2015 cfa level 2 book 3 corp finance qa
DESCRIPTION
2015 CFA Level 2 Book 3 Corp Finance QATRANSCRIPT
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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
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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
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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.
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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
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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
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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
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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
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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
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90
BBoItengrinderbecauseitsEAAishigherthanthePintogrinderEAA
CPintogrinderbecauseitsEAAishigherthantheBoltengrinderEAA
ZAreGoldbeIg,scommentsaboutrealoptionscorrect?
ANofbrCommentlandComment2.
BNofbrCommentlandYesfbrComment2.
CYesfbrCommentlandNofbrComment2.
25IsB0hmmostlikelycoITectIBgardingCommentAaboutthel0millioninvestmentandCommentBaboutusingtheaftertaxcostofdebt?
ANofbrbothcomments.
BYesfbrbothcomments.
CNofbrCommentAandYesfbCommentB.
26IsB0hmmostlikelycorrectregardingCommentCthatitisacceptabIetouseeitherNPVorIRRandCommentDabouttheimmediateimpactonEPS?
ANorbothcomments.
BYesfbbothcomments.
CNofbrCommentCandYesfbCommentD
ThefowinginfOmationeIatestoQuestions2732
BabaraSimpsonisaseIsideanaystwithSmithRiccadiSecurities.Simpsoncoversthepharmaceutica>indust
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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
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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