Introduction

Assignment 1
Time Value Adjustment

Question 3.2:
The following series of cash flows exists:

Time Period Amount

t=1 $300
t=2 $200
t=3 $100
t=4 $100

Show at least four different ways you could set up the cash flow stream to
solve for the present value of this stream of cash inflows.

Problem 3.6: Future Value (Note: Ignore any tax considerations)

Your firm has a retirement plan that matches all contributions on a one-to-
two basis. That is, if you contribute $2,000 per year, the company will
add $1,000 to make it $3,000. The firm guarantees an 8% return on the
funds. Alternatively you can “do it yourself”; you think you can earn
11% on your money this way. The first contribution will be made 1 year
from today. At that time, and every year thereafter, you will put $2,000
into the retirement account. If you want to retire in 25 years, which way
are you better off?

Problem 3.8: Present Value

Olympia Electric has a line of large motors that no longer fits its corporate
image. It is attempting to determine the minimum selling price for the
small motors line. Olympia presently receives $250,000 per year after
taxes in cash flows from the line. If the opportunity cost of capital is
16%, how much should Olympia ask if it thinks the life expectancy of the
line is as follows?
a. 10 years
b. 20 years
c. infinity
Problem 3.13: Internal Rate of Return
You are the winner in the Down South Lottery. As a result you have the
choice between three alternative payment plans:
Plan I: A lifetime annuity of $60,425 annually, with the first payment one
year from now.
Plan II: A 70,000 annual annuity for 20 years, with the first payment 1
year from now.
Plan III: $800,000 today
Your life expectancy is 45 more years. Ignoring any tax effects,
determine the following:
a. At what interest rate would you be indifferent between Plans I and III?
b. At what interest rate would you be indifferent between Plans II and III?
c. At what interest rate (to the nearest whole number) would you be
indifferent between Plans I and II?
d. What if (c) is now changed so you know the interest rate for both Plans
I and II is 12% for the first 20 years? What rate would you have earn on
the remaining 25 years of the $60,425 annuity to be indifferent between
Plans I and II?

Problem 3.16: Cost of Alternative Loans

Hacienda Winery needs $500,000 for expansion of its warehouse. The
company plans to finance $100,000 with internally generated funds but
wants to secure a loan for the remainder. The contracting firm’s finance
subsidiary has offered to provide the loan based on six annual payments of
$97,300 each. Alternatively, Hacienda’s bankers will lend the firm
$400,000, to be repaid in six equal annual installments (covering both
principal and interest) at a 15 percent interest rate. Finally, an insurance
firm would also loan the money; it requires a lump sum payment of
$750,000 at the end of 6 years.
a. Based on the respective annual percentage costs of the three loans,
which one should Hacienda select?
b. What other considerations might be important in addition to cost?

Problem 3.18: Future Value and Compounding

How much would you have in the future in each of the following cases?
a. $2,500, invested today, if continuous compounding is employed, the
nominal rate is 9 percent, and the period is 2 1/2 years.
b. $4.80, invested today, if the nominal rate is 12.6 percent continuously
compounded, and the period is 15 years.
c. $100 invested today, if the nominal rate is 14 percent compounded
annually, and the period is 10 years.
d. Same as in (c), except interest is compounded continuously.
 Assignment 2

Valuation of Bonds and Stocks

Question 4.3:
(Note: In answering 4.3, ignore any reinvestment problem associated with
the future interest to be received.)

The rate of return you will receive on a bond if you buy it today and hold
it until maturity is its yield to maturity, YTM.

a. What happens to the YTM as market interest rates change?

b. Will you receive any more, or any less, if interest rates change as long
as you hold the bond to maturity? Why?
c. Will you receive any more, or any less, as interest rates change if you
are forced to sell before maturity? Why?

Question 4.5:
Does a high price/earnings ratio mean a firm is a “growth firm?” Explain.

Problem 4.2: Bond Price Change and Time to Maturity

Find the current market price of a 20-year, 9% coupon rate bond with par
value of $1,000, if interest is paid annually and if current market rates are
(a) 11% or (b) 7%. What are the current market prices if everything is the
same except the bond has only (1) 10 years to maturity, or (2) 2 years to
maturity? What can we say about the relative influence of changing market
interest rates on the market prices of short-term versus long-term bonds?
Can you speculate on why this is so?

Problem 4.3: Yield to Maturity

Sandberg Engineering has some 15-year, $1,000 par bonds outstanding
which have a coupon rate of 9% and pay interest annually. What is the
yield to maturity on the bonds if their current market price is
a. $1,180?
b. $800?
c. Would you be willing to pay $800 if your minimum required rate of
return was 11%? Why or why not?

Problem 4.7: Implied Growth Rate

 Reilly Supermarkets’ common stock is selling at $54, the cash dividend
expected next year (at time t = 1) is $3.78 per share, and the required rate
is of return is 15 percent. What is the implied compound growth rate (to
infinity) in cash dividends?

Problem 10: Constant Versus Nonconstant Growth

Brett is contemplating the purchase of a small, one-island service station.
After-tax cash flows are presently $20,000 per year, and his required rate
of return is 14%
a. What is the maximum price Brett should pay for the service station if
he expects cash flows to grow at 4% per year to infinity?
b. If Brett decides he needs a 15% return, and there will be no growth in
after-tax cash flows for 3 years, followed by a 10% per year for years 4
and 5, followed by 3% growth to infinity, what is the maximum amount
he should pay?

Problem 4.14: Forgoing Cash Dividends

Downing Enterprises is a no-growth firm that pays cash dividends of $8
per year. Its current required rate of return is 12%.
a. What is Downing’s current market price?
b. Management is considering an investment that will convert the firm
into a constant-growth firm, but it requires stockholders to forgo cash
dividends for the next 6 years. When cash dividends are resumed in year
7, they will be $8 plus the expected constant growth of 11% [i.e., ($8)
(1.11)] from year 6 to infinity. If its new required return is 16%, will the
stockholders be better off?
c. What happens if everything is the same as in (b), except that the
growth rate is only 10%.

Assignment 3
Risk and Return
Question 5.1:
(Note: In answering 5.1 (b), you must consider whether it is absolute risk,
or relative risk, CV, that is important.)

Security A has a mean of 25 and a standard deviation of 15; security B

has a mean of 40 and a standard deviation of 10.
a. Which security is riskier? Why?
b. What if the standard deviation on security B was 15? 20?

Problem 5.2: Portfolio Risk

(Note: In (a), convert the individual security returns for A and B to a
single series of returns via 0.50(60) + 0.50(50) = 55, which has a 0.30
probability of occurrence. Do the same for A and B for the other two
probabilities, and then for A and C. Once you have the probability
distributions in (a), then in (b) you can treat the returns like that of a
single security.)

Securities A, B, and C have rates of return and probabilities of occurrence

as follows:

Security Return (%)

Probability A B C
0.30 60 50 10
0.40 40 30 50
0.30 20 10 90

a. Calculate the probability distribution of expected rates of return for a

portfolio composed 50% of security A and 50% of security B. Now do
the same for a portfolio composed of 50% security A and 50% security
C.
b. Calculate the expected value (or mean) and the standard deviation for
portfolios AB and AC from (a).
c. Which portfolio has the highest expected return? The lowest risk?
Which portfolio is preferable?
d. Assume that the standard deviation calculated for portfolio AC is 21%,
but that everything else remains the same. Which portfolio would now
be preferable? Why?

Problem 5.3: Correlation and Standard Deviation

 Consider two stocks, A and B, with their expected returns and standard
deviations, as follows:
_ A B
expected return, k 15% 10%
standard deviation, s 10 8

a. What is the expected return if the portfolio contains equal amounts

(0.50) of each security?
b. What is the standard deviation for the equally weighted portfolio in (a)
if the correlation between the security return is (1) Corr ab = +1.00 (2)
Corr ab = +0.50, and (3) Corr ab = -0.50?
c. How does the decrease in the portfolio standard deviation (as the
correlation between the security returns drops) relate to the diversifiable
and nondiversifiable risk?

Problem 5.9: Portfolio Required Return

Excallibur Fund has a total investment in five stocks as follows:

Investment
Stock (market value) Beta
1 $3.0 million 0.50
2 2.5 million 1.00
3 1.5 million 2.00
4 2.0 million 1.25
5 1.0 million 1.50

The risk-free rate, kRF, is 7 percent, and the returns on the market portfolio
are given by the following probability distribution:

Probability kM
0.10 8%
0.20 10
0.30 13
0.30 15
0.10 17

What is Excalibur Fund’s required rate of return?

Problem 5.11: Required Return and Common Stock Valuation

 Danford Products has dividends today, D0, of $2 per share, an expected
growth rate of 9 percent per year to infinity, a beta of 1.40, kM = 13%,
and kRF = 8%.
a. What is the required rate of return?
b. What is the current market price of Danford’s common stock?
c. Danford is contemplating the divestiture of an unprofitable but stable
revenue-producing division. The effect will be to increase the growth rate
in cash dividends to 11 percent, and also increase beta to 1.60. What will
be the new market value?
d. Instead of (c), Danford could merge with another firm that is a steady
cash producer but is less risky. The effect would be to lower beta to 1.20
and reduce the growth rate in dividends to 8 percent. What would be the
market value in that case?
e. Instead of either (c) or (d), a new, aggressive management could be
brought in. Beta would go to 2.00, and the growth rate in dividends
would be 13 percent. Now what would be the stock price?
f. Is Danford better off staying where it is, or moving to one of the plans
outlined in (c), (d), or (e)? Which plan should the firm choose? Why is
this the best plan?

Problem 5.13: Risk, Correlation, and Stock Price

(Note: bj = ( sj)(CorrjM)/sM)

O’Meara Instruments is in the process of evaluating the effect of different

factors on its market value. O’Meara expects to pay dividends of $3 a
year from now (D1 = $3), and the growth rate in its dividends is 4 percent
per year until infinity. O’Meara estimates the following:

kRF = 6%, kM = 11%, sj = 16%, sM =10% and CorrjM = 0.50.

a. What is the required rate of return for O’Meara and the current market
value of its stock?
b. What is O’Meara’s required rate of return and stock market value if
everything stays the same, except that its correlation with the market
increases to 0.75?
c. If all the conditions are as in (a) except that sj increases to 64 percent
and sM increases to 20 percent, what is the required rate of return and
market price for O’Meara?
d. If all the conditions are as in (a) except that sj decreases to 8 percent,
what is the required rate of return and market price for O’Meara?

Problem 5.14: Disequilibrium and Stock Price

The stock of Ross Furniture is currently selling for $25. You have
evaluated the future prospects of both the firm and the market and made
the following estimates. Ross is expected to pay a dividend of $2.00 at t =
1, and this dividend is expected to grow indefinitely at 6 percent a year.
The standard deviation for Ross and the market are 10 percent and 6.25
percent, respectively. The correlation between the returns for Ross and
for the market is +0.80. If the return on the market is 14 percent and the
risk-free rate is 8 percent, is Ross a good buy?
 Assignment 4
The Opportunity Cost of Capital
Capital Structure

Question 6.1:
“Internally generated funds are costless. Accordingly, the cost of new
common stock is the only relevant cost of common equity for cost of
capital purposes.” Evaluate this statement.

Problem 6.1: After-Tax Cost of Debt

Calculate the after-tax cost of debt under the following conditions if the
maturity value of the debt is $1,000, interest is paid annually, and the
corporate tax rate is 35 percent.

a. Coupon interest rate is 8 percent, proceeds are $900, and the life is 20
years.
b. Bond pays $100 per year in interest, proceeds are $960, and life is 10
years.
c. Coupon interest rate is 14 percent, proceeds are $1,120, and bond has
30-year life.
d. Proceeds are $1,000, coupon interest rate is 12 percent, and the life is 5
years.

Problem 6.2: Cost of Preferred Stock

What is the after-tax cost of preferred stock under the following
circumstances?
a. Par is $80, dividend is $8 per year, and the proceeds are $76.
b. Proceeds are $46, and dividends are $7.
c. Par is $60, dividend is 9 percent (of par), and proceeds are $55.
d. Par is $40, dividend is 11 percent (of par), and proceeds are $40.

Problem 6.5: Cost of Common: All Three Approaches

 Luxury Suites has hired you as a consultant to estimate its cost of common
equity. After talking with its CFO and an econometric forecasting firm,
you have come up with the following facts and estimates:

Estimates Year Dividends per Share

P0 = $85 -5 $1.21
bLuxury Suites = 1.50 -4 1.21
Treasury security rate = 10% -3 1.30
Market yield on comparable -2 1.40
quality long-term debt = 13% -1 1.71
Expected return on the market 0 1.86
portfolio = 16%
Expected risk premium of stocks
over bonds = 4%
Current earnings per share, EPS = $5.75

Luxury Suites plans to use 30 percent debt and 70 percent equity for its
incremental financing. Also, the firm’s marginal tax rate is 33 percent.
a. What do you estimate the past growth rate in cash dividends per share
has been? Employ this as your estimate of g (round to the nearest whole
number).
b. What is the estimated cost of common equity employing the following
approaches: (1) dividend valuation, (2) CAPM, and (3) bond yield plus
expected risk premium?
c. Explain why one of the estimates from (b) is substantially lower than
the other two.
d. Take an average of all three answers from (b) for your estimate of
Luxury’s cost of common equity.
d. What is your estimate of Luxury’s opportunity cost of capital? How
confident of it are you?

Capital Structure

Question 12.1:
Assume the MM no-tax model holds, A firm exists that has 20 percent of
its capital structure in the form of debt, which has a cost of 6 percent.
Now the firm moves to 60 percent debt in its capital structure, again with
a cost of 6 percent. What two effects occur as the firm moves from 20
percent debt to 60 percent debt? How do these effects counterbalance
each other?

Question 12.3:
 Explain Miller’s personal tax model. Under what circumstances does it
lead to the same conclusion as MM without corporate taxes? With
corporate taxes?

Problem 12.5: Levered and Unlevered Firms

Graphics Resources is an unlevered firm with an EBIT of $4 million. Its
tax rate is 40 percent, and the opportunity cost of equity capital is 15
percent. Assume that the MM tax case holds and that Graphics is fairly
valued.
a. What is the market value of Graphics?
b. Suppose that Graphics now issues $10 million of 8 percent bonds.
What is the new market value of Graphics?
c. Assume there are two firms, Y and Z, that are identical in all respects
to the unlevered Graphics and the levered Graphics, respectively. Explain
what will happen if the current market value of Y is $14 million, while
that of Z is $23 million.

Problem 12.6: Personal and Corporate Taxes

Debt-Free Co. is an unlevered firm that has an equilibrium market value
of $7 million. The firm is contemplating issuing $4 million of 10 percent
coupon bonds. The firm has a corporate tax rate of 30 percent and has
estimated that the tax rates for its investors are 20 percent on stock income
and 25 percent on bond income. Assume that Miler’s personal tax case
holds.
a. If only corporate taxes exist, what is the new total value of the firm and
gain from leverage?
b. With both corporate and personal taxes, what is the gain from leverage
and total value of the firm?
c. Why is the gain from leverage (or, alternatively, the total value of the
firm) less in (b) than in (a)?

Cover homework & Review for test

Test
 Assignment 5
Capital Budgeting Techniques

Problem 7.1: Payback Versus NPV

Cash flow streams for two mutually exclusive projects are given below.
After-Tax Cash Inflows
Year Project A Project B
1 $300 $600
2 $400 $200
3 $ 50 $100
4 $ 50 $700

Project A requires an initial investment of $600, and project B requires

an initial investment of $1,000.
a. Use the payback period to determine which project should be selected.
b. If the opportunity cost is 8%, determine the net present value for both
projects.
c. Which project should be chosen? What are the drawbacks of the
payback
period method?

Problem 7.6: NPV and IRR

Project A and B both require a $20,000 initial investment and have
projected cash inflows as follows:

After-Tax Cash Inflows

Year Project A Project B
1 $10,000 $7,000
2 $ 8,000 $7,000
3 $ 6,000 $7,000
4 $ 4,000 $7,000

a. Calculate each project’s net present value if the opportunity cost is 12

percent.
b. Calculate the internal rate of return for each project.
c. Should either project be rejected if they are independent?
d. Which project should be selected if they are mutually exclusive?
Problem 7.8: Conflicting Rankings
Michael’s Costumes is analyzing two mutually exclusive projects. Both
require an initial investment of $65,000 and provide cash inflows as
follows:

After-Tax Inflows
Year Project C Project D
1 $40,000 0
2 30,000 0
3 20,000 $104,200

a. If the opportunity cost is 10 percent, which product would

Michael’s choose if NPV is employed?

b. Calculate the internal rate of return for both projects. Which

project should be selected according to IRR? Why does the
difference in ranking occur?

Problem 7.10: Unequal Lives

Consider a firm in need of a stamping machine. It can buy a one-
speed machine that requires an initial investment of $350 and
produces after-tax cash inflows of $300 for each of 2 years, or it
can purchase a three-speed machine that costs $1,200 and produces
cash inflows of $500 for each of 4 years. Neither machine has any
resale value, and the opportunity cost is 16 percent. Which
machine should be purchased?

Problem 7.13: Capital Rationing

Terra Products has the following independent investments under
examination:

Initial After-Tax Cash Life of the

Project Investment Flow per Year Project (in years)
A $100,000 $ 39,000 4
B 50,000 12,000 6
C 80,000 39,000 3
D 60,000 15,000 7
E 75,000 25,000 5
F 90,000 25,000 6

Terra Products’ opportunity cost of capital is 14 percent.

a. In the absence of capital rationing, which projects should be selected?
What is the size (in total dollars) of the capital budget? The total NPV of
all of the projects selected?
b. Now suppose that a limit of $250,000 (maximum)is placed on new
capital projects. Which projects should be selected?
c. What is the total NPV determined in (b)? What is the loss to Terra
Products due to the capital rationing constraint?
 Assignment 6
Capital Budgeting Applications
Risk, Capital Budgeting, and Value Creation

Question 8.2:
Which of the following should be considered when calculating the
incremental CFs associated with a new warehouse? Assume the firm
owns the land but that existing buildings would have to be demolished.
a. Demolition costs and site clearance.
b. The cost of an access road built a year ago.
c. New forklifts and conveyer equipment for the warehouse.
d. The market value of the land and existing buildings.
e. A portion of the firm’s overhead
f. Lost earnings on other products due to managerial time spent during
the construction and stocking of the new warehouse
g. Future IRS depreciation on the old buildings and equipment
h. Landscaping for the warehouse
i. Financing costs related to the bonds issued to build the new warehouse.
j. The effects of inflation on future labor costs.

Problem 8.1: Overhead and Opportunity Costs

(Note: For simplicity in 8.1, ignore any impact of depreciation.)

Windsor Stores is considering opening a new store in Portland. Gross

cash inflows are expected to be $1,000,000 per year, and cash outflows
are predicted to be $800,000 per year. In addition, Windsor’s cost
accounting department estimates that overhead costs of $75,000 per year
should be charged to the new store. These costs include the store’s share
of the firm’s management salaries, general administrative expenses, and
so forth. Finally, the new store is expected to reduce CFBTs by $50,000
per year from one of the firm’s existing stores. Windsor’s marginal tax
rate is 30 percent.
a. If all the overhead consists of fixed costs that will be incurred whether
or not the new store is opened, what is the relevant operating CF?
b. What if $50,000 of the overhead consists of variable costs related to
the new store, and $25,000 consists of fixed overhead costs? What is the
relevant operating CF now?

Problem 8.9 Expansion

 A firm is considering a major expansion of its operations. If it
expands, the firm anticipates an initial investment in equipment of
$500,000 that will be depreciated via straight-line depreciation
over 5 years. The projected cash inflows are $200,000, $250,000,
$200,000, $200,000, and $150,000, respectively, over the 5 years.
At that time the resale value of the equipment is estimated to be
$125,000. The marginal tax rate is 35 percent, and the opportunity
cost of capital is 15 percent.
a. Should the investment be made?
b. After running the analysis in (a) you remember that if the
investment is made the firm will have to use a building that is
presently rented out for $70,000 per year (before taxes) payable in
advance (i.e., at t = 0, t = 1,..., t = 4). Does this new information
affect the decision you reached in (a)?

Problem 8.11: Replacement

Hinkle Manufacturing bought a $145,000 piece of equipment 2
years ago; its present five year straight-line depreciated value is
$87,000. Because of substantial increases in the demand for used
equipment, it can be sold today for $125,000 (before taxes). If
kept, however, it will last 5 more years and produce expected cash
flows, CFBTs, of $13,000 for each of 5 years. A replacement
machine costs $180,000, and it is expected to produce CFBTs of
$28,000 for each of 5 years. Assume neither machine has any
resale value in 5 years. If the marginal tax rate is 34 percent and
the discount rate is 10 percent, should the equipment be replaced,
assuming straight-line depreciation is employed for both pieces of
equipment?

Problem 8.14: Interrelated Projects

SouthWest Developers has designed an apartment building that
will cost $7 million and produce after-tax cash inflows of $1.5
million for each year of its 10 year life. The firm also has plans for
a recreation center that would cost $3.2 million and produce after-
tax cash flows of $600,000 per year for 10 years. The firm owns
land near Los Angeles and must decide which project to build.
The land is large enough to accommodate both projects.
SouthWest believes that if both projects are built next to each
other, the residents of the apartment building will use the
recreation center and increase its expected cash inflows to
$700,000 per year. If the opportunity cost of capital is 14 percent,
what should the company do?

Chapter 9: Risk, Capital Budgeting, and Value Creation

Problem 9.6: Sequential Analysis
Holmes has developed chocolate marbles. The product will be test
marketed in the southeastern United States for 2 years, requires an
initial investment of $2 million, and because of heavy promotional
expenses is not expected to generate any positive CFs during the
first 2 years. There is a 60 percent chance that demand for the
chocolate marbles will be satisfactory; if that is so, an $8 million
after-tax cash investment will be incurred at t = 2 to market the
chocolate marbles in the eastern half of the United States.
Subsequent CFs are as follows:

$4,000,000 $7,000,000 $6,000,000 $3,000,000

3 4 5 6

If the test-market results are unfavorable (40 percent chance), then

the chocolate marbles will be withdrawn from the market. Once
consumer preferences are known, Holmes considers chocolate
marbles an average-risk project requiring a 14 percent return.
During the test-marketing phase a 25 percent return is required.
What decision should Holmes make?

Problem 9.10 Break-Even Analysis

Jacobi Hats is considering the extension of an existing product line. The
incremental initial investment is $1.4 million, and the rest of the
assumptions are as follows:
1. Depreciation for tax purposes to zero will occur over 7 years via
straight-line; the economic life is also 7 years.
2. Variable costs are 30 percent of estimated sales.
3. Fixed costs are $100,000.
4. The tax rate is 40 percent and the discount rate is 20 percent.
What is the per year financial break-even level of sales?
 Assignment 7
Deciding Whether to Merge

Problem 8B.1: Basic Merger Analysis

DeLucia Equipment is analyzing the possible acquisition of Borgia
Products. DeLucia’s market value is $3,000,000, and its market price per
share is $40. Borgia’s market value is $800,000; DeLucia estimates the
incremental value, Dvalue, is $250,000, and the total purchase price would
be $1,000,000.
a. If cash is used, what is the NPV of the proposed acquisition?
b. What is the NPV if stock is employed?
c. Why is the NPV for a cash-financed merger greater than if stock is
employed? How much more cash could be offered if the NPV for a cash-
financed deal just equaled the NPV for the stock-financed deal?

Problem 8B.4: Incremental Cash Flows and Merger Analysis

Lawrence Inc. is examining the possible acquisition of Berry
Manufacturing. Lawrence has estimated the following anticipated
incremental benefits and investments:

Year DCFBT DDep* DInvestment

0 $ 0 $ 0 $ 50,000
1 80,000 30,000 100,000
2 150,000 60,000 25,000
3 150,000 60,000
4 150,000 25,000
5 60,000

* DDep is for the DInvestment in the column immediately to the right.

a. If Lawrence’s tax rate is .30, calculate the incremental after-tax cash

flows , DCF, expected form Berry.
b. The market value of Lawrence before the merger is $900,000, and
Berry’s premerger market value is $400,000. The market price per share
of Lawrence’s stock is $100, and the appropriate opportunity rate is 12%.
Calculate the NPV for both a cash-financed and a stock financed merger if
Lawrence pays a premium of 25% above Berry’s current market value.
Problem 9.13: Keep Versus Abandon
Bavaro corporation sells a number of specialized product lines. Due to
increasing competition, the CFs for its Gamma product line are estimated
as follows:
$350,000 $250,000 $150,000 $100,000

1 2 3 4

A competitor has approached Bavaro and offered $650,000, after taxes,

for the product line. If Bavaro’s opportunity cost for this product line is
17 percent, what should it do?
 Assignment 8
Leasing, Options, and convertibles

Question 14.5:
It has been argued that convertibles have substantial advantages to firms
as a means of financing. When compared to straight debt, firms get cheap
debt financing because they pay less than the going market interest rate
for the debt. When compared with selling common stock directly, firms
are able to sell common stock at a price above the current market price of
the firms’ common stock. Thus, firms are in a “heads I win, tails you
lose” situation. Evaluate this argument.

Problem 14.1: Lease Evaluation

(Note: Ignore the half-year convention when calculating depreciation.)

Mercer Industries needs three trucks that cost $100,000 in total. Miles
Leasing has offered to lease the trucks to Mercer for a total of $25,000 per
year for each of 5 years, with the lease payments payable in advance.
Mercer will depreciate the trucks via straight-line depreciation over their
5-year normal recovery period, the firm’s marginal tax rate is 30 percent,
and Mercer’s before-tax cost of debt is 10 percent. Should Mercer lease
or purchase the trucks? (Assume that the capital budgeting decision has
already been made and the acquisition of the trucks is desirable.)

Problem 14.4: Alternative Lease Situations

(Note: Ignore the half-year convention when calculating depreciation.)

Schure Benefit is evaluating leasing or purchasing an asset that has a

positive capital budgeting NPV. The following basic conditions exist:
CLA0 is $210,000, n is 3, depreciation is straight-line, T is 35 percent, L is
$82,000, ki is 11 percent, lease payments are made annually in advance,
and k is 15 percent.
a. Determine the base case NPVlease.
b. Determine the effect of the following conditions on the lease versus
purchase decision for Schure Benefit.
(1) If the asset is purchased, Schure will incur incremental operating costs
of $5,000 (before taxes) per year.
(2) If the asset is purchased, Schure estimates the before-tax resale value
will be $40,000.
 c. Now suppose that CLA0 is $325,000, L is $90,000, n is 5, depreciation
is straight-line, ki is 13 percent, and k is 16 percent. If the asset is
purchased, Schure will incur incremental operating costs of $10,000
(before taxes) per year. Finally, Schure estimates the before-tax resale
value will be $75,000. Should Schure now lease or purchase the asset?

Problem 14.5: Maximum Lease Payment

(Note: Ignore the half-year convention when calculating depreciation.)

Runyan Marsh is considering a lease arrangement as a means of acquiring

the use of some new equipment. The equipment costs $150,000, has a 3-
year normal recovery period, and straight-line depreciation will be
employed. If purchased, the after-tax resale value will be $10,000. The
marginal tax rate is 30 percent, the appropriate opportunity cost of capital,
k, is 14 percent, and the before-tax cost of debt is 11.43 percent. If the
three lease payments are made in advance, what is the maximum lease
payment Runy Marsh can make and still lease the asset? Assume the
capital budgeting NPV is positive.

OPTIONS PROBLEMS

1. Walmart offers 30 day “rainchecks” as a way to attract loyal customers. A

raincheck gives the customer the right to buy a product that is out-of-stock
today. If the customer returns during the next 30 days, he or she may buy the
product at today’s price even if the future price rises. If the product price at
Walmart today is $72, the value of the product (price at competitor stores
today) is $74, the risk-free rate is 12% and the standard deviation of return is
.15, what is the value of the raincheck?

2. You can abandon a project at the end of 1 year and receive $100,000. If
you continue the project you expect to receive cash flows worth $160,000 in
present value. The risk-free rate is 10%, and return standard deviation is
1.30.

a. Find the value of the option to abandon.

b. If the return standard deviation falls to .20, what should happen to the
value of the option (no need to make calculations unless you can not answer
otherwise)? Explain why.
3. You have a cancer drug project that requires a $10 million investment.
The project will provide cash flows with present value of $8 million when
considered alone. However, you estimate that if you make the investment in
the first cancer drug, you will be able to develop a second improved cancer
drug in two years that requires an investment of $10 million and will yield
cash flows of $11 million present value. Assume the risk-free rate is 10%
and the return standard deviation is .60.

a. Should you accept the project?

b. Suppose the first cancer drug project can be delayed one year but you
lose the chance to do the second drug. Should you accept the project now or
wait?
 Assignment 9
Analyzing Accounting Statements

Problem 19.5: Financial Ratios

Walker Products is applying for a bank loan. It has given the bank the
following data:

Balance Sheet

Cash $ 40,000 Accounts payable $ 5,000

Accounts receivable 40,000 Notes payable 20,000
Inventory 70,000 Long-term debt 75,000
Net plant and equipment 225,000 6% preferred stock 25,000
total assets $375,000 Common stock ($5 par) 150,000
Retained earnings 100,000
Total $375,000

Sales $390,000
Net income $ 61,500
Dividends per share on common stock$ 0.80
Market price per share of common stock $ 60

As part of your analysis of the firm’s request for a loan, you have decided to
calculate the following items: (1) the number of shares of common stock
outstanding, (2) earnings per share of common stock, (3) dividend payout,
(4) return on total assets, (5) return on equity, (6) current ratio and (7) quick
ratio.
a. What are the calculated amounts for the seven items?
b. What can you conclude about the past profitability of Walker Products
based on this data? Lacking any other information, would you recommend
approving or disapproving the loan request?

Problem 19.6: Company Analysis

The following data are taken from the annual report of Khalin Drug Stores.
In addition, relevant industry data are provided.
a. Compute the ratios for Khalin corresponding to the industry ratios.
b. What are its strengths (weaknesses) compared to the retail drug industry?
 Khalin Drug Stores Balance Sheet as of January 31 (in thousands)
Cash $ 8,143 Accounts payable $54,449
Receivables 5,596 Notes payable 7,711
Inventory 148,554 Accrued expenses 28,823
Other current 11,608 Deferred income taxes 20,347
Net long-term assets 132,609 Long-term debt and leases 103,662
Total $306,510 Stockholder’s equity 91,518
Total $306,510

Khalin Drug Stores Income Statement for Year Ended January 31

(in thousands)
Sales $761,734
Cost of goods sold 550,930
Gross profit 210,804
Selling, general, and administrative expenses $156,070
Depreciation 10,784 166,854
EBIT 43,950
Interest 15,245
EBIT 28,705
Taxes 12,056
Net Income $ 16,649

Retail Drug Industry Ratios

Current 2.00 Total asset turnover 3.20
Quick 0.50 Total debt to total assets 0.43
Days sales outstanding Times interest earned 3.00
(365-day year) 12 days net profit margin 3.33%
Inventory turnover 4.00 Return on total assets 10.60%
Long-term asset Return on equity 18.40%
turnover 8.00

Financial Planning and Forecasting

Question 20.4
Gates Electronics is considering making the following policy changes. In
each case, indicate whether in the next period the move will provide more
cash inflows and/or reduce outflows (+), provide more outflows and/or
reduce inflows (-), or have an indeterminate or no effect (0).

a. The firm becomes more socially responsible _____

b. Increased competition is leading to price cutting
and increased promotional expenses. _____
c. The firm decides to sell only for cash; previously some
 sales had been on credit. _____
d. By shifting to more debt, the firm expects its return on
equity to increase. _____
e. The firm decides to change its inventory method from
one GAAP method to another GAAP method. _____
f. The firm’s dividend payout ratio is reduced. _____
g. Congress changes the tax laws, resulting in longer
depreciation for tax purposes. _____

Problem 20.1: Statement of Cash Flows

The statement of cash flows for Amoco Corp. for 3 recent years was as
follows (in millions):

-2 -1 0 _
Cash Flows from Operating Activities _
Net income $1,953 $ 747 $1,360
Depreciation, depletion,
amortization, and
retirements and abandonments 2,059 2,418 2,295
Decrease (increase) in receivables (73) 672 (197)
Decrease (increase) in inventories (34)
Increase (decrease) in payables and
accrued liabilities 159 (1,367) 331
Deferred taxes and other items 603 297 257
Net cash provided by
operating activities $4,718 $2,842 $4,012
Cash Flows from Investing Activities _
Capital expenditures (3,881) (2,256) (2,332)
Proceeds from distribution
of property 185 97 129
Distribution of cash
of Cyprus Minerals Co. (23) ___ ___
New investments and advances (42) (192) (42)
Proceeds from sale of investments 25 131 119
Other __(11) __(32) __141
Net cash used in investing activities $(3,747) $(2,252) $(1,985)
Cash Flows from Financing Activities _
New long-term obligations 334 1,153 3
Repayment of long-term
obligations (375) (979) (259)
Cash dividends paid (872) (849) (847)
Issuances of common stock 127 161 603
Acquisitions of common stock (937) (363) (443)
Increase (decrease) in short-term
 obligations 324 (263) (9)
Net cash used in financing
activities $(1,399) $(1,140) $(952)
Increase (decrease) in cash
and marketable securities (428) (550) 1,075
Cash and marketable securities--
beginning of year 1,419 991 441
Cash and marketable securities--
end of year $ 991 $ 441 $1,516

Supplemental Cash Flow Information

The effect of foreign currency exchange fluctuations on total cash and
marketable securities balances was not significant. Net cash provided by
operating activities reflects cash payments for interest and income taxes as
follows:

-2 -1 0 _
Interest paid $ 459 $ 408 $ 398
Income taxes paid $1,368 $ 877 $ 861

a. Analyze the firm’s financial performance for the 3 years and comment
on the primary sources of cash, the primary uses of cash, and any apparent
trends. How else (in terms of a general approach) could the operating
section of the statement be constructed?
b. What else would you like to know that is not reflected or apparent on
Amoco’s statement of cash flows?

Problem 20.6: Cash Budget

Hawkes Company is preparing plans for the next 6 months. The firm’s
special concern is a $2.5 million note that comes due in September. Sales
(actual for May and June, and forecast for the rest) are as follows:

May $ 3,400,000 October $1,800,000

June 3,500,000 November 1,500,000
July 4,000,000 December 1,400,000
August 2,500,000 January 1,500,000
September 2,000,000
 Sales are 10% for cash, 75% credit collected in the next month, and 15%
credit collected in 2 months. There are no bad debts. Purchase of raw
materials are made as follows: 20% of sales 2 months ahead, paid in the
month following the purchase; and 30% of sales expected 1 month ahead,
paid in the month following the purchase; and 30% of sales expected 1
month ahead, paid in the month following the purchase. Wages, selling,
and administrative expenses are estimated to be as follows:

July $ 1,000,000 October $ 700,000

August 900,000 November 700,000
September 800,000 December 700,000

In addition, there are lease payments of $100,000 per month. Interest

payments on long-term borrowing of $300,000 in both August and
November are required. Taxes of $325,000 are payable in September and
December. Finally, there is the short-term note of $2,500,000 payable in
September. There are no cash dividends or other inflows or outflows.
Hawke’s beginning cash balance is $430,000 on July 1, and its required
minimum balance is $400,000.
a. prepare a monthly cash budget for the last six months of the year.
b. Will Hawkes be able to pay off the $2,500,000 note in full and on
time?
c. Suppose that due to a recession sales falls off, but production does not
decline as rapidly. Also, customers take longer to pay their bills. What
effect might these changes have on Hawke’s ability to repay the note?

Problem 20.10: Financing Growth

Camden Corporation has decided to embark on a rapid expansion. Its
most recent income statement and balance sheet are as follows:

Income Statement (in millions)

Sales $30.0
Cost of goods sold 15.0
Selling general, and administrative expenses 6.0
EBIT 9.0
Interest 1.0
EBT 8.0
Taxes (30%) 2.4
Net income 5.6
Cash dividends 3.0
Transferred to retained earnings $ 2.6
 Balance Sheet (in millions
Current assets $ 6.0 Accounts payable $ 2.0
Long-term assets 14.0 Note payable 2.0
Total assets $20.0 Long-term debt 6.0
Common stock 3.0
Retained earnings 7.0
Total liabilities and
stockholders’ equity $ 20.0

In attempting to determine its financial condition and needs, Camden

believes the following will happen:

Sales $40.0
Cost of goods sold Same percent of sales as current year
Selling, general, and
administrative expenses $ 9.0
Interest $ 1.0 (initially, before additional
financing)
Taxes Same percent of EBT
Cash dividends $ 3.0 (initially)
Current assets $ 7.0
Long-term assets $23.0
Accounts payable $ 3.0
Notes payable $ 2.0
Long-term debt $ 6.0 (initially)
Common stock $ 3.0

a. Based on these estimates, prepare a pro forma income statement and

balance sheet for Camden. How much additional financing (regardless of
where it comes from) do you estimate the firm needs?
b. What happens if Camden acquires sufficient additional long-term debt
financing to keep its ratio of total debt to total assets at its original level?
Assume interest expenses increase by $500,000.
c. By cutting its cash dividends in addition to the step taken in(b), can
Camden finance all its cash needs? What do you think will happen to the
market price of Camden’s common stock if it cuts cash dividends? Do
you see any alternative means of raising the needed funds?
 Assignment 10
Raising Long-Term Funds
Long-Term Liability Management

Question 10.3
Differentiate among par value, book value, and market value per share.
Why is market value generally the only important figure? Under what
limited circumstances may par value or book value be of some
importance? Explain.

Problem 10.3: Underwritten versus Best Efforts

Stale Electronics, a new and rather speculative firm, wishes to raise
additional capital by selling stock and going public. The firm’s
investment banker has suggested two alternatives. Plan I is a firm
commitment offering of 1 million shares at $7.50 per share, with an
underwriting fee of 8% of the gross proceeds. Plan II is a best efforts
offering at $7.75 per share, subject to an underwriting commission of 3%
of the expected gross proceeds sold, plus a $150,000 fee. The “best
guess” is that 95% of the issue would be sold under plan II.
a. Based on the net proceeds to the firm, which plan should Slate choose?
b. Does your answer change if only 90% of the issue can be sold under
plan II.
c. All things considered, which plan would you recommend? Why?

Problem 10.8: Alternative Approaches to Pricing a New Issue

(Note: Ignore any flotation or issuance costs.)

Apollo Energy is planning its first public offering. Its past growth in cash
dividends and earnings has averaged 10% per year. Based on the number
of shares Apollo is planning to issue, cash dividends and earnings per
share for next year (t = 1) are expected to be $0.90 and $2, respectively.
The firm’s investment banking firm, Great Associates, has recommended
that the stock be issued at a price of $15 per share.

a. What is the P/E ratio implied by the recommended market price?

b. Two firms similar to Apollo Energy have the following characteristics:

Firm Y Firm Z
 Expected EPS $ 1.50 $ 3.00
Expected DPS 0.80 1.25
Expected growth rate/year 7% 9%
Market Price $ 15.00 $ 45.00

For firm Y and firm Z, determine (1) their P/E ratios (2) their implied k s.
Then calculate an estimated market price for Apollo Energy using first the
separate P/E’s and ks’s, and then an average of them. Based on these
comparable firms, what range of prices is implied for Apollo?
c. What required return, or cost of equity capital, ks, is implied by the
price of $15 if investors’ expectations of the future are consistent with the
past?
d. You believe the rate calculated in (c) is high; it should be between 11.5
and 13 percent. The expected growth rate of 10% is okay. What issue
price is implied, given these estimates?
e. Based on your analysis in (a) through (d), how would you respond to
Best Associate’s proposal?

Long-Term Liability Management

Question 11.1:
As corporate treasurer, how would the following conditions influence
your willingness to include a sinking fund provision and the need for a
call feature in a new bond issue?
a. Market interest rates are expected to fall.
b. Your firm anticipates heavy cash outflows in relation to its cash needs
in the next 5 to 10 years.
c. Market interest rates are expected to fluctuate substantially, both above
and below the coupon rate on the new issue.

Problem 11.1: Restrictions on Additional Debt

Door County Corporation has no short-term debt, but it does have $10
million, 10 percent coupon rate mortgage bond outstanding with a limited
open-end provision. Additional 10 percent mortgage debt can be issued as
long as all the following restrictions are met:
1. Ratio of debt to equity (i.e., total debt/total stockholders’ equity)
remains below 0.4
2. Interest coverage (i.e., EBIT/interest) is at least 5.
3. The depreciated value of the mortgaged assets is at least 2.5 times the
mortgage debt.
 The firm has a depreciated value of mortgage assets of $60 million, equity
of $80 million, and earnings before interest and taxes, EBIT, of $12
million. Assuming that half the new bond issue would be used to add
assets to the base of mortgaged assets, how much additional debt can Door
County Corporation issue?

Problem 11. 8: Coupon-Bearing versus Zero-Coupon Bonds

Keeley needs $100 million in new debt financing. If the firm uses a
coupon-bearing bond, the interest rate is 9 1/2% and the bond will be
issued at par. If it uses a zero-coupon bond, the interest rate is 9.2 %.
Assume that interest is paid annually and either bond will have a maturity
of 10 years.
a. If the coupon bearing bond is employed, (1) what is the per year
interest, and (2) what is the cash outflow (ignoring any taxes) in the tenth
year?
b. If the zero-coupon bond is employed:
(1) What is the par value of the zero-coupon bond in order to raise the
$100 million needed?
(2) What is the imputed interest in year 1? In year 2?
(3) What is the cash outflow in the tenth year?
c. What can we say about the cash flow demands that the two securities
will place on Keeley?