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THE FINANCIAL ENVIRONMENT

Exercise

1. Given the following data, find the expected rate of inflation during

the next year.

r* = real risk-free rate = 3%.

Maturity risk premium on 10-year T-bonds = 2%. It is zero on 1-year

bonds, and a linear relationship exists.

Default risk premium on 10-year, A-rated bonds = 1.5%.

Liquidity premium = 0%.

Going interest rate on 1-year T-bonds = 8.5%.

2. Suppose that the annual expected rates of inflation over each of the

next five years are 5 percent, 6 percent, 9 percent, 13 percent, and 12

percent, respectively. What is the average expected rate of inflation

over the 5-year period?

3. You are given the following data:

r* = real risk-free rate = 4%

Constant inflation premium = 7%

Maturity risk premium = 1%

Default risk premium for AAA bonds = 3%

Liquidity premium for long-term T-bonds = 2%

Assume that a highly liquid market does not exist for long-term T-

bonds, and the expected rate of inflation is a constant. Given these

conditions, the nominal risk-free rate for T-bills is _____, and the

rate on long-term Treasury bonds is _____.

4. Drongo Corporation’s 4-year bonds currently yield 7.4 percent. The

real risk-free rate of interest, r*, is 2.7 percent and is assumed to

be constant. The maturity risk premium (MRP) is estimated to be 0.1%(t

- 1), where t is equal to the time to maturity. The default risk and

liquidity premiums for this company’s bonds total 0.9 percent and are

believed to be the same for all bonds issued by this company. If the

average inflation rate is expected to be 5 percent for years 5, 6, and

7, what is the yield on a 7-year bond for Drongo Corporation?

5. Assume that r* = 2.0%; the maturity risk premium is found as MRP =

0.1%(t - 1) where t = years to maturity; the default risk premium for

corporate bonds is found as DRP = 0.05%(t - 1); the liquidity premium

is 1.0 percent for corporate bonds only; and inflation is expected to

be 3 percent, 4 percent, and 5 percent during the next three years and

then 6 percent thereafter. What is the difference in interest rates

between 10-year corporate and Treasury bonds?

6. A fixed-income analyst has made the following assessments:

(1) The real risk-free rate is expected to remain at 2.5 percent for

the next ten years.

(2) Inflation is expected to be 3 percent this year, 4 percent next

year, and 5 percent a year thereafter.

(3) The maturity risk premium is 0.1%(t - 1), where t = the maturity

of the bond (in years).

A five-year corporate bond currently yields 8.5 percent. What will be

the yield on the bond, one year from now, if the above assessments are

correct, and the bond’s default premium and liquidity premium remain

unchanged?

7. The real risk-free rate of interest is 3 percent. The market expects

that inflation will be 3 percent each year for the next 5 years, and

then will average 5 percent a year thereafter. The maturity risk

premium is estimated to be MRPt = 0.1(t - 1)%. In other words, the

maturity risk premium on a two-year security is 0.1 percent or 0.001.

What is the yield on a Treasury bond which matures in twelve years?

8. The real risk-free rate of interest is 2 percent. The market expects

that inflation will be 3 percent each year for the next five years, and

then will average 5 percent a year thereafter. The maturity risk

premium is estimated to be MRPt = 0.1(t - 1)%. In other words, the

maturity risk premium on a two-year security is 0.1 percent or 0.001.

A ten-year corporate bond yields 8.6 percent. What is the yield on an

8-year corporate bond that has the same default risk and liquidity as

the ten-year bond?

EXERCISE:

ANALYSIS OF FINANCIAL STATEMENTS

i. Russell Hotel Management Group has $100 million in total assets and

its corporate tax rate is 40 percent. The company recently reported

that its basic earning power (BEP) ratio was 15 percent and that its

return on assets (ROA) was 9 percent. What was the company’s

interest expense?

ii. The Charleston Company is a relatively small, privately owned firm.

Last year the company had after-tax income of $15,000, and 10,000

shares were outstanding. The owners were trying to determine the

equilibrium market value for the stock, prior to taking the company

public. A similar firm which is publicly traded had a price/earnings

ratio of 5.0. Using only the information given, estimate the market

value of one share of Charleston's stock.

iii. You are given the following information: Stockholders' equity =

$1,250; price/earnings ratio = 5; shares outstanding = 25;

market/book ratio = 1.5. Calculate the market price of a share of

the company's stock.

iv. A firm has a profit margin of 15 percent on sales of $20,000,000. If

the firm has debt of $7,500,000, total assets of $22,500,000, and an

after-tax interest cost on total debt of 5 percent, what is the

firm's ROA?

v. Culver Inc. has earnings after interest but before taxes of $300.

The company's before-tax times-interest-earned ratio is 7.00.

Calculate the company's interest charges.

vi. Tapley Dental Supply Company has the following data:

Net income: $240 Sales: $10,000 Total assets: $6,000

Debt ratio: 75% TIE ratio: 2.0 Current ratio: 1.2

BEP ratio: 13.33%

If Tapley could streamline operations, cut operating costs, and raise

net income to $300, without affecting sales or the balance sheet (the

additional profits will be paid out as dividends), by how much would

its ROE increase?

vii. Your company had the following balance sheet and income statement

information for 2003:

Balance sheet:

Cash $ 20

A/R 1,000

Inventories 5,000

Total C.A. $ 6,020 Debt $ 4,000

Net F.A. 2,980 Equity 5,000

Total Assets $ 9,000 Total claims $ 9,000

Income statement:

Sales $10,000

Cost of goods sold 9,200

EBIT $ 800

Interest (10%) 400

EBT $ 400

Taxes (40%) 160

Net Income $ 240

The industry average inventory turnover is 5. You think you can

change your inventory control system so as to cause your turnover to

equal the industry average, and this change is expected to have no

effect on either sales or cost of goods sold. The cash generated

from reducing inventories will be used to buy tax-exempt securities

which have a 7 percent rate of return. What will your profit margin

be after the change in inventories is reflected in the income

statement?

viii. The Wilson Corporation has the following relationships:

Sales/Total assets 2.0

Return on assets (ROA) 4%

Return on equity (ROE) 6%

What is Wilson’s profit margin and debt ratio?

ix. Cleveland Corporation has 100,000 shares of common stock outstanding.

The company’s net income is $750,000 and its P/E is 8. What is the

company’s stock price?

Exercise

FINANCIAL PLANNING

Additional funds needed

i. Jill's Wigs Inc. had the following balance sheet last year:

Cash $ 800 Accounts payable $ 350

Accounts receivable 450 Accrued wages 150

Inventory 950 Notes payable 2,000

Net fixed assets 34,000 Mortgage 26,500

Common stock 3,200

Retained earnings 4,000

Total liabilities

Total assets $36,200 and equity $36,200

Jill has just invented a non-slip wig for men which she expects will

cause sales to double from $10,000 to $20,000, increasing net income

to $1,000. She feels that she can handle the increase without adding

any fixed assets. (1) Will Jill need any outside capital if she pays

no dividends? (2) If so, how much?

Forecasting additions to retained earnings

ii. Kenney Corporation recently reported the following income statement

for 2011(numbers are in millions of dollars):

Sales $7,000

Total operating costs 3,000

EBIT $4,000

Interest 200

Earnings before tax (EBT) $3,800

Taxes (40%) 1,520

Net income available to

common shareholders $2,280

The company forecasts that its sales will increase by 10 percent in

2012 and its operating costs will increase in proportion to sales.

The company’s interest expense is expected to remain at $200 million,

and the tax rate will remain at 40 percent. The company plans to pay

out 50 percent of its net income as dividends, the other 50 percent

will be additions to retained earnings. What is the forecasted

addition to retained earnings for 2012?

Additional funds needed

iii. Brown & Sons recently reported sales of $100 million, and net income

equal to $5 million. The company has $70 million in total assets.

Over the next year, the company is forecasting a 20 percent increase

in sales. Since the company is at full capacity, its assets must

increase in proportion to sales. The company also estimates that if

sales increase 20 percent, spontaneous liabilities will increase by

$2 million. If the company’s sales increase, its profit margin will

remain at its current level. The company’s dividend payout ratio is

40 percent. Based on the AFN formula, how much additional capital

must the company raise in order to support the 20 percent increase in

sales?

AFN with excess capacity

iv. A firm has the following balance sheet:


Accounts receivable 20 Notes payable 40

Inventory 20 Long-term debt 80

Fixed assets 180 Common stock 80

Retained earnings 20

Total liabilities

Total assets $240 and equity $240

Sales for the year just ended were $400, and fixed assets were used

at 80 percent of capacity, but its current assets were at optimal

levels. Sales are expected to grow by 5 percent next year, the profit

margin is 5 percent, and the dividend payout ratio is 60 percent.

How much additional funds (AFN) will be needed?


v. Splash Bottling's December 31st balance sheet is given below:



Inventory 40 Accrued wages and taxes 15

Net fixed assets 75 Long-term debt 30

Common equity 70

Total liabilities

Total assets $150 and equity $150

Sales during the past year were $100, and they are expected to rise

by 50 percent to $150 during next year. Also, during last year fixed

assets were being utilized to only 85 percent of capacity, so Splash

could have supported $100 of sales with fixed assets that were only

85 percent of last year's actual fixed assets. Assume that Splash's

profit margin will remain constant at 5 percent and that the company

will continue to pay out 60 percent of its earnings as dividends. To

the nearest whole dollar, what amount of nonspontaneous, additional

funds (AFN) will be needed during the next year?


vi. A firm has the following balance sheet:



Inventory 10 Long-term debt 40

Fixed assets 90 Common stock 40


Total assets $120 Total liabilities and equity $120

Fixed assets are being used at 80 percent of capacity; sales for the

year just ended were $200; sales will increase $10 per year for the

next 4 years; the profit margin is 5 percent; and the dividend payout

ratio is 60 percent. Assume that underutilized fixed assets cannot

be sold. What are the total external financing requirements for the

entire 4 years, i.e., the total AFN for the 4-year period?


vii. Baxter Box Company's balance sheet showed the following amounts as of

December 31st:


Accounts receivable 40 Accruals 5

Inventory 50 Notes payable 20

Net fixed assets 100 Long-term debt 20

Common stock 20


Total assets $200 Total liabilities and equity $200

Last year the firm's sales were $2,000, and it had a profit margin of

10 percent and a dividend payout ratio of 50 percent. Baxter Box

operated its fixed assets at 80 percent of capacity during the year.

The company expects to increase next year's sales by 37.5 percent, to

$2,750, but the profit margin is expected to fall to 3 percent, and

the dividend payout ratio is expected to rise to 60 percent. What is

Baxter Box's additional funds needed (AFN) for next year?

Expected growth rate

viii. Apex Roofing Inc. has the following balance sheet (in millions of

dollars):

Current assets $3.0 Accounts payable $1.2

Net fixed assets 4.0 Notes payable 0.8

Accrued wages and taxes 0.3

Total current liabilities $2.3

Long-term debt 1.2

Common equity 1.5

Retained earnings 2.0

Total assets $7.0 Total liabilities and equity $7.0

Last year's sales were $10 million, and Apex estimates it will need

to raise $2 million in new debt and equity next year. You have

identified the following facts: (1) it pays out 30 percent of

earnings as dividends; (2) a profit margin of 4 percent is projected;

(3) fixed assets were used to full capacity; and (4) assets and

spontaneous liabilities as shown on last year's balance sheet are

expected to grow proportionally with sales. If the above assumptions

hold, what sales growth rate is the firm anticipating? (Hint: You can

use the AFN equation to help answer this problem.)

Risk and Return: The Basics

1. A stock’s return has the following distribution;

Demand for the services Probabability Rate of return

of the company of occurrence if this demand occurs.

Weak 0.1 (50%)

Below average 0.2 (5)

Average 0.4 16

Above average 0.2 25

Strong 0.1 60

Calculate the stock’s expected return, standard deviation, and coefficient of variation

2 An individual has $35,000 invested in a stock which has a beta of 0.8 and $40,000 invested in a stock with a

beta of 1.4. If these are the only two investments in her portfolio, what is her portfolio’s beta?

3 Assume that the risk-free rate is 5% and the market risk premium is 6%. What is the expected return for the

overal stock market? What is the required rate of return on a stock that has a beta of 1.2?

4 The market and stock J have the following probability distributions:

Probability rM rJ

0.3 15% 20%

0.4 9 5

0.3 18 12

a. Calculate the expected rates of return for the market and Stock J

b. Calculate the standard deviation for the market and Stock J

c. Calculate the coefficients of variation for the market and Stock J

5 Suppose rRF =5%, rM = 10% and rA = 12%

a. Calculate Stock A’s beta

b. If Stock A’s beta were 2.0, what would be A’s new required rate of return?

6. You hold a diversified portfolio consisting of a $10,000 investment in each of 20 different common stocks

(i.e., your total investment is $200,000). The portfolio beta is equal to 1.2. You have decided to sell

one of your stocks which has a beta equal to 0.7 for $10,000. You plan to use the proceeds to purchase

another stock which has a beta equal to 1.4. What will be the beta of the new portfolio?

7. You are an investor in common stock, and you currently hold a well-diversified portfolio which has an

expected return of 12 percent, a beta of 1.2, and a total value of $9,000. You plan to increase your

portfolio by buying 100 shares of AT&E at $10 a share. AT&E has an expected return of 20 percent

with a beta of 2.0. What will be the expected return and the beta of your portfolio after you purchase

the new stock?

8. A stock has an expected return of 12.25 percent. The beta of the stock is 1.15 and the risk-free rate is 5

percent. What is the market risk premium?

TIME VALUE OF MONEY

1. Present and future value for different interest rates.

a. An initial $500 compounded for 10 years at 6 percent

b. An initial $500 compounded for 10 years at 12 percent

c. The present value of $500 due in 10 years at a 6 percent discount rate.

2. Future value of an annuity

Find the future value of the following annuities.

a. $400 per year for 10 years at 10 percent (ordinary annuity)

b. $200 per year for 5 years at 5 percent (ordinary annuity)

c. $400 per year for 5 years at 0 percent (ordinary annuity)

d. $400 per year for 10 years at 10 percent (annuity due)

e. $200 per year for 5 years at 5 percent (annuity due)

f. $400 per year for 5 years at 0 percent (annuity due)

3. Present value of an annuity

Find the present value of the following annuities.

a. $400 per year for 10 years at 10 percent (ordinary annuity)

b. $200 per year for 5 years at 5 percent (ordinary annuity)

c. $400 per year for 5 years at 0 percent (ordinary annuity)

d. $400 per year for 10 years at 10 percent (annuity due)

e. $200 per year for 5 years at 5 percent (annuity due)

f. $400 per year for 5 years at 0 percent (annuity due)

4. Find the amount to which $500 will grow under each of the following

conditions:

a. 12 percent compounded annually for 5 years

b. 12 percent compounded semiannually for 5 years

c. 12 percent compounded quarterly for 5 years

d. 12 percent compounded monthly for 5 years

5. Find the present value of $500 due in the future under each of the

following conditions;

a. 12 percent nominal rate, semiannual compounding, discounted back 5 years

b. 12 percent nominal rate, quarterly compounding, discounted back 5 years

c. 12 percent nominal rate, monthly compounding, discounted back 1 year

6.

a. Set up an amortization schedule for a $25,000 loan to be repaid in equal installments at the end of each of the next 5 years. The

interest rate is 10 percentt.

b. How large must each payment be if the loan is for $50,000? Assume that the interest rate remains at 10 percent and that the loan is

paid off over 5 years.

Additional Questions

i. You deposit $2,000 in a savings account that pays 10 percent

interest, compounded annually. How much will your account be worth

in 15 years?

ii. You deposit $1,000 in a savings account that pays 9 percent interest,

compounded annually. How much will your account be worth in 6 years?

iii. You can earn 8 percent interest, compounded annually. How much must

you deposit today to withdraw $10,000 in 6 years?

iv. You can earn 15 percent interest, compounded annually. How much must

you deposit today to withdraw $4,000 in 10 years?

v. In 1958 the average tuition for one year at an Ivy League school was

$1,800. Thirty years later, in 1988, the average cost was $13,700.

What was the growth rate in tuition over the 30-year period?

vi. Suppose you invested $1,000 in stocks 10 years ago. If your account

is now worth $2,839.42, what rate of return did your stocks earn?

BONDS AND THEIR VALUATION

i. Assume that you wish to purchase a bond with a 30-year maturity, an

annual coupon rate of 10 percent, a face value of $1,000, and

semiannual interest payments. If you require a 9 percent nominal

yield to maturity on this investment, what is the maximum price you

should be willing to pay for the bond?

ii. A bond has an annual 8 percent coupon rate, a maturity of 10 years, a

face value of $1,000, and makes semiannual payments. If the price

is $934.96, what is the annual nominal yield to maturity on the bond?

iii. A bond has an annual 11 percent coupon rate, an annual interest

payment of $110, a maturity of 20 years, a face value of $1,000, and

makes annual payments. It has a yield to maturity of 8.83 percent.

If the price is $1,200, what rate of return will an investor expect

to receive during the next year?

iv. You intend to purchase a 10-year, $1,000 face value bond that pays

interest of $60 every 6 months. If your nominal annual required rate

of return is 10 percent with semiannual compounding, how much should

you be willing to pay for this bond?

v. Assume that you wish to purchase a 20-year bond that has a maturity

value of $1,000 and makes semiannual interest payments of $40. If

you require a 10 percent nominal yield to maturity on this

investment, what is the maximum price you should be willing to pay

for the bond?


1. Callaghan’s bonds have 10 years remaining to maturity. Interest is paid

annually, the bonds have a $1,000 par value, and the coupon interest rate

is 8%. The bonds have a yield to maturity of 9%. What is the current market

price of these bonds?

2. Health Foods’s bonds have 7 years remaining to maturity. The bonds have

a face value of $1,000 and a yield to maturity of 8%. They pay interest

annually and have a 9 percent coupon rate. What is their current yield?

3. The Garraty Company has two bond issues outstanding. Both bonds pay

$100 annual interest plus $1,000 at maturity. Bond L has a maturity of 15

years, and Bond S a maturity of 1 year.

a. What will be the value of each of these bonds when the going rate of interest is (1) 5 percent, (2) 8 percent, and (3) 12 percent? Assume

that there is only one more interest payment to be mad on Bond S.

EXERCISE

STOCKS AND THEIR VALUATION

1. Warr Hotel Corporation just paid a dividend of $1.50 a share (i.e.

D0=$1.50). The dividend is expected to grow 5 percent a year for the next 3

years, and then 10 percent a year thereafter. What is the expected dividend

per share for each of the next 5 years?

2. Thomas Brothers is expected to pay a $0.50 per share dividend at the end

of the year (i.e., D1= $0.50). The dividend is expected to grow at a

constant rate of 7 percent a year. The required rate of return on the

stock, rs, is 15 percent. What is the value per share of the company’s

stock?

3. Harrison Airline stock currently sells for $20 a share. The stock just

paid a dividend of $1.00 a share (i.e., D0=$1.00). The dividend is expected

to grow at a constant rate of 10 percent a year. What stock price is

expected 1 year from now? What is the required rate of return on the

company’s stock?

4. A company currently pays a dividend of $2 per share, D0= 2. It is

estimated that the company’s dividend will grow at a rate of 20 percent per

year for the next 2 years, then the dividend will grow at a constant rate

of 7 percent thereafter. The company’s stock has a beta equal to 1.2, the

risk-free rate is 7.5 percent, and the market risk premium is 4 percent.

What would you estimate is the stock’s current price?


i. A share of common stock has just paid a dividend of $3.00. If the

expected long-run growth rate for this stock is 5 percent, and if

investors require an 11 percent rate of return, what is the price of

the stock?

ii. The last dividend paid by a company was $2.20. Klein's growth rate

is expected to be 10 percent for one year, after which dividends are

expected to grow at a rate of 6 percent forever. The company’s

stockholders require a rate of return on equity (rs) of 11 percent.

What is the current price of the stock?

iii. Assume that you plan to buy a share of XYZ stock today and to hold it

for 2 years. Your expectations are that you will not receive a

dividend at the end of Year 1, but you will receive a dividend of

$9.25 at the end of Year 2. In addition, you expect to sell the

stock for $150 at the end of Year 2. If your expected rate of return

is 16 percent, how much should you be willing to pay for this stock

today?

iv. A share of common stock has just paid a dividend of $2.00. If the

expected long-run growth rate for this stock is 15 percent, and if

investors require a 19 percent rate of return, what is the price of

the stock?

v. Thames Inc.’s most recent dividend was $2.40 per share (i.e., D0 =

$2.40). The dividend is expected to grow at a rate of 6 percent per

year. The risk-free rate is 5 percent and the return on the market

is 9 percent. If the company’s beta is 1.3, what is the price of the

stock today?

vi. Albright Motors is expected to pay a year-end dividend of $3.00 a

share (D1 = $3.00). The stock currently sells for $30 a share. The

required (and expected) rate of return on the stock is 16 percent.

If the dividend is expected to grow at a constant rate, g, what is g?

vii. The last dividend paid by Klein Company was $1.00. Klein's growth

rate is expected to be a constant 5 percent for 2 years, after which

dividends are expected to grow at a rate of 10 percent forever.

Klein's required rate of return on equity (rs) is 12 percent. What

is the current price of Klein's common stock?

viii. Waters Corporation has a stock price of $20 a share. The stock’s

year-end dividend is expected to be $2 a share (D1 = $2.00). The

stock’s required rate of return is 15 percent and the stock’s

dividend is expected to grow at the same constant rate forever. What

is the expected price of the stock seven years from now?

ix. Cartwright Brothers’ stock is currently selling for $40 a share. The

stock is expected to pay a $2 dividend at the end of the year. The

stock’s dividend is expected to grow at a constant rate of 7 percent

a year forever. The risk-free rate (rRF) is 6 percent and the market

risk premium (rM – rRF) is also 6 percent. What is the stock’s beta?

x. NOPREM Inc. is a firm whose shareholders don't possess the preemptive

right. The firm currently has 1,000 shares of stock outstanding; the

price is $100 per share. The firm plans to issue an additional 1,000

shares at $90.00 per share. Since the shares will be offered to the

public at large, what is the amount per share that old shareholders

will lose if they are excluded from purchasing new shares?

BASICS OF CAPITAL BUDGETING

1. Project K has a cost of $52,125, its expected net cash inflows

are $12,000 per year for 8 years, and its cost of capital is 12

percent.

a. What is the project’s payback period (to the closest year)? b. What is the project’s discounted payback period? c. What is the project’s NPV? d. What is the project’s IRR? e. Whata is the project’s MIRR?

2. Your division is considering two investment projects, each of

which requires an up-front expenditure of $15 million. You estimate

that the investments will produce the following net cash flows:

Year Project A Project B

1 $ 5,000,000 $ 20,000,000

2 10,000,000 10,000,000

3 20,000,000 6,000,000

What are the two projects’ net present values, assuming the cost of

capital is 10 percent? 5 percent? 15 percent?


i. The Seattle Corporation has been presented with an investment

opportunity which will yield cash flows of $30,000 per year in Years

1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in

Year 10. This investment will cost the firm $150,000 today, and the

firm's cost of capital is 10 percent. Assume cash flows occur evenly

during the year, 1/365th each day. What is the payback period for

this investment?

ii. As the director of capital budgeting for Denver Corporation, you are

evaluating two mutually exclusive projects with the following net

cash flows:

Project X Project Z

Year Cash Flow Cash Flow

0 -$100,000 -$100,000

1 50,000 10,000

2 40,000 30,000

3 30,000 40,000

4 10,000 60,000

If Denver's cost of capital is 15 percent, which project would you

choose?

iii. Two projects being considered are mutually exclusive and have the

following projected cash flows:

Project A Project B

Year Cash Flow Cash Flow

0 -$50,000 -$50,000

1 15,625 0

2 15,625 0

3 15,625 0

4 15,625 0

5 15,625 99,500

If the required rate of return on these projects is 10 percent, which

would be chosen and why?

Problems

Project Cash Flow Analysis

1. Lotus Hotel is considering an expansion project. The necessary equipment

could be purchased for $9 million, and the project would also require an

initial $3 million investment in net operating working capital. The tax

rate is 40 percent. What is the project’s initial investment outlay?

2. Nixon Spa Management is trying to estimate the first year operating cash

flow (at t=1) for a proposed project. The financial staff has collected the

following information:

Projected sales $10 million

Operating costs (not including depreciation) $7million

Depreciation $ 2 million

Interest expense $ 2 million

The tax rate is 40%. What is the project’s operating cash flow for

the first year (t=1)?

3. The Cameron Restaurant is evaluating the proposed acquisition of new

equipment. The base price of the equipment is $108,000, and it would cost

another $12,500 to modify it for special use by the restaurant. The

equipment falls into the MACRS 3-year class, and it would be sold after 3

years for $65,000. The equipment would require an increase in net working

capital (inventory) of $ 5,500. The equipment would have no effect on

revenues, but it is expected to save the firm $44,000 per year in before-

tax operating costs, mainly labor. The marginal tax rate is 35 percent.

a. What is the net cost of the machine for capital budgeting purposes?

(That is, what is the year 0 net cash flow?)

b. What are the net operating cash flows in Years 1, 2, and 3?

c. What is the terminal year cash flow?

d. If the project’s cost of capital is 12 percent, should the equipment

be purchased?


i. The Target Copy Company is contemplating the replacement of its old printing

machine with a new model costing $60,000. The old machine, which originally

cost $40,000, has 6 years of expected life remaining and a current book

value of $30,000 versus a current market value of $24,000. Target's

corporate tax rate is 40 percent. If Target sells the old machine at market

value, what is the initial after-tax outlay for the new printing machine?

ii. Dandy Product's overall weighted average required rate of return is 10

percent. Its yogurt division is riskier than average, its fresh produce

division has average risk, and its institutional foods division has below-

average risk. Dandy adjusts for both divisional and project risk by adding

or subtracting 2 percentage points. Thus, the maximum adjustment is 4

percentage points. What is the risk-adjusted required rate of return for a

low-risk project in the yogurt division?

iii. Mars Inc. is considering the purchase of a new machine which will reduce

manufacturing costs by $5,000 annually. Mars will use the MACRS accelerated

method to depreciate the machine, and it expects to sell the machine at the

end of its 5-year operating life for $10,000. The firm expects to be able

to reduce net operating working capital by $15,000 when the machine is

installed, but required working capital will return to the original level

when the machine is sold after 5 years. Mars's marginal tax rate is 40

percent, and it uses a 12 percent cost of capital to evaluate projects of

this nature. If the machine costs $60,000, what is the project’s NPV?

THE COST OF CAPITAL

1. David Ortiz Hotel has a target capital structure of 40 percent

debt and 60 percent equity. The yield to maturity on the company’s

outstanding bonds is 9 percent, and the company’s tax rate is 40

percent. CFO of the hotel has calculated the company’s WACC as 9.96

percent. What is the company’s cost of equity capital?

2. Tunnel Management can issue pertetual preferred stock at a price

of $50 a share. The issue is expected to pay a constant annual

dividend of $3.80 a share. The floation cost on the issue is

estimated to be 5 percent. What is the company’s cost of preferred

stock, rps?

3. The Heuser Company’s currently outstandingg 10 percent coupon

bonds have a yield to maturity of 12 percent. Heuser believes it

could issue at par new bonds that would provide a similar yield to

maturity. If its marginal tax rate is 35 percent, what is Heuser’s

after-tax cost of debt?

4. On January 1, the total market value of the Tysseland Company was

$60 million. During the year, the company plans to raise and invest

$30 million in new projects. The firm’s present market value capital

structure, shown below, is considered to be optimal. Assume that

there is no short-term debt.

Debt $30,000,000

Common equity 30,000,000

Total capital 60,000,000

New bonds will have an 8 percent coupon rate, and they will be sold

at par. Common stock is currently selling at $30 a share.

Stockholders’ required rate of return is estimated to be 12 percent,

consisting of dividend yield of 4 percentand an expected constant

growth rate of 8 percent. (The next expected dividend is $1.20, so

$1.20/$30 = 4%) The marginal corporate tax rate is 40 percent.

a. To maintain the present capital structure, how much of the new investment must be financed by common equity?

b. Assume that there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing

additional shares of equity. What is the WACC?

Additional Question i. Bouchard Company's stock sells for $20 per share, its last dividend

(D0) was $1.00, and its growth rate is a constant 6 percent. What is

its cost of common stock, rs?

ii. Your company's stock sells for $50 per share, its last dividend (D0)

was $2.00, and its growth rate is a constant 5 percent. What is the

cost of common stock, rs?

iii. An analyst has collected the following information regarding

Christopher Co.:

The company’s capital structure is 70 percent equity, 30 percent

debt.

The yield to maturity on the company’s bonds is 9 percent.

The company’s year-end dividend is forecasted to be $0.80 a

share.

The company expects that its dividend will grow at a constant

rate of 9 percent a year.

The company’s stock price is $25.

The company’s tax rate is 40 percent.

The company anticipates that it will need to raise new common

stock this year. Its investment bankers anticipate that the

total flotation cost will equal 10 percent of the amount issued.

Assume the company accounts for flotation costs by adjusting the

cost of capital. Given this information, calculate the

company’s WACC.

iv. The Global Advertising Company has a marginal tax rate of 40 percent.

The last dividend paid by Global was $0.90. Global's common stock is

selling for $8.59 per share, and its expected growth rate in earnings

and dividends is 5 percent. What is Global's cost of common stock?

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