Problems-Finance Fall, 2014

8/11/2019 Problems-Finance Fall, 2014

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Problem Sets

CCBU 517Corporate Financial Management

Fall, 2014

Show your work. In the instances where I ask you to use Excel, be sure to show the

arguments in your formula. Even if you use a financial calculator to answer the

questions, please show the formula that you used to solve the problem and the key stepsyou took to solve it. Also, be neat and organized when presenting your work.

CHAPTER 1AN OVERVIEW OF CORPORATE FINANCE AND THE

FINANCIAL ENVIRONMENT

1. What is the objective of the firm?

2. Why is this a good objective?

3. What are Free Cash Flows? How are Free Cash flows calculated?

4. Why do we want to measure value based on futureexpected free cash flows and not just current freecash flows?

5. What are the 5 uses of Free Cash Flows?

6. What are 3 ways that managers can increase the value of their firm?

7. What is the Principal/Agent Problem in relation to the structure of a corporation?

8. What are 3 ways that the Principal/Agent problem can be minimized in a company through corporategovernance? Note: Take a look at Chapter 13 Section 2 on Corporate Governance. This will provideyou with some ideas on this question.

9. Explain how mortgages get securitized today? Contrast that with how mortgages were sold to

home-buyers in the 1950s. Who bore the risk of mortgage default in the 1950s? Who bears the risktoday in a world of securitizized mortgages?

10.What are 10 reasons behind the financial meltdown from 6 years ago?

11.What are 4 features of the Dodd-Frank bill that was passed in 2010 that are designed to help preventthe next financial crisis?


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CHAPTER 2FINANCIAL STATEMENTS, CASH FLOWS, AND TAXES

1. You are given the Balance Sheet and Income Statement for Acme Corp in the embedded spreadsheet.

Chapter 2 HomeworkProblem.xlsx

a) Create a Statement of Cash Flows for Acme from this information.b) Demonstrate that the Net Operating Capital in 2013 is the same number as Investor Supplied

funds in 2013?c) What is Free Cash Flows (FCF) for 2013?d) Calculate the uses of Free Cash Flows (FCF) in 2013 and show that the sum of them equals the

total in your answer above.e) What is the Return on Invested Capital (ROIC) for 2013?f) What is the Economic Value Added (EVA) for 2013

g) What is the Market Value Added (MVA) in 2013?h) How much Federal tax did Acme pay in 2013?

2. A company experienced a decline in net operating profit after taxes (NOPAT). Which of the followingcan help explain this decline? Note: there is only one answer.

a. Sales revenues increasedb. Dividends increasec. Interest expense increased.d. Taxes increased

3. All else being equal, which of the following would cause a decrease in net operating working capital?Note: There can be more than one answer.

a. Notes Payable increases.b. Long-Term Debt increases.c. Accounts Payables decrease.d. Accounts Receivables decrease.e. Inventories increase

4. The CFO of a company suggests should it issue $300 million worth of common stock and use theproceeds to reduce some of the company's outstanding debt. Assume that the company adopts thispolicy, and that total assets and operating income (EBIT) remain the same. The company's tax ratewill also remain the same. Which of the following will occur:

a. The company's net income will increase.b. The company's taxable income will fall.c. The company will pay less in taxes.d. All of the answers above are correct.


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5.

5. Which of the following best describes free cash flow? Note: there is only one answer.

a. Free cash flow is the amount of cash flow available for distribution to shareholders afterall necessary investments in operating capital have been made.

b.c.

Free cash flow is the net change in the cash account on the balance sheet.Free cash flow is the amount of cash flow available for distribution to all investors after all

necessary investments in operating capital have been made.d. Free cash flow is equal to net income plus depreciation.

6. As measured in dollars, what would be the EVA of a firm if it was earning just normal profits?

7. A company recently reported that its dividends per share were $4.00 (Dividends / Number of shares).The company pays out 50% of its Net Income in dividends. The company has 1,500,000 shares ofstock outstanding. The company's interest expense was 10% on $10M of debt. The corporate tax rateis 40 percent. What was the company's operating income (EBIT)?

a. $1,980,000

b. $17,780,000c. $21,000,000

8. Given the information in the previous question and assuming that the company has annual depreciationof $500K and gross investments of $1M, what is the firms free cash flow for the year?

9. A company has sales of $12.5M, operating expenses of $9.25M and a ROS of 11%. Its WACC is10% and it's EVA is $500K. Assume a tax rate of 40%.

a) What is the Interest Expense for this company?

b) What is the Net Operating Capital for this company?

.Corporations face the following tax schedule:

Taxable Income Tax on Base Rate$ 0 - $ 50,000 0 15%$ 50,000 - $ 75,000 7,500 25%$ 75,000 - $100,000 13,750 34%$100,000 - $335,000 22,250 39%

A company has $85,000 of taxable income from its operations.

a. What is the tax liability of this company?b. What is the average tax rate for this company?


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CHAPTER 3ANALYSIS OF FINANCIAL STATEMENTS

1. Other things held constant, which of the following will notaffect the quick ratio? (Assume thatcurrent assets equal current liabilities.)

a. Fixed assets are sold for cash which is put into the cash account on the balance sheet.b. Cash is used to purchase inventories.

c. Cash is used to pay off accounts payable.d. Accounts receivable are collected and the funds put into the Cash account.e. Long-term debt is issued to pay off a short-term bank loan.

2.

2. Company R and Company S each have the same operating income (EBIT) and basic earning power(BEP) ratio. Company S, however, has a lower times-interest-earned (TIE) ratio. Which of thefollowing statements is most correct?

a. Company S has a higher ROA.b. Company S has a higher net income.c. Company S has a higher interest expense.

d. Statements a. and b. are correct.e. Statements a., b., and c. are correct.

3. Which of the following actions will increase a company's Basic Earning Power (BEP)? There is onecorrect answer.

a. Reduce interest payments by reducing/restructuring debt.b. Managing inventories better to reduce their inventory holdings.c. Reduced tax rates.d. Adjusting the capital structure to more debt and less equity.e. Reduce sales but operating expenses and depreciation remain the

same.

4. Which of the following alternatives could potentially result in a net increase in a company's free cashflow for the current year?

a. Reducing the days-sales-outstanding ratio. Additional cash generated would be put intothe Cash account on the Balance Sheet.

b. Decreasing the accounts payable balance.c. Reductions in investments in plant and equipment.

5.

5. Which of the following could result in an improvement in the Return on Equity (ROE) of a company?Note: There can be more than one correct answer.

a. The company is able to finance its debt with a lower interest rate than before.b. The company decides to buy back stock (reducing the number of shares outstanding)

by issuing more debt.c. Sales decline due to a slump in the economy. Assume there is no change in operating

expenses.d. Energy costs increase as gas prices rise thereby increasing operating expenses.


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6. Suppose a company has a Total Asset Turnover = 2.00, BEP = 9%, TIE = 3.0, a tax rate of 40% andTotal Assets = $1,000. What is the companys ROS?

a. 1.8%b. 2.0%c. 2.8%d. 5.0%

7. Suppose you have the following information about a firm. Assume a 40% tax rate.

Total Asset Turnover (TAT) 2.00

BEP 9.0%

TIE 3.00

Assets $1,000

Common Equity $500

Using the DuPont formula, determine the ROE. Show all 3 terms of the DuPont formula in your

calculations.

a. 6.2%b. 7.2%c. 12.5%

8. A company uses only common equity capital (zero debt). Its sales last year were $1M, its netincome was $100K and its ROE was 9%. Stockholders recently voted in a new management teamthat has promised to lower costs and increase the ROE to 12%. What profit margin would thecompany need in order to achieve the 12% ROE target, holding everything else constant?

9. A company has the following financial metrics.

Sales $1,200

Debt Ratio 0.5

Total Asset Turnover 2.0

Fixed Asset Turnover 3.0

Inventory Turnover 12.0

Current Assets / Current Liabilities 1.5

Cash/Current Assets 20%

Accounts Receivable / Accounts Payable 80%

Notes Payable / Current Liabilities 20%

Given this information, complete the following Balance Sheet.

Assets LiabilitiesCash ? Accruals ?

Accounts receivable ? Accounts payable ?


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Inventory ? Notes payable ?

Current Assets ? Current Liabilities ?

Plant & Equipment ? Long-Term Debt ?

Common Equity & Retained Earnings ?

Total Assets ? Total Liabilities & Shareholder Equity ?

10.Last year a company had sales of $500K, operating costs of $400K and year-end assets of $250K.The debt/total assets ratio was 30%, the interest rate on the debt was 5% and the firms tax ratewas 40%. Now suppose the firm had used a 55% debt ratio instead of a 30% ratio. Assume thatsales and total assets would not be affected and that the interest rate and tax rate remained thesame as before. By how many percentage points would ROE change in response to the change inthe capital structure?

11.You are given the following information: Stockholders' equity (booked equity) = $1,250;

price/earnings ratio = 5; shares outstanding = 25; market/book for equity ratio = 1.5. Calculate themarket price of a share of the company's stock.

a. $33.33b. $75.00c. $100.00d. $166.67

12.A company has the following data for the current year:

Sales $950

Opex Exp+Depre $400Debt Ratio (Debt/Assets) 50%

Debt $3,500

Tax Rate 40%

Interest Rate on Debt 6%

Sales will grow 20% next year. Operating expenses & Depreciation will grow 10%. And as a result ofthe sales growth, assets will grow at 10% but the same Debt/Asset ratio will be maintained.

a) What is the ROA, ROS and Total Asset Turnover for the current year?b) As a result of the sales change, what will be the revised ROA, ROS and Total Asset Turnover?

13.A company has 100,000 shares of common stock outstanding. The company's stock price = $27per share and its P/E is 10. What are the earnings (Net Income) of this company?

14.Your company had the following balance sheet and income statement information for 2013:


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The industry average for DSO is 20 days. You think you can change your collectionsprocedures so that you can achieve that average. The result of your efforts is that this isexpected to generate additional cash for you since your collections will be accelerated.

You plan on buying tax-exempt securities which pays 6% interest annually. The interestpayments you receive are interest income to your company and are added to your net incomefrom operations. Because these are tax exempt, they boost your net income on a dollar-for-dollar basis. What will your profit margin be after the change in your collections procedure isreflected in the income statement?

15.A firm has $1M in debt and pays 6% annual interest on that debt, has sales of $2 million, a tax rateof 40 percent, and a net profit margin (ROS) of 10%. What is the firm's times-interest-earnedratio?

CHAPTER 4TIME VALUE OF MONEY

1. You deposit $1,700 in a savings account that pays 1.5 percent interest, compounded annually. Howmuch will your account be worth in 25 years? Show the formula and the compounding factor youused to calculate your answer.

2. You can earn 4 percent interest, compounded annually. How much must you deposit today towithdraw $5,500 in 5 years? Make sure you show the formula and the present value factor you usedto calculate your answer.

.

Balance Sheet:

Assets LiabilitiesCash $300 Accruals $0

A/R $800 Accounts Payable $0

Inventories $2,500 Notes Payable $0

Current Assets $3,600 Current Liabilities $0

Debt $2,500

Net Fixed Assets $3,900 Equity $5,000

Total Assets $7,500 Total Liabilities $7,500

Income Statement:

Sales $8,500

Cost of goods sold $6,000

EBIT $2,500

Interest (10%) $250

EBT $2,250

Taxes (40%) $900

Net Income $1,350ROS

15.9%


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3. Suppose you invested $10,000 in stocks 35 years ago. If your account is now worth $36,500, whatannual rate of return did your stocks earn? Show the formula and calculations used to determineyour answer.

4. You are currently investing your money in a bank account which has a nominal annual rate of 1%compounded annually. If you invest $10,000 today, how many years will it take for your account togrow to $20,000? Solve the problem algebraically.

a. 35 years

b. 70 yearsc. 140 years

5. What is the future value of a 15-year ordinary annuity with annual payments of $200, evaluated at a 3percent interest rate? Show the formula used and the annuity factor you used to calculate your answer.

6. What is the present value of a 5-year ordinary annuity with annual payments of $250, evaluated at a 5percent interest rate? Show the formula and discounting factor used to calculate your answer.

7. Suppose that instead of an ordinary annuity, this was an annuity due. What would be the present valueof this annuity?

8. If a 5-year ordinary annuity has a present value of $1,500, and the interest rate is 2 percent, what is theamount of each annuity payment? Show your formula and interest factor.

9. You have the opportunity to buy a perpetuity which pays $1,000 annually. Your required rate of returnon this investment is 2 percent. What is the highest price would you be willing to pay for thisperpetuity?

10.You are given the following end-of-year cash flows. Assuming a 7% interest rate, what is the present

value of these cash flows? Solve this algebraically.

Year 1 Year 2 Year 3 Year 4

$4,000 $4,000 $4,500 $4,800

11.Which of the following investments would provide an investor the highest effective annual return?a. An investment which has a 8.6 percent nominal rate with daily compounding.b. An investment which has a 8.9 percent nominal rate with monthly compounding.c. An investment which has a 9.5 percent nominal rate with quarterly compounding.d. An investment which has a 9.6 percent nominal rate with semi-annual compounding.

12.Suppose we have a 10-year ordinary annuity that has a present value of $1,000 and an nominal annualinterest rate is 9.5 percent. If interest is compounded quarterly, what is the value of the quarterlypayment?

a. $37.50b. $39.00c. $52.45


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13.You borrow $300,000 at a 6.00% interest rate. You make annual payments (at the end of the year) for20 years.

a. What is your annual payment?b. How much interest did you pay in year 10?c. How much principal will you pay in year 5?d. What is the total amount of interest you will pay?e. Demonstrate that your loan is fully paid up at the end of year 20.

Solve for this using the appropriate annuity formula and Excel table.

CHAPTER 6Risk and Return

1. Stock A has a beta of 1.5 and Stock B has a beta of .9. Which one of the following statements iscorrect? Note: There is only one correct answer.

a. The required return on Stock A will be greater than Stock B.

b. The slope of the SML for Stock A is steeper than Stock B.c. Stock B is riskier than the entire market.d. The required return on Stock B will be greater than Stock A.

2. A risk-averse investor is considering two possible assets to be held on a standalone basis. The possiblereturns and related probabilities (i.e. the probability distributions) for each assets are as follows:

Asset X Asset Y

Prob r Prob r

5% -5% 5% -2%

15% 5% 15% 4%

25% 6% 20% 4%25% 7% 25% 9%

30% 12% 35% 11%

Considering both its return and risk, which asset is preferred? Why?


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3. Given the returns and probabilities for assets X and Y below, which asset would be preferred if youwere interested in minimizing your relative risk?

Asset X Asset Y

Prob r Prob r

5% -2% 5% 2%

15% 5% 15% 4%

25% 6% 20% 7%

25% 7% 25% 9%

30% 12% 35% 14%

4. You are a risk-averse investor. Suppose two stocks had the following historical returns

Stock A Stock B

Year 1 10% 10%

Year 2 11% 7%

Year 3 9% 12%

Year 4 13% 10%

Year 5 7% 12%

Further suppose you have 3 investment optionsa) hold only Stock A, b) hold only Stock B or c) hold aportfolio consisting of 50% of each stock. Which would you choose? Why?

5. Which of the following statements are correct?a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate

all the risk from the portfolio.b. Diversifiable (or company-specific or unsystematic) risk can be reduced by forming a

large portfolio, but even highly diversified portfolios will still be subject to market (orsystematic) risk.

c. Only if the portfolio beta is greater than 1 will unsystematic risk be reduced by addingstocks to a portfolio.

6. Suppose the correlation coefficient between two stocks is equal to +1. Can you reduce your risk bycreating a portfolio that consists of these two stocks? Explain your reasoning.

7. Suppose two investments yield the same fixed return as measured in dollars, say, $100. But the returnto one security has certainty (such as a US Treasury obligation) and the return to the other is uncertain(such as a junk bond which may default). And further suppose that, for the moment, the price of eachsecurity is $1,000 and the percentage return of each is 10%. This situation cannot persist as investorsbuy and sell these bonds in response in response to the perceived risk differences. What would be apossible equilibrium price and return for each security?

a. Treasury Security: Price = $800, r = 16.67%Junk Bond: Price = $1,200, r = 8.33%

b. Treasury Security: Price = $1,500, r = 6.67%Junk Bond: Price = $850, r = 11.8%

c. Treasury Security: Price = $1,200, r = 20%Junk Bond: Price = $750, r = 12%


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8. Stock A and Stock B each have an expected return of 15 percent, a standard deviation of 20 percent,and a beta of 1.2. The returns of the two stocks are not perfectly correlated as the correlationcoefficient is 0.6. You have put together a portfolio which is 50 percent Stock A and 50 percentStock B. Which of the following statements is correct? Note: There is only one correct answer.

a. The portfolio's expected return is greater than 15 percent.

b. The portfolio's beta is less than 1.2.

c. The portfolio's standard deviation is greater than 20 percent.

d. None of the statements are correct.

9. The required rate of return on the stock using the Security Market Line formula is 8% when therequired return on an average stock in the market (rm) is 10 percent. The risk-free rate is 2%.

What will be the percentage change in the return to this stock if rm increases by 10 percent? (Note:Not 10 percentage points but 10%. So, for example, if rm=10%, 1.1 x 10% = 11%.) Note that therisk-free rate is unchanged.

10.Assume that the risk-free rate, rRF, is 6 percent and the market risk premium, (rM- rRF), is 5 percent.Assume that required returns are based on the CAPM (Security Market Line formula). Your $1million portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 investedin a stock that has a beta of 0.8. Which of the following statements is correct? (Note: There is only 1correct answer.)

a. The portfolio's required return is less than 11 percent.b. If the risk-free rate remains unchanged but the market risk premium increases by 2

percentage points (from 5% to 7%), the required return on your portfolio will increase bymore than 2 percentage points.

c. If the market risk premium remains unchanged but expected inflation increases by 2percentage points, the required return on your portfolio will increase by more than 2

percentage points.d. If the stock market is efficient, your portfolio's expected return should equal the expected

return on the market, which is 11 percent.

11.What condition holds when a stock is in equilibrium -a. The expected future return equals the current return.b. The expected return equals the required return.c. Beta = 1.

Note: there is only one correct answer.

12. If markets are semi-strong efficient, can the average investor successfully pick individual stocks?Explain your reasoning.


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CHAPTER 5BONDS AND THEIR VALUATION

1. Will an unsecured bond (i.e. a bond with no asset as collateral) have a higher or lower yield-to-maturity than a mortgage-backed bond? Explain your reasoning.

2. The Yield Curve is generally positively slopedTreasury bills have a lower yield than Treasurybonds. What explains the unusual situation when a Treasury bill has a higher yield-to-maturity than a

20-year Treasury bond?

3. Which of the following statements is correct? (Note: There can be more than one correct answer.)

a.b.

All else equal, short-term bonds have less reinvestment risk than long-term bonds.All else equal, long-term bonds have a greater maturity risk premium than short-term bonds.

c. Corporate securities have a smaller inflation premium than a similar Treasury security.d. All bonds have the same liquidity risk premium.e. All bonds have the same default risk premiumf. All of the above answers are false.

4. Suppose the U.S. Federal Government defaults on paying the interest on its debt obligations. What doyou think will happen to yields on Federal Government debt obligations? Explain your reasoning.

5. Assume interest rates on 10-year federal government and 10-year corporate bonds were as follows:

US Treasury bond = 7.72% Corporate A-Rated Bonds = 9.64%Corporate AAA-Rated Bonds = 8.72% Corporate BBB-Rated Bonds = 10.18%

The differences in rates among these issues were caused primarily by -a. Tax effects.

b. Default risk differences.c. Maturity risk differences.d. Inflation differences.e. Answers b and d are correct.

6. You would like to minimize your interest rate risk (maturity risk) and your default risk. Which of thepossible bonds listed below best satisfies your requirements?a. AAA bond with 10 years to maturity.b. BBB perpetual bond.c. BBB bond with 10 years to maturity.d. AAA bond with 5 years to maturity.e. AA bond with 5 years to maturity.f. 90-day Treasury Bill

7. You noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for$950. The annual coupon rate is 10 percent and there are 4 years to maturity. If the required return onthis investment is 11 percent, should you make the purchase?


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8. Consider a $1,000 par value bond with a 5 percent annual coupon. The bond pays interest annually.There are 7 years remaining until maturity. What is the current yield on the bond assuming that therequired return on the bond is 9 percent?

a. 9.00%b. 6.26%c. 4.78%

9. A bond has a par value = $1,000. The annual required rate of return on this bond is currently 7 percent,

and interest is paid semi-annually. The bond matures in 5 years and its current market value is$1041.58. What is the semi-annual coupon payment?

a. $35b. $40c. $80

10.The current yield-to-maturity on a 10-year corporate bond is 7%. You are given the followinginformation on this bond.

r* = real risk-free rate on Treasury & corporate bonds = .5%Maturity risk premium = 1%

Inflation premium = 2%Liquidity premium = .5%

What is the default risk premium for this bond?

11.A 20-year bond has a par value of $1,000 with a coupon return of 8.5% and a yield-to-maturity(YTM) of 11%. What is the price of this bond? Provide your answer using the NPV, PV and Pricefunctions in Excel.

CHAPTER 7STOCKS AND THEIR VALUATION

1. A share of common stock has just paid an annual dividend of $ 3.50 (D0). If the expected dividendgrowth rate for this stock is 3 percent (g) and investors require a 10 percent rate of return (rs). What isthe price of the stock?

a. $36.05b. $50.00c. $51.50

2. Given the information in the previous question, what would be the expected share price in period 2(P2)?

3. What is the dividend yield on this stock in period 0?

4. What is the expected rate of return on this stock? Show your answer by considering the dividend yieldand capital gains yield.


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5. The last dividend paid by a company was $3.00 (D0=$3.00). The dividend next year is expected to be$3.50 (D1=$3.50) and the dividend two years out is expected to be $4.00 (D2=$4.00). After that, thedividend growth rate is expected to be 4 percent forever. The company's stockholders require a rate ofreturn on equity (rs) of 12 percent. What is the current price of the stock?

a. $47.76b. $75.90c. $75.90

6. A company has decided to undertake a large capital project. And there is a need for additional funds.The financial manager plans to issue preferred stock with a perpetual annual dividend of $4.00 pershare. If the required return on this stock is currently 6 percent, what should be the price of the stock?

a. $45.33b. $66.66c. $67.66

7. The most recent dividend of a company was $2.50 per share (i.e., D0= $2.50). The dividend isexpected to grow at a rate of 4 percent per year. The risk-free rate is 1 percent and the return on themarket is 8 percent. If the company's beta is 1.1, what is the price of the stock today? Note: You need

to use the CAPM and constant dividend growth model to solve this.

8. A stock is currently selling for $30 a share. The stock is expected to pay a $1 dividend at the end of theyear (D1= $1). The stock's dividend is expected to grow at a constant rate of 2 percent a year forever.The risk-free rate (rRF) is 1 percent and the market risk premium (rM- rRF) is 5 percent. What is thebeta for this stock?a. .866b. 1.06c. 1.62

9. You are given the following data:

(1) The FCF = $200,000.(2) It is expected to grow 2% per year.(3) The WACC is 9%(4) The company has a capital structure of 30% debt and 70% equity.(5) The company has 100,000 shares outstanding.

What is the stock price?

10.A company has a current stock price of $47. This company is planning to pay a dividend of $2.50 pershare two years from now, (i.e., D2= $2.50). The company is planning to pay the same dividend each

of the following 2 years (D3= $2.50 and D4= $2.50) and will then increase the dividend to $3.00 forthe subsequent 2 years (i.e., D5 and D6). After that time the dividends will grow at a constant rate of 5percent per year. If the required return on the company's common stock is 10 percent per year, what isexpected dividend at the end of year 1 (D1)?

a. $1.80b. $2.45c. $2.50


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11.A company has 1.1M subscribers to its service. The Price/100K Subscribers ratio is $4.50. Using amarket-multiple analysis, what is the price of a share of stock for this company?

d. $4.50e. $45.50f. $49.50

12.A company has a stock price of $30.00 per share (P0= $30.00). The dividend per share in the currentperiod is $2.00 (D0= $2.00). The expected capital gains yield or long-run growth rate (g) for thecompany is a constant 1.5 percent (g=1.5%). What is the company's capital gains yield and dividendyield?

a. Capital gains yield = 1.5%; Dividend yield = 6.76%.b. Capital gains yield = 6.76%; Dividend yield = 1.5%.c.. Capital gains yield = 1.5%; Dividend yield = 6.66%.

CHAPTER 9THE COST OF CAPITAL

1. Why do we use the after-tax cost of debt but the before-tax cost of equity when calculating ourWACC?

2. Some people argue that retained earnings are free money because a company does not have to payfees to investment bankers when it issues new stock. Therefore, the firm doesnt have to worry aboutthe return on the projects that it invests in with these funds. Evaluate the validity of that statement.

3. Which of the following is notconsidered a capital component for the purpose of calculating the

weighted average cost of capital as it applies to capital budgeting?a. Long-term debt.b. Common stock.c. Receivablesd. Preferred stocke. Notes Payablef. All of the above are considered capital components for WACC and capital budgeting

purposes.

4. For a typical firm with a given capital structure of debt and common equity, which of the following iscorrect?

a. rd> rs> WACC.b. rs> rd> WACC.c. rs> WACC > rd.d. WACC > rs> rd.


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5. A company's capital structure consists of common stock and debt. Which of the following events willreducethe company's WACC?

a. An increase in the market risk premium.

b. An increase in the risk-free rate.

c. An increase in the tax rate.

d. An increase in expected inflation.

e. An increase in the companys beta.

f. An increase in the projected dividend growth rate.

6. If a company uses the same discount rate to evaluate all its projects, the firm will most likely become -a. Riskier over timeb. Less risky over timec. There is no reason to expect its risk position or value to change over time as a result of its

use of a single discount rate.

7. You have the following information about a company -

- A company wishes to finance its projects with 30% debt,10% preferred stock and 60% common stock.

- The company can issue bonds at a yield to maturity of 6.5percent.

- The cost of preferred stock is 7.5 percent.- The company's common stock currently sells for $40 a

share.- The company's dividend is currently $2.10 a share (D0 =

$2.10), and is expected to grow at a constant rate of 5percent per year.

- Assume that there is no flotation cost on debt andpreferred stock, and no new stock will be issued.

- The company's tax rate is 40 percent.

What is the company's weighted average cost of capital (WACC)?

a. 8.23%b. 8.73%c. 9.79%

8. A company has a weighted average cost of capital of 11.5 percent. Its target capital structure is 55percent equity and 45 percent debt. The company has sufficient retained earnings to fund the equityportion of its capital budget. The before-tax cost of debt is 9 percent, and the company's tax rate is 30

percent. If the expected dividend next period (D1) and current stock price are $5 and $45,respectively, what is the company's growth rate (g)?

a. 2.68%b. 3.44%c. 4.64%


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CHAPTER 10THE BASICS OF CAPITAL BUDGETING: EVALUATING CASH

FLOWS

1. What are three reasons why the NPV method preferred to the payback period method (notdiscounted payback period) when evaluating cash flows?

2. A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of the

following independent projects should the company accept? Note: there is only one correctanswer.

a. Project A requires an up-front expenditure of $1,000,000 and generates an internal rate of return9.7 percent.

b. Project B has a modified internal rate of return of 9.5 percent.

c. Project C requires an initial investment of $1,000,000 and generates a net present value of -$3,2

d. Project D has an internal rate of return of 10.2 percent.

e. Project E has a Discounted Payback Period of 24 months.

f. None of the projects above should be accepted.

3. A company has an investment opportunity which will yield the following cash flows (in thousandsof dollars). Assuming the cash flows occur evenly during the year, what is the payback period forthis investment?

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Flow -$40 $5 $10 $15 $15 $15

a. 3.00 yearsb. 3.33 years

c. 3.67 years

d. 4.00 years

4. What is the discounted payback period for these cash flows? Assume a WACC of 9%.

5. Given the cash flows in the previous problem and assuming a 9% WACC, calculate the NPV forthis project. Should this project be undertaken?

6. Using Excel, calculate the IRR for this stream of cash flows. Does your answer confirm the

results of the previous problem?


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7. A company has a project which has the following cash flows

If the cost of capital is 10%, what is the Modified Internal Rate of Return(MIRR)? Solve this problem algebraically (i.e. not using Excel).

a. 25.7%b. 30.2%c. 36.3%

8. Suppose you had the following cash flows.

YearCashflows

0 -$1,000

1 $200

2 $250

3 $300

4 $350

5 $400

Using Excel and assuming a WACC and reinvestment rate of 6%, what is the MIRR?

a) 9.6%b) 10.6%c) 13.5%

9. Suppose we have a project with an upfront investment of $2,000 and positive cash flows of $100per year for the next 100,000 years. The appropriate discount rate is 4%. Further suppose that weare evaluating this project before the time of spreadsheets and computers. So we need to make thiscalculation the old fashioned way using good ol paper and pencil. Determine the NPV of thisproject.

a. Cant be calculated because of the number of years involved.b. -$250c. $0d. $500

CHAPTER 11

CASH FLOW ESTIMATION AND RISK ANALYSIS

1. A company is thinking about expanding their business by opening another shop on property theypurchased for cash 10 years ago. Which of the following items should be included in the analysis ofthis endeavor? (Answer with a Yes or No.) And why?

a. The property was cleared of trees and brush 5 years ago at a cost of $5,000.b. The new shop is expected to affect the profitability of the existing shop since some current

customers will transfer their business to the new shop. The company estimates that profits

YearCashFlows

0 -$500

1 $300

2 $300

3 $300


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at the existing shop will decrease by 10 percent.c. The company can lease the entire property to another company (that wants to grow

flowers on the lot) for $5,000 per year.d. The company needs to purchase inventory to stock the shop prior to its opening.e. The company must pay workers to keep the shop running.f.g.

A competitor has a shop across the street selling similar goods.The cash outlay that you made 10 years ago for this property.

2. What is the impact on the cash flows of a project when you switch from straight-line depreciation toMACRS accelerated depreciation? Why?

3. A company is contemplating the replacement of its old printing machine with a new model costing$80,000. The old machine, which originally cost $60,000, has a current book value of $30,000 versusa current market value of $35,000. The company has corporate tax rate is 40 percent. If the companysells the old machine at market value, what is the net after-tax outlay for the new printing machine?

a. -$40,000b. -$46,000

c. -$47,000

4. A company is considering the introducing a new product. Annual sales are expected to be 30,000units per year for 5 years. Each unit will sell for $4.00. No inflation is anticipated. This will requireinvestment in machinery of $90,000. Operating expenses are expected to be $85,000 per year. Thecompany will use the MACRS accelerated method to depreciate the machine, and it expects to sell themachine at the end of its 5-year operating life for $6,000. The firm expects its net operating workingcapital to increase at the beginning of the project by 3% x annual sales resulting in a cash outflow.During the course of this project, there will be no net change to net operating working capital. But itsworking capital requirements will decline by 3% x annual sales at the end of 5 years as inventoriesare sold. This will result in a cash inflow. The marginal tax rate for this company is 40 percent, andit uses a 7 percent cost of capital to evaluate projects like this. What is the NPV of this project?Should the company go ahead with the project?

Below is the appropriate depreciation schedule.MACRS

Year Percent1 0.202 0.323 0.194 0.125 0.116 0.06

5. For a +/- 10% change in its base value, is the NPV more sensitive to a change in the amount ofequipment required or the unit price? Show your answer in a sensitivity table.


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6. A company is considering an investment in a new product. There are 3 stages to this project.

Stage 1: The company will invest $10,000 at t=0 for the product design and testing. The companybelieves there is a 60% probability that this phase will be successful and the project will continue. Ifthis stage is not successful, the project will be abandoned with zero salvage value.

Stage 2: If Stage 1 is successful, the company will create a prototype in Stage 2. This will cost

$500,000 at t=1. If the prototype tests well, the company will go into production. If it does not testwell, then the company will abandon the project and the prototype will be sold for $100,000. Thecompany estimates that the probably of testing success is 80%. If Stage 2 is successful, the companywill go into Stage 3.

Stage 3: This would require further investments of $1,000,000 at t=2. The product will then be sold inperiod t=3. (In other words, there is one period of sales.) If the economy is strong, the companybelieves that its net cash flows in t=3 will be $3,000,000. If the economy is average, the net cashflows in t=3 will be $1,500,000. The probability of a strong economy is 50% and an average economyis 50%.

The companys WACC is 12%.

a) What is the expected NPV of this project?b) What is the expected standard deviation of this project?c) What is the Coefficient of Variation of this project?

Note: The easiest way to set this up is use a decision tree similar to the examples in the book.

CHAPTER 12CORPORATE VALUATION AND FINANCIAL PLANNING

1. A company had the following balance sheet last year:

Assets Liabilities & Equity

Cash $300 Accounts payable $2,150

Accounts receivable $500 Accrued wages $650

Inventory $1,000 Notes payable $1,000

Current Assets $1,800 Current Liabilities $3,800

Net fixed assets $27,000 Mortgage $16,800

Common stock $4,200Retained earnings $4,000

Total assets $28,800 Total liabilities and equity $28,800


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The company has just invented a product which it expects will cause sales to increase by 50% from$10,000 to $15,000, increasing net income by $2,000 of which 50% will retain and 50% will bedistributed to shareholders as dividends. As a result of the sales increase, current assets will increaseby 50% as will current liabilities (excluding notes payable). Fixed assets will increase by 20% tosupport the increased sales.

(1) Will the company need any outside funding?(2) If it does require outside funding, how much does it need? (Assume any outside funding is donethrough an increase in notes payable.)

a. No; $0. No AFN required. And no surplusb. Yes; $3,900 in AFNc. Yes; $4,100 in AFNd. No; there will be a $150 surplus.

2. You are given the Income Statement and Balance Sheet for Acme in the embedded spreadsheet.

Chapter 12

Homework Problem.xl

Calculate the followinga. Horizon Valueb. Value of Operationsc. Share price.d. Will the company have surplus or deficit financing requirements? How much?

Note: There are a series of assumptions that should underlie your analysis. Assume that the variousfinancial ratios are the same for every year as the current 2013 ratios. Assume that the sales growthrate and the dividend growth rate is the same as their 2013/2012 values. Run your projections for 5years.

a) Horizon Valuei) $1,979ii) $2,155iii) $2,432

b) Value of Operationsi) $1,668ii) $1,768iii) $2,155

c) Share Price

i) $10.23ii) $11.67iii) $14.67

d) Financing requirementsi) Surplus. $10ii) Deficit: $32iii) Deficit: $27


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3. If Acme improves its COGS (excluding depreciation) by 1 percentage point (e.g. from 87.2% of salesto 86.2% of sales), what will be the new share price?

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Problems-Finance Fall, 2014