Question

3. The following information is for DEF, Inc. a national consumer products company:

Liabilities and Equity	Book values	Target Capital Structure
Notes Payable	$200	3%
Long-term Debt	1,000	15%
Preferred Stock	500	5%
Common equity	4,200	77%

Assume that you are an analyst preparing to calculate DEF’s WACC and that the company’s target capital structure values above are unknown to you. Further, assume that DEF’s cost of debt and cost of equity values are significantly different from each other. How will your estimate of WACC be affected by using weights calculated from the known book values rather than the unknown target capital structure in your calculations?

4. GHI is considering two investment proposals. Estimated cash flows are below. Each will require an initial cash outlay, followed by several years of positive cash flows. Each project will terminate and all assets will be liquidated in year 6. GHI’s WACC is 9%.

Year	Project 1	Project 2
Initial outlay	$1,000,000	$500,000
1	$160,000	$120,000
2	$200,000	$120,000
3	$300,000	$120,000
4	$400,000	$120,000
5	$350,000	$120,000
6 included salvage	$300,000	$150,000

1. Calculate NPV, IRR, MIRR, PI, and payback period for each project.
2. These projects are substitutes, so GHI will choose at most one of them. What is your recommendation? Should they go with Project 1, Project 2, or neither? Explain your reasoning.

Answer 1

3]

Book value weight of each source of capital = book value of source of capital / total book value

The book value weight of each source of capital is calculated below :

Book value weight of each source of capital = book value of source of capital / total book value

The book value weight of each source of capital is calculated below :

As it can be seen in the table above, the book value weights are not significantly different from the target weights. Therefore, the WACC calculated using the book value weights will not be significantly different from the WACC calculated using the  target weights.