Question

You have just calculated your firm's WACC. Your boss has asked you to do an NPV analysis of a potential new project, but you realise that the project is riskier than the firm's other projects. What should you do? Select one: a. Reject the project. b. Conduct the NPV analysis using the WACC as the discount rate. c. Conduct the NPV analysis using an appropriate discount rate, which will be higher than the firm's WACC. d. Conduct the NPV analysis using an appropriate discount rate, which will be lower than the firm's WACC.

Based on the Pure Expectations Theory, what would you expect to happen if long-term interest rates were greater than the geometric average of current and expected future short-term interest rates? Select one: a. Investors will sell long-term securities and buy short-term securities, pushing long-term rates up and short-term rates down. b. Investors will sell long-term securities and buy short-term securities, pushing long-term rates down and short-term rates up. c. Investors will buy long-term securities and sell short-term securities, pushing long-term rates down and short-term rates up. d. Investors will buy long-term securities and sell short-term securities, pushing long-term rates up and short-term rates down.

Firm ABC Ltd has debt valued at $16 million, ordinary shares valued at $30 million and preference shares valued at $6 million. The before-tax cost of debt is 2.9%, the cost of ordinary shares is 13.4% and the cost of preference shares is 6.6%. The tax rate is 25%. What is the firm's Weighted Average Cost of Capital? Select one: a. 7.04% b. 9.16% c. 9.38% d. 8.97%

Answer 1

Part 01:

In this question we can't reject the project outright just because it is risky. We need to calculate the NPV of the project. Since we know the WACC for the company and this project is riskier than the project which company generally takes. We will consider a discount rate higher than WACC. Thus the correct answer is

c. Conduct the NPV analysis using an appropriate discount rate, which will be higher than the firm's WACC.

Part 02:

According to pure expection theory the return that an investor makes by buying mutiple short term bonds is equal to the return he makes by buying one long term bond.

explaining with example, the investor makes same money weather he invests in two consecutive one year bond or a single two year bond.

In the question it says that long term interest rate are greater than geometric average of short term. This means that people will sell the short term bonds and buy the long term bonds. This will lead to return of long term bond coming down and returns of short term bonds going up. This will keep happening untill the short term and long term interest rates become equal.

Thus the correct answer is:

c. Investors will buy long-term securities and sell short-term securities, pushing long-term rates down and short-term rates up

Part C:

In this we do the WACC calculation. The formula and calculation is in the pictures below:

Thus based on above calculation correct answers is b 9.16%