# What are the weights of equity and debt in the capital structure?

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What are the weights of equity and debt in the capital structure?

Year Tortuga return S&P 500 return

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1 12 7

2 22 16

3 -2 -3

4 14 9

5 9 8

6 19 21

7 16 17

8 -10 -5

9 7 9

10 12 14

After Brooks calculates beta he employs formula (1) above along with the risk-free rate and market risk premium to determine the cost of equity. The firm’s weighted average cost of capital is a function of its equity market capitalization, cost of equity, short- and long-term debt amounts and costs, and the tax rate. Using formula (2) below, Brooks can find the firm’s weighted average cost of capital (WACC). WACC = walked(1-T) + weeke where: WACC = weighted average cost of capital wd = weight of debt to total capital (note: this includes short- and long-term) kd = cost of debt using yield to maturity and current values for short-term T = corporate tax rate we = weight of market capitalization to total capital ke = cost of equity determined with CAPM Tortuga Tarpon Classic The company has two separate research teams working on the project and they develop two distinctly different fishing combinations. The two rod and reel combinations are test marketed with guides and past tournament champions and demand forecasts are determined. Most fishing gear has a relatively short life due to continual product innovation. Manufacturing of the two combinations is estimated to require an upfront cost of \$5 million to retool the machine shop. The process for manufacturing the two combinations differ and ongoing variable costs are not the same. The net cash flows for the entire ten year expected life of the product is shown in Table 2 as Project A and Project B (all figures are \$thousands of net cash flow). Project A focuses on hand tooled fishing equipment which results in a more labor-intensive process, but also allows for personalized features for customers. The price charged for customization offset the slower hand tooling process to generate substantial net cash flows. Part of the upfront \$5 million includes the costs of training more machinists in the art of hand tooling, which is similar to watchmaking but with a few less moving parts. Project A is anticipated to generate lower cash flows in the early years due to the length of time required to get machinists who are adept at hand tooling to customer specifications. In fact, during the first year there will be continued expenses to attain these skills which causes year one net cash flows to be negative. Over time the cash flows increase as more machinists gain proficiency. The project is expected to experience lower cash flows towards the end of its life due to market saturation. Due to the quality of the reels, they are built to last and seldom fail or wear out. Technological obsolescence is certain although Tortuga will be investing cash flows into research and development to launch the next generation at the conclusion of the Tortuga Tarpon Classic life cycle. Project B employs a mechanized approach to the large-scale production of standardized equipment. Although the approach does not allow for personalization, it does allow Tortuga to build its inventory quickly and capture positive net cash flows immediately. The upfront expense is almost completely devoted to tooling equipment procurement and the number of units produced will be much higher and at lower price points than the approach of Project A. At the end of both projects life it is assumed that there will be zero salvage value as the pace of innovation will require a complete re-tooling for the next generation and the useful life of the equipment will have been fully realized. Brooks realizes that he will need to calculate the firm’s cost of capital discount rate and apply this to the cash flow projections of both projects. He recalls all of the assignments he completed at university and is thankful to have been so well-prepared for this task. He gets a cup of coffee, sits down at his desk, and gets to work. Figure 2 Project Net Cash Flows for Tortuga Fishing Equipment (\$thousands)

Year Project A Project B

1 -900 950

2 200 950

3 900 950

4 1800 950

5 2500 950

6 2500 950

7 1800 950

8 1200 950

9 800 950

10 200 950

Since Brooks is new to his role, you have been asked to review his work and assess the financial viability of the projects. Given the importance of this decision you are helping to make sure the firm makes the right choice.

Specific Questions

1.What are the weights of equity and debt in the capital structure? (Rd & Re)

2. What decision rules will you use to help Tortuga reach a decision?

3. What are the strengths and weaknesses of each of the evaluation tools?

*please show work in excel if possible

What are the weights of equity and debt in the capital structure?

What are the weights of equity and debt in the capital structure?

What are the weights of equity and debt in the capital structure?

What are the weights of equity and debt in the capital structure?

What are the weights of equity and debt in the capital structure?

What are the weights of equity and debt in the capital structure?