Corporate Finance Spring 2012

Study Guide Problems

Solving for N for an annuity i. You are nominal $900 at account a. b. c. d. e. 40 168 175 221 335

Answer: b

Diff: E

currently investing your money in a bank account which has a annual rate of 9 percent, compounded monthly. If you invest the end of each month, how many months will it take for your to grow to $301,066.27 (rounded to the nearest month)? months months months months months

Time for a sum to double Answer: d Diff: E ii. You are currently investing your money in a bank account which has a nominal annual rate of 7 percent, compounded monthly. How many years will it take for you to double your money? a. 8.67 b. 9.15 c. 9.50 d. 9.93 e. 10.25 years years years years years

Effective annual rate Answer: e Diff: M iii. You have just taken out a 10-year, $12,000 loan to purchase a new car. This loan is to be repaid in 120 equal end-of-month installments. If each of the monthly installments is $150, what is the effective annual interest rate on this car loan? a. b. c. d. e. 6.5431% 7.8942% 8.6892% 8.8869% 9.0438%

Required annuity payments Answer: b Diff: E iv. If a 5-year ordinary annuity has a present value of $1,000, and if the interest rate is 10 percent, what is the amount of each annuity payment? a. b. c. d. e. $240.42 $263.80 $300.20 $315.38 $346.87

Corporate Finance Spring 2012

Study Guide Problems

Quarterly compounding Answer: a Diff: E v. If $100 is placed in an account that earns a nominal 4 percent, compounded quarterly, what will it be worth in 5 years? a. $122.02 b. $105.10 c. $135.41 d. $120.90 e. $117.48 Net income vi.

Answer: b

Diff: M

Edge Brothers recently reported net income of $385,000. The tax rate is 40 percent. The companys interest expense was $200,000. What would have been the companys net income if they would have been able to double their operating income (EBIT), assuming that the companys tax rate and interest expense remain unchanged? a. b. c. d. e. $ 770,000 $ 890,000 $ 920,000 $1,100,000 $1,275,000

Corporate Finance Spring 2012

Study Guide Problems

Answer: e

Diff: M

Swann Systems is forecasting the following income statement for the upcoming year: Sales Operating costs (excluding depreciation) Gross margin Depreciation EBIT Interest EBT Taxes (40%) Net income $5,000,000 3,000,000 $2,000,000 500,000 $1,500,000 500,000 $1,000,000 400,000 $ 600,000

The companys president is disappointed with the forecast and would like to see Swann generate higher sales and a forecasted net income of $2,000,000. Assume that operating costs (excluding depreciation) are always 60 percent of sales. Also, assume that depreciation, interest expense, and the companys tax rate, which is 40 percent, will remain the same even if sales change. What level of sales would Swann have to obtain to generate $2,000,000 in net income? a. b. c. d. e. $ 5,800,000 $ 6,000,000 $ 7,200,000 $ 8,300,000 $10,833,333 Answer: b What is its net Diff: M

Net operating profit after taxes (NOPAT) viii. A company has the following income statement. operating profit after taxes (NOPAT)? Sales Costs Depreciation EBIT Interest expense EBT Taxes (40%) Net income a. b. c. d. e. $ 90 $120 $150 $180 $200 $1,000 700 100 $ 200 50 $ 150 60 $ 90

Corporate Finance Spring 2012

Study Guide Problems

Answer: c

Diff: M

Bates Motors has the following information for the previous year: Net income = $200; Net operating profit after taxes (NOPAT) = $300; Total assets = $1,000; and Total net operating capital = $800. The information for the current year is: Net income = $500; Net operating profit after taxes (NOPAT) = $400; Total assets = $1,300; and Total net operating capital = $900. What is the free cash flow for the current year? a. b. c. d. e. $100 $200 $300 $400 $500 Answer: b Casey Motors recently reported the following information: Net income = $600,000. Tax rate = 40%. Interest expense = $200,000. Operating capital = $9 million. After-tax cost of capital = 10%. Diff: M

EVA x.

What is the companys EVA? a. ($300,000) b. ($180,000) c. $ 0 d. $200,000 e. $400,000 Future stock price Answer: b Diff: M xi. Graham Enterprises anticipates that its dividend at the end of the year will be $2.00 a share (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate of 7 percent a year. The risk-free rate is 6 percent, the market risk premium is 5 percent, and the company's beta equals 1.2. What is the expected price of the stock five years from now? a. b. c. d. e. $52.43 $56.10 $63.49 $70.49 $72.54

Corporate Finance Spring 2012

Study Guide Problems

Capital gains yield and dividend yield Answer: e Diff: M xii. Conner Corporation has a stock price of $32.35 per share. The last dividend was $3.42 (i.e., D0 = $3.42). The long-run growth rate for the company is a constant 7 percent. What is the companys capital gains yield and dividend yield? a. b. c. d. e. Capital Capital Capital Capital Capital gains gains gains gains gains yield yield yield yield yield = 7.00%; Dividend yield = 10.57%. = 10.57%; Dividend yield = 7.00%. = 7.00%; Dividend yield = 4.31%. = 11.31%; Dividend yield = 7.00%. = 7.00%; Dividend yield = 11.31%.

Preferred stock value Answer: d Diff: E xiii. Johnston Corporation is growing at a constant rate of 6 percent per year. It has both common stock and non-participating preferred stock outstanding. The cost of preferred stock (rps) is 8 percent. The par value of the preferred stock is $120, and the stock has a stated dividend of 10 percent of par. What is the market value of the preferred stock? a. b. c. d. e. $125 $120 $175 $150 $200

Preferred stock yield Answer: c Diff: E xiv. A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is currently $50, what is the nominal annual rate of return? a. b. c. d. e. 12% 18% 20% 23% 28%

Multiple part: (The following information applies to the next six problems.) Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its cost of debt before tax is 12%, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 40 percent. 5

Corporate Finance Spring 2012

Study Guide Problems

Answer: e

Diff: M

Answer: d

Diff: E

Cost of common stock: CAPM Answer: c Diff: E xvii. What is Rollins' cost of common stock (rs) using the CAPM approach? a. b. c. d. e. 13.6% 14.1% 16.0% 16.6% 16.9%

Cost of common stock: DCF Answer: c Diff: E xviii. What is the firm's cost of common stock (rs) using the DCF approach? a. b. c. d. e. 13.6% 14.1% 16.0% 16.6% 16.9%

Cost of common stock: Risk premium Answer: c Diff: E xix. What is Rollins' cost of common stock using the bond-yield-plus-riskpremium approach? a. b. c. d. e. WACC xx. 13.6% 14.1% 16.0% 16.6% 16.9% Answer: a What is Rollins' WACC? a. b. c. d. e. 13.6% 14.1% 16.0% 16.6% 16.9% 6 Diff: E

Corporate Finance Spring 2012

Study Guide Problems

i.

Solving for N for a single payment Financial calculator solution: PV FV PMT I N = = = = = 0 301,066.27 -900 9/12 = 0.75 ? = 168 months.

Answer: b

Diff: E

ii.

Time for a sum to double PV FV PMT I N = -1 = 2 = 0 = 7/12 = ? = 119.17 months = 9.93 years.

Answer: d

Diff: E

iii.

Effective annual rate

Answer: e

Diff: M

Given: Loan Value = $12,000; Loan Term = 10 years (120 months); Monthly Payment = $150. N = 120 PV = -12,000 PMT = 150 FV = 0 Solve for I/YR = 0.7241 12 = 8.6892%. However, this is a nominal rate. To find the effective rate, enter the following: NOM% = 8.6892 P/YR = 12 Solve for EFF% = 9.0438%.

iv.

Required annuity payments

Answer: b

Diff: E

2 | PMT

3 | PMT

4 | PMT

5 | PMT

Years

Numerical solution: $1,000 = PMT((1-(1/1.15))/.1) PMT = $1,000/3.7908 = $263.80. Financial calculator solution: Inputs: N = 5; I = 10; PV = -1,000; FV = 0.

Output: PMT = $263.80.

Corporate Finance Spring 2012

Study Guide Problems

v.

Quarterly compounding Time Line:

Answer: a

Diff: E

10

11

12

13

14

15

16

17

18

19 20 Qtrs

-100 FV = ?

Numerical solution: $100(1.0120) = $100(1.2202) = $122.02. Financial calculator solution: Inputs: N = 20; I = 1; PV = -100; PMT = 0. vi. Net income

Output: FV = $122.02. Answer: b Diff: M

We need to work backwards through the income statement to get the EBIT. EBIT $841,667 ($641,667 + $200,000) Interest 200,000 EBT $641,667 ($385,000/0.6) Tax (40%) NI $385,000 If EBIT doubles: EBIT $1,683,334 Interest 200,000 EBT $1,483,334 Tax (40%) 593,334 NI $ 890,000

($841,667 2)

($1,483,334 0.6)

Corporate Finance Spring 2012

Study Guide Problems

Answer: e

Diff: M

Working up the income statement to get sales you calculate the new sales level should be $10,833,333. Sales Operating costs (excl. depr.) Gross margin Depreciation EBIT Interest EBT Taxes (40%) Net income $10,833,333 6,500,000 $ 4,333,333 500,000 $ 3,833,333 500,000 $ 3,333,333 1,333,333 $ 2,000,000 $4,333,333/0.4 $3,833,333 + $500,000 $3,333,333 + $500,000 $2,000,000/0.6

viii. Net operating profit after taxes (NOPAT) NOPAT = EBIT(1 - T) = $200(1 - 0.4) = $120.

Answer: b

Diff: M

ix.

Free cash flow

Answer: c

Diff: M

Free cash flow = NOPAT - Net investment in total net operating capital = $400 - ($900 - $800) = $400 - $100 = $300. x. EVA Answer: b Diff: M

EVA = EBIT(1 - T) - (Operating capital)(After-tax cost of capital). Note that EBIT = Earnings before taxes plus interest expense. Earnings before tax = EBT =

$600,000 = $1,000,000. 0.6

EBIT = $1,000,000 + $200,000 = $1,200,000. EVA = $1,200,000(0.6) - $9,000,000(0.10) = -$180,000. xi. Future stock price First, find D6 = $2.00(1.07)5 = $2.805. 0.05(1.2) = 0.12. Answer: b Diff: M

Then, calculate rs = 0.06 +

It follows that: P5 = $2.805/(0.12 - 0.07) = $56.10.

Corporate Finance Spring 2012

Study Guide Problems

xii.

Capital gains yield and dividend yield

Answer: e

Diff: M

Calculate D1 as $3.42 1.07 = $3.66. The dividend yield is $3.66/$32.35 = 11.31%. The capital gains yield is equal to the longrun growth rate for this stock (since constant growth) or 7%.

xiii. Preferred stock value

Answer: d

Diff: E

The dividend is calculated as 10% $120 = $12. We know that the cost of preferred stock is equal to the dividend divided by the stock price or 8% = $12/Price. Solve this expression for Price = $150. (Note: Non- participating preferred stockholders are entitled to just the stated dividend rate. There is no growth in the dividend.) xiv. Preferred stock yield Annual dividend = $2.50(4) = $10. rps = Dps/Vps = $10/$50 = 0.20 = 20%. Answer: c Diff: E

xv.

Cost of debt

Answer: e

Diff: M

Time line: 0 1 2 3 4 40 6-month rd / 2 ? Periods PMT = 60 VB = 1,000 60 60 60 60 FV = 1,000

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are equal. Thus, the before-tax cost of debt to Rollins is 12 percent. The after-tax cost of debt equals: rd,After-tax = 12.0%(1 - 0.40) = 7.2%. Financial calculator solution: Inputs: N = 40; PV = -1,000; PMT = 60; FV = 1,000; Output: I = 6.0% = rd/2. rd = 6.0% 2 = 12%. rd(1 - T) = 12.0%(0.6) = 7.2%.

xvi.

Cost of preferred stock Cost of preferred stock:

Answer: d rps = $12/$100(0.95) = 12.6%.

Diff: E

10

Corporate Finance Spring 2012

Study Guide Problems

xvii. Cost of common stock: CAPM Cost of common stock (CAPM approach): rs = 10% + (5%)1.2 = 16.0%. xviii Cost of common stock: DCF Cost of common stock (DCF approach): $2.00(1.08) rs = + 8% = 16.0%. $27 xix. Cost of common stock: Risk premium

Answer: c

Diff: E

Answer: c

Diff: E

Answer: c

Diff: E

Cost of common stock (Bond yield-plus-risk-premium approach): rs = 12.0% + 4.0% = 16.0%. xx. WACC Answer: a Diff: E

WACC = wdrd(1 - T) + wpsrps + wcers = 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.0%) = 13.56% 13.6%.

Good Luck

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