3\% \times (1 - 0.4)$$ $$WACC = 0.6 \times 11.9\% + 0.4 \times 7.3\% \times 0.6$$ $$WACC = 7.14\% + 1.752\%$$ $$WACC = 8.892\%$$ Rounded to two decimal places, the WACC is 8.89%.

Question 3

An investment banking firm has estimated the following after-tax cost of debt and cost of equity for Red Deer Luxury Mountain Travel Tours.

$\begin{array}{ccc}
  \text {  Proportion of Debt} &  \text {  After-tax Cost of Debt }&  \text {  Cost of Equity }\
\hline  30 \%  &3.5 \% &10.5\% \
 40 \% & 3.8\% &  11.3\%  \
50 \%  & 5.0 \%  &  12.9\%  \
60\%&7.2\%&14.5\%
\end{array}$
 What is the cost of capital for Red Deer's optimal capital structure given the above information?

Accepted Answer

C

Question 4

The Edmonton Eskimos Football Club has estimated the following cost of debt (before-tax) and cost of equity for its food and beverage operations.

$\begin{array}{ccc}
  \text {  Proportion of Debt} &  \text {  After-tax Cost of Debt }&  \text {  Cost of Equity }\
\hline  30 \%  &9.5 \% &14.4\% \
 40 \% & 9.7\% &  15.2\%  \
50 \%  & 10.1 \%  &  16.2\%  \
60\%&11.8\%&18.5\%
\end{array}$
What is the cost of capital for the Edmonton Eskimos' optimal capital structure given the above information and a 40% effective tax rate?

Accepted Answer

The cost of capital is calculated using the weighted average cost of capital (WACC) formula. For the 50% debt proportion, the after-tax cost of debt is 10.1% * (1 - 0.4) = 6.06%. The WACC is then (0.5 * 6.06%) + (0.5 * 16.2%) = 11.13%.

Question 5

A project's net present value is a measure of a project's contribution to firm value.

Accepted Answer

Net Present Value (NPV) measures the difference between the present value of cash inflows and outflows over a period of time. A positive NPV indicates that the project is expected to add value to the firm, thus contributing to its overall value.

Question 6

What is the profitability index for an acceptable capital budgeting project?

Accepted Answer

The profitability index for an acceptable capital budgeting project is greater than 1.0, indicating that the present value of future cash flows is greater than the initial investment.

Question 7

A capital budgeting project has a net investment of $1,000,000 and is expected to generate net cash flows of $350,000 annually for 4 years. What is the internal rate of return?

Accepted Answer

The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. In this case, the IRR can be found using financial calculators or spreadsheet software by inputting the initial investment as a negative value (-$1,000,000) and the annual net cash flows of $350,000 for 4 years. The correct IRR for these cash flows is approximately 14.96%.

Question 8