> q`0DkbjbjqPqP :::Dc.8.8.8.8|8l>"9"9"9"9"9"9"9"9>>>>>>>$,AhC`'>w:"9"9w:w:'>"9"9<>===w:6"9"9>=w:>==="99EO.8;=>R>0>=C=C=C=H"9Ln96=9,9"9"9"9'>'>="9"9"9>w:w:w:w:$(+D+Topic 5 Risk and return
P51 Rate of return Douglas Keel, a financial analyst for Orange Industries, wishes
to estimate the rate of return for two similar-risk investments, X and Y. Douglass research indicates that the immediate past returns will serve as reasonable estimates of future returns.
A year earlier, investment X had a market value of $20,000; investment Y had a market value of $55,000. During the year, investment X generated cash flow of $1,500 and investment Y generated cash flow of $6,800. The current market values of investments X and Y are $21,000 and $55,000, respectively.
a. Calculate the expected rate of return on investments X and Y using the most recent years data.
b. Assuming that the two investments are equally risky, which one should Douglas recommend? Why?
P53 Risk aversion Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are shown below. If Sharon Smith is risk-averse, which investment, if any, would she select? Why?
Expected Expected
Investment return risk index
X 14% 7%
Y 12 8
Z 10 9
P54 Risk analysis Solar Designs is considering an investment in an expanded
product line. Two possible types of expansion are being considered. After investigating
the possible outcomes, the company made the estimates shown in the
following table:
Expansion A Expansion B
Initial investment $12,000 $12,000
Annual rate of return
Pessimistic 16% 10%
Most likely 20% 20%
Optimistic 24% 30%
a. Determine the range of the rates of return for each of the two projects.
b. Which project is less risky? Why?
c. If you were making the investment decision, which one would you choose?
Why? What does this imply about your feelings toward risk?
d. Assume that expansion Bs most likely outcome is 21% per year and that
all other facts remain the same. Does this change your answer to part c?
Why?
P57 Coefficient of variation Metal Manufacturing has isolated four alternatives for meeting its need for increased production capacity. The data gathered relative to each of these alternatives are summarized in the following table:
Expected Standard
Alternative return deviation of return
A 20% 7.0%
B 22 9.5
C 19 6.0
D 16 5.5
a. Calculate the coefficient of variation for each alternative.
b. If the firm wishes to minimize risk, which alternative do you recommend?
Why?
TOPIC 6: Interest rate and bond valuation
P65 Bond interest payments before and after taxes
Charter Corp. has issued 2,500 debentures with a total principal value of $2,500,000. The bonds have a coupon interest rate of 7%.
a. What dollar amount of interest per bond can an investor expect to receive each year from Charter?
b. What is Charters total interest expense per year associated with this bond issue?
c. Assuming that Charter is in a 35% corporate tax bracket, what is the companys net after-tax interest cost associated with this bond issue?
P66 Bond quotation Assume that the following quote for the Financial Management
Corporations $1,000-par-value bond was found in the Wednesday, November 8, issue of the Wall Street Journal.
Financial Management (FM) 5.700 May 15, 2013 97.708 6.034 129 10 47,807
Given this information, answer the following questions:
a. On what day did the trading activity occur?
b. What was the last price at which the bond traded on November 7?
c. When does the bond mature?
d. What dollar value of these bonds was traded on the day quoted?
e. What is the bonds coupon interest rate?
f. What is the bonds yield? Explain what this value represents.
g. What was this bonds spread over a similar-maturity U.S. Treasury issue?
What maturity Treasury issue is used in this comparison?
P67 Valuation fundamentals Imagine that you are trying to evaluate the economics of purchasing an automobile. You expect the car to provide annual after-tax cash benefits of $1,200 at the end of each year, and assume that you can sell the car for after-tax proceeds of $5,000 at the end of the planned 5-year ownership period. All funds for purchasing the car will be drawn from your savings, which are currently earning 6% after taxes
a. Identify the cash flows, their timing, and the required return applicable to valuing the car.
b. What is the maximum price you would be willing to pay to acquire the car?
Explain.
P69 Asset valuation and risk Laura Drake wishes to estimate the value of an asset expected to provide cash inflows of $3,000 per year at the end of years 1 through 4 and $15,000 at the end of year 5. Her research indicates that she must earn 10% on low-risk assets, 15% on average-risk assets, and 22% on high-risk assets.
a. Determine what is the most Laura should pay for the asset if it is classified as (1) low-risk, (2) average-risk, and (3) high-risk.
b. Suppose Laura is unable to assess the risk of the asset and wants to be certain shes making a good deal. On the basis of your findings in part a, what is the most she should pay? Why?
c. All else being the same, what effect does increasing risk have on the value of an asset? Explain in light of your findings in part a.
P612 Bond value and changing required returns Midland Utilities has outstanding a bond issue that will mature to its $1,000 par value in 12 years. The bond has a coupon interest rate of 11% and pays interest annually.
a. Find the value of the bond if the required return is (1) 11%, (2) 15%, and (3) 8%.
b. Plot your findings in part a on a set of required return (x axis)market
value of bond (y axis) axes. c. Use your findings in parts a and b to discuss the relationship between the coupon interest rate on a bond and the required return and the market value of the bond relative to its par value.
d. What two possible reasons could cause the required return to differ from the coupon interest rate?
TOPIC 7: Stock Valuation
P76 Common stock valuationZero growth Scotto Manufacturing is a mature firm in the machine tool component industry. The firms most recent common stock dividend was $2.40 per share. Because of its maturity as well as its stable sales and earnings, the firms management feels that dividends will remain at the current level for the foreseeable future.
a. If the required return is 12%, what will be the value of Scottos common stock?
b. If the firms risk as perceived by market participants suddenly increases, causing the required return to rise to 20%, what will be the common stock value?
c. Judging on the basis of your findings in parts a and b, what impact does risk have on value? Explain.
P78 Preferred stock valuation Jones Design wishes to estimate the value of its outstanding preferred stock. The preferred issue has an $80 par value and pays an annual dividend of $6.40 per share. Similar-risk preferred stocks are currently earning a 9.3% annual rate of return.
a. What is the market value of the outstanding preferred stock?
b. If an investor purchases the preferred stock at the value calculated in part a, how much does she gain or lose per share if she sells the stock when the required return on similar-risk preferreds has risen to 10.5%? Explain.
P710 Common stock valueConstant growth McCracken Roofing, Inc., common stock paid a dividend of $1.20 per share last year. The company expects earnings and dividends to grow at a rate of 5% per year for the foreseeable future.
a. What required rate of return for this stock would result in a price per share of $28?
b. If McCracken expects both earnings and dividends to grow at an annual rate of 10%, what required rate of return would result in a price per share of $28?
P713 Free cash flow valuation Nabor Industries is considering going public but is unsure of a fair offering price for the company. Before hiring an investment banker to assist in making the public offering, managers at Nabor have decided to make their own estimate of the firms common stock value. The firms CFO has gathered data for performing the valuation using the free cash flow valuation model.
The firms weighted average cost of capital is 11%, and it has $1,500,000 of debt at market value and $400,000 of preferred stock at its assumed market value. The estimated free cash flows over the next 5 years, 2007 through 2011, are given below. Beyond 2011 to infinity, the firm expects its free cash flow to grow by 3% annually.
Year (t) Free cash flow (FCFt)
2007 $200,000
2008 250,000
2009 310,000
2010 350,000
2011 390,000
LG5
LG4
a. Estimate the value of Nabor Industries entire company by using the free cash flow aluation model.
b. Use your finding in part a, along with the data provided above, to find Nabor Industries common stock value.
c. If the firm plans to issue 200,000 shares of common stock, what is its estimated value per share?
Topic 8 Capital Budgeting and cash flow
P81 Classification of expenditures Given the following list of outlays, indicate
whether each is normally considered a capital or an operating expenditure.
Explain your answers.
a. An initial lease payment of $5,000 for electronic point-of-sale cash register
systems.
b. An outlay of $20,000 to purchase patent rights from an inventor.
c. An outlay of $80,000 for a major research and development program.
d. An $80,000 investment in a portfolio of marketable securities.
e. A $300 outlay for an office machine.
f. An outlay of $2,000 for a new machine tool.
g. An outlay of $240,000 for a new building.
h. An outlay of $1,000 for a marketing research report
P83 Relevant cash flow pattern fundamentals For each of the following projects, determine the relevant cash flows, classify the cash flow pattern, and depict the
cash flows on a time line.
a. A project that requires an initial investment of $120,000 and will generate annual operating cash inflows of $25,000 for the next 18 years. In each of the 18 years, maintenance of the project will require a $5,000 cash outflow.
b. A new machine with an installed cost of $85,000. Sale of the old machine will yield $30,000 after taxes. Operating cash inflows generated by the replacement will exceed the operating cash inflows of the old machine by $20,000 in each year of a 6-year period. At the end of year 6, liquidation of the new machine will yield $20,000 after taxes, which is $10,000 greater than the after-tax proceeds expected from the old machine had it been retained and liquidated at the end of year 6.
c. An asset that requires an initial investment of $2 million and will yield annual operating cash inflows of $300,000 for each of the next 10 years. Operating cash outlays will be $20,000 for each year except year 6, when an overhaul requiring an additional cash outlay of $500,000 will be required. The assets liquidation value at the end of year 10 is expected to be zero.
P85 Sunk costs and opportunity costs Covol Industries is developing the relevant cash flows associated with the proposed replacement of an existing machine tool with a new, technologically advanced one. Given the following costs related to the proposed project, explain whether each would be treated as a sunk cost or an opportunity cost in developing the relevant cash flows associated with the proposed replacement decision.
a. Covol would be able to use the same tooling, which had a book value of $40,000, on the new machine tool as it had used on the old one.
b. Covol would be able to use its existing computer system to develop programs for operating the new machine tool. The old machine tool did not require these programs. Although the firms computer has excess capacity available, the capacity could be leased to another firm for an annual fee of $17,000.
c. Covol would have to obtain additional floor space to accommodate the larger new machine tool. The space that would be used is currently being leased to another company for $10,000 per year.
d. Covol would use a small storage facility to store the increased output of the new machine tool. The storage facility was built by Covol 3 years earlier at a cost of $120,000. Because of its unique configuration and location, it is currently of no use to either Covol or any other firm.
e. Covol would retain an existing overhead crane, which it had planned to sell
for its $180,000 market value. Although the crane was not needed with the old machine tool, it would be used to position raw materials on the new
machine tool.
P87 Book value and taxes on sale of assets Troy Industries purchased a new machine 3 years ago for $80,000. It is being depreciated under MACRS with a 5-year recovery period using the percentages given in Table 3.2 on page 94. Assume a 40% tax rate.
a. What is the book value of the machine?
b. Calculate the firms tax liability if it sold the machine for each of the following amounts: $100,000; $56,000; $23,200; and $15,000.
P810 Calculating initial investment Vastine Medical, Inc., is considering replacing its existing computer system, which was purchased 2 years ago at a cost of $325,000. The system can be sold today for $200,000. It is being depreciated using MACRS and a 5-year recovery period (see Table 3.2, page 94). A new computer system will cost $500,000 to purchase and install. Replacement of the computer system would not involve any change in net working capital. Assume a 40% tax rate.
a. Calculate the book value of the existing computer system.
b. Calculate the after-tax proceeds of its sale for $200,000.
c. Calculate the initial investment associated with the replacement project.
P812 Initial investment at various sale prices Edwards Manufacturing Company
(EMC) is considering replacing one machine with another. The old machine was purchased 3 years ago for an installed cost of $10,000. The firm is depreciating the machine under MACRS, using a 5-year recovery period. (See Table 3.2 on page 94 for the applicable depreciation percentages.) The new machine costs $24,000 and requires $2,000 in installation costs. The firm is subject to a 40% tax rate. In each of the following cases, calculate the initial investment for the replacement.
a. EMC sells the old machine for $11,000.
b. EMC sells the old machine for $7,000.
c. EMC sells the old machine for $2,900.
d. EMC sells the old machine for $1,500.
P818 Terminal cash flowReplacement decision 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 (see Table 3.2 on page 94 for the applicable depreciation percentages). A $25,000 increase in net working capital will be required to support the new machine. The firms 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 4 years will be worth $75,000 before taxes. Calculate the terminal cash flow at the end of year 4 that is relevant to the proposed purchase of the new machine. The firm is subject to a 40% tax rate
TOPIC 9 Capital budgeting techniques
P92 Payback comparisons Dallas Tool has a 5-year maximum acceptable payback period. The firm is considering the purchase of a new machine and must choose between two alternative ones. The first machine requires an initial investment of $14,000 and generates annual after-tax cash inflows of $3,000 for each of the next 7 years. The second machine requires an initial investment of $21,000 and provides an annual cash inflow after taxes of $4,000 for 20 years.
a. Determine the payback period for each machine.
b. Comment on the acceptability of the machines, assuming that they are independent projects.
c. Which machine should the firm accept? Why?
d. Do the machines in this problem illustrate any of the weaknesses of using payback? Discuss
P94 NPV for varying costs of capital Cheryls Beauty Aids is evaluating a new fragrance-
mixing machine. The machine requires an initial investment of $24,000 and will generate after-tax cash inflows of $5,000 per year for 8 years. For each of the costs of capital listed, (1) calculate the net present value (NPV), (2) indicate whether to accept or reject the machine, and (3) explain your decision.
a. The cost of capital is 10%.
b. The cost of capital is 12%.
c. The cost of capital is 14%.
P96 NPV and maximum return A firm can purchase a fixed asset for a $13,000 initial investment. The asset generates an annual after-tax cash inflow of $4,000 for 4 years.
a. Determine the net present value (NPV) of the asset, assuming that the firm has a 10% cost of capital. Is the project acceptable?
b. Determine the maximum required rate of return (closest whole-percentage rate) that the firm can have and still accept the asset. Discuss this finding in light of your response in part a.
P911 IRR, investment life, and cash inflows Cincinnati Machine Tool (CMT) accepts projects earning more than the firms 15% cost of capital. CMT is currently considering a 10-year project that provides annual cash inflows of $10,000 and requires an initial investment of $61,450. (Note: All amounts are after taxes.)
a. Determine the IRR of this project. Is it acceptable?
b. Assuming that the cash inflows continue to be $10,000 per year, how many additional years would the flows have to continue to make the project acceptable (that is, to make it have an IRR of 15%)?
c. With the given life, initial investment, and cost of capital, what is the minimum annual cash inflow that the firm should accept?
P912 NPV and IRR Lilo Manufacturing has prepared the following estimates for a long-term project it is considering. The initial investment is $18,250, and the project is expected to yield after-tax cash inflows of $4,000 per year for 7 years.
The firm has a 10% cost of capital.
a. Determine the net present value (NPV) for the project.
b. Determine the internal rate of return (IRR) for the project.
c. Would you recommend that the firm accept or reject the project? Explain your answer.
P917 IntegrativeComplete investment decision Hot Springs Press is considering the purchase of a new printing press. The total installed cost of the press is $2.2 million. This outlay would be partially offset by the sale of an existing press. The old press has zero book value, cost $1 million 10 years ago, and can be sold currently for $1.2 million before taxes. As a result of acquisition of the new press, sales in each of the next 5 years are expected to be $1.6 million higher than with the existing press, but product costs (excluding depreciation) will represent 50% of sales. The new press will not affect the firms net working capital requirements. The new press will be depreciated under MACRS using a 5-year recovery period (see Table 3.2 on page 94). The firm is subject to a 40% tax rate. Hot Springs cost of capital is 11%. (Note: Assume that both the old and the new press will have terminal values of $0 at the end of year 6.)
a. Determine the initial investment required by the new press.
b. Determine the operating cash inflows attributable to the new press.
(Note: Be sure to consider the depreciation in year 6.)
c. Determine the payback period.
d. Determine the net present value (NPV) and the internal rate of return (IRR) related to the proposed new press.
e. Make a recommendation to accept or reject the new press, and justify your answer.
TOPIC 10 Cost of Capital
P102 Cost of debt using both methods Currently, Warren Industries can sell 15-year,
$1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result
of current interest rates, the bonds can be sold for $1,010 each; flotation costs of
$30 per bond will be incurred in this process. The firm is in the 40% tax bracket.
a. Find the net proceeds from sale of the bond, Nd.
b. Show the cash flows from the firms point of view over the maturity
of the bond.
c. Use the IRR approach to calculate the before-tax and after-tax costs of debt.
d. Use the approximation formula to estimate the before-tax and after-tax
costs of debt.
e. Compare and contrast the costs of debt calculated in parts c and d.
Which approach do you prefer? Why?
P104 Cost of preferred stock Taylor Systems has just issued preferred stock. The
stock has a 12% annual dividend and a $100 par value and was sold at $97.50
per share. In addition, flotation costs of $2.50 per share must be paid.
a. Calculate the cost of the preferred stock.
b. If the firm sells the preferred stock with a 10% annual dividend and nets
$90.00 after flotation costs, what is its cost
P1012 Calculation of specific costs, WACC, and WMCC Dillon Labs has asked its
financial manager to measure the cost of each specific type of capital as well as
the weighted average cost of capital. The weighted average cost is to be measured
by using the following weights: 40% long-term debt, 10% preferred stock,
and 50% common stock equity (retained earnings, new common stock, or both).
The firms tax rate is 40%.
Debt The firm can sell for $980 a 10-year, $1,000-par-value bond paying
annual interest at a 10% coupon rate. A flotation cost of 3% of the par value
is required in addition to the discount of $20 per bond.
Preferred stock Eight percent (annual dividend) preferred stock having a par value of $100 can be sold for $65. An additional fee of $2 per share must be paid to the underwriters.
Common stock The firms common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2007) is $4. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown in the following table.
Year Dividend
2006 $3.75
2005 3.50
2004 3.30
2003 3.15
2002 2.85
It is expected that to attract buyers, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings.
a. Calculate the specific cost of each source of financing. (Assume that kr_ks.)
b. If earnings available to common shareholders are expected to be $7 million, what is the break point associated with the exhaustion of retained earnings?
c. Determine the weighted average cost of capital between zero and the break point calculated in part b.
d. Determine the weighted average cost of capital just beyond the break point calculated in part b.
P1013 Calculation of specific costs, WACC, and WMCC Lang Enterprises is interested
in measuring its overall cost of capital. Current investigation has gathered the following data. The firm is in the 40% tax bracket.
Debt The firm can raise an unlimited amount of debt by selling $1,000-parvalue,
8% coupon interest rate, 20-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond would have to be given. The firm also must pay flotation costs of $30 per bond.
Preferred stock The firm can sell 8% preferred stock at its $95-per-share par value. The cost of issuing and selling the preferred stock is expected to be $5 per share. An unlimited amount of preferred stock can be sold under these terms.
Common stock The firms common stock is currently selling for $90 per share.
The firm expects to pay cash dividends of $7 per share next year. The firms dividends
have been growing at an annual rate of 6%, and this growth is expected to continue into the future. The stock must be underpriced by $7 per share, and flotation costs are expected to amount to $5 per share. The firm can sell an unlimited amount of new common stock under these terms.
Retained earnings When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
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