FIN 390 Exam #2

You are evaluating your firm's capital structure. Assume that the marginal corporate tax rate is 30%. If the firm permanently borrows $100 million at an interest rate of 8%, what is the increase in value of a levered firm relative to the value of an unlevered firm using MM model with only corporate taxes?

$30 million

Cold Duck Brewing Company is considering issuing a new 15 year debt issue that would pay an annual coupon payment of $95. Each bond in the issue would carry a $1,000 par value and would be expected to be sold for a market price equal to its par value. Cold Duck's CFO has pointed out that the firm will incur a flotation cost of 3% when initially issuing the bond issue. Remember, these flotation costs will be subtracted from the proceeds the firm will receive after issuing its new bonds. The firm's marginal federal-plus-state tax rate is 30%. What is the after-tax cost of debt with flotation costs?

6.65%

A sunk cost is a cash outlay that has already occurred and cannot be recovered whether the project is accepted or rejected:

A marketing study is a good example of a sunk cost. If the firm has paid for the study already, those costs are immaterial to the current project analysis. It is the cost the firm paid in the past and is unrecoverable. Accepting or rejecting a project will not change them, so they should not be included in capital budgeting analysis.

When a project has an NPV of $0, the project is earning a rate of return equal to the project's weighted average cost of capital. It is OK to accept a project with an NPV of $0 because the project is earning the required minimum rate of return:

A project will have an NPV of $0 when the project is earning a rate of return that is equal to the project's WACC. Although firms prefer a project's NPV to be positive - the larger the better - it is OK for a firm to accept a project with a $0 NPV because the project is earning a rate of return equal to the minimum required rate of return. A firm will reject a project with a negative NPV because a negative NPV indicates the project is earning a rate of return less than the required rate.

Most capital budgeting projects involve acquiring a fixed asset in order to get the project started:

Asset, shipping, and installation costs and the after-tax proceeds from the sale of any fixed assets being replaced should be included in the estimate of incremental cash flows associated with a project.

Given the following cash flows for mutually exclusive projects L and S, find the crossover rate and select the statement that is correct: Year: Cash Flow L: Cash Flow S Year 0: -100: -100 Year 1: 20: 80 Year 2: 60: 40 Year 3: 100: 50

CF0 = 0 CF1 = -60 CF2 = 20 CF3 = 50 IRR = 9.46% Above the crossover rate of 9.46% NPV and IRR lead to the different decisions.

T/F Compared to accelerated depreciation, straight-line depreciation typically increases a project's NPV by increasing the depreciation tax shield earlier in the project's life.

False

embedded rate, or historical rate

In contrast to marginal rate, this is the cost of - or return required on - an existing capital component

Suppose you have two mutually exclusive projects. Project A and Project B and the projects will be repeated at the end of their initial lives. Both projects should be evaluated using a 10% WACC. Based on the cash flows below, which project should you accept? Year: A: B 0: -50: -50 1: 25: 45 2: 25: 45 3: 25: - 4: 25: - 5: 25: -

Project A because it has a higher NPV than Project B

A project requires an initial investment in equipment of $90,000 and thus requires an initial investment in working capital of $5,000 (at t = 0). You expect the project to produce sales revenue of $120,000 per year for three years. You estimate manufacturing costs at 60% of revenues. The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for $10,000 and also recover the investment in net working capital. The corporate tax rate is 30% and the cost of capital is 15%. Calculate the NPV of the project.

$10.156

MBE Products is considering expanding into a new line of business by investing in a new piece of equipment. This project requires an increase in inventories of $20,000, with accounts payable increasing by $5,000 as well, at t = 0. The project is expected to operate for 4 years. At the end of the project's life (t = 4), the equipment is expected to be fully depreciated and the estimated salvage value of the equipment is $32,000. The company expects that it will fully recover the NOWC investment when the project is completed. The tax rate is 30%. What is the terminal cash flow at t = 4?

$37,400

Kasper Film Co. must liquidate some equipment that is being replaced. The equipment originally cost $22,500, at which 75% has been depreciated. The used equipment can be sold today for $5,000 and its tax rate is 40%. What is the after-tax cash flow for the sale of this equipment?

$5,250 $22,500 x 0.75 = $16,875 $22,500 - $16,875 = $5,625 $5,626 x 0.40 = $2,250 $5,000 - $2,250 = $5,250

Merriwether Building has FCF of $13 million, a tax rate of 40%, no debt, no short-term investments, and has a zero growth rate. The current stock price is $40 per share. It has 2.5 million shares of stock outstanding . If it moves to a capital structure that has 40% debt and 60% equity (based on market values), its weighted average cost of capital would be 10% and the value of the company operations would be $130 million. What would its stock price be if it changes to the new capital structure?

$52

The firm's most recent free cash flow to the firm (FCFF) was $60 million and its tax savings due to interest was $0.7 million. Its unlevered cost of equity is 15% and its pre-tax cost of debt is 7%. Free cash flows and tax savings are expected to grow at a constant rate of 4%. Assuming the corporate tax rate is 30%, use the compressed adjusted present value model to determine the value of the levered firm.

$551.82

Capital budgeting decisions are critical to the long-term performance and success of a business organization. This is because capital investments:

- tend to involve sizable cash outlays; - have multiyear life spans, which means that any mistakes will have to be dealt with for a long time; - are difficult to reverse without incurring large additional expenses - tend to determine and reflect the firm's future activities, markets, and productive technologies and, therefore, affect the firm's long-term performance and profitability For these reasons, capital budgeting decisions are relatively inflexible and require careful and deliberate planning. If these expenditures are made before they are required or desired, the firm may incur unnecessary financing costs, such as interest expense on borrowed funds or additional dividends on new shares sold to finance the investments. On the other hand, if the expenditures are made after they are needed or desired, then the firm may be unable to satisfy increased consumer demand, unable to take advantage of market opportunities, or unable to replace failing, obsolete, or inefficient equipment or facilities prior to its failure, obsolescence, or the realization of unnecessarily high costs.

Capital budgeting projects include:

- the purchase of a new or replacement piece of equipment, real estate, or building for the purpose of expanding an existing product or service line or to enter a new line of business; - expenditures for an advertising campaign, research and development program, or employee education and training program; - investments in permanent increases of target inventory levels or accounts receivable levels; - mergers and acquisitions Examples include: - Universal Computer Corp.'s purchase of a competitor's subsidiary - Atlanta Aeronautics Co.'s purchase of a new piece of equipment Investments in normal levels of inventory or accounts receivable, investments in short-term marketable securities, and the purchase of office supplies do NOT constitute capital expenditures or capital budgeting activities because these activities produce cash benefits that will NOT las beyond one year or one operating cycle.

Bailey and Sons has an unlevered beta of 0.57 and its tax rate is 40%. What would Bailey's beta be if its capital structure consists of 40% debt and 60% equity?

0.798 or 0.80

If preferred stock with an annual dividend of $20 sells for $150, and has flotation cost of 6%. The firm's marginal tax rate is 40%. What is the preferred stock's required rate of return?

14.18% $20/$150 x (1 - 0.06)

5 years ago, Barton Industries issued 25-year noncallable, semiannual bonds with a $2,000 face value and a 6% coupon, semiannual payment ($60 payment every 6 months). The bonds currently sell for $845.87. If the firm's marginal tax rate is 40%, what is the firm's after-tax cost of debt?

25 - 5 = 20 years left Semiannual N = 20 x 2 = 40; I/Y = ?; PV = -845.87; PMT = 60 (0.06/2 x 2000); FV = 2000 I/Y = 7.6679 x 2 = 15.34% The firm's marginal tax rate is 40%, so the after-tax cost of debt, rd x (1 - T) = 0.1534 x (1 - 0.40) = 0.09204 = 9.2%

You are an analysts tasked with estimating the firm's target capital structure weights. The total market value of preferred stock is $4,000. The total market value of common stock is $80,000. Short-term debt consists of bank loans that currently cost 9%, with interest payable quarterly and these loans are used to finance receivables and inventories on a seasonal basis, so bank loans are zero in the off season. The long-term debt consists of 30-year, semi-annual bonds. Assume the market value of long-term debt equals the book value. You are given the following balance sheet information: Accounts Payable: $12,000 Accruals: $9,000 Short-Term Debt: $8,000 Long-Term Debt: $45,000 What is the capital structure weight of debt?

34.88%

Allen Air Lines must liquidate some equipment that is being replaced. The equipment originally cost $18.4 million, of which 80% has been depreciated. The used equipment can be sold today for $4.6 million, and its tax rate is 35%. What is the equipment's after-tax net salvage value?

Equipment's original cost: $18,400,000 Depreciation (80%): $14,720,000 Book Value: $3,680,000 Gain on Sale = $4,600,000 - $3,680,000 = $920,000 Tax on Gain = $920,000(0.35) = $322,000 After-tax net salvage value = $4,600,000 - $322,000 = $4,278,000

T/F When evaluating a division of a company or a specific project that is high risk, the project should be evaluated at a lower WACC than the firm's overall WACC to reflect the higher risk.

False

T/F Capital budgeting is the process of planning and controlling investments in assets that are expected to produce cash flows for one year or less.

False: it has to be for more than one year

T/F The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we will focus on historical costs.

False: should focus on marginal costs not historical

Indirect cash flows often affect a firm's capital budgeting decisions:

However some of these indirect cash flows are relevant to capital budgeting decisions (because they represent marginal cash flows that depend on the project's acceptance), but others should be ignored.

If an independent project with conventional, or normal, cash flows is being analyzed, the net present value (NPV) and internal rate of return (IRR) methods ALWAYS agree:

If a project has normal, or conventional, cash flows that means the project's cash flows change signs only once. For an independent project, if the NPV is positive, the IRR will be greater than the WACC. If the NPV is negative, the IRR will be less than the WACC. For this reason, the decision to accept or reject a project using the IRR and NPV methods will always agree.

Financing costs are excluded from the estimate of incremental cash flows because the costs of raising capital are reflected in the discount rate used to calculate the project's NPV:

If cash outflows from interest or dividend payments were included, financing costs would be double-counted.

Suppose a company will issue new 20 year debt with a par value of $1,000 and a coupon rate of 9%, paid annually. The issue price will be $1,000. The tax rate is 40%. If the flotation cost is 4% of the issue proceeds, then what is the after-tax cost of debt? Disregard the tax shield from the amortization of flotation costs. What if the flotation costs were 10% of the bond issue?

If flotation costs are 4% of the issue price, then they total $1,000(0.04) = $40. This is less than de minimis of $1,000(0.25%)(20) = $50, so the costs are amortized linearly. The annual amortized cost is $40/20 = $2.00 per year. The tax benefit from this amortized cost is $2.00(0.40) = $0.80 per year. This is the amount by which you reduce the after-tax coupon payment to calculate the after-tax cost of debt. N = 20; I/Y = ?; PV = 1,000 x (1 - 0.40) = 960; PMT = -90 x (1 - 0.40) + $0.80 = -$53.20; FV = -1,000 I/Y = 5.66%, this is the after-tax component cost of debt if flotation costs are 4%. If flotation costs are 10% of the proceeds, then they total $1,000(0.10) = $100, which is greater than de minimis of $1,000(0.25%)(20) = $50, so the constant yield method is used. N = 20; I/Y = ?; PV = 1,000 x (1 - 0.10) = 900; PMT = -90; FV = -1,000 I/Y = 10.19%, which is the yield to maturity if you consider the after-tax flotation cost proceeds as the issue price. Multiply this by (1 - T) to get the after-tax component cost of debt = 0.1019 x (1 - 0.40) = 6.11%.

Projects will either end within a given life cycle or go on indefinitely. Either way, you must include the terminal value in the estimate of incremental cash flows:

If the project has a definite life span, the terminal value of cash flows will be the recovery of NWC and the after-tax proceeds from the sale of any assets used in the project. If the project has an indefinite life, you can use the formula for a growing perpetuity to estimate the terminal value. PVt = CFt+1/(r - g)

Even though depreciation is a non cash expense, it should be included in the estimate of cash flows associated with a particular project:

It is a tax-deductible expense and will reduce the amount of taxes paid.

The profitability index (PI) is a capital budgeting tool that provides another way to compare a project's benefits and costs:

It is computed as a ratio of the discounted value of the net cash flows expected to be generated by a project over its life (the project's expected benefits) to its net cost (NINV). A project's PI value can be interpreted to indicate a project's discounted return generated by each dollar of net investment required to generate those returns.

The net present value (NPV) is considered one of the most common and preferred criteria that generally lead to good investment decisions.

It measures a project's expected contribution to shareholder wealth. To calculate NPV, find the present value of each cash flow and the sum of all present value cash flows. You will discount the cash flows at the WACC if the project has the same risk as the firm's project.

Rick's Construction (RC) needs a new piece of equipment. RC can either lease the equipment or borrow from a local bank and buy the equipment. Assume that RC's tax rate is 30%. If the company leased the asset on a 2-year lease, the payment would be $55 at the beginning of each year. If RC borrowed and bought the equipment, the bank would charge 10% interest on the loan. Assume this lease s classified as a guideline lease by the IRS. Suppose you calculate the PV of owning as 72.88. What is the Net Advantage to Leasing (NAL) and should RC lease or buy the equipment?

NAL = -32.12, therefore RC should lease

When evaluating mutually exclusive projects, firms should evaluate:

NPV because it selects the project that maximizes value

Suppose Bumbly will be issuing debt to support this project and other capital budgeting projects this year. The firm's interest expense will increase by $700,000. Should the change in interest expense be included in the analysis?

No. Interest expense should not be included in capital budgeting analysis because it is a financing cost. Financing costs are embedded in the firm's required return, so including the interest expense would be a double counting of the firm's financing costs.

The basis of capital budgeting:

One of the most important financial management activities that firm undertakes is its evaluation and allocation of investment funds to support its future survival and growth. These activities may be motivated by the desire to expand the firm's revenues, reduce its costs, or satisfy its mandatory or voluntary legal, health, and safety requirements. They may have, more or less, multiyear effects on the organization and may or may not be considered as capital budgeting activities.

An opportunity cost is the cash flow forgone from the best alternative use of the assets used in the project:

Opportunity costs are included in capital budgeting evaluations. The classic example is forgone rent. If a project uses factory space that could otherwise be rented, the "lost" rent is a relevant factor in deciding whether to go ahead with the project.

Messman Manufacturing will issue common stock to the public for $50. The expected dividend and the growth in dividends are $3.25 per share and 4%, respectively. If the flotation costs is 14% of the issue's gross proceeds, what is the cost of external equity (re)?

Po = $50 D1 = $3.25 g = 4% F = 14% re = ? re = [D1/((1 - F) x Po)] + g = [$3.25/((1 - 0.14) x $50)] + 0.04 = 0.1156 or 11.56%

Given the following information, which mutually exclusive project should you accept? Years: Cash Flow X: Cash Flow Y Year 0: -100: -100 Year 1: 20: 80 Year 2: 60: 45 Year 3: 100: 40 WACC: 10%: 10% NPV: $42.90: $39.97 IRR: 27.96%: 35.18% MIRR: 23.90%: 23.05%

Project X

Given the following projects' coefficient of variation, which project has the most risk? Coefficient variation of X: 1.1 Coefficient variation of Y: 0.8 Coefficient variation of Z: 1.4

Project Z

In general, firms are reluctant to issue new common stock to raise additional financial capital due to the magnitude of the flotation costs and the negative signals sent to the marketplace.

Remember, according to the academic literature, less than 2% of firms raise external financial capital by selling new common shares. This reluctance is attributable, in part, to the magnitude of the flotation costs associated with the sale and the market's negative interpretation of the sale for the firm's current share price and its potential future investments. As a result, most firms won't issue new common shares unless absolutely required to maintain the firm's target capital structure.

The financial staff of Cairn Communications has identified the following information for the first year of the roll-out of its new proposed service: Projected sales: $22 million Operating costs: $7 million (not including depreciation) Depreciation: $4 million Interest expense: $4 million The company faces a 40% tax rate. What is the project's operating cash flow for the first year (t = 1)?

Sales Revenues ($22,000,000) - Operating costs ($7,000,000) - Depreciation ($4,000,000) = Operating income before taxes ($11,000,000) x Taxes (40%) =($4,400,000). Operating income before taxes ($11,000,000) - Taxes ($4,400,000) = Operating income after taxes ($6,600,000) + Depreciation ($4,000,000) = Operating cash flow ($10,600,000)

A project has an initial cost of $38,525, expected net cash inflows of $15,000 per year for 9 years, and a cost of capital of 13%. What is the project's payback period?

Since the cash flows are a constant $15,000, calculate the payback period as: $38,525/$15,000 = 2.57 years

Lee Manufacturing's value of operations is equal to $900 million after a recapitalization. (The firm had no debt before the recap.) Lee raised $300 million in new debt and used this to buy back stock. Lee had no short-term investments before or after the recap. After the recap, wd = 1/3. The firm had 20 million shares before the recap. What is P (The stock price after the recap)?

Spost = (1 - wd)(Vop) = (1 - 1/3)($900,000,000) = $600,000,000 Ppost = [Spost + (Dnew - Dold)]/nprior = [$600,000,000 + ($300,000,000 - $0)]/20 = $45.00

A project has an initial cost of $52,125, expected net cash inflows of $12,000 per year for 7 years, and a cost of capital of 12%. What is the project's discounted payback period?

Step 1: Calculate the PV of each cash flow. PV of CF0 = -52,125 PV of CF1: N = 1; I/Y = 12; PV = ?; PMT = 0; FV = -12000 PV of CF2-CF7: N = 2-7; I/Y = 12; PV = ?; PMT = 0; FV = -12000 PV of CF0 = -52,125 PV of CF1 = 10,714.29 PV of CF2 = 9,566.33 PV of CF3 = 8,541.36 PV of CF4 = 7,626.22 PV of CF5 = 6,809.12 PV of CF6 = 6,079.57 PV of CF7 = 5,428.19 Step 2: Calculate the cumulative discounted cash flow for each year. Cumulative Discount: Year 0: -52,125 (+10714.29) Year 1: -41,410.71 (+9566.33) Year 2: -31,844.38 (+8541.36) Year 3: -23,303.02 (+7626.22) Year 4: -15,676.80 (+6809.12) Year 5: -8,867.68 (+6079.57) Year 6: -2,788.11 (+5428.19) Year 7: 2,640.08 Step 3: Calculate the number of years until the cumulative value is positive. It took 6 years for the value to become positive, so: 6 + (2788.11/5428.19) = 6 + 0.514 = about 6.51 years

When there is a conflict, a key to resolving this is the assumed reinvestment rate. The NPV calculation implicitly assumes that intermediate cash flows are reinvested at the required rate of return, and the IRR calculation assumes that the rate at which cash flows can be reinvested is the internal rate of return (IRR): As a result, when evaluating mutually exclusive projects, the NPV method is usually the better decision criterion:

The IRR assumes that intermediate cash flows can be reinvested and continue earning the IRR. For most firms, it is more accurate to assume that the firm can reinvest cash flows at the WACC, not the IRR. Remember, the WACC is the opportunity cost of capital and represents the rate at which external capital can be attained. The WACC is the assumed reinvestment rate when calculating the NPV. If a firm had poor access to external capital markets but many high IRR projects, the IRR reinvestment rate would make sense. This situation is rare because firms with good investment opportunities generally have access to external capital markets. Therefore, the assumption built into the NPV method (reinvestment rate equals WACC) is more valid.

The internal rate of return (IRR) refers to the compound annual rate of return that a project generates based on its up-front cost and subsequent cash flows:

The IRR is the cost of capital at which the project's NPV is zero. The IRR is solved by setting the NPV equation equal to zero and solving for the interest rate.

St. Johns River Shipyards' wielding machine is 10 years old, fully depreciated, and has no salvage value. However, even though it is old, it is self-functional as originally designed and can be used for quite a while longer. St. Johns River Shipyards is considering replacing the old wielder with a new wielder. The new wielder will cost $200,000 and have an estimated life of 8 years with no salvage value. The new wielder will be much more efficient, however, and this enhanced efficiency will increase earnings before depreciation by $55,000 per year. The new machine will be depreciated over a 5 year life using straight line depreciation. The applicable corporate tax is 40%, and the project cost of capital is 10%. Find the NPV and determine whether the old wielder should be replaced by the new one?

The NPV of the project is $36,705.15 and the old wielder should be replaced.

An unlevered firm has a value of $800 million. An otherwise identical but levered firm has $150 million in debt. Under the MM zero-tax model, what is the value of the levered firm?

The Vu = $800,000,000. With zero taxes, MM show that Vl = Vu. Therefore, Vl= Vu = $800,000,000.

differences between marginal rate and embedded rate

The costs of new (marginal) and existing (embedded) capital components will usually differ due to changes in the company's risk profile, interest rates, and borrowing and lending conditions in the financial markets

The flotation costs associated with the sale of debt securities are lower than those associated with new common stock issues.

The flotation costs associated with the sale of debt securities are lower than the associated with new equity securities. Remember, debt issues tend to be sold in larger blocks to a smaller number of institutional investors, while equity issues are sold in smaller blocks to a larger number of individual and institutional investors. As a result, the marketing and selling costs of equity issues are greater than they would otherwise be for a comparable debt issue.

marginal rate

The required return (or cost) of newly-issued debt that usually differs from the average cost of the financial capital raised by a firm in the past; The cost of - or return required on - a newly-issued capital component, since it refers to the rate (cost) of the next dollar of financial capital raised using a particular capital component

Why is the before-tax cost of debt (rd) multiplied by one minus the tax rate in both the earlier equation and the weighted average cost of capital (WACC) equation?

The required return to debt holders (rd) is not equal to the company's cost of debt because the interest payments are tax deductible for the borrowing firm. This means that the government essentially pays part of a company's total cost of debt financing.

Suppose the Schoof Company has this book value balance sheet: Current Assets: $30,000,000 Fixed Assets: $70,000,000 Total Assets: $100,000,000 Current Liabilities: $20,000,000 Notes Payable: $10,000,000 Long-Term Debt: $30,000,000 Common Stock (1 million shares): $1,000,000 Retained Earnings: $39,000,000 Total Liabilities and Equity: $100,000,000 The notes payable are to banks, and the interest rate on this debt is 9%, the same as the rate on new bank loans. These bank loans are not used for seasonal financing but instead are part of the company's permanent capital structure. The long-term debt consists of 30,000 bonds, each with a par value of $1,000, an annual coupon interest rate of 7%, and a 20-year maturity. The going rate of interest on new long-term debt (rd) is 12%, and this is the present yield to maturity on the bonds. The common stock sells at a price of $50 per share. Calculate the firm's market value capital structure.

The total book value and market value of the current liabilities and notes payable are both $30,000,000: = (Current Liabilities $20,000,000 + Notes Payable $10,000,000). 0.07 x $1,000 = $70 = Payment The bonds have a value of: N = 20; I/Y = 12; PV = ?; PMT = -70; FV = -1000 PV = $626.53 The total market value of the long-term debt is: 30,000($626.53) = $18,795,834.56. There are 1 million shares outstanding, and the stock sells for $50 per share. Therefore, the market value of the equity is $50,000,000: = (1,000,000 x $50). The market value capital structure is thus: Short-term debt: $30,000,000.00; 30.37% Long-term debt: $18,795,834.56; 19.02% Common Equity: $50,000,000.00; 50.61% Total Capital: $98,795,834.56; 100% $30,000,000.00 + $18,795,834.56 + $50,000,000.00 = $98,795,834.56 $30,000,000.00/$98,795,834.56 = 0.3037 $18,795,834.56/$98,795,834.56 = 0.1902 $50,000,000.00/$19,795,834.56 = 0.5061

Which of the following statements about operating leases is false?

They are fully amortized.

Cannibalization is the effect on the firm from accepting a project, though that effect is not reflected directly in the project's operating cash flows:

This happens, for example, when customers purchase new products instead of or as a substitute for the firm's existing products. These effects may be difficult to estimate and predict.

Projects W and X are mutually exclusive projects. Their cash flows and NPV profiles are shown as follows. Year: Project W: Project X Year 0: ($1000): ($1500) Year 1: $200: $350 Year 2: $350: $500 Year 3: $400: $600 Year 4: $600: $750 -Graph- If the weighted average cost of capital (WACC) for each project is 18%, do the NPV and IRR methods agree or conflict?

Timing and size differences between mutually exclusive projects lead to conflicts between NPV and IRR methods. The sum of Project X's undiscounted cash flows is greater than the sum of Project W's undiscounted cash flows. Project X is larger than Project W, and the vertical intercept of Project X's NPV profile is greater than the vertical intercept of Project W's NPV profile. As the WACC for each project increases, Project X's larger cash flows are discounted more steeply, and the NPV difference decreases. At some WACC (the crossover rate), the projects have the same NPV; at greater WACCs, Project W has a higher NPV. Project W has a higher IRR than Project X because its NPV profile has a greater horizontal intercept. The IRR method would choose Project W over Project X. At a WACC of 18%, Project W has a higher NPV because its NPV profile is higher than Project X's NPV profile. The NPV method would choose Project W over Project X. Therefore, the NPV and IRR methods agree.

When firms make capital budgeting decisions, they should concern themselves with incremental cash flows, not net income, when evaluating projects:

To determine the incremental cash flows associated with a capital project, an analyst should include the project's fixed-asset expenditures, the project's depreciation expense, and changes in net working capital associated with the project. It should NOT include the project's financing costs.

The tax consequences resulting from a project represent incremental cash flows and should therefore be included when estimating a project's expected cash flows:

To do so, use the marginal tax rate because it equals the tax rate applicable to the next dollar of taxable income.

T/F If two firms are identical except for debt and EBIT falls by the same amount for both firms, ROE will be lower for the levered firm.

True

T/F Real options are opportunities for managers to take different actions during the project's life in response to changing market conditions, influencing the size and risk of project cash flows. Real options include the option to delay the timing of the investment, expand capacity and grow if market conditions are better than expected, or abandon the project if it is unsuccessful.

True

Purple Lemon Fruit Company is considering issuing a new 25 year debt issue that would pay an annual coupon payment of $75. Each bond in the issue would carry a $1,000 par value and would be expected to be sold for a market price equal to its par value. Purple Lemon's CFO has pointed out that the firm will incur flotation costs of 2% when initially issuing the bond issue. Remember, these flotation costs will be SUBTRACTED from the proceeds the firm will receive after issuing its new bonds. The firm's marginal federal-plus-state tax rate is 30%. To see the effect of flotation costs on Purple Lemon's after-tax cost of debt, calculate the before-tax and after-tax costs of the firm's debt issue with and without its flotation costs:

Use your financial calculator to determine the before-tax cost of debt by solving for the bond's yield to maturity (YTM). In this case, it is unnecessary since the bond is selling at a price equal to its par value, which means its YTM is equal to its coupon rate. - Before-Tax Cost of Debt: rd = $75/$1000 = 0.075 = 7.5% or; N = 25; I/Y = ?; PV = -1000; PMT = 75; FV = 1000 You can solve for the firm's after-tax cost of debt by multiplying the before-tax cost of debt by one minus the tax rate. [rd x (1 - T)] - After-Tax Cost of Debt: 0.075 x (1 - 0.30) = 0.0525 = 5.25% When the problem states that Purple Lemon Fruit Company will incur a flotation cost of 2% when issuing these bonds, it means that the firm's investment bankers will receive 2% of the proceeds from the sale of the bond issue as their fee. As a result, Purple Lemon will receive only 98%, or $1,000 x (1 - 0.02) = $980.00 as net proceeds for each new bond sold. To compute the before-tax cost of debt net of the issue's flotation costs, you will need to adjust the present value (PV) of the bond to reflect the net proceeds of the sale ($980) when you input the relevant information into your financial calculator. N = 25; I/Y = ?; PV = -980; PMT = 75; FV = 1000 - Before-Tax Cost of Debt: rd = 7.68% Now that you know that the before-tax cost of debt with flotation costs taken into account is 7.68%, you can solve for the after-tax cost of the debt. - After-Tax Cost of Debt = 0.0768 x (1 - 0.30) = 0.0538 = 5.38% Because Purple Lemon Fruit Company received less than the bond's par value as a result of the issue's flotation costs, both its before-tax and after-tax costs of debt are greater than the corresponding costs in the absence of the flotation costs.

An unlevered firm has a value of $700 million. An otherwise identical but levered firm has $120 million in debt at a 6% interest rate. Its pre-tax cost of debt is 6% and its unlevered cost of equity is 11%. No growth is expected. Assuming the corporate tax rate is 35%, use the MM model with corporate taxes to determine the value of the levered firm.

Vl = Vu + TD = $700,000,000 + 0.35($120,000,000) = $742,000,000

An unlevered firm has a value of $800 million. An otherwise identical but levered firm has $40 million in debt at a 6% interest rate, which is its pre-tax cost of debt. Its unlevered cost of equity is 12%. After Year 1, free cash flows and tax savings are expected to grow at a constant rate of 2%. Assuming the corporate tax rate is 30%, use the compressed adjusted present value model to determine the value of the levered firm. (HINT: The interest expense at Year 1 is based on the current level of debt).

Vl = Vu + [(rd)(D)(Tc)/(rsu - g)] = $800,000,000 + [(0.06)($40,000,000)(0.30)/(0.12 - 0.02)] = $800,000,000 + $7,200,000 = $807,200,000

Shi Import-Export's balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common equity. Shi's tax rate is 30%, rd = 6%, rps = 7.1%, and rs = 14%. If Shi has a target capital structure of 30% debt, 5% preferred stock, and 65% common stock, what is its WACC?

WACC = (wd)(rd)(1 - T) + (wps)(rps) + (ws)(rs) WACC = (0.30)(0.06)(1 - 0.30) + (0.05)(0.071) + (0.65)(0.14) = 0.1072 or 10.72%

Shi Import-Export's balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common equity. Shi's tax rate is 30%, rd = 8%, rps = 6.9%, and rcs = 13%. If Shi has a target capital structure of 40% debt, 5% preferred stock, and 55% common stock, what is its WACC?

WACC = [Wd x Rd x (1 - T) + (Wps x Rps) + (Wcs + Rcs)] (0.40 x 0.08 x (1 - 0.30) + (0.05 x 0.069) + (0.55 x 0.13) = 0.09735

Firms raise capital from retained earnings before issuing new common stock because of their lower cost relative to newly-issued common stock. Market conditions have no factor on this.

When firms have the choice of relying on retained earnings or issuing new common stock, they should always prefer to spend their retained earnings dollars first - due to their lower cost relative to the cost of newly-issued common stock. The market conditions relative to issuing new equity is irrelevant when deciding whether to spend the firm's retained earnings dollars before or after it has spent the proceeds generated by issuing new common shares.

White Lion Homebuilders has a current stock price of $25 per share, and is expected to pay a per-share dividend of $3.40 at the end of next year. The company's earnings and dividends growth rate are expected to grow at a constant rate of 3.80% into the foreseeable future. If Alpha Moose expected to incur flotation costs of 3.60% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock should be:

When flotation costs are charged, a firm will receive only a portion of the capital provided by investors; the remainder will go to the investment bank that helped raise the capital. As a result, to provide investors with their desired required rate of return on the investment, each dollar must earn a rate that is greater than the investors' required rate of return. In this example, Alpha Moose Transporters is paying flotation costs of 3.60%. This means that the firm will be able to keep and invest only 96.40% of the amount that investors supplied. You can use the following equation to calculate the cost of equity associated with issuing new stock (rs) net of any flotation costs: Cost of New Stock (rs) = [D1/Po x (1 - F)] + g rs = D1/Pnet + g Therefore, White Lion Homebuilders's cost of new equity is: rs = [$3.40/$25 x (1 - 0.036)] + 0.038 = 0.1791 or 17.91% Another approach to incorporating the effect of flotation costs on the cost of a company's new external equity is by adjusting the cost of a project's initial investment instead of adjusting the firm's cost of capital.

Net Working Capital (NWC) is the difference between current assets and current liabilities. An increase in NWC results in a cash outflow; a decrease results in a cash inflow:

When projects require an increase in inventory, accounts receivable, or accounts payable, in results in an increase in NWC and an outflow of cash. Most projects require an increase in NWC at the beginning of the project and a decrease in NWC at the end of the project. Incremental cash flows will therefore reflect a cash outflow at the beginning of the project and a cash inflow at the end.

If the facility could be leased out for $25,000 per year, would this affect the analysis?

Yes, this is an opportunity cost and should be included.

The net operating working capital of a firm will decrease if there is:

a decrease in accounts receivable

Firms that carry preferred stock in their capital mix want to not only distribute dividends to common stockholders but also maintain credibility in the capital markets so that they can raise additional funds in the future and avoid potential corporate raids from preferred stockholders. Ten years ago, Happy Lion Manufacturing issued a perpetual preferred stock issue - called PS Alpha - that pays a fixed dividend of $8.50 per share and currently sells for $100 per share. Happy Lion's management team is considering issuing a second issue of perpetual preferred stock. If the new issue - tentatively called PS Beta - is actually sold, the company will incur an underwriting (or flotation) cost of 5.40%. In addition, the underwriters are anticipating the need to pay a dividend of $16.25 per share to attract new investors, and is expecting to sell the new shares for $92.00 per share. a) As a component in Happy Lion's weighted average cost of capital (WACC), PS Alpha shares currently exhibit a cost of: b) If Happy Lion elects to issue its PS Beta shares, what will it pay per share in flotation costs and what will it receive in net proceeds per share from its underwriters? c) Based on its underwriters' best estimates of the issue's expected future dividend and market price, the marginal cost of the PS Beta issue is expected to be:

a) Because the PS Alpha issue was issued ten years ago, its flotation costs are irrelevant to the computation of the issue's current contribution to the company's WACC. In addition, since PS Alpha is a perpetual preferred stock issue, then its cost of capital can be calculated by dividing its annual dividend, Dps, by its current market price, Pps. rps = Dps/Pps rps = $8.50/$100 = 0.0850, or 8.50% Remember, since preferred stock dividends are paid using after-tax dollars, then Harry Lion's 8.50% preferred stock component cost is already expressed in after-tax terms and no further adjustment is necessary. b) Since the PS Beta issue is another perpetual issue, you can use the equation presented above to compute the issue's cost to the firm. However, before you do so, it is necessary to calculate the net proceeds that Happy Lion will receive after the underwriters deduct their flotation fees. The underwriters' flotation cost can be expressed either as a percentage of the value of the entire bond or as the percentage of the value of an individual bond. In this case, management has been told that if the issue is sold, the underwriters' fees will be 5.40% of the bond's sale price ($92.00 per share). Therefore, the flotation costs and net proceeds can be computed as: Expected Flotation Costs = Expected Sale Price x Flotation Cost Percentage Expected Net Proceeds = Expected Sale Price - Expected Flotation Costs which; = Expected Sale Price x (1 - Expected Flotation Cost Percentage) Expected Flotation Costs = $92 per share x 0.054 = $4.97 per share Expected Net Proceeds = $92 per share x (1 - 0.054) = $87.03 or; $92.00 per share - $4.97 per share = $87.03 per share Therefore, while Happy Lion's shares are sold for $92.00 per share, the company only receives $97.03 per share as net proceeds of the sale. The underwriters are paid $4.97 per share for their underwriting expertise as well as their marketing and selling activities. c) Remember, PS Beta is a perpetual preferred stock issue, and as such, its cost can be computed by dividing the dividend by the current market price of a share. However, since this issue has not yet been sold, then the flotation costs associated with the issue's sale must be included in the analysis. Therefore, the denominator in the calculation must be adjusted to reflect the net market price of the PS Beta shares. This means that the net price can be computed in two ways: Cost of Preferred Stock (rps) = Annual Dividend (Dps)/Current Net Market Price (Pps); rps = Dps/Pps = Dps/Pps x (1 - F) = Dps/Pps - Per Share Flotation Costs Therefore, the after-tax cost of Happy Lion's PS Beta preferred stock issue - net of its expected flotation costs - is: rps = $16.25/[$92.00 x (1 - 0.054)] = $16.25/$87.03 = 0.1867 or 18.67% Companies should not make tax adjustments when calculating the after-tax cost of preferred stock because preferred dividends are not tax deductible, so the company bears their full cost. Because there are no tax savings, no tax adjustments are made when calculating the cost of preferred stock.

Purple Whale Foodstuffs Inc. is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,500,000. The company has been basing capital budgeting decisions on a project's NPV; however, its new CFO wants to start using the IRR method for capital budgeting decisions. The CFO says that the IRR is a better method because percentages and returns are easier to understand and to compare to required returns. Purple Whale Foodstuffs Inc.'s WACC is 7%, and project Delta has the same risk as the firm's average project. The project is expected to generate the following net cash flows: Year: Cash Flows Year 1: $300,000 Year 2: $425,000 Year 3: $475,000 Year 4: $450,000 a) Which of the following is the correct calculation of project Delta's IRR? b) If this is an independent project, the IRR method states that the firm should reject project Delta: c) If the project's cost of capital were to increase, how would that affect the IRR?

a) CF0 = -1,500,000 CF1 = 300,000 CF2 = 425,000 CF3 = 475,000 CF4 = 450,000 IRR = 3.689 or 3.69% This means that if the cost of capital for this project we're 3.69%, the project would have an NPV of $0. Because project Delta's IRR is less than Purple Whale Foodstuffs Inc.'s WACC of 7%, the project will have a negative NPV. b) The IRR identifies the cost of capital where NPV equals zero (where the project breaks even). The IRR is the project's expected rate of return, assuming that intermediate cash flows also earn the IRR. If the IRR is less than the cost of the capital invested in the project, shareholders will lose value on the investment. Therefore, projects whose IRR is less than the WACC should be rejected. In this case, project Delta's IRR is 3.69%, and the company's WACC is 7%, so Purple Foodstuffs Inc. should reject the project. c) The IRR is the internal rate of return, or the project's expected return if intermediate cash flows earn the same return as the IRR. The IRR is the cost of capital that forces the NPV to equal zero; hence, the calculated IRR is independent of a project's cost of capital. So, the IRR would not change.

Talbot Industries is considering launching a new product. The new manufacturing equipment will cost $13 million, and production and sales will require an initial $5 million investment in net operating working capital. The company's tax rate is 30%. a) What is the initial investment outlay? b) The company spent and expensed $150,000 on research related to the new project last year. Would this change your answer? c) Rather than build a new manufacturing facility, the company plans to install the equipment in a building it owns but is not now using. The building could be sold for $1.5 million after taxes and real estate commissions. How would this affect your answer?

a) Equipment: $13,000,000 NWC Investment: $5,000,000 Initial Investment Outlay: $18,000,000 b) No, last year's $150,000 expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis. c) The project's cost will increase. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible after-tax sale price must be charged against the project as a cost.

The Perez Company has the opportunity to invest in one of two mutually exclusive machines that will produce a product it will need for the foreseeable future. Machine A costs $11 million but realizes after-tax inflows of $5 million per year for 4 years. After 4 years, the machine must be replaced. Machine B costs $13 million and realizes after-tax inflows of $3.5 million per year for 8 years, after which it must be replaced. Assume that machine prices are not expected to rise because inflation will be offset by cheaper components used in the machines. The cost of capital is 12%. a) Using the replacement chain approach to project analysis, by how much would the value of the company increase if it accepted the better machine? Machine A is the better project and will increase the company's value by $6.85 million. b) What is the equivalent annual annuity for each machine? Machine A: $1.38 million Machine B: $0.88 million

a) NPV of Project A: CF0 = -11,000,000 CF1 = 5,000,000 F1 = 4 I = 12 NPV = 4,186,746.73 Extended NPV of Project A: CF0 = -11,000,000 CF1 = 5,000,000 CF2 = 5,000,000 CF3 = 5,000,000 CF4 = -6,000,000 CF5 = 5,000,000 CF6 = 5,000,000 CF7 = 5,000,000 CF8 = 5,000,000 I = 12 NPV = 6,847,499.97 NPV of Project B: CF0 = -13,000,000 CF1 = 3,500,000 F1 = 8 I = 12 NPV = 4,386,739.18 b) EAA for Machine A: N = 4; I/Y = 12; PV = ?; PMT = 5; FV = 0 PV = -15.19 The NPV is $15.19 - $11 = $4.19 million. We convert this to an equivalent annual annuity by inputting: N = 4; I/Y = 12; PV = - 4.19; PMT = ?; FV = 0. PMT = EAA = $1.38 million EAA for Machine B: N = 8; I/Y = 12; PV = -4.39; PMT = ?; FV = 0. PMT = EAA = $0.88 million Again the EAA method demonstrates that Machine A is the better project since EAAa > EAAb.

Your division is considering two investment projects, each of which requires an up-front expenditure of $26 million. You estimate that the cost of capital is 8% and that the investments will produce the following after-tax cash flows (in millions of dollars): Year: Project A: Project B Year 1: 5 million: 20 million Year 2: 10 million: 10 million Year 3: 15 million: 8 million Year 4: 20 million: 6 million a) What is the regular payback period for each of the projects? Project A: 2.73 years Project B: 1.60 years b) What is the discounted payback period for each of the projects? Project A: 3.06 years Project B: 1.87 years c) If the two projects are independent and the cost of capital is 8%, which project or projects should the firm undertake? Both Project A and Project B have positive NPVs, so the firm should undertake both projects. d) If the two projects are mutually exclusive and the cost of capital is 5%, which project should the firm undertake? Since the two projects are mutually exclusive, the firm should undertake Project A because it has the higher NPV. e) If the two projects are mutually exclusive and the cost of capital is 15%, which project should the firm undertake? Since the two projects are mutually exclusive, the firm should undertake Project B because it has the higher NPV. f) What is the crossover rate? 13.53% g) If the cost of capital is 8%, what is the modified IRR (MIRR) of each project? According to the MIRR approach, if Project A and Project B were mutually exclusive, Project A would be chosen because it has the higher MIRR. This is consistent with the NPV approach.

a) Payback of Project A: Year: Cash Flows: Cumulative: Year 0: -26,000,000: -26,000,000 (+5,000,000) Year 1: 5,000,000: -21,000,000 (+10,000,000) Year 2: 10,000,000: -11,000,000 (+15,000,000) Year 3: 15,000,000: 4,000,000 (+20,000,000) Year 4: 20,000,000: 24,000,000 2 + (11,000,000/15,000,000) = 2 + 0.7333 = 2.73 years Payback of Project B: Year: Cash Flows: Cumulative: Year 0: -26,000,000: -26,000,000 (+20,000,000) Year 1: 20,000,000: -6,000,000 (+10,000,000) Year 2: 10,000,000: 4,000,000 (+8,000,000) Year 3: 8,000,000: 12,000,000 (+6,000,000) Year 4: 6,000,000: 18,000,000 1 + (6,000,000/10,000,000) = 1 + 0.60 = 1.60 years b) Discounted Payback of Project A: Year: Cash Flows: Cash Flows: Cumulative Year 0: -26,000,000: -26,000,000: -26,000,000 Year 1: 5,000,000: 4,629,629.63: -21,370,370.37 Year 2: 10,000,000: 8,573,388.20: -12,796,982.17 Year 3: 15,000,000: 11,907,483.62: -889,498.55 Year 4: 20,000,000: 14,700,597.06: 13,811,098.50 3 + (889,498.55/14,700,597.06) = 3 + 0.061 = 3.06 years Discounted Payback of Project B: Year: Cash Flows: Cash Flows: Cumulative Year 0: -26,000,000: -26,000,000: -26,000,000 Year 1: 20,000,000: 18,518,518.52: -7,481,481.38 Year 2: 10,000,000: 8,573,388.20: 1,091,906.72 Year 3: 8,000,000: 6,350,657.93: 7,442,564.65 Year 4: 6,000,000: 4,410,179.12: 11,852,743.77 1 + (7,481,481.48/8,573,388.20) = 1 + 0.87 = 1.87 years c) NPV of Project A: CF0 = -26,000,000 CF1 = 5,000,000 CF2 = 10,000,000 CF3 = 15,000,000 CF4 = 20,000,000 I = 8 NPV = 13,811,098.50 NPV of Project B: CF0 = -26,000,000 CF1 = 20,000,000 CF2 = 10,000,000 CF3 = 8,000,000 CF4 = 6,000,000 I = 8 NPV = 11,852,743.77 d) NPV of Project A; Cost of Capital @ 5%: NPV = 17,243,813.02 NPV of Project B; Cost of Capital @ 5%: NPV = 13,964,829.47 e) NPV of Project A; Cost of Capital @ 15%: NPV = 7,207,071.58 NPV of Project B; Cost of Capital @ 15%: NPV = 7,643,390.35 f) Crossover Rate: ∆Project CF0 = 0 (26-26) CF1 = -15,000,000 (5-20) CF2 = 0 (10-10) CF3 = 7,000,000 (15-8) CF4 = 14,000,000 (20-6) IRR = 13.53% g) MIRR of Project A: CF0 = 0 CF1 = 5,000,000 CF2 = 10,000,000 CF3 = 15,000,000 CF4 = 20,000,000 I = 8 NPV = 39,811,098.50 N = 4; I/Y = 8; PV = 39,811,098.50; PMT = 0; FV = ? FV = -54,162,560.00 N = 4; I/Y = ?; PV = -26,000,000; PMT = 0; FV = 54,162,560 I/Y = 20.14% MIRR of Project B: CF0 = 0 CF1 = 20,000,000 CF2 = 10,000,000 CF3 = 8,000,000 CF4 = 6,000,000 I = 8 NPV = 37,852,743.77 N = 4; I/Y = 8; PV = 37,852,743.77; PMT = 0; FV = ? FV = -51,498,240.00 N = 4; I/Y = ?; PV = -26,000,000; PMT = 0; FV = 51,498,240 I/Y = 18.63%

Happy Dog Soap Company is considering investing $500,000 in a project that is expected to generate the following net cash flows: Year: Cash Flows Year 1: $275,000 Year 2: $425,000 Year 3: $425,000 Year 4: $400,000 a) Happy Dog uses a WACC of 8% when evaluating proposed capital budgeting projects. Based on these cash flows, determine this project's PI. b) Happy Dog's decision to accept or reject this project is independent of its decisions on other projects. Based on the project's PI, the firm should accept the project. c) By comparison, the net present value (NPV) of this project is $750,389. On the basis of this evaluation criterion, Happy Dog should invest in the project because the project will increase the firm's value.

a) To compute the PI of Happy Dog project, divide the present value of the project's future cash flows by the initial investment in the project. First, calculate the present, or discounted, value (PV) of the project's expected future cash flows, as follows: CF0 = -500,000 CF1 = 275,000 CF2 = 425,000 CF3 = 425,000 CF4 = 400,000 I = 8 NPV = 750,389.2718 Next, divide the present value of the firm's future cash flows by the project's initial investment of $500,000 to determine the project's PI: PI = NPV + Initial Investment/Initial Investment = 750,389.27 + 500,000/500,000 = 1,250,389.27/500,000 = 2.500779 This means that this project is expected to produce $2.5008 of present value for each dollar invested in this project. b) The project's PI of 2.5008 tells you that the firm expects to produce $2.5008 of present value for each $1 invested in the project. When using the PI to evaluate an independent project, you will accept projects with a PI greater than 1.00 and reject projects with a PI less than 1.00. When comparing mutually exclusive projects, you want to accept the project with the highest PI. c) The NPV of this project is computed (above^ in "a") and/or as the difference between the discounted value of the project's net cash flows and the cost of the investment. That is: NPV (Project 1) = PV (Net Cash Flows) - Cost of Investment = $1,250,389 - $500,000 = $750,389

The president of the company you work for has asked you to evaluate the proposed acquisition of a new chromatograph for the firm's R&D department. The equipment's basic price is $71,000, and it would cost another $16,500 to modify it for special use by your firm. The chromatography, which falls into the MACRS 3-year class, would be sold after 3 years for $28,000. The MACRS rates for the first 3 years are 0.3333, 0.4445, and 0.1481. Use of the equipment would require an increase in net working capital (spare parts inventory) of $3,350. The machine would have no effect on revenues, but it is expected to save the firm $27,490 per year in before-tax operating costs, mainly labor. The firm's marginal federal-plus-state tax rate is 40%. Cash outflows and negative NPV value, if any, should be indicated by a minus sign. a) What is the Year-0 net cash flow? $90,850 b) What are the net operating cash flows in Years 1, 2, and 3? Do not include recovery of NWC or salvage value in Year 3's calculation here. Year 1: $28,160 Year 2: $32,052 Year 3: $21,678 c) What is the additional cash flow in Year 3 from NWC and salvage? $22,744 d) If the project's cost of capital is 12%, what is the NPV of the project? Should the chromatography be purchased? NPV = -$8,538 It should not be purchased because NPV is negative.

a) Total Cost for the Machine = Base Price + Installation Charges + Increases in NWC = $71,000 + $16,500 + $3,350 = $90,850 b) After-Tax Cost Savings = Before-Tax Operating Costs x (1 - Tax Rate) = $27,490 x (1 - 0.40) = $16,494 Depreciation = Depreciable Basis x Allowance Factor Depreciable Basis = Base Price + Installation Charges = $71,000 + $16,500 = $87,500 Year 1 Depreciation: $87,500 x 0.3333 = $29,163.75 Year 2 Depreciation: $87,500 x 0.4445 = $38,893.75 Year 3 Depreciation: $87,500 x 0.1481 = $12,958.75 Depreciation Savings = Depreciation x Tax Rate Year 1 Savings: $29,163.75 x 0.40 = $11,665.50 Year 2 Savings: $38,893.75 x 0.40 = $15,557.50 Year 3 Savings: $12,958.75 x 0.40 = $5,183.50 Net Cash Flow = After-Tax Cost Savings + Depreciation Tax Savings Year 1: $16,494 + $11,665.50 = $28,159.50 Year 2: $16,494 + $15,557.50 = $32,051.50 Year 3: $16,494 + $5,183.50 = $21,677.50 c) Year 4 Allowance Factor = 1.000 - (0.3333 + 0.4445 + 0.1481) = 0.0741 Book Value for Year 4 = Depreciable Basis x Year 4 Allowance Factor = $87,500 x 0.0741 = $6,483.75 Salvage Value - Book Value = $28,000 - $6,483.75 = $21,516.25 Tax on Salvage Value = $21,516.25 x 0.40 = $8,606.50 Year 3 Cash Flow = Salvage Value - Tax on Salvage Value + Return of NWC = $28,000 - $8,606.50 + $3,350 = $22,743.50 d) Net CF Year 3 = After-Tax Cost Savings + Depreciation Tax Savings + After-Tax Salvage Value + Return of NWC = $16,494 + $5,183.50 + ($28,000 - $8,606.50) + $3,350 = $44,421 Net CF for Year 1 & Year 2 = After-Tax Cost Savings + Depreciation Savings Net CF Year 1: $16,494 + $11,665.50 = $28,159.50 Net CF Year 2: $16,494 + $15,557.50 = $32,051.50 CF0 = -90,850 CF1 = 28,159.50 CF2 = 32,051.50 CF3 = 44,421 I = 12 NPV = -8,538.34

Consider the case of Happy Dog Soap Company: Suppose Happy Dog Soap Company is evaluating a proposed capital budgeting project (project Alpha) that will require an initial investment of $500,000. The project is expected to generate the following net cash flows: Years: Cash Flows Year 1: $325,000 Year 2: $500,000 Year 3: $425,000 Year 4: $475,000 a) The company's WACC is 10%, and project Alpha has the same risk as the firm's average project. Based on the cash flows, what is project Alpha's net present value (NPV)? b) Happy Soap Dog Company's decision to accept or reject project Alpha is independent of its decisions on other projects. If the firm follows the NPV method, it should accept project Alpha:

a) Using a financial calculator: CF0 = -500,000 CF1 = 325,000 CF2 = 500,000 CF3 = 425,000 CF4 = 425,000 I = 10 NPV = CPT = 852,418 Remember, the NPV is the sum of the present value of all of the project's cash flows. Project Alpha's NPV is $852,418. This is the value of the project in today's dollars. b) The NPV measures a project's contribution to shareholder wealth. The NPV method states that independent projects should be accepted if their NPV is greater than zero. A positive NPV thus indicates that investors are more than compensated for the project's risk and investment, and this excess value accrues to shareholders. The NPV of $852,418 shows project Alpha adds $852,418 of shareholder value to the firm. Because the project will contribute to shareholder value, it should be accepted.

Capital expenditures:

are cash payments for assets that are expected to generate cash flows for periods greater than one year.

The MM theory with corporate taxes implies that firms' optimal capital structure is 100% debt. In practice, this is not true because:

bankruptcy and its associated costs are a disadvantage to debt

The new project is likely to have a negative impact on the company's existing related products:

cannibalization example; should be included in the capital budgeting analysis

A firm's cost of equity can be estimated using the:

capital asset pricing model (CAPM), bond-yield-plus-risk-premium approach, constant dividend growth approach

A project will have more than one IRR if, and only if, the:

cash flow pattern exhibits more than one sign change

Most of the purchases for this project will be made using cash, causing cash in the company to decrease:

change in NWC example; should be included in the capital budgeting analysis

The capital budgeting process in a company involves:

evaluation of cash flows, risk analysis, correlation with the portfolio of projects in the company, etc. To make this process more streamlined, firms identify whether the projects qualify as a capital budgeting project or not and generally analyze them in different vertical categories.

Conducting scenario analysis on a capital budgeting project helps managers see the:

expected range of outcomes on a proposed project from changing more than one variables

The pecking order theory of capital structure implies that:

firms prefer internal finance and firms prefer debt to equity when external financing is required

Summerland Resort's common stock is currently trading at $100 per share. The stock is expected to pay a dividend of $2.00 per share at the end of the year, and the company's average ROE is 15% and its retention ratio is 45%. Estimate the growth rate then find the cost of common equity.

g = retention rate x ROE = 0.45 x 0.15 = 0.0675 Rcs = $2.00/$100 + 0.0675 = 0.0875 or 8.75%

The yield to maturity on the company's long-term debt is:

generally used to calculate the cost of debt because more often than not, the capital is being raised to fund long-term projects.

An independent investment is acceptable if the profitability index (PI) of the investment is:

greater than or equal to 1.00

Which of the following is an advantage of sensitivity analysis in capital budgeting projects?

it can help identify the project's most important variables

When a project has a PI less than 1.00:

it will have a negative NPV, an NPV less than $0.

When a project has a PI of 1.00:

it will have an NPV equal to $0.

When a project has a PI greater than 1.00:

it will have an NPV greater than $0.

It is important to emphasize that the cost of debt is the interest rate on:

new debt, NOT outstanding debt because our primary concern with the cost of capital is its use capital budgeting decisions.

Capital expenditures are in contrast to:

normal operating expenditures

The project will use some equipment that the firm owns but isn't using currently. However, a used-equipment dealer has offered to buy the equipment:

opportunity cost example; should be included in the capital budgeting analysis

The project will use some raw materials that the firm has in its inventory and can sell at a certain price:

opportunity cost example; should be included in the capital budgeting analysis

According to the trade-off theory of capital structure:

optimal capital structure occurs when the tax benefits of debt just offset the increases in the costs of distress

Normal operating expenditures:

pay for assets that are expected to generate cash flows for period of one year or less.

Booher Book Stores has a beta of 1.0. The yield on a 3-month T-bill is 5%, and the yield on a 10-year T-bond is 6.5%. The market risk premium is 4.5%, and the return on an average stock in the market last year was 14%. What is the estimated cost of common equity using CAPM?

rs = rRF + bi(RPm) = 0.065 + 1.0(0.045) = 0.1100 or 11.00%

What signal is sent to the market when a firm decides to issue new stock to raise capital?

stock price is too high

You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) _____ cost.

sunk cost

Bumbly invested in research and development to come up with this new product:

sunk cost example; should NOT be included in the capital budgeting analysis - Money previously spend on marketing research, research and development, and testing of prototypes is a sunk cost because it can't be recovered. The marketing costs will be gone whether Bumbly takes on this new project or not.

Because interest is tax deductible, the relevant cost of new debt used to calculate a firm's WACC is:

the after-tax cost of debt, rd x (1 - T).

For these reasons, the yield to maturity on outstanding debt (which reflects current market conditions) is:

the better measure of the cost of debt than the coupon interest rate.

If a bond is selling at a price equal to its par value, then:

the bond's yield to maturity is equal to its coupon rate.

Which of the following statements is correct?

the capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price

marginal cost of new debt

the cost of debt that is relevant when companies are evaluating new investment projects that is to be raised to finance the new project

A firm's before-tax cost of debt, rd, is:

the interest rate that firm must pay on new debt.

Capital budgeting transactions require:

the making of capital expenditures.

If a firm is more concerned about the quick recovery of its initial investment than it is about the amount of value created, then the firm is most apt to evaluate a capital project using:

the payback method of analysis

Capital budgeting:

the process of planning and controlling investments in assets that are expected to produce cash flows for more than one year.

The after-tax cost of debt is used in calculating WACC because we are interested in maximizing the value of the firm's stock, and:

the stock price depends on after-tax cash flows.

The rate at which the firm has borrowed in the past is irrelevant because:

we need to know the cost of new capital.