FIN 305 Chapters 7-12

XXYou want a seat on the board of directors of Four Keys, Incorporated. The company has 250,000 shares of stock outstanding and the stock sells for $51 per share. There are currently 5 seats up for election. If the company uses cumulative voting, how many shares do you need to guarantee that you will be elected to the board?XX

41,668 shares. Shares necessary = {[1/(1 + 5)] × 250,000} + 1 = 41,668 shares

A stock had returns of 16.91 percent, −10.70 percent, 22.06 percent, and 13.43 percent for the past four years. What is the standard deviation of the returns?

Average return = (.1691 − .1070 + .2206 + .1343)/4 Average return = .1043, or 10.43% Variance = 1/3[(.1691 − .1043)2 + (−.1070 − .1043)2 + (.2206 − .1043)2 + (.1343 − .1043)2] Variance = .02109 Standard deviation = .021091/2 Standard deviation = .1452, or 14.52%

Brummitt Corporation, is evaluating a new 4-year project. The equipment necessary for the project will cost $2,500,000 and can be sold for $301,000 at the end of the project. The asset is in the 5-year MACRS class. The depreciation percentage each year is 20.00 percent, 32.00 percent, 19.20 percent, 11.52 percent, and 11.52 percent, respectively. The company's tax rate is 24 percent. What is the aftertax salvage value of the equipment?

Book value = $2,500,000(.1152 + .0576) Book value = $432,000 Tax refund (due) = ($432,000 − 301,000)(.24) Tax refund (due) = $31,440 Aftertax salvage value = $301,000 + 31,440 Aftertax salvage value = $332,440

Charlotte's Crochet Shoppe has 11,300 shares of common stock outstanding at a price per share of $65 and a rate of return of 11.21 percent. The company also has 340 bonds outstanding, with a par value of $1,000 per bond. The pretax cost of debt is 5.93 percent and the bonds sell for 94.2 percent of par. What is the firm's WACC if the tax rate is 25 percent?

Common stock:11,300 × $65=$ 734,500 Debt:340 × $1,000 × .942=320,280 Total value: $ 1,054,780 WACC = 11.21%($734,500/$1,054,780) + 5.93%($320,280/$1,054,780)(1 − .25) WACC = 9.16%

Further From Center has 12,400 shares of common stock outstanding at a price of $58 per share. It also has 325 shares of preferred stock outstanding at a price of $88 per share. There are 400 bonds outstanding that have a coupon rate of 7.7 percent paid semiannually. The bonds mature in 39 years, have a face value of $2,000, and sell at 113 percent of par. What is the capital structure weight of the preferred stock?

Common stock:12,400 × $58=$ 719,200 Preferred stock:325 × $88=28,600Debt:400 × $2,000 × 1.13=904,000 Total value: $ 1,651,800 XP = $28,600/$1,651,800 XP = .0173

Western Electric has 23,000 shares of common stock outstanding at a price per share of $61 and a rate of return of 13.90 percent. The firm has 6,000 shares of 7.00 percent preferred stock outstanding at a price of $86.00 per share. The preferred stock has a par value of $100. The outstanding debt has a total face value of $350,000 and currently sells for 102 percent of face. The yield to maturity on the debt is 8.49 percent. What is the firm's weighted average cost of capital if the tax rate is 21 percent?

Common stock:23,000 × $61=$ 1,403,000 Preferred stock:6,000 × $86.00=516,000 Debt:1.020 × $350,000=357,000 Total value: $ 2,276,000 RP = $7.00/$86.00 RP = .0814, or 8.14% WACC = 13.90%($1,403,000/$2,276,000) + 8.14%($516,000/$2,276,000) + 8.49%($357,000/$2,276,000)(1 − .21) WACC = 11.47%

A stock currently sells for $81. The dividend yield is 3.5 percent and the dividend growth rate is 4.8 percent. What is the amount of the dividend to be paid in one year?

D1 = .035($81) = $2.84

You purchased GARP stock one year ago at a price of $62.45 per share. Today, you sold your stock and earned a total return of 18.07 percent. The stock paid dividends of $2.20 per share over the year. What was the capital gains yield on your investment?

Dividend yield = $2.20/$62.45 Dividend yield = .0352, or 3.52% Capital gains yield = 18.07% − 3.52% Capital gains yield = 14.55%

CDB stock is currently priced at $66. The company will pay a dividend of $4.01 next year and investors require a return of 10.1 percent on similar stocks. What is the dividend growth rate on this stock?

Dividend yield = $4.01/$66 = .0608, or 6.08% Dividend growth rate = 10.10% − 6.08% = 4.02%

A stock just paid a dividend of $5.45 and is expected to maintain a constant dividend growth rate of 4.5 percent indefinitely. If the current stock price is $79, what is the required return on the stock?

Dividend yield = [$5.45(1 + .045)]/$79 = .0721, or 7.21% Required return = 4.5% + 7.21% = 11.71%

The common stock of Flavorful Teas has an expected return of 21.15 percent. The return on the market is 15 percent and the risk-free rate of return is 2.7 percent. What is the beta of this stock? (End of Chap. 11)

E(R) = .2115 = .027 + β(.150 − .027) .1845 = .123β β = 1.50

Too Young, Incorporated, has a bond outstanding with a coupon rate of 6.7 percent and semiannual payments. The bond currently sells for $1,919 and matures in 17 years. The par value is $2,000. What is the company's pretax cost of debt?

Enter N = 34, PV = −$1,919, PMT = (6.7/2)*2000 = $67.00, and FV = $2,000 Solve for I/Y = 3.56% $1,919 = $67.00{1 − [1/(1 + R)34]}/R + $2,000/R34 R = .0356, or 3.56% YTM = 3.557% × 2 YTM = 7.11%

Galvatron Metals has a bond outstanding with a coupon rate of 6.2 percent and semiannual payments. The bond currently sells for $1,926 and matures in 18 years. The par value is $2,000 and the company's tax rate is 21 percent. What is the company's aftertax cost of debt?

Enter N = 36, PV = -1926, PMT = (6.2/2)*2000, FV = 2000 Solve for I/Y = 3.28 $1,926 = $62.00{1 − [1/(1 + R)36]}/R + $2,000/R36 R = .0328, or 3.28% YTM = 3.280% × 2 YTM = 6.55% RD = 6.55% * (1 − .21) RD = 5.18%

A company's after-tax cost of equity is based on the tax deductibility of dividends paid to shareholders.

False

A company's cost of capital is the sum of its pre-tax cost of debt and equity financing.

False

A division whose risk profile is significantly different that the company's overall risk profile would benefit by using the company-wide WACC for capital budgeting purposes.

False

The cost of preferred stock is not a source of long-term capital financing and should be excluded from a WACC calculation.

False

The probability of drawing the "ace-of-spades" from a deck of cards is greater than the probability of rolling a "2" on a single roll of dice.

False

The returns of a stock with a mean of 10 and a standard deviation of 15 would range from 10-25 percent 68 percent of the time.

False

The risk premium on a small company stock is primarily attributable to the adverse effects of inflation.

False

True or False: A $100 investment in a stock that splits 2-for-1 will be worth $200 immediately after the stock split.

False

True or False: A company wants to use land that it owns to build a new manufacturing plant. Alternatively, the company can sell the land for $5 million. The value of the land should be excluded from the cost of the new manufacturing plant when analyzing the project's cash flows.

False

True or False: A designated market maker is a stock exchange agent who arranges security transactions among investors.

False

True or False: Erosion is a form of sunk costs that should be excluded from the analysis of a project's cash flows for capital.

False

True or False: Noncumulative preferred dividends in arrears are first in the order of priority of dividends to be paid.

False

True or False: The cost of architectural blueprints incurred in May relating to a store's potential expansion should be considered in the decision in June to expand the store.

False

True or False: The cost of land purchased 5 years ago should be included in the cost of a project involving the land.

False

The AAR is an acceptable capital budgeting method only if used as an option of last resort.

False: Capital budgeting decisions should never be based on AAR. A better option is always available.

Inflation is an example of a "specific" risk.

False: It is a systematic risk

The more stocks in an investment portfolio, the more diversified the portfolio becomes, and the less the portfolio is exposed to systematic risk.

False: Less exposed to unsystematic risk

True or False: Research and development costs already incurred on an experimental drug should be considered in the decision of whether to proceed with the drug's further research and development.

False: Sunk cost should not be attributed to decision

The net present value of an investment represents the difference between the investment's future cash flows and the initial cost of the investment.

False: The net present value of an investment represents the difference between the PRESENT VALUE of an investment's future cash flows and the initial cost of the investment.

One advantage of the Profitability Index is its ability to distinguish between the better of two mutually exclusive acceptable projects.

False: The profitability index considers only the value created for each dollar of invested capital. It does not consider the overall value created by the capital investment.

True or False: Scenario analysis involves isolating the project variable that presents the greatest forecasting risk.

False: This describes sensitivity analysis

If the risk premium on the stock market was 6.63 percent and the risk-free rate was 2.49 percent, what is the stock market return?

Market return = 6.63% + 2.49% Market return = 9.12%

Upton Umbrellas has a cost of equity of 10.9 percent, the YTM on the company's bonds is 5.6 percent, and the tax rate is 21 percent. The company's bonds sell for 94.1 percent of par. The debt has a book value of $390,000 and total assets have a book value of $946,000. If the market-to-book ratio is 2.56 times, what is the company's WACC?

Market value of debt = .941($390,000) Market value of debt = $366,990 Book value of equity = $946,000 − 390,000 Book value of equity = $556,000 Market value of equity = 2.56($556,000) Market value of equity = $1,423,360 Market value of company = $366,990 + 1,423,360 Market value of company = $1,790,350 WACC = 10.9%($1,423,360/$1,790,350) + 5.6%($366,990/$1,790,350)(1 − .21) WACC = 9.57%

Lakeside Winery is considering expanding its winemaking operations. The expansion will require new equipment costing $693,000 that would be depreciated on a straight-line basis to zero over the 6-year life of the project. The equipment will have a market value of $185,000 at the end of the project. The project requires $55,000 initially for net working capital, which will be recovered at the end of the project. The operating cash flow will be $150,400 a year. What is the net present value of this project if the relevant discount rate is 11 percent and the tax rate is 23 percent? (End of Chap. 9)

NPV = −$693,000 − 55,000 + $150,400(PVIFA11%,6) + [$55,000 + (1 − .23)($185,000)]/1.116 NPV = −$6,162

A project is expected to generate annual revenues of $131,300, with variable costs of $79,900, and fixed costs of $20,400. The annual depreciation is $4,700 and the tax rate is 22 percent. What is the annual operating cash flow?

OCF = ($131,300 − 79,900 − 20,400)(1 − .22) + .22($4,700) OCF = $25,214

Burke's Corner currently sells blue jeans and T-shirts. Management is considering adding fleece tops to its inventory to provide a cooler weather option. The tops would sell for $58 each with expected sales of 4,050 tops annually. By adding the fleece tops, management feels the firm will sell an additional 260 pairs of jeans at $68 a pair and 395 fewer T-shirts at $29 each. The variable cost per unit is $36 on the jeans, $20 on the T-shirts, and $32 on the fleece tops. With the new item, the depreciation expense is $38,000 a year and the fixed costs are $73,000 annually. The tax rate is 22 percent. What is the project's operating cash flow?

OCF = [4,050($58 − 32) + 260($68 − 36) − 395($29 − 20) − 73,000](1 − .22) + .22($38,000) Cash flow = $37,271

You're trying to determine whether or not to expand your business by building a new manufacturing plant. The plant has an installation cost of $21.8 million, which will be depreciated straight-line to zero over its four-year life. If the plant has projected net income of $1,975,000, $2,225,000, $2,194,000, and $1,406,000 over these four years, what is the project's average accounting return (AAR)?

Our definition of AAR is the average net income divided by the average book value. The average net income for this project is: Average net income = ($1,975,000 + 2,225,000 + 2,194,000 + 1,406,000)/4 Average net income = $1,950,000 And the average book value is: Average book value = ($21,800,000 + 0)/2 Average book value = $10,900,000 So, the AAR for this project is: AAR = Average net income/Average book value AAR = $1,950,000/$10,900,000 AAR = .1789, or 17.89%

Sankey Company has earnings per share of $3.30. The benchmark PE is 17.5 times. What stock price would you consider appropriate? (End of Chap. 7)

P = $3.30(17.5) = $57.75

Stoneheart Group is expected to pay a dividend of $3.23 next year. The company's dividend growth rate is expected to be 3.6 percent indefinitely and investors require a return of 12 percent on the company's stock. What is the stock price?

P0 = $3.23/(.120 − .036) = $38.45

You are considering purchasing stock in Canyon Echo. You feel the company will increase its dividend at 4.2 percent indefinitely. The company just paid a dividend of $3.23 and you feel that the required return on the stock is 10.4 percent. What is the price per share of the company's stock?

P0 = [$3.23 × (1 + .042)]/(.104 − .042) = $54.28

Keidis Industries will pay a dividend of $3.15, $4.25, and $5.45 per share for each of the next three years, respectively. In four years, you believe that the company will be acquired for $49.00 per share. The return on similar stocks is 11.0 percent. What is the current stock price?

P0=Cf1/(1+R)+Cf2/(1+R)^2 ... P = $3.15/(1 + .110) + $4.25/(1 + .110)2 + $5.45/(1 + .110)3+ $49.00/(1 + .110)4 P = $42.55

McKerley Corporation has preferred stock outstanding that will pay an annual dividend of $5.95 per share with the first dividend exactly 11 years from today. If the required return is 4.05 percent, what is the current price of the stock?

P10 = $5.95/.0405 = $146.91 P0 = $146.91/(1 + .0405)10 = $98.77

The Bell Weather Company is a new firm in a rapidly growing industry. The company is planning on increasing its annual dividend by 15 percent a year for the next 4 years and then decreasing the growth rate to 6 percent per year. The company just paid its annual dividend in the amount of $2.90 per share. What is the current value of one share of this stock if the required rate of return is 8.40 percent?

P4 = ($2.90 × 1.154 × 1.06)/(.084 − .06) = $224.02 P0 = ($2.90 × 1.15)/1.084 + ($2.90 × 1.152)/1.0842 + ($2.90 × 1.153)/1.0843 + ($2.90 × 1.154)/1.0844 + $224.02/1.0844 = $175.72

What is the beta of a portfolio comprised of the following securities? (Q19)

Portfolio value = $4,300 + 5,300 + 7,800 Portfolio value = $17,400 βPortfolio = 1.50($4,300/$17,400) + 1.61($5,300/$17,400) + 1.00($7,800/$17,400) βPortfolio = 1.309

You have gathered the following information on your investments. What is the expected return on the portfolio? (Q17)

Portfolio value = 380($47) + 350($33) + 290($59) Portfolio value = $46,520 Weight of F = 380($47)/$46,520 = .3839 Weight of G = 350($33)/$46,520 = .2483 Weight of H = 290($59)/$46,520 = .3678 Portfolio expected return = .3839(13.60%) + .2483(10.30%) + .3678(10.80%) Portfolio expected return = 11.75%

Countess Corporation is expected to pay an annual dividend of $4.75 on its common stock in one year. The current stock price is $75.15 per share. The company announced that it will increase its dividend by 3.85 percent annually. What is the company's cost of equity?

RE = ($4.75/$75.15) + .0385 RE = .1017, or 10.17%

The stock in Bowie Enterprises has a beta of 1.22. The expected return on the market is 11.40 percent and the risk-free rate is 2.90 percent. What is the required return on the company's stock?

RE = .0290 + 1.22(.1140 − .0290) RE = .1327, or 13.27%

An asset has an average return of 10.61 percent and a standard deviation of 20.54 percent. What range of returns should you expect to see with a 95 percent probability?

Range = 10.61% +/− (20.54% × 2) Range = −30.47% to 51.69%

A stock has a beta of 1.29 and an expected return of 11.57 percent. If the risk-free rate is 4.4 percent, what is the stock's reward-to-risk ratio?

Reward-to-risk ratio = (.1157 − .044)/1.29 Reward-to-risk ratio = .0556, or 5.56%

You purchased 1,150 shares of Barrett Golf Corporation stock at a price of $36.71 per share. While you owned the stock, you received dividends totaling $.57 per share. Today, you sold your stock at a price of $39.66 per share. What was your total dollar return on the investment?

Total dollar return = ($39.66 − 36.71 + .57) × 1,150 Total dollar return = $4,048

A company's WACC is the weighted-average after-tax cost of a company's long-term capital financing.

True

A company's after-tax cost of debt presumes the tax deductibility of interest expense relating to long-term debt financing.

True

A stock with a beta of 1.5 is on average 50 percent more volatile than the stock market as a whole.

True

If the risk-free rate is 4 percent and the market risk premium is 8 percent, then it is reasonable to expect a 12 percent return on a project with an average risk profile.

True

The WACC is appropriate for a division whose projects have a risk profile similar to the company's overall risk profile.

True

The capital asset pricing model tells us the reward for bearing risk in the financial markets, and is the "required return" used in our NPV and IRR calculations.

True

The capital structure weights of a WACC calculation are based on the total market value of the underlying securities to which the capital costs relate.

True

The risk premium is the return above the risk-free rate required by investors for taking risk.

True

The sum of a company's capital structure weights must always = 1. No exceptions

True

True or False: An increase in net working capital at the beginning of a project is typically shown as a cash flow in at the end of the project.

True

True or False: Creating classes of common stock allows a company's original owners to raise capital and still maintain control of the company.

True

True or False: Determining the effects of best-to-worse-case sales quantity on a project's NPV is a form of scenario analysis.

True

True or False: Opportunity cost is a relevant cost that should be included in the initial cost of a project.

True

True or False: The depreciation tax shield is the amount by which a firm's tax bill is reduced as a result of depreciation expense.

True

Two stocks with a correlation coefficient of -1 are perfectly correlated,

True

Using the WACC to discount a project's future cash flows would not be appropriate if the cash flows are reasonably assured.

True

A project with an IRR equal to the required return will have an NPV of $0.

True: A project's IRR is the rate at which the project's NPV is $0. A project whose IRR is > than the required return will have NPV > $0. Conversely, a project whose IRR is < than the required return will have NPV < $0. A project whose IRR is = the required return will have NPV = $0.

The payback method is popular among CFOs because of its bias toward short-term projects.

True: In some instances, a CFO may not want to commit capital to long-term projects and will use the payback method to identify such projects. Aside from this, the payback method is not good basis on which to make capital budgeting decisions.

A project with an NPV > $0 will always have an acceptable IRR.

True: NPV > $0 is the acceptance criteria of the NPV capital budgeting method. By definition, NPV > $0 means the project's IRR is greater than the required return, and vise-versa.

True or False: Common shareholders have voting power above that of preferred shareholders.

True: Preferred stockholders have no voting power

The IRR of a project is the return at which the project's NPV is $0.

True: This is the definition of IRR.

Alpha Industries is considering a project with an initial cost of $7.7 million. The project will produce cash inflows of $1.35 million per year for 9 years. The project has the same risk as the firm. The firm has a pretax cost of debt of 5.52 percent and a cost of equity of 11.21 percent. The debt-equity ratio is .57 and the tax rate is 24 percent. What is the net present value of the project?

WACC = (1/1.57)(11.21%) + (.57/1.57)(5.52%)(1 − .24) WACC = 8.66% NPV = −$7,700,000 + $1,350,000(PVIFA8.66%,9) NPV = $505,583

Take It All Away has a cost of equity of 11.14 percent, a pretax cost of debt of 5.34 percent, and a tax rate of 24 percent. The company's capital structure consists of 66 percent debt on a book value basis, but debt is 32 percent of the company's value on a market value basis. What is the company's WACC?

WACC = .68(11.14%) + .32(5.34%)(1 − .24) WACC = 8.87%

A portfolio consists of 210 shares of Stock C that sells for $39 and 175 shares of Stock D that sells for $36. What is the portfolio weight of Stock C?

Weight of C = 210($39)/[210($39) + 175($36)] Weight of C = .5652

Consider the following two mutually exclusive projects: YearCash Flow (A)Cash Flow (B)0−$ 416,000−$ 35,500148,50019,500257,50014,200374,50014,1004531,00010,900 The required return on these investments is 12 percent. a.What is the payback period for each project? Note: Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16. b. What is the NPV for each project? Note: Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16. c. What is the IRR for each project? Note: Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16. d. What is the profitability index for each project? Note: Do not round intermediate calculations and round your answers to 3 decimal places, e.g., 32.161. e. Based on your answers in (a) through (d), which project will you finally choose? (End of Chap. 8)

a. The payback period for each project is: A: 3 + ($235,500/$531,000) = 3.44 years B: 2 + ($1,800/$14,100) = 2.13 years The payback criterion implies accepting Project B, because it pays back sooner than Project A. b. The NPV for each project is: A: NPV = −$416,000 + $48,500/1.12 + $57,500/1.122 + $74,500/1.123 + $531,000/1.124 NPV = $63,629.95 B: NPV = −$35,500 + $19,500/1.12 + $14,200/1.122 + $14,100/1.123 + $10,900/1.124 NPV = $10,194.12 The NPV criterion implies we accept Project A because Project A has a higher NPV than Project B. c. The IRR for each project is: A: $416,000 = $48,500/(1 + IRR) + $57,500/(1 + IRR)2 + $74,500/(1 + IRR)3 + $531,000/(1 + IRR)4 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 16.78% B: $35,500 = $19,500/(1 + IRR) + $14,200/(1 + IRR)2 + $14,100/(1 + IRR)3 + $10,900/(1 + IRR)4 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 26.52% The IRR decision rule implies we accept Project B because the IRR for B is greater than the IRR for A. d. The profitability index for each project is: A: PI = ($48,500/1.12 + $57,500/1.122 + $74,500/1.123 + $531,000/1.124)/$416,000 PI = 1.153 B: PI = ($19,500/1.12 + $14,200/1.122 + $14,100/1.123 + $10,900/1.124)/$35,500 PI = 1.287 e. The profitability index criterion implies accepting Project B because its PI is greater than Project A's. In this instance, the NPV criterion implies that you should accept Project A, while the payback period, IRR, and profitability index imply that you should accept Project B. The final decision should be based on the NPV since it does not have the ranking problem associated with the other capital budgeting techniques. Therefore, you should accept Project A.