Final ReviewFinal ReviewPreparationPreparation for the final for the final examexam

Review TopicsReview TopicsCapital BudgetingCost of CapitalMergers & AcquisitionsInternational FinanceCases

Capital BudgetingCapital Budgeting Understand the role of capital budgeting

techniques in the capital budgeting process. Calculate, interpret, and evaluate the

payback period. Calculate, interpret, and evaluate the net

present value (NPV). Calculate, interpret, and evaluate the

internal rate of return (IRR). Use net present value profiles to compare

NPV and IRR techniques. Discuss NPV and IRR in terms of conflicting

rankings and the theoretical and practical strengths of each approach.

Capital BudgetingCapital BudgetingAdministrative Steps:

◦Identify Projects◦Collect Data◦Analyze Profit and Risk◦Gain Regulatory Approvals◦Arrange Financing◦Implement◦Control

Capital BudgetingCapital BudgetingNPV vs. IRR

◦ Conflicting rankings between two or more projects using NPV and IRR sometimes occurs because of differences in the timing and magnitude of cash flows.

◦ This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project.

◦ NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.

Capital BudgetingCapital BudgetingOn a purely theoretical basis, NPV is the better

approach because:◦ NPV assumes that intermediate cash flows are

reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR,

◦ Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR.

Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return.

Capital Budgeting – Problem Capital Budgeting – Problem 1 1

Pound Industries is attempting to select the best of three mutually exclusive projects. The initial investment and after-tax cash inflows associated with these projects are shown in the following table:

a. Calculate the payback period for each project

b. Calculate the NPV of each project, assuming that the firm has a cost of capital equal to 13%

c. Calculate the IRR for each project

d. Summarize the preferences dictated by each measure and indicate which project you would recommend. Explain why

Cash Flows Project A Project B Project C

Initial Investment CFo

$60,000 $100,000 $110,000

Cash Inflows (t=1 to 5)

$20,000 $31,500 $32,500

Capital Budgeting – Solution Capital Budgeting – Solution 11Payback Period:

◦ Project A: $60,000 / $20,000 = 3.0 years◦ Project B: $100,000 / $31,500 = 3.2 years◦ Project C: $110,000 / $32,500 = 3.4 years

NPV:◦ CF0 = -60,000 , C01 = 20,000, F01 = 5, I =

13% NPVa = $10,345◦ NPVb = 10,793◦ NPVc = 4,310

IRR:◦ IRRa = 20%◦ IRRb = 17%◦ IRRc = 15%

Capital Budgeting – Problem Capital Budgeting – Problem 22 Russell Industries is considering replacing a

fully depreciated machine that has a remaining useful life of 10 years with a newer, more sophisticated machine. The new machine will cost $200,000 and will require $30,000 in installation costs. It will be depreciated under MACRS using a 5-year recovery period. A $25,000 increase in net working capital will be required to support the new machine. The firm’s managers plan to evaluate the potential replacement over a 4-year period. They estimate that the old machine could be sold at the end of 4 years to net $15,000 before taxes; the new machine at the end of year 4 has a value of $75,000 that is relevant to the proposed purchase of the new machine. The firm is subject to a 40% tax rate.

Capital Budgeting – Solution Capital Budgeting – Solution 22After-tax proceeds from sale of new asset:

Proceeds from sale of new machine 75,000

− Tax on sale of new machine l (14,360)

Total after-tax proceeds-new asset 60,640

− After-tax proceeds from sale of old asset

Proceeds from sale of old machine (15,000)

+ Tax on sale of old machine 2 6,000

Total after-tax proceeds-old asset (9,000)

+ Change in net working capital 25,000

Terminal cash flow 76,640

l Book value of new machine at end of year.4: [1 − (0.20 + 0.32+ 0.19 + 0.12) × ($230,000)] = $39,100

$75,000 − $39,100 = $35,900 recaptured depreciation

$35,900 × (0.40) = $14,360 tax liability

2 Book value of old machine at end of year 4: $0

$15,000 − $0 = $15,000 recaptured depreciation

$15,000 × (0.40) = $6,000 tax benefit

Cost of CapitalCost of CapitalDebt or Equity?Optimal Capital StructureLeverageCost of Capital

◦Cost of Debt◦Cost of Equity◦Cost of Preferred Stock

Cost of Capital – Problem (part Cost of Capital – Problem (part 1)1) Edna Reporting Studios Inc, reported earnings available

to common stock of $4,200,000 last year. From those earnings, the company paid dividends of $1.26 on each of each $1,000,000 common shares outstanding. The capital structure of the company includes 40% debt, 10% preferred stock and 50% common stock. It’s taxed at a rate of 40%.

a. If the market price of the common stock is $40 and dividends are expected to grow at a rate of 6% per year for the foreseeable future, what is the cost of financing with retained earnings?

b. If under pricing and flotation costs on new shares of common stock amount to $7.00 per share, what is the company’s cost of new common stock financing?

c. The company can issue $2.00 dividend preferred stock for a market price of $25.00 per share. Flotation costs would amount to $3.00 per share. What is the cost of preferred stock financing?

Cost of Capital – Solution (part Cost of Capital – Solution (part 1)1)

(a) Cost of Retained Earnings

r$1.26(1 0.06) $1.34

k 0.06 3.35% 6% 9.35%$40.00 $40.00

(b) Cost of New Common Stock

s$1.26(1 0.06) $1.34

k 0.06 4.06% 6% 10.06%$40.00 $7.00 $33.00

(c) Cost of Preferred Stock

p$2.00 $2.00

k 9.09%$25.00 $3.00 $22.00

Cost of Capital – Problem (part Cost of Capital – Problem (part 2)2)

d. The company can issue $1,000-par-value, 10% coupon, 5-year bonds that can be sold for $1,200 each. Flotation costs would amount to $25.00 per bond. Use the estimation formula to figure the approximate cost of new debt financing.

e. What is the maximum investment that Edna Recording Studios can make in new projects before it must issue new common stock?

f. What is the WACC for projects with a cost at or below the amount calculated in part e?

g. What is the WACC for projects with a cost above the amount calculated in part e, assuming that the debt across all ranges remains at the percentage calculated in part d?

Cost of Capital – Solution (part Cost of Capital – Solution (part 2)2)

(d) d

$1,000 $1,175$100 $65.005k 5.98%

$1,175 $1,000 $1,087.502

ki 5.98% (1 0.40) 3.59%

(e) common equity$4,200,000 ($1.26 1,000,000) $2,940,000

BP $5,880,0000.50 0.50

(f) WACC (0.40)(3.59%) (0.10)(9.09%) (0.50)(9.35%)

WACC 1.436 0.909 4.675

WACC 7.02% This WACC applies to projects with a cumulative cost between 0 and $5,880,000.

(g) WACC (0.40)(3.59%) (0.10)(9.09%) (0.50)(9.44%)

WACC 1.436 0.909 4.72

WACC 7.07%

This WACC applies to projects with a cumulative cost over $5,880,000.

Mergers & Acquisitions – Mergers & Acquisitions – Problem 1Problem 1 Toni’s Typesetters is analyzing a possible

merger with Pete’s Print Shop. Toni’s has a tax loss carry forward of $200,000, which it could apply to Pete’s expected earnings before taxes of $100,000 per year for the next five years. Using a 34% tax rate, compare the earnings after taxes for Pete’s over the next 5 years both without and with the merger.

Mergers & Acquisitions – Mergers & Acquisitions – Solution 1Solution 1

After-Tax Earnings Without the Merger Year 1 Year 2 Year 3 Year 4 Year 5

EBIT $100,000 $100,000 $100,000 $100,000 $100,000 Taxes 34,000 34,000 34,000 34,000 34,000 AT Earnings $66,000 $66,000 $66,000 $66,000 $66,000

After-Tax Earnings With the Merger

Year 1 Year 2 Year 3 Year 4 Year 5 Earnings before losses $100,000 $100,000 $100,000 $100,000 $100,000 Tax Loss Carry Forward 100,000 100,000 0 0 0 Earnings before taxes $0 $0 $100,000 $100,000 $100,000 Taxes 0 0 34,000 34,000 34,000 AT Earnings $100,000 $100,000 $66,000 $66,000 $66,000

Mergers & Acquisitions – Mergers & Acquisitions – Problem 2Problem 2The Riverside Company is considering the acquisition of the Hudson Corporation by exchanging 1.5 shares of its stock for each share of Hudson common stock. The Riverside Company does not expect any change in its price/earnings multiple after the merger. Some key data on the companies follow.

Riverside Co. Hudson Corp.

Earnings available for common stock $281,250 $62,500 Number of shares of common stock outstanding 112,500 18,750 Market price per share $56.25 $62.50

(a) Calculate the ratio of exchange based on market prices.

(b) Calculate the earnings per share (EPS) and price/earnings (P/E) ratio for each company.

(c) Calculate the P/E ratio used to purchase Hudson Corp.

(d) Calculate the expected market price per share of the merged firm.

Mergers & Acquisitions – Mergers & Acquisitions – Solution 2Solution 2(a) Ratio of exchange (Market price per share of acquiring firm number of shares exchanged) Market price per share of target firm

($56.25 1.5) $62.50

1.35

(b) Riverside Co. EPS $281,250 $112,500

$2.50

Riverside Co. P/E $56.25 $2.50

22.5

Hudson Corp. EPS $62,500 $18,750

$3.33

Hudson Corp. P/E $62.50 $3.33

18.77 (c) P/E ratio to purchase Hudson Corp.:

1.5 $56.25 $84.38

$84.38 $3.33 25.34 P/E

(d) EPS of merged firm ($281,250 + $62,500) $343,750

= = = $2.44(18,750 1.5) + 112,500 140,625

Price per share EPS P/E

$2.44 22.5

$54.90

International FinanceInternational Finance Understand the major factors that influence

the financial operations of multinational companies (MNCs).

Describe the key differences between purely domestic and international financial statements –consolidation, translation of individual accounts, and international profits.

Discuss exchange rate risk and political risk, and explain how MNCs manage them.

Describe foreign direct investment, investment cash flows and decisions, the MNCs’ capital structure, and the international debt and equity market instruments available to MNCs.

Discuss the role of the Eurocurrency market in short-term borrowing and investing (lending) and the basics of international cash, credit, and inventory management.

Review recent trends in international mergers and joint ventures.

International FinanceInternational FinanceFloating exchange rate key factors:

◦Relative Interest Rates◦Relative Inflation Rates◦Relative Economic Growth Rates

Exposure to Foreign Currency Risk:◦Economic Exposure◦Transactions Exposure◦Translation Exposure

Case StudiesCase Studies

For the exam:Netscape IPONational Wind PowerLockheed Martin & LoralMassachusetts Carnegie Bank