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1
1.Assume we are in an otherwise perfect, frictionless world with corporate taxes. Firm X has a debt-to-equity ratio of 2.25, its cost of equity is 12%, and its cost of debt is 6%. The corporate tax rate is 35%. If the firm converts to a debt-to-equity ratio of 1.25, what will its new WACC be?
2.
"Mr. Stone, I must say you are making a mistake. I know you have spent $6,000 on research and development to develop this project, but that money must not be used as a negative cash flow of the project." Apparently, Mr. Stone does not understand the concept of: Select one: a. sunk costs. O b. variable costs. opportunity costs. O d. depreciation not taken. side-effect costs.
Expert Solution
1.
Calculating the weight of debt capital and weight of equity capital.
Weight of debt Capital= debt/(debt+Equity)
= 1.25/(1+1.25)=55.55
Weight of equity capital=Equity/(debt+Equity)
=1/(1+1.25)=44.45
WACC=[weight of equity capital x cost of equity capital]+(weight of debt X cost of debt) (1-tax)
=(44.45%*12)+(55.55%*6)(1-.35)
=(5.333+2.16666)
=7.50%
New weighted average cost of capital will be 7.50%.
2.
Answer is a. Sunk Costs.
Sunk cost is a Cost which do not have Time Value of Money.
These are the costs which are already incurred and so it will not affect the decision.
Therefore, in the given problem Research and Development costs are the costs which are already incurred.
So it is a Sunk Costs.
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