03 Apr Cost of Capital Models
11601Please read the instructions carefully and review the attached rubric. Please ensure all points on the rubric are discussed in the paper. Our book is Fundamentals of Corporate Finance 5th edition (but 4th works fine as well) by Parrino, Bates, Gillan, and Kidwell. Publisher is Wiley. Please use that book if possible.
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The concept of after-tax weighted average cost of capital (WACC) is a foundation when assessing cost of capital and investment options. The assessment will present the opportunity to assess a financing transaction and build upon your understanding of this cost of capital concept and demonstrate your ability to calculate the after-tax WACC.
Read the scenario and address the checklist items below.
Scenario: You are an angel investor who has been approached by an entrepreneur to assess an investment opportunity.
An entrepreneur asks for $100,000 to purchase a diagnostic machine for a healthcare facility. The entrepreneur hopes to maintain as much equity in the company as possible, yet the angel investor began negotiations saying he wanted the transaction to be financed with 50% debt and 50% equity. As the angel investor, you assign a cost of equity of 14% and a cost of debt at 10% . Based on Year 1 sales projections, the entrepreneur assures you a return on investment (ROI) of 9%; conceptually this will cover the first year’s pretax cost of debt and allow for planned equity growth and a refinancing model for Year 2. You will use an after tax weighted average cost of capital (AT- WACC) model which includes the after-tax cost of debt and proportionate costs of debt versus equity. A 32% marginal tax rate is applied.
Address the following checklist items:
Explain the tax benefits of debt financing.
Calculate the AT-WACC with a 50% debt and 50% equity financing structure.
Apply the calculated AT-WACC to explain why this is or is not a viable investment for you as the angel investor.
Explain a financial restructuring AT-WACC (given changes to proportions of % debt versus % equity financing) that would create a positive ROI.
Explain why you as the angel investor would require more or less debt versus equity financing. Be sure to note the role of the Unified Commercial Code-1 (UCC-1) document in this transaction and the order of claim on assets in times of a bankruptcy.
Include a strong thesis statement, introduction, and conclusion. The main points of the response should be developed and explained clearly with appropriate financial and accounting terminology.
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