FIN331Fall 2010 Extra CreditDr. Rhee

1.Which one (s) is (are) an external financing and has the flotation cost?

a. Retained earningsb. Bondsc. Preferred stockd. a & be. b & c Answer: eRetained earnings are internal source of fund. Issuing bonds, preferred stocks, and common stocks are external source of fund, which have the floation cost.

2.The costs of financing from different sources are as follows:IEF = 5%, EEF=6%, cost of debt before tax = 5%, tax rate=20%, the size of retained earnings=$30m. The capital structure is: We=40% and Wd=60%. Determine the WAMCC before and after the break point.

a. 4.4% 4.8%b. 4.4% 5.2%c. 4.6% 4.8%d. 4.6% 5.2%e. 4.8% 5.2%Answer: a5%*(1 0.2)*0.6 + 5%*0.4 = 4.4%, 5%*(1 0.2)*0.6 + 6%*0.4 =4.8%

3.Given D1 = $1.00 and K=10%, what is the value of the stock at 8% growth rate? If the current price of the stock is $50, would you buy it? a. $55, Buyb. $54, Buyc. $55, Dontd. $54, Donte. $50, IndifferentAnswer: ePV=D1/(k-g)=1.00/(0.10 - 0.08) = $50. Since the price=PV, you are indifferent.

4.For a preferred stock with the dividend amount of $2.00 each quarter, what is the PV of it with an annual discount rate of 8%? If the price of the preferred stock is $80, what is the yield (ROI, APR) of this security?

a. $60, 8%b. $80, 8%c. $60, 10%d. $80, 10%e. $100, 10%Answer: eV0 = D/k = 8/0.08 = $100. ROI = (80+8)/80 = 10%

5.I checked the Microsoft stock price at 9:12am this morning. It was $24.88. The last 12 month trailing (ttm) net earnings is $14.58 billion with 9 billion shares. What is the 12 month trailing EPS and P/E ratio?

a. $1.62, 15.36 b. $2.26, 13.31 c. $1.26, 17.88 d. $2.32, 12.21 e. $1.18, 20.33 Answer: aEPS = NE/Shares Outstanding = $14.58/9 = $1.62P/E = Price per share/Earnings per share = $24.88/$1.62 = 15.36

6.For a common stock with the current dividend amount of = $.70 (Do = .70), what is the (P)V of it with an annual discount rate of 12% and the dividend is expected to grow at the rate of 10% per annum forever?

a. $33.5b. $35.0c. $38.5d. $45.0e. $37.5 Answer: cV0 = D1 / (k-g) = (0.70* 1.1)/(0.12-0.10) = 38.5

7.The preemptive right is important to shareholders because it

a.allows managers to buy additional shares below the current market price.b.will result in higher dividends per share.c.is included in every corporate charter.d.protects the current shareholders against a dilution of their ownership interests.e.protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.Answer: d

8.Which of the following statements is CORRECT?

a.The constant growth model takes into consideration the capital gains investors expect to earn on a stock.b.Two firms with the same expected dividend and growth rate must also have the same stock price.c.It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant.d.If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stocks dividend yield is also 5%.e.The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.Answer: a Statement a is true, because the expected growth rate is also the expected capital gains yield. All the other statements are false.

9.The Francis Company is expected to pay a dividend of D1 = $1.25 per share at the end of the year, and that dividend is expected to grow at a constant rate of 6.00% per year in the future. The company's beta is 1.15, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is the company's current stock price?

a.$28.90b.$29.62c.$30.36d.$31.12e.$31.90Answer: aD1$1.25b1.15rRF4.00%RPM5.50%g6.00%rs = rRF + b(RPM) =10.33%P0 = D1/(rs g)$28.90

10.Goode Inc.'s stock has a required rate of return of 11.50%, and it sells for $25.00 per share. Goode's dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D0?

a.$0.95b.$1.05c.$1.16d.$1.27e.$1.40Answer: bStock price$25.00Required return11.50%Growth rate7.00%P0 = D1/(rs g), so D1 = P0(rs g) =$1.1250Last dividend = D0 = D1/(1 + g)$1.05

11.You must estimate the intrinsic value of Noe Technologies stock. The end-of-year free cash flow (FCF1) is expected to be $27.50 million, and it is expected to grow at a constant rate of 7.0% a year thereafter. The companys WACC is 10.0%, it has $125.0 million of long-term debt plus preferred stock outstanding, and there are 15.0 million shares of common stock outstanding. What is the firm's estimated intrinsic value per share of common stock?

a.$48.64b.$50.67c.$52.78d.$54.89e.$57.08Answer: c FCF1$27.50Constant growth rate7.0%WACC10.0%Debt & preferred stock$125Shares outstanding15Total firm value = FCF1/(WACC g) =$916.67Less: Value of debt & preferred-$125.00Value of equity$791.67Number of shares15Value per share = Equity value/Shares =$52.78

12.Carter's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, what is its nominal (not effective) annual rate of return?

a.8.03%b.8.24%c.8.45%d.8.67%e.8.89%Answer: e Pref. quarterly dividend$1.00Annual dividend = Qtrly dividend 4 =$4.00Preferred stock price$45.00Nom. required return = Annual dividend/Price =8.89%

13. Capital structure refers to

a. The types of projects a firm invests in.b. The mixture of short-term and long-term debt. c. The amount of debt and equity a firm hasd. Short-term assets and short-term liabilities. e. The size, timing, and risk Answer: c

14.Which of the following statements is CORRECT?

a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.d. If a companys beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.e. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a companys WACC.Answer: a Statement a is true, because interest payments on debt are tax deductible. The other statements are false.

15.What is the % of total financing by equity if the total $12m funding include $7.5m from debt?

a. 35%b. 37.5%c. 46.5%d. 50%e. 62.5%Answer: bComponent of capital: (LT)debt, PFD stocks, and Common Equity. Therefore (12-7.5)/12 = 37.5%

16.The amount of retained earnings limit the size of internal equity financing. If the amount of retained earnings is $25m, where do you have a switch from the internal to external equity financing in terms of the size of the total funding when the equity financing accounts for 25% of the total funding and the remaining is from debt?

a. $150mb. $100mc. $180md. $130me. $150m Answer: b25m/.25=$100m

17.Long-term debt of Topstone Industries is currently selling for $1,045. Its face value is $1,000. The issue matures in 10 years and pays an annual coupon of 8% of face. What is the before-tax cost of debt for Topstone if the company is in 30% tax bracket?

a. 6.75%b. 7.35%c. 6.85%d. 7.45%e. 8.35%Answer: bFind YTM. N=10, PV=-1045, PMT=80, FV=1000 => I/Y= 7.35%

18.Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925, and the companys tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

a.4.28%b.4.46%c.4.65%d.4.83%e.5.03%Answer: cCoupon rate7.00%Periods/year2Maturity (yr)20Bond price$925.00Par value$1,000Tax rate40%

Calculator inputs:N = 2 2040PV = Bond's price-$925.00PMT = Coupon rate Par/2$35FV = Par = Maturity value$1,000I/YR3.87%Times periods/yr = before-tax cost of debt7.74%= After-tax cost of debt (A-T rd) for use in WACC4.65%

19.Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?

a.12.70%b.13.37%c.14.04%d.14.74%e.15.48%Answer: bExpected EPS1$3.50Payout ratio65%Expected dividend, D1 = EPS Payout$2.275Current stock price$32.50g6.00%F5.00%re = D1/(P0 (1 F)) + g 13.37%

20.Which of the following statements is CORRECT?

a.A change in a companys target capital structure cannot affect its WACC.b.WACC calculations should be based on the before-tax costs of all the individual capital components.c.Flotation costs associated with issuing new common stock normally reduce the WACC.d.If a companys tax rate increases, then, all else equal, its weighted average cost of capital will decline.e.An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.Answer: d Statement d is true, because the cost of debt for WACC purposes = rd(1 T), so if T increases, then rd(1 T) declines.

21.Which of the following statements is CORRECT?

a.The WACC as used in capital budgeting is an estimate of a companys before-tax cost of capital.b.The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.c.The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.d.There is an opportunity cost associated with using retained earnings, hence they are not free.e.The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.Answer: d

22.Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

a.10.69%b.11.25%c.11.84%d.12.43%e.13.05%Answer: cD0$0.80P0$22.50g8.00%D1 = D0 (1 + g)$0.864rs = D1/P0 + g11.84%

23.Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

a.0.57%b.0.63%c.0.70%d.0.77%e.0.85%Answer: c Tax RateOld rate, 40%New rateCoupon rate7.00%7.00%Periods/year22Maturity (yr)2020Bond price = Par value$1,000.00$1,000.00Old and New tax rates40%30%

Calculator inputs:N = 2 204040PV = Bond's price-$1,000.00-$1,000.00PMT = Coupon rate Par/2$35.00$35FV = Par = Maturity value-$1,000-$1,000I/YR3.50%3.50%Times periods/yr = before-tax cost of debt7.00%7.00% = After-tax cost of debt (A-T rd) for use in WACC4.20%4.90%Difference = Cost at new rate Cost at old rate =0.70%

24.S. Bouchard and Company hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the DCF approach, by how much would the cost of equity from retained earnings change if the stock price changes as the CEO expects?

a.-1.49%b.-1.66%c.-1.84%d.-2.03%e.-2.23%Answer: c Old PriceNew PriceD0$0.85$0.85P0$22.00$40.00g6.00%6.00%D1 = D0 (1 + g)$0.901$0.901rs = D1/P0 + g10.10%8.25%Difference, rs0 rs1-1.84%

25.Sapp Truckings balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The balance sheet also shows that the company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs?

a.1.55%b.1.72%c.1.91%d.2.13%e.2.36%Answer: e P0$22.50Book value weights-WRONG!!!Shares outstanding (millions)10CapitalWeightsCost ratesProductbond coupon rate (not used)7.00%Debt$45.0040.91%3.60%1.47%YTM = rd6.00%Equity$65.0059.09%14.00%8.27%rs14.00%Total$110.00100.00%WACC =9.75%Tax rate40%BV debt (millions)$45.00Market value weights--RIGHT!!!BV equity (millions)$65.00CapitalWeightsCost ratesProductMV debt (millions)$50.00Debt$50.0018.18%3.60%0.65%MV equity (millions) = # sh P0 =$225.00Equity$225.0081.82%14.00%11.45%AT cost of debt = rd(1T)3.60%Total$275.00100.00%WACC =12.11%Difference = 2.36%

26.What would you do for capital budgeting if you have limited resources?

a. Focus on the projects the firm has already invested inb. Reduce short-term and long-term debt.c. Rank good looking projects and choose from the most profitable onesd. evaluate to determine good projectse. Determine the size, timing, and risk of a firm's future cash flows. Answer: c

27.What is the decision rule for IRR?

a. Accept a project when IRR > 0 b. Accept a project if at the IRR the NPV is positive c. Reject any project if the IRR is below 10% d. Accept a project if the IRR exceeds the firm's bank borrowing rate e. Accept a project if the IRR exceeds the firm's required rate of returnAnswer: e

28.What is the % of total financing by common equity if the total $12m funding include $7.5m from debt assuming no preferred stocks are used?

a. 35%b. 37.5%c. 46.5%d. 50%e. 62.5%Answer: bIRR decision rule: accept when IRR > WAMCC

29.You have only three investment opportunities as follows: Project A with 5% return, Project B with 7% return, Project C with 9% return. What should be the required rate of return when you consider for Project B?

a. 5%b. 7%c. 9%d. 12%e. 14%Answer: aTo accept B, required return should be less than the expected return of C, and higher or equal to the expected return of A

30.Lasik Vision Inc. recently analyzed the project whose cash flows are shown below. However, before Lasik decided to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative, in which case it should be rejected.

Old WACC: 8.00%New WACC: 11.25%Year0123Cash flows-$1,000$410$410$410

a.-$59.03b.-$56.08c.-$53.27d.-$50.61e.-$48.08Answer: a

Old WACC: 8.00%New WACC: 11.25%Year0123Cash flows-$1,000$410$410$410

Old NPV = $56.61New NPV = -$2.42Change = -$59.03

31.Hindelang Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: 12.25%Year01234Cash flows-$850$300$320$340$360

a.13.42%b.14.91%c.16.56%d.18.22%e.20.04%Answer: c

WACC: 12.25%Year01234Cash flows-$850$300$320$340$360Compounded values$424.31$403.20$381.65$360.00

TV = Sum of comp'ed inflows: $1,569.16

MIRR = 16.56%Found as discount rate that equates PV of TV to cost, discounted back 4 years @ WACCMIRR = 16.56%Alternative calculation, using Excel's MIRR function

32.Stern Associates is considering a project that has the following cash flow data. What is the project's payback?

Year012345Cash flows-$1,100$300$310$320$330$340

a.2.31 yearsb.2.56 yearsc.2.85 yearsd.3.16 yearse.3.52 yearsAnswer: e Year012345Cash flows-$1,100$300$310$320$330$340Cumulative CF-$1,100-$800-$490-$170$160$500Payback = 3.52

33.Which of the following statements is CORRECT?

a.An NPV profile graph shows how a projects payback varies as the cost of capital changes.b.The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases.c.An NPV profile graph is designed to give decision makers an idea about how a projects risk varies with its life.d.An NPV profile graph is designed to give decision makers an idea about how a projects contribution to the firms value varies with the cost of capital.e.We cannot draw a projects NPV profile unless we know the appropriate WACC for use in evaluating the projects NPV.Answer: d

34.Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

a.A projects NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV.b.The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.c.If a projects NPV is greater than zero, then its IRR must be less than the WACC. d.If a projects NPV is greater than zero, then its IRR must be less than zero.e.The NPVs of relatively risky projects should be found using relatively low WACCs.Answer: b 35.Datta Computer Systems is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year0123Cash flows-$1,100$450$470$490

a.9.70%b.10.78%c.11.98%d.13.31%e.14.64%Answer: d Year0123Cash flows-$1,100$450$470$490

IRR = 13.31%

36.Masulis Inc. is considering a project that has the following cash flow and WACC data. What is the project's discounted payback?

WACC: 10.00%Year01234Cash flows-$950$525$485$445$405

a.1.61 yearsb.1.79 yearsc.1.99 yearsd.2.22 yearse.2.44 yearsAnswer: d WACC: 10.00%Year01234Cash flows-$950$525$485$445$405PV of CFs-$950$477$401$334$277Cumulative CF-$950-$473-$72$262$539Payback = 2.22---2.22 -

37.Tesar Chemicals is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates the NPV. If the decision is made by choosing the project with the higher IRR rather than the one with the higher NPV, how much, if any, value will be forgone, i.e., what's the chosen NPV versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. NPV will have no effect on the value gained or lost.

WACC: 7.50%Year01234CFS-$1,100$550$600$100$100CFL-$2,700$650$725$800$1,400

a.$138.10b.$149.21c.$160.31d.$171.42e.$182.52Answer: a First, recognize that NPV makes theoretically correct capital budgeting decisions, so the highest NPV tells us how much value could be added. We calculate the two projects' NPVs, IRRs, and MIRRs, but the MIRR information is not needed for this problem. We then see what NPV would result if the decision were based on the IRR (and the MIRR). The difference between the NPV is the loss incurred if the IRR criterion is used. Of course, it's possible that IRR could choose the correct project.

WACC: 7.5000%Year01234TVMIRRCFS -$1,100$550$600$100$100Compounded CFs:673.77686.94107.00100.00$1,567.719.5469%CFL -$2,700$650$725$800$1,400Compounded CFs:796.28830.05856.001400.00$3,882.339.6663%

MIRR, L = 9.67%IRR, L = 10.71181%NPV, L = $224.3065MIRR, S = 9.55%IRR, S = 12.24157%NPV, S = $86.2036MIRR Choice: LIRR Choice: SNPV Choice: LNPV using MIRR: $224.31NPV using IRR: $86.20NPV using NPV: $224.31

Lost value using IRR versus MIRR: $138.10Loss below: 7.9850%Lost value using MIRR versus NPV: $0.00Loss below: 10.1638%Lost value using IRR versus NPV: $138.10Loss below: 10.1638%

38.Yonan Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the shorter payback, some value may be forgone. How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost.

WACC: 10.25%Year01234CFS-$950$500$800$0$0CFL-$2,100$400$800$800$1,000

a.$24.14b.$26.82c.$29.80d.$33.11e.$36.42Answer: d WACC: 10.250%Crossover = 11.093%Year01234CFS -$950$500$800$0$0CFL -$2,100$400$800$800$1,000Cumulative CF, S-$950-$450$350$350$350Cumulative CF, L-$2,100-$1,700-$900-$100$900Payback S = 1.56 --1.56 --Payback L = 3.10 ----3.10

NPV, L =$194.79NPV, S =$161.68Value lost$33.11

39.A company is considering a new project. The CFO plans to calculate the projects NPV by estimating the relevant cash flows for each year of the projects life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the companys overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

a.All sunk costs that have been incurred relating to the project.b.All interest expenses on debt used to help finance the project.c.The investment in working capital required to operate the project, even if that investment will be recovered at the end of the projects life.d.Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.e.Effects of the project on other divisions of the firm, but only if those effects lower the projects own direct cash flows.Answer: c

40.Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?

a.Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.b.Revenues from an existing product would be lost as a result of customers switching to the new product.c.Shipping and installation costs associated with a machine that would be used to produce the new product.d.The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.e.It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.Answer: d

41.A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?

a.In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, double count it.b.Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.c.When estimating the projects operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.d.Capital budgeting decisions should be based on before-tax cash flows.e.The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis.Answer: a

42.Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow?

Equipment cost (depreciable basis)$65,000Sales revenues, each year$60,000Operating costs (excl. deprec.)$25,000Tax rate35.0%

a.$30,258b.$31,770c.$33,359d.$35,027e.$36,778Answer: aEquipment cost$65,000Depreciation rate33.0%

Sales revenues$60,000 Operating costs (excl. deprec.)25,000 Depreciation 21,450Operating income (EBIT)$13,550 TaxesRate = 35% 4,743After-tax EBIT$ 8,808 + Depreciation 21,450Cash flow, Year 1$30,258

43.Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV?

Risk-adjusted WACC10.0%Net investment cost (depreciable basis)$65,000Straight-line deprec. rate33.3333%Sales revenues, each year$65,500Operating costs (excl. deprec.), each year$25,000Tax rate35.0%

a.$15,740b.$16,569c.$17,441d.$18,359e.$19,325Answer: eWACC10.0%Years0123Investment cost-$65,000Sales revenues$65,500$65,500$65,500 Operating costs (excl. deprec.)25,00025,00025,000 Depreciation rate = 33.333% 21,667 21,667 21,667Operating income (EBIT)$18,833$18,833$18,833 TaxesRate = 35% 6,592 6,592 6,592After-tax EBIT$12,242$12,242$12,242 + Depreciation 21,667 21,667 21,667Cash flow-$65,000$33,908$33,908$33,908NPV$19,325

44.Liberty Services is now at the end of the final year of a project. The equipment originally cost $22,500, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%. What is the equipments after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale.

a.$5,558b.$5,850c.$6,143d.$6,450e.$6,772Answer: b% depreciated on equip.75%Tax rate40%

Equipment cost$22,500 Accumulated deprec. 16,875Current book value of equipment$ 5,625Market value of equipment 6,000Gain (or loss): Market value Book value$ 375Taxes paid on gain () or credited (+) on loss -150AT salvage value = market value +/ taxes$ 5,850

45.Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow?

Equipment cost (depreciable basis)$70,000Sales revenues, each year$42,500Operating costs (excl. deprec.)$25,000Tax rate35.0%

a.$11,814b.$12,436c.$13,090d.$13,745e. $14,432Answer: cEquipment cost$70,000Depreciation rate, Year 47.0%

Sales revenues$42,500 Operating costs (excl. deprec.)25,000 Depreciation 4,900Operating income (EBIT)$12,600 TaxesRate = 35% 4,410After-tax EBIT$ 8,190 + Depreciation 4,900Cash flow, Year 4$13,090

46.A firm is considering a new project whose risk is greater than the risk of the firms average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?

a.Increase the estimated IRR of the project to reflect its greater risk.b.Increase the estimated NPV of the project to reflect its greater risk.c.Reject the project, since its acceptance would increase the firms risk.d.Ignore the risk differential if the project would amount to only a small fraction of the firms total assets.e.Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.Answer: e

47.Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects:

ProjectRiskExpected ReturnAHigh15%BAverage12%CHigh11%DLow9%ELow6%

Which set of projects would maximize shareholder wealth?

a.A and B.b.A, B, and C.c.A, B, and D.d.A, B, C, and D.e.A, B, C, D, and E.Answer: cStatement c is true; the others are false. The following table shows the required return for each project on the basis of its risk level.

ExpectedReq'd returnProjectRiskReturnfor this riskDecisionAHigh15%12%acceptBAverage12%10%acceptCHigh11%12%rejectDLow9%8%acceptELow6%8%reject

48.As a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with the following data. What is the Year 1 cash flow?

Sales revenues, each year$42,500Depreciation$10,000Other operating costs $17,000Interest expense$4,000Tax rate35.0%

a.$16,351b.$17,212c.$18,118d.$19,071e.$20,075Answer: e This problem is a bit harder than some of the earlier ones because it provides information on interest, and some students might incorrectly include it as an input. We like this wrinkle because it's important for students to know not to include financing costs in the cash flows.

Sales revenues$42,500 Operating costs (excl. deprec.)17,000 Depreciation 10,000Operating income (EBIT)$15,500 TaxesRate = 35% 5,425After-tax EBIT$10,075 + Depreciation 10,000Cash flow, Year 1$20,075

49.Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?

YearDepreciation Rate10.2020.3230.1940.1250.1160.06

a.$8,878b.$9,345c.$9,837d.$10,355e.$10,900Answer: eDeprec.AnnualYear-endYearRateBasisDeprec.Book Value10.20$50,000$10,000$40,00020.3250,00016,00024,00030.1950,0009,50014,50040.1250,0006,0008,50050.1150,0005,5003,00060.0650,000 3,00001.00$50,000

Gross sales proceeds$12,500Book value, end of Year 4 8,500Profit$ 4,000Tax on profitRate = 40% 1,600AT salvage value = market value +/ taxes$10,900

50.TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

WACC10.0%Pre-tax cash flow reduction for other products (cannibalization)-$5,000Investment cost (depreciable basis)$80,000Straight-line deprec. rate33.333%Sales revenues, each year for 3 years$67,500Annual operating costs (excl. deprec.)-$25,000Tax rate35.0%

a.$3,636b.$3,828c.$4,019d.$4,220e.$4,431Answer: b t = 0t = 1t = 2t = 3Investment (Basis)WACC = 10%$80,000Sales revenues$67,500$67,500$67,500 Cannibalization cost-5,000-5,000-5,000 Operating costs (excl. deprec.)-25,000-25,000-25,000 Basis x rate = deprec.Rate = 33.33% -26,667 -26,667 -26,667Operating income (EBIT)$10,833$10,833$10,833 TaxesRate = 35% -3,792 -3,792 -3,792After-tax EBIT$ 7,042$ 7,042$ 7,042 + Depreciation 26,667 26,667 26,667Cash flow-$80,000$33,708$33,708$33,708NPV$3,828