82

ThetotaIvaIueofthecompany(oftheasset)istheNPVpIustheoriginaIequityinvestmentplustheoriginaldebtinvestment.

Thec>aimsvaluationapproachvaluesanassetbyva>uingthecIaimsagainsttheasset.Forexamp>e,anassetfinancedwithdebtandequityhasavaIueequaltotheva>ueofthedebtp>ustheva>ueoftheequity.

PacticePobIemS

CoIiglll20llCFAIUule

1FlTCOisconsideringthepurchaseofnewequipment.Theequipmentcosts$350,000,andanadditional$ll0,000isneededtoinstallit.TheequipmentwiIbedepreciatedstraight-linetozerooverafive-yearlife.Theequipmentwi>>generateadditionalannualrevenuesof$265,000,anditwiI>haveannualcashoperatingexpensesof$83,000.TheequipmentwiIbesoldfbr$85000aherfiveyears.AninventoIinvestmentof$73,000isrequiredduringthe>ifboftheinvestment.FITCOisinthe40percenttaxbracketanditscostofcapitalisl0percent.WhatistheprqectNPV?

A$52,l22.

B610g0.

Cg744g.

2.Afierest1matingaprOiect,sNPVtheanaIystisadvisedthatthefjxedcapitaloutlaywi>lberevisedupwardby$l00,000ThefixedcapitaIoutIayisdepreciatedstraight-IineoveraneightyearIifb.Thetaxrateis10percentandtherequiredrateofetumisl0percent.Nochangesincashoperatingrevenues,cash0peratingexpenses,orsaIvageva>ueareexpectedWhatistheeffbctontheprqectNPV?

Al00,000decrease.

B73,325decrease.

C$5g,g88decrease.

3.WhenassembIingthecashf>owstocaIculateanNPVorlRR,theprQiect,saffer-taxinterestexpensesshouIdbesubtactedhomthecashfowsfbr:

AtheIRRcaIcuIation,butnottheNPVcalculation

B.boththeNPVcalcuIationaHdtheIRRcalculation.

CneithertheNPVcalculationnortheIRRca>cuIation

4.StandardCorporationisinvesting$400,000offixedcapitalinaprQ}ectthatwillbedepreciatedstraightinetozerooveitstenyearlifbAnnuaIsaIesareexpectedtobe20,000ahdanluaIcashoperatingexpensesareexpectedtobeII0,000.An

iIvestmentof$40000innetworkingcapitaIisrequiredovertheprOject,s>ife.Thecorporateincometaxrateis30percent.WhatistheaHertaxoperatingcashfowexpectedinyearone?

A63,000.

B92,000.

C$>03,000

5Fiveyearsago,FraterZahn,sCompanyinvested38million30millioninfixedcapitalandanother8milioninworkingcapitalinabakey.Today,FraterZahn,sisseIlingthefixedassetsfbr2lmillionandliquidatingtheinvestmentinworkingcapita.ThebookvaIueofthefixedassetsisl5millionandthemarginaltaxrateis40percent.

ThefiRhyear,saffertaxnonoperatingcashfowtoFraterZahn,siscmsto:

AZ0.6miIion.

B23.0miion

C26.6million.

ThefoowinginfOmationeIatestoQuestiohs68

McConachieCompanyisconsideIingthepurchaseofanew400-tonstampingpressThepresscosts$360,000,andanadditiona>$40,000isneededtoinsta>lit.Thepresswi>lbedepreciatedstraightIinetozeooverafiveyearlifC.ThepresswiIlgeneratenoadditionalrevenues,butitwillreducecashoperatingexpensesby$l40,000annually.Thepresswillbesoldfbr$l20,000afterfiveyears.AhinventoIyinvestmentof60,000isquiredduIingtheIifboftheinvestment.McConachieisinthe40percenttaxbracket.

6WhatistheMcConachienetinvestmentoutIay?

A400,000

B420,000

C$160000.

7McConachie,sincrementaannuaIafetaxoperatingcashfowiscbsesto:

Al6,000.

Bl24,000.

C$l10,000.

8WhatistheterminaIyearaffertaxnon-operatingcashf>owattheendofyearfive?

A$l08,000.

B$l32,000.

Cl80,000 83

84

TheoowinginfomationeIatestQuestions91

LindaPyleisheadofanalystrecmitingfbrPPASecurities.Shehasbeenveicantpool.AfbwofhercorporatefinancequestionsandprobIemsaregivenbelow

Conceptl

Concept2

Concept3

Concept4

Acompanyinvestsindepreciab>eassets,financedpaItlybyissuingfixed-ratebonds.Ifinf>ationislowerthanexpected,thevalueoftherealtaxsavingsfiFomdepreciationandthevalueoftherealafter-taxinterestexpensearebothreduced.,,

SensitivityanaIysisandscenarioanalysisareusefhltooIsfbrestimatingtheimpactonaprqect,sNPVofchangingthevalueofonecapita!budgetinginputvaeatatime.,,

Whencompanngtwomutuallyexclusivepectswithunequallives,theIRisagoodapproachfbrchoosingthebetterprO>ectbecauseitdoesnotequireequallives

,,

Prqect-specificbetasshouldbeusedinsteadofcompanybetaswhenevertheriskoftheprqectdiffrsfiomthatofthecompany.

ProblemFontenotCompanyisinvestingel00inaprqectthatisbeingdepreciatedstraight-linetozerooveratwo-yearlifbwithnosalvagevaIue.TheprO>ectwiIlgenerateearningsbefbreinterestandtaxesofe50eachyearfbrtwoyearsFontenot,sweightedaveragecostofcapitaIandrequiredrateofretumfbrtheprOjectaebothl2percent,anditstaxateis30percent.

9FoConceptlthestatementiscorrectregardingtheeffbctson:

AthereaItaxsavigsomdepeciation,buticorectregadingtheeaIaetaxinterestexpense.

BboththereaItaxsavingsfiomdepreciationandthereaIaftertaxinterestexpense.

CneitherthereaItaxsavingsfibmdepreciationnortheea!afIertaxinterestexpense

I0PorConcept2,thestatementiscorrectregarding:

AsensitivityanaIysis,butnotcorrectregardingscenanoanaIysis.

Bscenarioanaysis,butnotcorrectregadingsensitivityanalysis.

CbothsensitivityanalysisandScenarioanalysiS.

lIArethestatementsidentifiedasConcept3adConcept4corect?

ANofbrConcepts3and4.

BNofbrConcept3,butyesfbrConcept4.

CYesfbrConcept3,butnofbrConcept4.

12Theaher-taxoperatingcashf>owsineurosfbrthePontenotCompanyare:

A50inbothyears.

B70inbothyears.

C85inbothyears.

13TheeconomicincomeineurosfbrtheFontenotCompanyis;

Al7.24inYearlandg.IlinYear2.

Bl776inYearland248ginYear2.

C248ginYearlandl7.76inYear2.

l4ThemarketvaIueaddedMVAineurosfbrtheFontenotCompanyiscbsesto

A38.87.

B3g.g2.

C43.65.

TheowingihfOmatioeIatestQuestions1520

ThecapitalbudgetingcommitteefbrLarocheIndustriesismeeting.LarocbeisaNoIthAmercancongIomeratethathasseveraldivisions.Oneofthesedivisions,LaocheLiveIy,operatesalaIgef>eetofvansLaroche,smanagementiseva!uatingwhetheritisoptima!tooperatenewvansfbrtwo,three,orfburyearsbefbrerep>acingthemThemanagershaveestimatedtheinvestmentoutlay,annualaHertaxoperatingexpensesandaer-taxsalvagecashf>owsfbreachoftheservicelives.BecauserevenuesandsomeoperatingcostsareunaffbctedbythechoiceofseviceIifb,theyweeignoredintheanaIysisLaocheLive,soppotunitycostofflmdsisl0percent.Thefb>>owingtablegivesthecashf>owsinthousandsofCanadiandoIIasC

SeviCeLiIneStmentYe1YeHr2Yen3Ye1SMlge

2years

3years

yearS

-40,000

40,000

-40,000

l2,000

l2,000

-l2,000

-l5,000

5,000

-l5,000

-20,000

-20,000-25,000

20,000

l7,000

l2,000

85

SchoemanProducts,anotherdivisionofLarochehasevaluatedseveraIinvestmentprO>ectsandnowmustchoosethesubsetofthemthatfitswithinitsC$10millioncapitalbudget.TheoutlaysandNPVsfbrthesixprO>ectsaregivenbelow.SchoemancaVnotbuyfTactionaIprO>ects,andmustbuya>lornoneofaprO>ect.ThecurrencyamountsareinmillionsofCanadiandolIars.

PmiectOutMyPV0fFutueOhShFl0wsNPVB6332

5

I0BI8

l

u86

l23456

SchoemanwantstodeterminewhichsubsetofthesixprO}ectsisoptimal.

AfjnalpmposacomesfibmthedivisionSocietySevices,whichhasaninvestmentopportunitywitharea>optiontoinvestfUItherifconditionswarrant.Thecmcia>detaiIsareasfb>lows:

TheoriginaIprqect:

AnoutayofCl90millionattimezero.

Cashf>owsofC$40milIionperyearfbrYearsl-l0ifdemandishigh,,

Cashf>owsofC$20miIIionperyearfbrYearsl-l0ifdemandislow.,,

AdditionalcashfIowswiththeoptionaIexpansionprO>ect:

AnoutIayofC$Ig0miIIionattimeone

CashfowsofC40millionperyearfbrYeas2l0ifdemandishigh.,,

CashfowsofC20miIlionperyearfbrYears2l0ifdemandisIow.

Whetherdemandishigh,,orIow,,inYears>-l0wiIberevealedduringthefirstyearTheprobabilityofhigh,,demandis0.50,andtheprobabiIityoflow,,demandis0.50.

TheoptiontomaketheexpansioninvestmentdependsonmakingtheinitialIftheinitialinvestmentisnotmade,theoptiontoexpanddoesnotexist.

inves

InordertoputaIIcapitaIbudgetingproposaIsonanequaIfbotingtheprqectsshou>da>lusetherisk-fi?eeratefbrtheIcquiredrateofreturn

Suggestion2

Suggestion3

Suggestion

Becauseyoucannotexercisebothofthem,youshou>dnotpermitagivenprO>ecttohavebothanabandonmentoptionandanexpansion/growthoption,,

Whenrationingcapital,itisbettertochoosetheportfb>ioofinvestmentsthatmaximizesthecompanyNPVthanthepoItfbIiothatmaximizesthecompanyIR.,,

PrOjectbetasshouldbeusedfbrestablishingtherequiredrateofretumwhenevertheprqect,sbetaisdiffbrentomthecompany,sbeta.

l5WhatistheoptimalservicelifbfbrLarocheLiveIy,sf>eetofvans?

ATwoyears

BThreeyears.

CFouryears.

l6.TheoptimalsubsetofthesixpectsthatSchoemanisconsideingconsistsofPrqects:

Aland5.

B2,3and4.

C2,4,5,and6.

17.WhatistheNPV(C$mi>}ions)oftheoriginalprOjectfbrSocietyServiceswithoutconsideIingtheexpansionoption?

A6.l

B-5.66

C233.

l8.WhatistheNPV(C$miIlions)oftheoptimaIsetofinvestmentdeciSionsfbrSocietyServicesincIudingtheexpansionoption?

A6.34.

Bl268

C3l.03

l9ShouIdthecapitabudgetingcommitteeaccepttheintemaIaudito,sfistandsecondsuggestions,respectively?

ANofbrSuggestiosand287

88

BNofbrSuggestion>andYesfbrSuggestion2

CYesfbrSuggestionlandNofbrSuggestion2.

Z0ShoudthecapitaIbudgetingcommitteeaccepttheintemalauditor,sthirdandfburthsuggestions,respectiveIy?

ANofbrSuggestions3and4

BYesfbrSuggestions3and4

CNofbrSuggestion3andYesfbrSuggestion4

heOlIwinginOmationeIatestQuestiohs2126

MaximilianB0hmisreviewingseveraIcapitalbudgetingproposalsfiFomsubsidiariesofhiscompany.AIthoughhisreviewsdealwithseveInldetaiIsthatmayseem>ikeminutiaethecompanyplacesapremiumonthecareitexeIdsesinmakingitsinvestmentdecisions.

ThefirstproposalisaprOjectfbrRichieExpresswhichisinvesting$500,000,allinfixedcapital,inaprectthatwilhaveopeIatingincomeaftertaxesof20,000anddepreciationof$40,000eachyearfbrthenextthreeyeaIsRichieExpresswillselltheassetinthreeyears,paying30percenttaxesonanyexcessofthese>lingpnceoverbookvalue.Theproposalindicatesthata$617500terminalselIingpncewillenablethecompanytoearnal5percent

interna>rateofretumontheinvestmentB0hmdoubtsthatthistermina>valueestimateiscon.ect.

AnotherpropoSa>concemsGasupCompanywhichdoesnaturalgasexploration.AnewinvestmenthasbeenidentifiedbytheGasupfinancedepartmentwiththefbllowingpIDjectedcashf>ows:

Investmentout>aysare$6millionimmediatelyand$lmil>ionattheendofthefirstyear

Aftertaxoperatingcashfowsae05milionattheendofthefirstyearand4millionattheendofeachofthesecond,third,fburth,andfifhyearsInaddition,anaffer-taxoutf>owoccursattheendofthefive-yearprO>ectthathasnotbeenincludedintheoperatingcashfows:5millionIquiredfbrenvironmentalcleanup.

TherequiredrateofremrnonnamraIgasexplorationisl8percent

TheGasupanaIystisunsureaboutthecaIcuIationoftheNPVandtheIRRbecausetheout>ayisstagedovertWoyears.

FinaIly,DominionCompanyisevaluatingtwomutua>lyexc>usiveprQ>ects:ThePintogrinderinvoIvesanoutIayofl00,000annualaffertaxoperatmgcashfowsof45,000,anahertaxsalvagevaIueof$25,000,andathree-yearlife.TheBo>tengrinderhasanoutIayof$l25,000,annuaIaHertaxoperatingcashfowsof47,000,anaffertaxsalvagevaueof20,000,andafbur-year>ifb.Therequiredrateofretumisl0percent.ThenetpresentvaIue(NPV)andequivalentannualannuity(EAA)ofthePintogrinderare$30,69land$l2,34l,respectiveIy.Whichevergrinderischosen,itwillhavetoberep>acedattheendofitsservicelifb.Theanalystisunsureaboutwhichgrindershouldbechosen

B0hmandhiscoIeagueBethGoIdbe>ghaveanextendedconversationaboutcapitalbudgetingissues,inc>udingseveIalcommentslistedbelow.Go>dbergmakestwocommentsaboutrea>options:

Commentl

Comment2

Theabandonmentoptionisvaluablebutitshou>dbeexercisedonlywhentheabandonmentva>ueisabovetheamountoftheoIigina>investment.

IfthecostofareaIopiionis>essthanitsva>ue,thiswi>>increasetheNPVoftheinvestmentprO>ectinwhichthereaIoptionisembedded

Bbhmasomakesseveralcommentsaboutspecificprjectsunderconsideration

CommentA

CommentB

CommentC

Thelandandbui>dingwerepurchasedfiveyearsagofbr$l0million.Thisistheamountthatshou>dnowbeincludedinthefixedcapitalinvestment.,,

WecanimprovetheprOject,sNPVbyusingtheaftertaxcostofdebtasthediscountrate.Ifwefinancetheprqectwithl00percentdebt,thisdiscountratewouldbeappropectshaveconventionaIcashf>owpattemsandhavethesameinvestmentoutIays,itisacceptabIetouseeithertheNPVorIR,,

CommentDYoushouIdnotbaseacapitalbudgetingdecisiononitsimmediateimpactoneamingspersharePS.

Z1Whattenninalsellingpriceisrequiredfbral5percentintema>rateofretumontheRichieprOject?

A$588028.

B593,77l

C$625,83g.

22TheNPVandIRR,respectiveIy,oftheGasupCompanyinvestmentarecmsto

A$50g,600and2l.4%.

B$509,600and3l3%.

C$916,700and3l3%.

Z3OfthetwogrindersthattheDominionCompanyisevaluating,B0hmshouldrecommendthe:

ABoItengrindebecauseisNPVishighethanthePintoginderNPV89

90

BBoItengrinderbecauseitsEAAishigherthanthePintogrinderEAA

CPintogrinderbecauseitsEAAishigherthantheBoltengrinderEAA

ZAreGoldbeIg,scommentsaboutrealoptionscorrect?

ANofbrCommentlandComment2.

BNofbrCommentlandYesfbrComment2.

CYesfbrCommentlandNofbrComment2.

25IsB0hmmostlikelycoITectIBgardingCommentAaboutthel0millioninvestmentandCommentBaboutusingtheaftertaxcostofdebt?

ANofbrbothcomments.

BYesfbrbothcomments.

CNofbrCommentAandYesfbCommentB.

26IsB0hmmostlikelycorrectregardingCommentCthatitisacceptabIetouseeitherNPVorIRRandCommentDabouttheimmediateimpactonEPS?

ANorbothcomments.

BYesfbbothcomments.

CNofbrCommentCandYesfbCommentD

ThefowinginfOmationeIatestoQuestions2732

BabaraSimpsonisaseIsideanaystwithSmithRiccadiSecurities.Simpsoncoversthepharmaceutica>indust

Requiredrateofretumisl2percent

SimpsonisevaluatingthisinvestmenttoseewhetherithasthepotentialtoaffbctBayonnePharma,sstockprice.SimpsonestimatestheNPVoftheprO>ecttobee0.4lbiIlion,whichshou>dincreasethevalueofthecompany.

Simpsoniseva>uatingtheeffbctsofotherchangestohercapitaIbudgetingassumptions.ShewantstoknowtheeffbctofaswitchomstraightlinetoacceIerateddepciationonthecompany,soperatingincomeandtheprQjectsNPVShealsobelievesthattheinitia>outlaymightbemuchsmal>erthaninitia>Iyassumed.Specifica>ly,shethinkstheoutlayfbrfixedcapitalmightbee0.24bi>!ionIower,withnochangeinsa>vagevaIue

Whenreviewingherwork,Simpsonssupervisorprovidesthefb>lowingcomments.InotethatyouaIBrelyingheavi>yontheNPVapproachtovaluingtheinvestmentdecisionIdon,tthinkyoushoulduseanIytoarisewiththeBayonnePhannaprOect.Howeve,theequiva!entannuaannuitywoudbeamoreappropnatemeasuretousefbrtheprqectthantheNPV.IsuggestthatyoucomputeanEAA.

27SimpsonshoudestimatetheafetaxopeatingcashfowfbYears6and72respectivelytobec/O$es/to:

A60.3lbillionand602lbiIion

Be0.3lbil>ionande025biI>ion

Ce0.35billionande0.25biion

28SimpsonshouIdestimatetheinitialoutIayandthetermina>yearnon-operatingcashf>ow,respectively,tobec/b$es/to:

Ael.50billionand60.70billion

Be190bi>lionande0.70biI>ion

Ce1g0billionande0.90biion

29lsSimpson,sestlmateoftheNPVoftheprO>ectcorrect?

AYeS.

BNo.TheNPVis-60.0lbiIIion

CNTheNPVise0.34bilIion

30AswitchomstraightIinetoaccelerateddepreciationwouId:

A.increasetheNPVanddecreasethefirstyearoperatingincomeaftertaxes

BincreasethefirstyearoperatingincomeaHertaxesanddecreasetheNPV

CinceaseboththeNpVandfirstyearoperatingincomeaHetaxes

31.lftheoutlayislowebytheamountthatSimpsonsuggests,theprOiectNPVshouldincreasebyanamountccsto:

91

A60.0gbiIlion

Be0l4bilion

Ce0.l7bi>lion

3ZHowwou>dyouevaluatethecommentsbySimpson,ssupervisoraboutnotusingtheIRandaboutusingtheEAA?Thesupervisoris:

Aincorrectaboutboth

BcorrectaboutIRRandincorrectaboutEAA

CincorrectaboutRandcoTectaboutEAA

ThefoowinginfmatiohelatestoOuestions3338

MunHoeYipisva>uingPureCorporatlonPureisasimp>ecorporationthatisgoingoutofbusinessinfiveyears,distributingitsincometocreditorsandbondholdersasplannedinthefinanciaIstatementsbelow.Purehasalgpercentcostofequity,8l/3percentbefbre-taxcostofdebtl2percentweightedaveragecostofcapitaI,and40percenttaxrate,anditmaintainsa50percentdebt/valueratio.

YipisvaIuingthecompanyusingthebasiccapitaIbudgetingmethodaswellasothermethods,suchasEP,residualincome,andc!aimsvaluation.Yip,sresearchassistant,LindaRobinsonmakesthreeObservationsabouttheanalysis

ObservationlThepresentvaIueofthecompany,seconomicincomeshouldbeequaltothepresentvalueofthecashf>owsinthebasiccapitalbudgetingapproach.,,

Observation2TheeconomicincomeeachyearisequaItothecashflowminustheeconomicdepreciation,,

Observation3ThemarketvaIueaddedisthepresentva>ueofthecompany,seconomicprofit(EP),whichequalsthenetwoIthof77,973,,

543Zl0YeaF

BlnceSheets:

ASSets

Liabilities

Networth

InC0meSttementS:

Sales

VariabIecashexpenses

00040,000

33,929

6,07l

80,000

61,222

l5,778

l20,000

88,5gl

3l,10g

l60,000

>07,67l

52,329

200,000

l22,027

77,973

l80000200000220,00020000200,000

g01000l00,000>l0,000l20,000l0000092

20,000

40000

30,000

>0,>6g

l983l

7,g32

ll899

20,000

40000

40000

8,g73

3l,027

l2,4ll

l8,6l6

20,000

40,000

50,000

7,383

12,6l7

l7,047

25,570

20,000

0,000

60,000

5,352

54,648

2l,85g

3Z789

Fixedcashexpenses

DepreciationEBIT

>nterestexpense

EBT

Taxesat40percent

Netincomebefbresalvage

After-taxsalvageva>ueNetincome

Stements0fCashFl0ws:

Opertingcnshf0ws:

Netincome

DepreciationTotal

Finfmingcashf0ws:

Debtrepayment

Dividends/repurchasesTotal

InveStingCnSM>0wS:T0talcaShfl0wS:

ll,89gl8,6l625,57032,78g

ll,89g

10,000

5l,899

l4,357

37,542

-5l,8gg

0

0

33Economicincomeduringyearoneiscbses!to

A23l86.

B29,287.

C16,l0l.

34WhatisEPduIingYearl?

Al2,l0l.

B6,000.

C6,000

35WhatisresidualincomeduingYearl?

A-2,9l6.

B252.

C8,653.

36Whatisthevalueofequityattimezero?

A,055.

l86l6

10,000

58,6l6

l9,080

3g,536

58,6l6

0

0

25,570

40,000

65,570

24,369

l,20l

-65,570

0

0

32,78g

0,000

72,789

30,293

2,4g6

-72789

0

0

20,000

40,000

10,000

2827

37,l73

l4,86g

22,304

l2,000

34,301

3,304

40,000

74,304

33,g29

40,375

74,304

0

0

g3

B77,973.

Cl22,027.

37AreRobinson,sfirsttwcobservations,respectiveIycoect?

AYesfbrbothobservations.

BNofbrthefirstandYesfbrthesecond.

CYesfbrthefirstandNofbrthesecond

38WhichofthefbowingwouldbeYip,sosPWeIsponsetoRobinson,sthidobservation?

AThemarketvalueaddedisnotequaltothepresentvalueofEP,althoughthemarketva>ueofequityisequaltol22,027.

BThemarketvalueaddedisequa>tothepresentvalueofEP,whichinthiscaseis44,055.

CThemarketvalueaddedisnotequaltothepresentvalueofEPandmarketvalueaddedisequalto4,055.

Thefowin9infOmatiheIatestoQuestions3944

CarIosVelasquezCFA,isafinancialanalystwithEmbelesado,SA.,aSpanishmanufhcturerofsailboatsandsaiIingequipment.VelasquezisevaluatingaproposalfbrEmbe>esadotobuildsaiIboatsfbrafbreigncompetitorthatlacksproductioncapaciandsellsinadiffbrentmarket.ThesaiIboatprqectisperceivedtohavethesameriskasEmbeIesado,sotherprO>ects

Thepoposacoversaimitedtimehorizontheeyearsafterwhichthecompetitorexpectstobesituatedinanew,>argerproductionfhciIity.TheIimitedtimehorizonappealstoEmbelesado,whichcurrentlyhasexcesscapacitybutexpectstobeginitsownproductexpansioninsIightlymorethanthreeyears.

VeIasquezhascoIlectedmuchoftheinfbrmationnecessaIytoevaluatethisp1oposa>inExhibitsland2

ExMbdl.SelectedDmfbrSb0tP.0p0s!CrecyAm0MSin

eMi0s

005003662l2Initialfixedcapitaloutlay

AnnuaIcontractedrevenues

Annualoperatingcosts

Initia!workingcapitaIoutlay(recoveredatendoftheprqect)Annualdepreciationexpense(bothbookandtaxaccounting)Economic!ifbofftlcility(years)

91

05SaIvage(book)va>ueoffhciIityatendofprqect

ExpectedmaketvalueoffhciIityatendofprOect

Exhibit2SeeCtedDfbrEmbeleSad0,SA

28.6%

7l.4%

23l%

76.9%

8.5%

8.0%

l30%

35.0%

2years

Bookvalueoflong-tenndebt/totalassets

Bookva!ueofequity/tota>assets

Marketva!ueoflong-teImdebt/marketvalueofcompany

Marketva>ueofequity/marketvalueofcompany

Couponrateonexistinglong-teImdebtInterestrateonnewlong-termdebt

Costofequity

Marginaltaxrate

Maximumacceptablepaybackperiod

VelasquezrecognizesthatEmbelesadoiscurrentIyfinancedatitstaIgetcapitalstmctureandexpectsthatthecapitalstmcturewiI!bemaintainedifthesailboatprqlectisundertakenEmbe>esado,smanagersdisagreehowever,aboutthemethodthatshou>dbeusedtoevaluatecapitalbudgetingproposaIs.

OneofEmbelesado,svicepresidentsasksVe!asquezthefb>lowingquestions:

QuestionlWi!>prqectsthatmeetacorporation,spaybackcriterionfbracceptancenecesSaIilyhaveapositivenetpresentvalue(NPV)?

Question2Formutuallyexclusivepqects,willtheNPVandintemaIrateofretum(IR)methodsnecessariIyagreeonprqectranking?

Question3FothesaiIboatpmect,whatwiIIbetheeffbctsofusiHgacceerated

depreciation(fbrbothbookandtaxaccounting)insteadofstraight-linedepeciationonatheNPVandbthetotaInecashfowiHtheteminaIyear?

Question4Assumingal3peIcentdiscountrate,whatwiIbetheinceaseinthesaiIboatprqecfsNPViftheexpectedmarketva>ueofthefhcilityatendofprO>ectis6>5mi>lionratherthan65mil>ion?

39TheweightedaveragecostofcapitaIfbrEmbe>esadoisc/bses/to:

Al0.78%.

,5

B>l20%.

Cll.85%.

40.Thetotalnetcashf>ow(inemillions)fbrthesailboatprOjectinitsterminalyearisCseto:

A33.00.

B.3g.75.

C4300.

41TheRfbrthesailboatprqectiscbs!to:

Al8.5.

Blg.7.

C20.3.

12.ThebestresponsesthatVelasquezcanmaket0QuestionlandQuestion2are

Question2

No

Yes

No

Questionl

No

No

Yes

ABC

3.InresponsetoQuestion3,whataretheoskeyeffectsontheNPVandthetotaInetcashf>owinthetemlina>year,respectively?

TotaINetCashFIow

inTerminaIYear

Increase

Decrease

Increase

NPV

Increase

Increase

Decrease

ABC

4.InresponsetoQuestion4,theincreaseinthesaiboatprqectsNPVillemilIionsiscetO:

A450

B6.50

c6.76

hefoowiinfomationeIatestoQuestins550

MariaHernandezisaselsideanaystcoveringtheeIectonicsindustIyinSpainOneofthecompahiesshefbIIows,SGEIectronics,SA.,hasrecentIyannouncedpanstobeginpoducing

96

andsellinganewsenesofvideocameras.HerndndezestimatesthatthisprOectwiIIinceasethevalueofthecompanyand,consequently,sheplansonchangingherresearchopiniononthecompanyfTomahoId,,toabuy.,,HerinitiaIfinanciaIpedictionsfbrthepIOectare:

Pixedcapita>equipmentout>ayise2,750,000.

AtthebeginningoftheprO>ect,arequiredincreaseincurrentassetsofe200,000anda

requiredincreaseincurrent>iabilitiesof6l25,000.

StraightinedepreciationtozerooverafiveyearIifb.

Prqectlifboffiveyears.

IncmentalannualunitsaIesof3000ataunitpriceofe600

AnnuaMixedcashexpensesofel25,000;variablecashexpensesofel25perunit

Thecapitalequipmentisexpectedtobeso>dfbr6450,000attheendofYear5.Attheendofthepectthenetworkingcapitalinvestmentwillberecovered

Taxrateof40percent.

Basedonthecapitalassetpricingmodeltherequiredrateofretumisl2percent.

HemandezestimatestheexpectednetpresentvaluedPVofthepOiecttobeeg75,538andtheinternalrateofretum(IR)tobe246percent.SheaIsoperfbrmsasensitivityanalysisbychangingtheinputvariab>eassumptionsusedinherinitialanalysis.

WhenreviewingHemahdez,swork,hesupevisoArturoCostanotesthatshedidnotincIudechangesinthedepreciationmethod,initialfixedcapitaloutlay,orinf>ationassumptionsinhersensitivityanalysis.Asaresult,CostaasksthefbI>owingquestions:

Questionl

Question2

WhatwouldbetheeffbctontheprO}ect,sNPViftheinitiaIfixedcapitalequipmentoutayincreasedfom62750,000toe3,000000,eveIythingelseheIdconstant?,,

Howwouldahigherthanexpectedinf>ationrateaffbctthevalueoftherealtaxsavingsfTomdepreciationandthevalueoftherealafier-taxinterestexpenseeverythingeIseheIdconstant?,,

Question3Youareusingarequiredrateofremmofl2percentwhenthecompany,sweightedaveragecostofcapitaI(WACC)isl0percent.Whyareyouusingarequiredrateofretumfbrtheprqectgreaterthanthecompany,sWACC?

Befbreendingthemeeting,CostateIlsHemandez:Lastyearthecompanyproducedaprototypeatacostofe500,000.Nowmanagementishavingdoubtsaboutthemarketappea>oftheproductinitscurrentdesign,andsotheyareconsideringdelayingthestaItoftheprq>ectfbrayearunti!theprototypecanbeshowntoindustryexpeIts.

15UsingHemandez,sinitiaIfinanciaIpredictions,theestimatedannualaRer-taxoperatingcashfowiScsesto: g7

98

Ae780,000.

B6l,000,000.

Cel,075,000.

46UsingHemandezsinitiaIfinancialpredictions,theestimatedtelminaIyearaHer-taxnon-operatingcashf>owiscm$e$/to:

Aelg5,000.

B6270000.

Ce345,000

47.Hemandez,sbestresponsetoCosta,sfirstquestionisthattheprOject,sNPVwoulddecreasebyanamountcsesto:

Ael2,000.

B6l78,000.

Ce250,000

48HerMndez,sbes!responsetoCostassecondquestionisthat:

AreaItaxsavingsfibmdepeciatlonandaIinteestexpensewouIdbeIowe

BIataxsavingsfi.omdepreciationwouIdbehigherandrealintestexpensewouldbelower.

Crealtaxsavingsfi.omdepreciationwouIdbelowerandrealinterestexpensewou>dbehigher.

49Hernandez,sbesresponsetoCosta,sthirdquestionis:Because:

AtheprO>ectwillplotabovethesecuritymarketIine.

B.theprqectsbetaisgeaterthanthecompany,sbeta,,

CtheprOject,slRRisgreaterthantherequiredrateofretum

50Shou>dCosta,send-ofmeetingcommentsresuItinchangestoHemandez,scapitalbudgetinganalysis?

ANo.

BYes,butonIytoincorporatethepossibIede>ay.

CYes,toincopoateboththepossibIedeIayandthecostofpoducingtheprototype

shtuI

1Ciscorrect.

Outlay=FCInv+NWCInv-SaI0+T(Sal0-B0)

Outlay=(350,000+ll0,000)+73,000-0+0=$533,000

Theinsta>Iedcostis$350,000+$ll0,000=$460,000,sotheannualdepreciationis$460,000/5=$g2000.Theannualaffer-taxoperatingcashf>owfbrYearsl-5is

cF=(S-c-D)(I-T)+D=(265,000-83.000-02.000)(!-040)+92000

CI46,000< >

ThetenninalyearahetaxnonoperatingcashfowinYea5is

TNOCPSaI5NWlv-.Sa!5B585.00073.000

-040(85?000-0)TNOCF2,000

TheNPVis

94

70$

u

n

unU

?l

|+

00/009

0

6l

I5

+000

VPN

2BiscorrectTheadditionaannuadepreciationisl00,0008l2,500.Thedepreciationtaxsavingsis040($l2,500)=$5,000.ThechangeinprOjectNPVis

j

J

Pg

0

62+000.

00I-

0v/000I

DI

(8v

l00000

3Ciscorrect.FinancingcostsarenotsubtractedfiPomthecashfowsfbreithertheNPVotheIowinYearlshouldbe

CP=(S-C-D)(l-T)+D

20000lI00000.000I-0.3010,000=63`000+40000=$I03.000

5Ciscorrect.Theterminalyearafter-taxnon-operatingcashf>owis g9

TNOCSaINwCII-TSaIj-B:

2l8-0.02I-I52MIiIIion

6CiscorIcct.TheinvestmentoutIayis

OutayFCnvNWCInvSal.SaII-B0

60:000100060000-006000

7Aiscorrect.DepIcciationwil>be$400,000/5=$80,000peryear.Theannualaffer-taxoperatingcashflowis

CF=(S-C-D)(I-T)+D

Pl10.000-80.00I-04080.0000008Biscorrect.ThetenninaIyearnonoperatingcashfowis

TNOCFSaI5liwClnv-.SaI5B5

20,00060000-0.0I20.000032.000

9Ciscorrect.ThevaIueofthedepreciationtaxsavingsisincreasedandthevalueoftherea>afier-taxinterestexpenseisalsoincreased.Duetothelowerinf>ation,thevaluehasincreasedessentiaydiscountingataowerate

10Aiscorrect.Thestatementiscon.ectfbrsensitivityana>ysis,butnotfbrscenanoanalysis(inwhichseveralinputvariablesarechangedfbreachscenario)

1l.BiscoITect.EithertheIeast-commonmuItipIeof>ivesortheequivaIentannuaIannuityapproachshouldbeusedbothusetheNPV,nottheR.Conceptiscorrectasgiven

12Ciscorrect.TheprobIemgivesEBITnotEBlTDA

CF=(S-C-D)(l-T)+D=50(>-0.3)+50=e85eachyear

13Aiscorrect.Economicincomeisthecashf>owpIusthechangeinvalue,oreconomicincomeisthecashf>owminustheeconomicdepreciation(wewiIIusethesecondexpression):

0

P

!98

57

P0!56

I

8585-+

l27.24

EconocincomeYea2CE!iIi

=85-(75.89-0)=85-758g=EgIl

MCiscorrect.

EP=NOPAT-$WACC=EB!T(l-T)-WAC(YxCapiatetheequivalentannualannuityandchoosetheservicelifbwiththe!owestannualcostForatwo-yearservicelifb,theNPVis

-IZ-0L-NW0,000iT l.l02TheEAAPV46776.86,2,andl0is26,g5238.

Forathree-yearservicelife,theNPVis

I2000l500020.000I7000NPv=-40,000++

I0Zl0l-I.I0 Il0]=-65`559.73

TheEAAPV65,55g.73,3,andl0is26362.54

Porafbur-yearservice>ifb,theNPVis

l2000I.00020.00025000NPV==40,000++I.l0I,++l0I0 I0

l:872I26I.l0

101

TheEAAPV87Zl26,4andl0is275l2.6l

Thethree-yearservice>ifbhastheIowestannualcost.Larocheshouldreplacethevansevelythreeyeas.

16Aiscoect.TohelptheseIectionprocess,usetheprofitabilityindexfbreachpIOject,whichshowsthetotaIpesentvalueperdoarinvested.

PrOjectOutyfV0fFutueCshFl0wSNPVPIPlRnkl.4l9

l.100

1375

l.300

l375

l333

33l265

E6332

5

I0BI8

l

E86

l23456

TIytoincorporatethehighPIprectsintothebudgetusingtrialanderror.ThesetrialsincIudethefbl>owing:

Set0fPrqiectsT0tlOudayTotalNPV

ll3g

37

35

3g

land5

2,3,and4

2,3,and5

24,5and6

Amongthesetsofprqectssuggested,theoptimalsetistheonewiththehighestNPV,provideditstota!outIaydoesnotexceedC$40millionThesetconsistingofPrqectsland5producesthehighestNPV.

17BiScorrect

Ifdemandishigh,theNPVis

I(}10NW=-I00+Z-=C$55.783miIlion

/=III0/

lfdemandis1ow,,,theNPVis

NW,01-C,inII.l0

TheexpectedNPVis0.50557830.5067l0gC5.663milIion

I02

I8.Biscorrect.Assumeweareattime=lTheNPVoftheexpansion(attime>)ifdemandishigh,,is

NW-,01CnIII0

TheNPVoftheexpansion(attimel)ifdemandislowis

0

0

2

I

9

+09l--

C7.8Z0miIIionNPV

Theoptimaldecisionistoexpandifdemandishigh,,andnotexpandiflow.,,

BecausetheexpansionoptionisexercisedonIywhenitsvalueispositive,whichhappens50percentofthetime,theexpectedvalueoftheexpansionprqect,attimezero,is

NWCilThetotalNPVoftheinitialprOjectandtheexpansionprqectis

NPV=-C$5.663miIion+C$l8.346milIion=C$l2.683mil>ion

TheoptionaIexpansionprect,handledoptimally,addssufficientvauetomakethisapositiveNPVprqect.

|

1g.AiscoIect.Bothsuggestionsarebad.Invaluingprqects,expectedcashfowsshoudbediscountedatIcquiredratesofretumthatref>ecttheirrisk,notatarisk-fiFeeratethatignoresliskEventhoughbothoptionscannotbesimultaneous!yexercised,theycanbothaddvalueJfdemandishigh,youcanexercisethegrowthoptionandifdemandisIow,youcanexercisetheabandonmentoption.

20BiscoIectBothsuggestionsaregood.ChoosingprQectswithhighRsmightcausethecompanytoconcentrateonshort-termprO>ectsthatreducetheNPVofthecompanyWhenevertheprOjectriskdiffbrsfiomthecompanyiskaprOectspecificrequiredrateofretumshouldbeused

2Ciscorect.Theaetaxoperatingcashfowfbeachoftheextthreeyearsis20000+$40,000=$60000.ThebookvaIueinthreeyearswiIIbe$380,000(theoriginaIcostlessthreeyearsdepreciatio.SothetermiaIyeaaRetaxnonopeatmgcashfowwibeSal3-0.30(Sa>3-$380,000),whereSaMstheselIingprice.Foral5percentretum,thePVoffUturecashf>owsmustequaItheinvestment:

(Sa>3-380,000)0]

0

IaQ+

0u1

0

06I+

0M.

=a

0q

06!+

-

000

06--

000

005

5-

>cashflowpattem,theIRRhasauniquesoIutionTheNPVprofiIedecIinesastherequiredateofretuminceases,andtheNPVvaluecrossesthexaxis(requiredrateofretum)onlyonetime,at2l.4percent.

Z3Ciscorrect.BecausethemutualIyexcIusiveprqectshaveunequaIlives,theEAAshouId

beusedinsteadoftheNPV.TheNPVandEAAfbrthePintogrinderarecorrect.FortheBoItengIinder,theNPVis

446

J

00

0

0

9

I

0.

l

+

-

000q.

7

+000

52l

vPN

l04

TofmdtheBoItenEAA,taketheNPVfbBoItenandannuaIizeitfbfburyears1PV=37,644,and/=l0%).TheBo>tenEAAis$ll,876.ConsequentlythePintogrinderhasthebetteEAAof2,34l

24.Biscorrect.Goldbelg,sfirstcommentiswrongAprOiectshouldbeabandonedinthefUtureonlywhenitsabandonmentva>ueismorethanthediscountedvaIueoftheremainingcashf}ows.Go>dbeIg,ssecondcommentiscorrect.

25Aiscorrect.Thel0milionoriginaIcostisasunkcostandnotrelevantThecorrectinvestmentistoday,sopportunitycost,themarketvaluetodayThecorrectdiscountrateistheprOiectrequiredrateofretum

Z6Ciscorrect.Eveniftheyaethesamesize,ashorttermprOectwithahighIRRcanhavea>owerNPVthanalonger-tennprO>ect.TheimmediateimpactonEPSdoesnotcapturethefUlleffbctofthecashf>owsovertheprqect,sentirelifb.

Z7Aiscorrect.TheannuaIdepciationchargefbrYearsl6isl.560.25.AnnualaftertaxopeatlngcaskfIowsfbYears6are:

CFSCDlTD

CF0100250.z5l00025

CF=0.06+0.25=e03lbillion

AnnualaffertaxoperatingcashfowsfbrYears7l2are:

CFSCDTD

CF01002500400

CF=e0.2lbillion

28Biscorrect.

Outlayattimezerois:

OutIayFCInvNWCInvSaI0TSal0B0

Out>ay=l.50+040-0+0=6l.90bil>ion

TerminalyearaHer-taxnon-operatingcashf>owis

TNOCFSal2NWCInvTSaII2B2

TNOCF0500.400100.50060.70biIion

29Biscorrect.Thecashf>ows,computedinthefirsttwoquestionsareasfbIows

Time0

Timel-6

Time7=IZ

Time>2

l.90bilIion

e03lbiIIion

60.2lbiIion

e0.70biIIion

105

TheNPVis

,=

0I

72

>

0

I+

-

+-

6TH

+0,

I

NPV

NPV.,0I.2750.4707WE0.008billioH

E0.0Ibiion

30AiscoIect.AccelerateddepreciationshiRsdepreciationexpensetowardtheearlieryearssothatfirst-yearoperatingincomeaftertaxeswillbeIower.However,becausedepreciationisanoncashexpense,itmustbeaddedbacktooperatingincomeaftertaxesinordertoObtainafier-taxoperatingcashflow.Thisprocessshihscashf>owsfiFom>ateryearstoearlieryearsincreasingtheNPV.

CiscorIct.Theoutlayislowerby60.24,whichwilldecreasetheannualdepreciationby60.04fbrthefirstsixyears.TheannualadditionaltaxesomthelossofthedepreciationtaxsheIteraree0.04(0.10)=e00l6.Theafier-taxcashf>owsarehigherbye024attimezero(becauseofthesma>lerinvestment)andlowerbye0.0l6fbrthefirstsixyears.TheNPVincreasesby

b0.0l6Z-0.24-0.06580742E0.7biIIionNPV0.24I.2

>owfbIlowedbyinflows),themultipleI8,000

40,000

EBIT

EBIT(l-040)

D

Affer-taxsaIvage

CF 58,00064,00070,00076,000l06

CB=58000

Ii!Z!!Z:!I.I2.2jl.I2I.2524405.55

IFi

35Aiscorrect.

RINlBI

RlIl,8,9-0977,W3 =M,899-l4.8>5=-2,g}6

36Ciscorrect.Theva>ueofequityisthePVofcashdistributionstoequity

-

57

04+

6,

1

g

l

H

4I+

-

lU

7

}4+

m

,

,

0

I

0I

-

7.

4U5

73

-

Vp=I22`027

37BiscorectRobinson,sfirststatementiswrong.ThevaIueofanassetisthepresentvalueofitsfiltuecashfows.Economicincomeeachyearisthecashfowminuseconomicdepreciation,EICFEDForthiscompany,whichisdecIininginvalueeachyear,theeco0micdepeciationispositiveandEIisIessthanCFeachyear.ConsequentIy,thepresentvalueofeconomicincome(EI)willbelessthanthepresentvaIueoffUturecashfIowsCFRobinson,ssecondstatementiscoect.

38Biscorrect.MarketvaIueaddedisequaltothepresentvaIueofEP.Itsva>ue,however,isnotequaItothebookva!ueofequity.Theca>culationofMVAisshownbeIow:

513Z1Ye

l2,000l0.40Tllehnhyealigusincludethceffbctsofsavage.BebtaxsalvgCof2?000isaddedoEBlT.Theahertaxsalvageofl2,000isincludedinNOPAT

wA!il!!,lI2I.I22!>2jl07

l08

30,000

>8,000

200,000

24000

0000

24000

l60000

l9,200

50,000

30,000

>20,000

l4,400

60,000

36000

80,000

g,600

60,000

36,000

40,000

4,800

EBlT

NOPAT=EBlT(>-0.40)

Capital(beginning)$WACC=0.l2x

CapitalEP=NOPAT-

$WACC

6,000,800l5,60026,4003l,200

ThefiiihycarfiguIEsincludcthccffbcsofsalvagc.Bcfbtaxsalvaof20,00012000l0.40isaddedoEBIT.TlleaIieMsalvagCol2,000isincludedinNOPAT.

MvA!!!lL,I.l2l2I.I2I.I2

39BiscorrectTheweightedaveagecostofcapitaIfbrEmbelesadoiscaculatedas

WACCMaketweighodebtxAetacostofdebt

+(Ma!.ketofequi.20I%+9.007%

WACC=II.l98%=II.20%

(670000)inCiscorrectThisistheIRRfbraprqectwiththefbIIowihgcashf>owsYear0,629,750atYearsland2,ande43000atYear3.

l

Yes12Ye3

e60,000

25,000

20,000I

l5,000

5,250

9750

20000

29,750

l0,000

5,000

l,750

e3000

Revenues 660,000

Lessoperatingcosts Z5000

Lessdepreciationexpense 20,000

=Taxab>eincome l5,000

Lesstaxes35L=Netincome 9,750

Plusdepreciationexpense 20,000

=Aher-taxoperatingCF62g,750

+RecoverWC

+Salvagevalue

-Lesstaxesonsal.value@35%

=TenninalyearCF

TheIRRof202g%isreadi>yfbundwithafinancialcalcuIator

II2075070,000=29,750

YoucanaIso(reverse-engineer,,theanswerusingthechoicesgiveninthequestion

2.Aiscorrect.PrOjectswithshorterpaybacksdonotnecessarilyhaveapositiveNPV.FormutualyexclusivepOlects,theNPVandRcriteIiawiInotnecessaiyprovidethesameprqectranking

13BiscoIect.AdditionaldepreciationinearliertimeperiodswilIshieldEmbeIesadofiPomadditionaltaxes,thusincreasingthenetcashfIowsineaieyearsoftheprectandincreasingtheprqect,sNPVHoweverthisaIsomeansthattherewillbe>essdepreciationexpenseintheterminalyearoftheprQ>ect,thusshieIdingIessincomeandinceasingtaxes.Terminalyearnetcashfowwilllikelydecrease.

14.Aiscoect.Theentireel0milIionwibesubecttotaxes,resultinginanadditionale6.5miIlionaffertaxes.Asindicatedbe>ow,whendiscountedatl3percentfbrthreeyears,thishasapresentva>ueofe45048(roundedto6450milIion):

}0.0(!-0.J5) 05

4--

0=3

6

P

ll0

SaIes=pxO=E600x3`000=EI.800,000

Costs=VariabiecostxO+FiXedcoStS=(I25x],000)+EI25000=500,000

Depeciatiolexpesef27500005f55000

CI.800,000-500,000xI-0.40,s0000x0.40780.000220,000EI,00000

< >

Ciscorrect.ThetenninayearnonoperatingcashfowincludestheaftertaxsaIvagevalueandtherecoveryofnetworkingCapital=e450000x(l-040)+e75,000=6315,000.

Note:TerminaIyearrecoveyofnetwoIkigcapitalinvestmentDecreaseincurrentassets-Decreaseincurrentliabilities=e200,000-el25,000=

675,000)

q7Biscorrect.Ca>cuIations:Theoutlayishigherbye250,000,whichwillincIcaseannuaIdepreciationby650,000overthe5-yearperiodTheannualadditionaltaxsavingsfTomthehigherdepreciationexpenseis:50,000x(0.40)=20,000.TherefbreNPVshou>ddecreaseby:

v200gL200,,,012

8Aiscoect.Higherthanexpectedinfationincreasesthecorporation,sreaItaxesbecauseitreducesthevalueofthedepreciationtaxsheIter;itaIsodecreasesthereaIinteestexpensebecausepaymentstobondholdersinrealteImsarelowerthanexpected

19.Biscon.ect.WhenaprectismoreoressriskythanthecompanyprqectbetaandnotWACCshouIdbeusedtoestab!ishtherequiredrateofretumfbrthecapitalprO>ect.Inthiscase,therequiredrateofreturnisgreaterthantheWACC,whichmeanstheprQ>ectbetariskisgeaterthanthecompany,sbeta.

50.Biscorrect.Timingoptions(eg.,delayinvesting)shouldbeincludedintheNPVanaIysis,butsunkcostsshouldnot.

ModigIiani,Franco,andMertonHMiIIe.g58.TheCostofCapitaI,CorporationFinance,andtheTheoIyofInvestment.,,AeFCEoojcReview,vol48,n3:26l2g7.

Myers,Stewart,andNicholasS.Mluf984.CorporateFinancingandInvestmentDecisionsWhenFirmsHaveInfbrmationThatInvestorsDoNotHave.bqcEboo?,voll3:l87-22l.

Rajan,RaghuramG.,andLuigiZingaIes.lg95.WhatDoWeKnowaboutCapitalStmcture?SomeEvidencehomIntemationalDatabmqRce,vol50,n5:M2ll460.

PacticePbIems

CoIright20llCFAInstitute

1Ifinvestorshavehomogeneousexpectations,themaIketisefficient,andthereaenotaxes,notransactionscosts,andnobankruptcycosts,theModig>ianiandMi>lerPropositionIstatesthat:

AbankIuptcyIiskriseswithmoIleverage

Bmanagerscannotchangethevalueofthecompanybyusingmoreorlessdebt

Cmanagerscannotincreasethevalueofthecompanybyemp>oyingtaxsavingstrategies

2AccordingtoModiglianiandMiller,sPropositionIIwithouttaxes:

A.thecapita>structuredecisionhasnoeffbctonthecostofequity.

BinvestmentandthecapitalstIucturedecisionsareintedependent.

Cthecostofequityincreasesastheuseofdebtinthecapitalstructureincreases

3SupposetheweightedaveragecostofcapitaloftheGadgetCompanyisl0percent.IfGadgethasacapita>structureof50percentdebtand50percentequity,abefbre-taxcostofdebtof5percent,andamaginaItaxrateof20percent,thenitscostofequitycapitaIiscbses!tO:

Al2percent

B.l4peIcent

Cl6percent

4.Thecurrentweightedaveragecostofcapital(WACC)fbrVanderWeIdeisl0percentThecompanyannouncedadebtoffbringthatraisestheWACCtol3percent.TheoskeconclusionisthatfbrVanderWelde:

Athecompany,sprospectsareimproving

137

138

Bequityfinancingischeapethandebtfinancing.

Cthecompanysdebtequityatiohasmovedbeyondtheoptimalrange.

5Alelseequal,theuseofIongmaturitydebtisexpectedtobegeeinthosemarketsinwhich:

Ainflationislow.

Bcapitalmarketsarepassiveandil!iquid.

Cthelegalsystesprotectionofbondholders,intestsisweak.

6AccordingtothepeckingordertheoIy:

Anewdebtisprefeabletonewequity.

Bnewdebtisprefbabletointemalygeneratedfimds.

CnewequityisaIwaysprefbrabletoothersourcesofcapital

7Accordingtothestatlctrade-offtheoIy:

AdebtshoudbeusedonIyasalastresort.

BcompanieshaveaIoptimaIIeveIofdebt

CthecapitastmctuedecisionisieIevant.

ThefIIowmginfOmationeIatestoQuestiohs813

BarbaraAndradeisanequityanalystwhocoverstheentertainmentindustIyfbrGreengab>eCapitalPartners,amorgobaassetmanagerGreengabIeownsasignificantpositionwithaalgeuneaIizedcapitalgainiMoseIyBroadcastGoupMBG.OnaecentconfeencecaII,MBG,smanagementstatesthattheypIantoincreasetbepopotionofdebtinthecompany,scapitalstrucmre.Andradeisconcemedthae,sinvestment,shegatherstheinfbrmationaboutMBGgiveninExhibit1.

ExhibntlOl.rentSe!eCtedFhMmCMuMbmti0nlbFMBG

YieIdtomaturityondebtMarketvalueofdebt

Numbeofshaesofcommonstock

Marketpricepershareofcommonstock

CostofcapitaIifaIequity-financed

MarginaItaxate

8.00%

$l00milIion

l0milIion

$30

l0.3%

35%

V

AndradeexpectsthatanincreaseinMBG,sfinancia>leveragewillincreaseitscostsnfdebtandequity.BasedonanexaminationofsimilarcompaniesinMBG,sindustIy,AndradeestimatesMBG,scostofdebtandcostofequityatvanousdebt-to-totalcapita>ratios,asshowninExhibit2

Exhibit2Estimtes0fMBG,SbefbreTaxCosts0fDebtndEqity

Debtt0T0tlCapitRti0C0st0fDebtC0st0fEqity

20

30

40

50

7.7

8.4

93

l0.4

l2.5

l3.0

l40

>60

8MBGisbesscbedascuITently:

A25debtfinancedand75equityfinanced

B33%debt-financedand66%equity-financed

C75%debt-financedand25%equity-financed.

9BasedonExhibitsand2,theculentaHetaxcostofdebtfbrMBGiscbeto

A2.80.

B5.20%.

C7.65

10BasedonExhibitsland2,MBG,scurrentcostofequitycapitaIiscoesto:

Al030.

Bl080%.

Cl2.75%.

BasedonExhibitsland2whatdebttototalcapitalratiowouldminimizeMBG,sweightedaveragecostofcapital?

A20%

B30

C10%

l39

140

l2HoIdingopeIatingeamingsconstantanincreaseinthemarginaItaxrateto40percentwould:

Aresultina>owercostofdebtcapital

Bresultinahighercostofdebtcapital.

CnotaffCctthecompany,scostofcapital

13Accordingtothepeckingordertheoy,MBG,sannouncedcapitalstnlcturechange:

AisoptimalbecausedebtischeaperthanequityonanafteFtaxbasis.

Bmaybeoptimalifnewdebtisissuedafternewequityismadecomp>eteuseofasasourceofcapital

CmaybeoptimalifnewdebtisissuedafterintemallygeneratedfUndsaremadecompIeteuseofasasouIceofcapital

ThefOowinginfmatioheIatestoQuestions14191

LindsayWhite,CFA,isanana>ystwithafirminLondon,Eng>and.SheisresponsibIefbrcoveringfivecompaniesintheConsumerStap>esindustry.WhitebeIievesthedomesticandglobaIeconomieswillgrowslightlybe>owaverageoverthenexttwoyears,butsheisalsoconcemedaboutthepossibilityofamildrecessiontakingholdShehasbeenaskedtoreviewthecompaniesthatshecovers,andshehasco>>ectedinfbrmationaboutthem,presentedinExhibit1.WhitehasestimatedthatearningsbefbreinteestandtaxesEBlTwiIImainconstantfbrallfivecompaniesfbrthefbreseeablefhture.CuncncyisintermsoftheBritishpound.ThemaIginaIcoporatetaxrateis30fbrallfivecompanies.

ExIibitlSelectedC0mpnyFinCmDt

EBIT

Debt-to-equityratiomaketvaIue

DebtmarketvaIue

S&Pdebtrating

WeightedaveragecostofcapitaI

AquiusBemaGthH0lte Veg

600,000

060

2,000,000

A+

-

600,00000,000400,000

0.000.000.7l

400,000

062

0

na

>0%

0

na.

l0%

2,000,0002,000,000

A-A

-

Basedonconversationswithmanagementofthefivecompanies,aswe>lasonherownindependentresearchandanalysis,Whitenotesthefbllowing;

Aquaius:

hasIowerbondingcoststhandoesBema.

hasahigherpercentageoftangib>eassetstototalassetsthandoesBema.

hasahigherdegreeofoperatingleveragethandoesBema.

Gath8

investssignificant>ylessinreseamhanddevelopmentthandoesHolte.

hasamorehighlydeveIopedcoIporategovernancesystemthandoesHoIte.

hasmorebusinessriskthandoesHolte.

InadditionWhitehasreachedvariousconcIusionsregardingannouncementsbyBemaGarth,andVega:

Announcement Bemahasannouncedthatitwil>issuedebtandusetheproceedstorepurchasesharesAsaresu>tofthisdebt-financedsharerepurchaseprogram,Bemaindicatesthatitsdebt/equityratiowillincreaseto06anditsbefbre-taxcostofdebtwillbe6%.

ConclusionAsaIBsultoftheannouncedprogram,Bemastotalmarketva>ueshoulddecreasere>ativetoAquaIius,s.

AnnouncementGaIthhasannouncedthatitplanstoabandonthepiorpolicyofallequityfinancingbytheisSuanceoflmilionindebtinordertobuybackanequivaIentamountofequity.GaIth,sbefbre-taxcostofdebtis6%.

ConcIusionThischangeincapitaIstmctureiseasonabIe,butGarthshouldtakecaresubsequentlytomaintainalowerD/EratiothanHoIte.

AnnouncementVegahasannouncedthatitintendstoraisecapitaInextyear,butisunsureoftheappropriatemethodofraisingcapitaI

Conc>usion WhitehasconcIudedthatVegashouldapplythepeckingordertheoIytodeterminetheappopiatemethodofraisingcapitaI.

14.BasedontheModigIianiandMiIIerMMpropositionswithcoIpoatetaxes,Aquarius,sWACCiscm$cs/to:

A338

B787%

141

>42

15

Cll25%

BasedonMMpropositionswithcorporatetaxes,whatisBema,sweightedaveragecostofcapitaIaHerthecompetionofitsannounceddebtfinancedsharerepuchasepogam?

A6.52

B7.83%.

C8.88%.

l6BasedonExhibit1andWhite,snotes,whichofthefbllowingiseconsistentwithWhite,sconcIusionregardingBema,sannouncement?

ABema,sbondingcostswillbehigherthanAquarius,s

BBemawillhavealowerdegreeofoperatingleveragethandoesAquanus.

CBemawihavealowerpercentageoftangibleassetstototalassetsthandoesAquarius.

17BasedontheNpropositionswithcorporatetaxes,Garth,scostofequityafierthedebtissuanceisc/bses/to:

Al000

Bl0.85.

C.ll33%

l8BasedonExhibit1andWhite,snoteswhichofthefbllowingisconsistentwithWhite,sconcIusionregardingGarth,sannouncement?

AGarthhasmorebusinessIiskthandoesHo>te

B.GaIthinvestssignificantlylessinresearchanddevelopmentthandoesHoIte.

CGarthhasamorehilydevelopedcorporategovemancesystemthandoesHoIte

19BasedonWhite,sconcIusionregardingdetenniningtheappropnatemethodofraisingcapital,VegashouIdraisecapitalinthefb!Iowingoder;

Adebt,intemalfinancing,equity.

Bequity,debt,internalfinancing.

Cintemalfinancing,debtequity.

SIutionS

lBiscorrectPropositionI,orthecapitaIstuctueirreIevancetheoremstatesthatthelevelofdebtversusequityinthecapitalstructurehasnoeffbctoncompanyvalueinperfectmakets.

2.Ciscorrect.Thecostofequityriseswiththeuseofdebtinthecapita>structure,e.g,withincreasingfinancial>everage.

3CiscoIect.UsingEquationlfiomthereading:

000500.05I-0.200.50!0.I6orl6pecen.

Ciscorrect.Ifthecompany,sWACCincreasesasaresultoftakingonadditionaldebt,thecompanyhasmovedbeyondtheoptimaIcapitalrange.Thecostsoffinancialdistressmayoutweighanytaxbenefitstotheuseofdebt

5AiscoITect.TheuseofIong-mamIitydebtisexpectedtobeinverselyrelatedtothe>eve>ofinflation.

6Aiscorrect.AccordingtothepeckingordertheoIyinternallygeneratedfUndsareprefbrabletobothnewequityandnewdebt.Ifintemalfinancingisinsufficient,managersnextprefbrnewdebt,andfinaIlynewequity.

7Biscorrect.Thestatictrade-offtheoryindicatesthatthereisatrade-offbetweenthetaxshieldfiDminterestondebtandthecostsoffinanciaIdistress,leadingtoanoptima>amountofdebtinacompany,scapitaIstmcture.

8.Aiscoect.Themarketvalueofequityis30l0,000000300,000,000.Withthemarketva>ueofdebtequaIto$l00,000,000,themarketvalueofthecompanyis$l00,000000+$300,000,000=$400,000,000.Therefbre,thecompanyis$l00,000,000/$400,000,000=0.25or25%debt-financed

gBiscorrect.

l}/(I-/)=008(I-0.35)=0052=5.20%tc

OcSB

01

!liII-I

I;l:!l-0.35)003000.08l=0.l08=l0.80%

l1Biscorrect.Let1E

IH1C-

l43

AM20,it0.20.0770.5080250II00=I!.00%

AtD/I=30%,!h=(0.3)(0.08)(>-0.J5)+(0.7)(0.l30)=0I7=l071%

AM40lh010.00I-0.350.60400.I082=I082%

AtDs0,ib0.500I0.350.50l600l38=II.38%

1ZAiscoect.Theahertaxcostofdebtdecreasesasthemarginataxrateincreases.

13CiscorrectIfintemaygeneatedfUndshaveaIreadybeenfUyused,theuseofnewdebtmaybeoptimal,accordingtothepeckingordetheoryofcapitalstmcture

EBIT(l-/)}1MBiscorrect.

)\Ic

BecauseDE060andDZm,thenEZm0.603,333,333

So,ValueofcompanyDE2,000,0003,333,3335,333,333

EBIT(l-/)(600.000)(I-0.30)

- =5,333,333Because#1=

(600.000)(l-030) =0.0787=787%So,l! 05]33333

!IIHIiiHll

L-!;IHI-III=I0+l.68=lI68%

Therefbre

M4

|

w= IH-0I=I.58+7.30=8.88%

< >

I6Biscorrect.IfBema,sdegreeofoperatingleveragedecinesreIativetothatofAquarius,Bema,sbusinessriskwiIIaIsodeCIineeIativetoAquaius.AeIsebeingequaI,thisdeclinewouldbeexpectedtocseBema,smarketvauereativetoAquanus;e.g.,bydecreasingBema,scostofequity.

17Ciscorrect.

bb-tI-ITl-400,000!-0302.800.000l/=

/0 0I0

l).=l{/+/D=(MmiI!ion)+(030)(!milIioI>)=3.I0miIIioI]E1I30miIIionImilioIl2.l0miIIion

:II0-I-}b=!i]+(}{)-/J)(I-/)I0I.Il.33

< >

I8Aiscorrect.ThestatementimpliesthatGarthpossessesalowerabi>itytoassumedebtthandoesHoIte,aIIelsebeingequal

l9Ciscorrect.AccordingtothepeckingordertheoIy,managesprefbrintemalfinancingIfintemaIfInancingisnotsufficient,managersnextprefbrdebt,andfinallyequity.

M5

EOC03AEOC03BEOC03CEOC03DEOC03E