FIN390 Exam 2

Booher Book Stores has a beta of 1.1. The yield on a 3-month T-bill is 3%, and the yield on a 10-year T-bond is 8%. The market risk premium is 7.5%, and the return on an average stock in the market last year was 13%. What is the estimated cost of common equity using the CAPM? Round your answer to one decimal places.

rs = rRF + bi(RPM) = 0.08 + 1.1(0.075) = 16.3%. cost of equity:CAPM

Which of the following could be a direct cause of financing feedback? I. Issuing additional common stock II. Purchasing additional buildings with internally generated funds III. An unexpected increase in sales IV. Borrowing from the bank

I and IV

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. _________ is the cash flow that the firm forgoes as a result of accepting the project under consideration. In general, these are cash flows of the next best alternative to the project.

an opportunity cost

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.

Bumbly spent nearly $1.1 million in market research to develop new product ideas.

sunk cost

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 25%, rd = 6%, rps = 7.7%, and rs = 11%. If Shi has a target capital structure of 30% debt, 5% preferred stock, and 65% common stock, what is its WACC? Round your answer to two decimal places.

30% Debt; 5% Preferred Stock; 65% Common Stock; rd = 6%; T = 25%; rps = 7.7%; rs = 11%. WACC = (wd)(rd)(1 - T) + (wps)(rps) + (ws)(rs)WACC = 0.30(0.06)(1 - 0.25) + 0.05(0.077) + 0.65(0.11) = 8.89%. WACC

As a result, when evaluating mutually exclusive projects, the _______ is usually the better decision criterion.

NPV method 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.

F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but it would like to add some debt to take advantage of the tax shield. Its investment banker has indicated that the pre-tax cost of debt under various possible capital structures would be as follows: Market Debt-to- Value Ratio (wd) Market Equity-to- Value Ratio (ws) Market Debt-to Equity Ratio (D/S) Before-Tax Cost of Debt (rd) 0.0 1.0 0.00 6.0 % 0.10 0.90 0.1111 6.4 0.20 0.80 0.2500 7.0 0.30 0.70 0.4286 8.2 0.40 0.60 0.6667 10.0 F. Pierce uses the CAPM to estimate its cost of common equity, rs, and at the time of the analaysis the risk-free rate is 5%, the market risk premium is 6%, and the company's tax rate is 25%. F. Pierce estimates that its beta now (which is "unlevered" because it currently has no debt) is 0.8. Based on this information, what is the firm's optimal capital structure, and what would be the weighted average cost of capital at the optimal capital structure? Do not round intermediate calculations. Round your answers to two decimal places. Debt: ____% Equity: ____% WACC: ____%

Tax rate = 25% rRF = 5% bU = 0.8 rM - rRF = 6% From data given in the problem and table we can develop the following table: wd ws D/S rd rd(1 - T) Levered betaa WACCc 0.0 1.0 0.0000 6.0% 4.50% 0.80 9.80% 9.80% 0.1 0.9 0.1111 6.4% 4.80% 0.87 10.20% 9.66% 0.2 0.8 0.2500 7.0% 5.25% 0.95 10.70% 9.61% 0.3 0.7 0.4286 8.2% 6.15% 1.06 11.34% 9.79% 0.4 0.6 0.6667 10.0% 7.50% 1.20 12.20% 10.32% Notes: a These beta estimates were calculated using the Hamada equation, b = bu[1 + (1 - T)(D/S)]. b These rs estimates were calculated using the CAPM, rs = rRF + (rM - rRF)b. c These WACC estimates were calculated with the following equation: WACC = (wd)(rd)(1 - T) + (ws)(rs). The firm's optimal capital structure is that capital structure which minimizes the firm's WACC. The WACC is minimized at a capital structure consisting of 20.00% debt and 80.00% equity. At that capital structure, the firm's WACC is 9.61%. Note: While the calculations above show values rounded to 2 decimal places, unrounded values should be used in your calculations.

Walkrun Inc. is unlevered and has a value of $600 billion. An otherwise identical but levered firm finances 40% of its capital structure with debt at a 6% interest rate. No growth is expected. Assume the corporate tax rate is 25%. Use the MM model with corporate taxes to determine the value of the levered firm. Enter your answer in billions. For example, an answer of $1 billion should be entered as 1, not 1,000,000,000. Round your answer to the nearest whole number.

VU = Value of the unlevered firm VL = Value of the levered firm T = Corporate tax rate D = Market value of debt Debt = $600 billion × 40% = $240 billion VL = VU + TD = $600 billion + 0.25($240 billion) = $660 billion.

DeYoung Entertainment Enterprises is considering replacing the latex molding machine it uses to fabricate rubber chickens with a newer, more efficient model. The current machine has a book value of $550,000 and is being depreciated by $110,000 per year over its remaining useful life of 5 years. The current machine would be worn out and worthless in 5 years, but DeYoung can sell it now to a Halloween mask manufacturer for $165,000. If DeYoung doesn't replace the current machine, it will have no salvage value at the end of its useful life. The new machine has a purchase price of $825,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $105,000. The applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52%, and 5.76%. Being highly efficient, it is expected to economize on electric power usage, labor, and repair costs, and, most importantly, to reduce the number of defective chickens. In total, an annual savings of $195,000 will be realized if the new machine is installed. The company's marginal tax rate is 25% and the project cost of capital is 15%. a What is the after-tax initial cash flow if the new machine is purchased and the old one is replaced? Round your answer to the nearest dollar. Cash outflow, if any, should be indicated by a minus sign. $ b What is the incremental depreciation tax shield each year (i.e., the change taxes due to the change in depreciation expenses) if the replacement is made? (Hint: First calculate the annual depreciation expense for the new machine and compare it to the depreciation on the old machine.) Do not round intermediate calculations. Round your answers to the nearest dollar. Negative values, if any, should be indicated by a minus sign. Year Incremental depreciationtax shield 1$ 2$ 3$ 4$ 5$ c What is the after-tax salvage value at Year 5? Do not round intermediate calculations. Round your answer to the nearest dollar. Negative value, if any, should be indicated by a minus sign. $ d What are the total incremental project cash flows in Years 0 through 5? What is the NPV? Do not round intermediate calculations. Round your answers to the nearest dollar. Negative values, if any, should be indicated by a minus sign. CF0$ CF1$ CF2$ CF3$ CF4$ CF5$ NPV$

a. New machine cost -$825,000 Salvage of old machine$165,000 Book value$550,000 Loss on sale of old machine-$385,000Tax effect of salvage = 0.25(Loss)$96,250 Total-$563,750 b. 12345 Old depreciation $110,000$110,000$110,000$110,000$110,000 Old tax shield: Depr. × T $27,500$27,500$27,500$27,500$27,500 Basis$825,000 MACRS depreciation rate 20.00%32.00%19.20%11.52%11.52% New depreciation $165,000$264,000$158,400$95,040$95,040 New tax shield: Depr. × T $41,250$66,000$39,600$23,760$23,760 Incremental depreciation $55,000$154,000$48,400-$14,960-$14,960 Incremental depreciation tax shield $13,750$38,500$12,100-$3,740-$3,740 c. Year 5 Salvage of new machine$105,000 Book value$47,520 Pre-tax profit from salvage$57,480 Tax on salvage$14,370 After-tax CF due to salvage$90,630 d. 012345 Initial cash flow-$563,750 Annual pre-tax savings$195,000$195,000$195,000$195,000$195,000 Annual after-tax savings$146,250$146,250$146,250$146,250$146,250 Incremental depreciation tax shield$13,750$38,500$12,100-$3,740-$3,740 After-tax CF due to salvage $90,630 Total project CF-$563,750$160,000$184,750$158,350$142,510$233,140 NPV = $16,588

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

change in NWC

Accounts payable and accrued liabilities represent obligations that the firm must pay off. Assuming everything else holds constant, if they increase, the firm's AFN will

decrease

One of the most important financial management activities that a 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. True or False: 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 Capital budgeting is the process of planning and controlling investments in assets that are expected to produce cash flows for more than one year. Capital budgeting transactions require the making of capital expenditures. Capital expenditures are cash payments for assets that are expected to generate cash flows for periods greater than one year. These expenditures are in contrast to normal operating expenditures, which pay for assets that are expected to generate cash flows for periods of one year or less.

What is one of the potential consequences of financing feedback that might cause the actual financing needs to be higher than initially thought? Financing feedback might

increase charges against net income, reducing the amount of available internally generated funds.

The factory that the project will use could be used for another project that is expected to have a slightly positive net present value (NPV).

opportunity cost

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

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

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

opportunity cost

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

sunk cost

Projects W and X are mutually exclusive projects. Their cash flows and NPV profiles are shown as follows. Year Project W Project X 0 -$1,000 -$1,500 1 $200 $350 2 $350 $500 3 $400 $600 4 $600 $750 If the weighted average cost of capital (WACC) for each project is 6%, do the NPV and IRR methods agree or conflict?

the methods conflict Timing and size differences between mutually exclusive projects lead to conflicts between the 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 6%, project X has a higher NPV because its NPV profile is higher than project W's NPV profile. The NPV method would choose project X over project W. Therefore, the NPV and IRR methods conflict.

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 all of the following except: The project's fixed-asset expenditures The project's financing costs The project's depreciation expense Changes in net working capital associated with the project

the projects financing costs 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 net present value (NPV). If cash outflows from interest or dividends payments were included, financing costs would be double-counted. 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. Even though depreciation is a noncash expense, it should be included in the estimate of cash flows associated with a particular project because it is a tax-deductible expense and will reduce the amount of taxes paid. 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. 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, it 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. 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, PVt=CFt+1/(r - g), to estimate the terminal value.

Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $90 a share with an annual dividend of $7.20 a share. Ignoring flotation costs, what is the company's cost of preferred stock, rps? Round your answer to the nearest whole number.

Pps = $90; Dps = $7.20; F = 0%; rps = ? rps=Dps/(Pps(1-F))=$7.20/($90(1-0.0))=8%. cost of preferred stock

Your division is considering two investment projects, each of which requires an up-front expenditure of $28 million. You estimate that the cost of capital is 11% and that the investments will produce the following after-tax cash flows (in millions of dollars): Year Project A Project B 1 5 20 2 10 10 3 15 8 4 20 6 a. What is the regular payback period for each of the projects? Round your answers to two decimal places. Project A: years Project B: years b. What is the discounted payback period for each of the projects? Do not round intermediate calculations. Round your answers to two decimal places. Project A: years Project B: years c. Calculate the NPV of the two projects. Do not round intermediate calculations. Round your answers to the nearest cent. Project A: $ Project B: $ Calculate the IRR of the two projects. Do not round intermediate calculations. Round your answers to two decimal places. Project A: % Project B: % If the two projects are independent and the cost of capital is 11%, which project or projects should the firm undertake? 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? The firm should undertake !Project A! e. If the two projects are mutually exclusive and the cost of capital is 15%, which project should the firm undertake? The firm should undertake !Project B! f. What is the crossover rate? Round your answer to two decimal places. % g. If the cost of capital is 11%, what is the modified IRR (MIRR) of each project? Do not round intermediate calculations. Round your answers to two decimal places. Project A: % Project B: %

a. Payback A (cash flows in thousands): Annual Period Cash Flows Cumulative 0 -$28,000 -$28,000 1 5,000 -23,000 2 10,000 -13,000 3 15,000 2,000 4 20,000 22,000 PaybackA = 2 + $13,000/$15,000 = 2.87 years. Payback B (cash flows in thousands): Annual Period Cash Flows Cumulative 0 -$28,000 -$28,000 1 20,000 -8,000 2 10,000 2,000 3 8,000 10,000 4 6,000 16,000 PaybackB = 1 + $8,000/$10,000 = 1.80 years. b. Discounted Payback A (cash flows in thousands): Annual Discounted @11% Period Cash Flows Cash Flows Cumulative 0 -$28,000 -$28,000.00 -$28,000.00 1 5,000 4,504.50 -23,495.50 2 10,000 8,116.22 -15,379.27 3 15,000 10,967.87 -4,411.40 4 20,000 13,174.62 8,763.22 Discounted PaybackA = 3 + $4,411.40/$13,174.62 = 3.33 years. Discounted Payback B (cash flows in thousands): Annual Discounted @11% Period Cash Flows Cash Flows Cumulative 0 -$28,000 -$28,000.00 -$28,000.00 1 20,000 18,018.02 -9,981.98 2 10,000 8,116.22 -1,865.76 3 8,000 5,849.53 3,983.77 4 6,000 3,952.39 7,936.16 Discounted PaybackB = 2 + $1,865.76/$5,849.53 = 2.32 years. c. NPVA = $8,763,219;IRRA = 22.16%. NPVB = $7,936,159;IRRB = 27.42%. Both projects have positive NPVs, so both projects should be undertaken. d. At a discount rate of 5%, NPVA = $15,243,813. At a discount rate of 5%, NPVB = $11,964,829. At a discount rate of 5%, Project A has the higher NPV; consequently, it should be accepted. e. At a discount rate of 15%, NPVA = $5,207,071. At a discount rate of 15%, NPVB = $5,643,390. At a discount rate of 15%, Project B has the higher NPV; consequently, it should be accepted. f. (cash flows in millions of dollars) Project Δ = Year CFA - CFB 0 $0 1 -15 2 0 3 7 4 14 IRRΔ = Crossover rate = 13.53%. g. Use 3 steps to calculate MIRRA @ r = 11%: Step 1: Calculate the NPV of the uneven cash inflow stream, so its FV can then be calculated. With a financial calculator, enter the cash inflow stream into the cash flow registers being sure to enter 0 for CF0, then enter I/YR = 11, and solve for NPV = $36,763,219. Step 2: Calculate the FV of the cash inflow stream as follows: Enter N = 4, I/YR = 11, PV = -36,763,219, and PMT = 0 to solve for FV = $55,809,155. Step 3: Calculate MIRRA as follows: Enter N = 4, PV = -28,000,000, PMT = 0, and FV = 55,809,155 to solve for I/YR = 18.82%. Use 3 steps to calculate MIRRB @ r = 11%: Step 1: Calculate the NPV of the uneven cash inflow stream, so its FV can then be calculated. With a financial calculator, enter the cash inflow stream into the cash flow registers being sure to enter 0 for CF0, then enter I/YR = 11, and solve for NPV = $35,936,159. Step 2: Calculate the FV of the cash flow stream as follows: Enter N = 4, I/YR = 11, PV = -35,936,159, and PMT = 0 to solve for FV = $54,553,620. Step 3: Calculate MIRRB as follows: Enter N = 4, PV = -28,000,000, PMT = 0, and FV = 54,553,620 to solve for I/YR = 18.15%. According to the MIRR approach, if the 2 projects were mutually exclusive, Project A would be chosen because it has the higher MIRR. This is consistent with the NPV approach. Note: While the calculations above show values rounded to the nearest cent and to the nearest dollar, unrounded values should be used to calculate the required values.

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 10%. Using the replacement chain approach to project analysis, by how much would the value of the company increase if it accepted the better machine? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answer to two decimal places. $ _____million What is the equivalent annual annuity for each machine? Do not round intermediate calculations. Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answers to two decimal places. Machine A: $ ______million Machine B: $ _____ million

A: (Millions of Dollars) Periods 0 10% 1 2 3 4 5 6 7 8 Cash flows -11 5 5 5 5 5 5 5 5 -11 -6 Machine A's simple NPV is calculated as follows: Enter CF0 = -11; CF1-4 = 5. Then enter I/YR = 10, and press the NPV key to get NPVA = $4.849 million. However, this does not consider the fact that the project can be repeated again. Enter these values into the cash flow register: CF0 = -11; CF1-3 = 5; CF4 = -6; CF5-8 = 5. Then enter I/YR = 10, and press the NPV key to get Extended NPVA = $8.161 ≈ $8.16 million. B: (Millions of Dollars) Periods 0 10% 1 2 3 4 5 6 7 8 Cash flows -13 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 For Machine B's NPV, enter these cash flows into the cash flow register, along with the interest rate, and press the NPV key to get NPVB = $5.672 ≈ $5.67 million. Machine A is the better project and will increase the company's value by $8.16 million. The EAA of Machine A is found by first finding the PV: N = 4, I/YR = 10, PMT = 5, FV = 0; solve for PV = $15.849. The NPV is $15.849 - $11 = $4.849 million. We convert this to an equivalent annual annuity by inputting: N = 4, I/YR = 10, PV = -4.849, FV = 0, and solve for PMT = EAAA = $1.530 ≈ $1.53 million. For Machine B, we already found the NPV of $5.672 million. We convert this to an equivalent annual annuity by inputting: N = 8, I/YR = 10, PV = -5.672, FV = 0, and solve for PMT = EAAB = $1.063 ≈ $1.06 million. Again, the EAA method demonstrates that Machine A is the better project since EAAA > EAAB.

Smiley Corporation's current sales and partial balance sheet are shown below. This year Sales $ 10,000 Balance Sheet: Liabilities Accounts payable $ 2,000 Notes payable $ 3,000 Accruals $ 1,400 Total current liabilities $ 6,400 Long-term bonds $ 2,000 Total liabilities $ 8,400 Common stock $ 1,500 Retained earnings $ 2,500 Total common equity $ 4,000 Total liabilities & equity $ 12,400 Sales are expected to grow by 10% next year. Assuming no change in operations from this year to next year, what are the projected spontaneous liabilities? Do not round intermediate calculations. Round your answer to the nearest dollar.

Accounts payable/Sales = $2,000/$10,000 = 20% Accruals/Sales = $1,400/$10,000 = 14% Projections: Sales = (1 + 0.10)($10,000) = $11,000 Accounts payable = 20%($11,000) = $2,200 Accruals = 14%($11,000) = $1,540 Total spontaneous liabilities = $3,740 projected spontaneous liabilities

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. _________ represent the effect of the current project's acceptance on cash flows of the firm's other projects. Because they depend on whether the current project is accepted, they should be included in the analysis.

Cannibalization A sunk cost is a cash outlay that has already occurred and can't 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. 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. 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.

Messman Manufacturing will issue common stock to the public for $40. The expected dividend and the growth in dividends are $3.00 per share and 4%, respectively. If the flotation cost is 15% of the issue's gross proceeds, what is the cost of external equity, re? Round your answer to two decimal places.

P0 = $40; D1 = $3.00; g = 4%; F = 15%; re = ? re = [D1/((1 - F)P0)] + g = [$3/((1 - 0.15)($40))] + 0.04 = 12.82%. the cost of equity and flotation costs

Green Moose Industries reported sales of $820,000 at the end of last year; but this year, sales are expected to grow by 6%. Green Moose expects to maintain its current profit margin of 24% and dividend payout ratio of 20%. The firm's total assets equaled $450,000 and were operated at full capacity. Green Moose's balance sheet shows the following current liabilities: accounts payable of $75,000, notes payable of $35,000, and accrued liabilities of $70,000. Based on the AFN (Additional Funds Needed) equation, what is the firm's AFN for the coming year?

Green Moose's sales are expected to increase by $49,200 ($820,000 x 0.06), to $869,200. The firm's spontaneous liabilities are its accounts payable and accrued liabilities. Remember that notes payable is not a spontaneous liability. The firm's spontaneous liabilities equal $145,000 ($75,000 + $70,000). Now you can use these values to solve for the firm's AFN, as follows: AFN = Required Increase in Assets - Increase in Spontaneous Liabilities−Increase in Retained Earnings = ((Ao/So))ΔS-(Lo/So)ΔS-[S1×M×(1 - Payout Ratio)] =$450,000/$820,000×$49,200-($145,000/$820,000)×$49,200-$869,200×0.24×(1−0.20) = −$148,586 Green Moose actually doesn't need to issue any external capital at all. It has an excess of funds available to invest in assets, as shown by the negative AFN. Additional Funds Needed (AFN)

Which of the following are assumptions of the sustainable (self-supporting) growth model? I. The firm pays out a constant proportion of its earnings as dividends. II. The firm will not issue any new common stock next year. III. The firm's total asset turnover ratio remains constant. IV. The firm's liabilities and equity must increase at the same rate. V. The firm must issue the same number of new common shares that it issued last year. VII. The firm maintains a constant ratio of assets to equity. VIII. The firm maintains a constant net profit margin.

I, II, III, VII, VIII

For which of the following reasons are capital budgeting decisions important to a business organization? Check all that apply. I Capital investments tend to be expensive. II Capital investments are easily and quickly reversed. III Capital investments affect the firm's long-term performance and profitability.

I, III Capital budgeting decisions are critical to the long-term performance and success of a business organization. This is because capital investments •tend to involve sizeable 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.

Which of the following statements about the financial planning process are true? I. A firm's performance-based compensation system should be focused on an employee's ability to create short-run profits because this will ultimately keep the firm's stock price the highest. II. Once a firm's forecasted financial statements are prepared, the firm must determine how much capital it will need to support these plans. III. Management must monitor operations after implementing a financial plan to detect deviations from the plan and adjust accordingly. IV. The firm will need to calculate the amount of funds it will be able to generate internally. If that is not enough capital to support the financial plan, the firm will need to raise external funds to support the financial plan or the plan will have to be revised to focus on the highest value opportunities. V. Management must monitor operations after implementing a financial plan to detect deviations from the plan and adjust accordingly. VI. Firms should use a performance-based management compensation system that is based on a manager's ability to achieve short-run success.

II, III, IV, V

Because of its excess funds, Green Moose Industries is thinking about raising its dividend payout ratio to satisfy shareholders. Green Moose could pay out 91.2% of its earnings to shareholders without needing to raise any external capital. (Hint: What can Green Moose increase its dividend payout ratio to before the AFN becomes positive?)

Much of the hard work for this problem was done to answer the previous question. You already know how much in total assets Green Moose needs to support this year's sales, and you know how much spontaneous liabilities that it is expected to produce. Now you can use the AFN equation to find out what dividend payout ratio would lead the AFN to equal zero, as follows: AFN = Required Increase in Assets−Increase in Spontaneous Liabilities−Increase in Retained Earnings $0 = A0/S0ΔS − L0/S0ΔS −(S1×M×(1−Payout Ratio)) $0 =($450,000/$820,000×$49,200)−($145,000/$820,000×$49,200)−($869,200×0.24×(1−Payout Ratio)) Payout Ratio = 0.912, or 91.2% Green Moose can pay up to 91.2 of its earnings as dividends and still not need to raise external capital.

Suppose the Schoof Company has this book value balance sheet: Current assets $30,000,000 Current liabilities$20,000,000 Notes payable 10,000,000 Fixed assets 70,000,000 Long-term debt 30,000,000 Common stock (1 million shares) 1,000,000 Retained earnings 39,000,000 Total assets$100,000,000 Total liabilities and equity$100,000,000 The notes payable are to banks, and the interest rate on this debt is 11%, 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 15-year maturity. The going rate of interest on new long-term debt, rd, is 10%, 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. Do not round intermediate calculations. Round the monetary values for final answers to the nearest dollar and final answer percentage values to two decimal places. Short-term debt $____ ____% Long-term debt ____ ____ Common equity ____ ____ Total capital $____ ____%

Note: While the calculations above show values to 2 and 4 decimal places, unrounded values should be used to calculate the required values. The book and market value of the notes payable are $10,000,000. The bonds have a value of V=$70([1/0.10] - [1/(0.10*(1+0.10)^15 )]) + $1,000((1+0.10)^-15) =$70(7.6061) + $1,000(0.2394)=$532.43 + $239.39 = $771.81761481. Alternatively, using a financial calculator, input N = 15, I/YR = 10, PMT = -70, and FV = -1,000 to arrive at a PV = $771.81761481. The total market value of the long-term debt is 30,000($771.81761481) = $23,154,528 (rounded to the nearest dollar). There are 1 million shares of stock outstanding, and the stock sells for $50 per share. Therefore, the market value of the equity is $50,000,000. The market value capital structure is thus: Short-term debt $10,000,000 12.03% Long-term debt $23,154,528 27.85% Common equity $50,000,000 60.13% Total capital $83,154,528 100.00%

Summerdahl Resort's common stock is currently trading at $37 a share. The stock is expected to pay a dividend of $1.00 a share at the end of the year (D1 = $1.00), and the dividend is expected to grow at a constant rate of 8% a year. What is the cost of common equity? Round your answer to two decimal places.

P0 = $37; D1 = $1.00; g = 8%; rs = ? rs = + g = ($1.00/$37.00) + 0.08 = 10.70%. cost of equity: dividend growth

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 32 million shares before the recap. What is P (the stock price after the recap)? Do not round intermediate calculations. Round your answer to the nearest cent.

PPost = (VopNew - Dold)/nprior = ($900 million - $0)/32 million shares = $28.13. Note: this is the price after issuing the new debt but before undertaking the repurchase. Also, SPost = (1 - wd)(VopNew) = (1 - 1/3)($900 million) = $600 million. This gives the ending equity value, which isn't asked for in this problem.

As a firm grows, it must support increases in revenue with new investments in assets. The self-supporting, or sustainable, growth model helps a firm assess how rapidly it can grow, while maintaining a balance between its cash outflows (increases in noncash assets) and inflows (funds resulting from increases in liabilities or equity). Consider the following case of Blue Elk Manufacturing: Blue Elk Manufacturing has no debt in its capital structure and has $100,000,000 in assets. Its sales revenues last year were $70,000,000 with a net income of $3,500,000. The company distributed $115,000 as dividends to its shareholders last year. Given the information above, what is Blue Elk Manufacturing's sustainable growth rate?

The self-supporting, or sustainable, growth rate is the maximum steady rate of growth a firm can achieve without changing the amount of leverage in its capital structure. The firm may need to raise external financing, but it will be able to do so in keeping with its capital structure and desired amount of leverage. Blue Elk Manufacturing has no debt in its capital structure and is financed 100% with equity; therefore, its assets-to-equity ratio (A/E) is 1.00. The sustainable, or self-generating, growth rate (gg) is calculated using the following formula: g = M×(1−POR)×S0/Aₒ* − Lₒ*-(M×(1−POR)×S0)M×1−POR×S0) where, g = the self-supporting growth rate, or the maximum growth rate that a firm could achieve if it had no access to external capital M = the firm's net profit margin, or the percentage of net income retained from a firm's net sales during a particular period of time POR = the firm's (dividend) payout ratio, or percentage of net income distributed to the firm's shareholders as cash dividends; can be calculated by dividing the firm's dividends per share (DPS) by its earnings per share (EPS) S0 = the firm's most recent net sales A0 = the firm's most recent amount of operating assets L0 = the firm's most recent amount of spontaneous liabilities, or sum of accounts payable and accruals The individual components of this formula are calculated as follows: Profit Margin (M)= Net Income/Sales = $3,500,000/$70,000,000 = 0.0500, or 5% Dividend Payout Ratio (POR)= Dividends/Net Income = $115,000/$3,500,000 = 0.0329, or 3.29% Asset Turnover Ratio =Sales/Assets Inverse of Asset Turnover Ratio (A/S) = Assets/Sales =$100,000,000/$70,000,000 = 1.4286 g=0.0500×(1−0.0329)×(1.0)/1.4286 −(0.0500×(1−0.0329)×(1.0)) = 0.0350, or 3.50%

Quillpen Company is unlevered and has a value of $25 billion. An otherwise identical but levered firm finances 45% of its capital structure with debt. Under the MM zero-tax model, what is the value of the levered firm? Enter your answer in billions. For example, an answer of $1 billion should be entered as 1, not 1,000,000,000. Round your answer to the nearest whole number.

VU = Value of the unlevered firm VL = Value of the levered firm With zero debt, the MM model is: VL = VU:VL = VU = $25 billion.

At year-end 2021, Wallace Landscaping's total assets, all of which are used in operations, were $1.55 million, and its accounts payable were $350,000. Sales, which in 2021 were $2.5 million, are expected to increase by 30% in 2022. Total assets and accounts payable are proportional to sales, and that relationship will be maintained. Wallace typically uses no current liabilities other than accounts payable. Common stock amounted to $600,000 in 2021, and retained earnings were $200,000. Wallace has arranged to sell $70,000 of new common stock in 2022 to meet some of its financing needs. The remainder of its financing needs will be met by issuing new long-term debt at the end of 2022. (Because the debt is added at the end of the year, there will be no additional interest expense due to the new debt.) Its net profit margin on sales is 3%, and 40% of earnings will be paid out as dividends. a. What was Wallace's total long-term debt in 2021? $_____ b. What were Wallace's total liabilities in 2021? $______ c. How much new long-term debt financing will be needed in 2022? (Hint: AFN - New stock = New long-term debt.) $______

While the calculations below show values to the nearest dollar and 2 and 4 decimal places, unrounded values should be used in your calculations. a. Total liability and equity= accounts payable + long term debt + common stock + retained earnings $1,550,000 = $350,000 + Long-term debt + $600,000 + $200,000 Long-term debt = $400,000 b. Total liab. = Accounts payable + Long-term debt = $350,000 + $400,000 = $750,000 c. Assets/Sales (A0 */S0) = $1,550,000/$2,500,000 = 62.00% L0 */Sales = $350,000/$2,500,000 = 14.00% 2022 Sales = (1.30)($2,500,000) = $3,250,000 AFN = (A0 */S0)ΔS - (L0 */S0)ΔS — (M)(S1)(1 — Payout ratio) - New common stock = (0.6200)($750,000) - (0.1400)($750,000) - (0.03)($3,250,000)(0.60)- $70,000 = $465,000 - $105,000 - $58,500 - $70,000 = $231,500 long term financing need

The Campbell Company is considering adding a robotic paint sprayer to its production line. The sprayer's base price is $970,000, and it would cost another $20,500 to install it. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $564,000. The MACRS rates for the first three years are 0.3333, 0.4445, and 0.1481. The machine would require an increase in net working capital (inventory) of $19,000. The sprayer would not change revenues, but it is expected to save the firm $383,000 per year in before-tax operating costs, mainly labor. Campbell's marginal tax rate is 25%. (Ignore the half-year convention for the straight-line method.) Cash outflows, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answers to the nearest dollar. a What is the Year-0 net cash flow? $ b What are the project recurring cash flows in Years 1, 2, and 3? Year 1:$ Year 2:$ Year 3:$ c What is the additional Year-3 cash flow (i.e, the after-tax salvage and the return of working capital)? $ d If the project's cost of capital is 12%, what is the NPV of the project? $

While the calculations below show values to the nearest dollar, unrounded values should be used in your calculations. a. The net initial cash flow is: Machine price -$970,000 Installation cost -$20,500 NWC required -$19,000 Year 0 CF -$1,009,500 b. The project recurring cash flows are: First, calculate deprecation basis, annual depreciation expenses, and the annual tax savings due to depreciation. The tax rate is 25%. Basis: Machine cost$970,000 Installation expense $20,500 Depreciation basis $990,500 Depreciation tax savings: Year 1 Year 2 Year 3 Year 4 Depreciation rates 33.330% 44.450% 14.810% 7.410% Depreciation expense $330,134 $440,277 $146,693 $73,396 Depreciation tax savings $82,533 $110,069 $36,673 Second, calculate the after-tax operating savings. Year 1 Year 2 Year 3 Before-tax operating savings $383,000 $383,000 $383,000 Tax on operating savings $95,750 $95,750 $95,750 After-tax operating savings $287,250 $287,250 $287,250 Third, calculate the total annual operating cash flows. Total annual after-tax operating CF Year 1 Year 2 Year 3 After-tax savings $287,250 $287,250 $287,250 Depreciation tax savings $82,533 $110,069 $36,673 Net operating cash flow $369,783 $397,319 $323,923 c. The additional Year-3 cash flows are: First, find the remaining book value: Salvage value calculation Additional Year-3 CF Depreciation basis $990,500 Total depreciation expense in Years 1 through 3 $917,104 Remaining book value $73,396 Second, calculate the tax on the salvage value: Salvage value $564,000 Remaining book value $73,396 Salvage minus remaining book value $490,604 Tax on gain $122,651 Third, calculate the Year-3 additional cash flow: Salvage value $564,000 Tax on salvage gain $122,651 NWC recovery $19,000 Additional Year-3 CF $460,349 d. The cost of capital is 12%. The total annual cash flows are: Year 0 Year 1 Year 2 Year 3 Year 0 CF ($1,009,500) Net operating CF 1$369,783 2$397,319 3$323,923 Additional Year-3 CF 3$460,349 Total CF ($1,009,500) $369,783 $397,319 $784,272 The NPV is $195,633

Along with the sensitivity analysis, Anusha is including a scenario analysis for the project in her report, giving the probability of the project generating a negative NPV. Her report includes the following information about the scenario analysis: Data Collected Outcome NPVj Probability (Pj) Pessimistic-$5.62 million0.35 Most likely$7.94 million0.30 Optimistic$16.45 million0.35 Probability Data for z z 0.03 0.06 0.09 -1.0 0.1515 0.1446 0.1379 -0.8 0.2033 0.1949 0.1867 -0.6 0.2643 0.2546 0.2451 -0.4 0.3336 0.3228 0.3121 Complete the missing information in Anusha's report: (Note: Round your answers to two decimal places.) The expected net present value of the project is !$6.17 million .Standard deviation of the net present value (the NPV of the project is likely to vary by) !$9.30 million.Assuming that probability distribution is normal, the value of z is !-0.66 .Thus, the project has a !25.46% chance to generate an NPV of less than $0.

You should have begun by calculating the expected NPV, using the following formula: Expected NPV = ∑(NPVj×Pj) Using the available data, the expected NPV is as follows: Expected NPV = (0.35×-$5.62 million) + (0.30×$7.94 million) + (0.35×$16.45 million) = $6.17million Next, you should have calculated the standard deviation, using the following formula: ? ?N/A? ? Using the expected NPV and the relevant data, the standard deviation is as follows: σ = √[(-$5.62 million - $6.17 million)2×0.35] + [($7.94 million - $6.17 million)2×0.30] + [($16.45 million - $6.17 million)2×0.35] = √86.5787 = $9.30 million On the next step you should have calculated the number of standard deviations NPV is away from its expected NPV. You should have used the following equation for the value of z: z = (NPV - Expected NPV) / σ Here, by setting the NPV to zero you can find the probability that the project will generate a negative NPV: z = ($0 - $6.17 million)/$9.30 million = −0.6634 , or −0.66 This means that the chance of the project's NPV becoming $0 is -0.6634, or -0.66 standard deviations below the mean on the standard normal probability distribution. Finally, you should have matched the value of z with its associated probability in the data table. The answer is a value of 0.2546, which means that there is a 25.46% chance that the actual NPV for the project will be less than $0.

Several factors affect a firm's need for external funds. Which of the following factors are likely to increase a firm's need for external capital—that is, its AFN (additional funds needed)? Check all that apply. a. The firm switches its supplier for the majority of its raw materials. The new supplier offers less favorable credit terms and thus reduces the trade credit available to the firm, resulting in a reduction in accounts payable. b. The firm increases its dividend payout ratio. c. The firm improves its production system and increases its profit margin.

a and b

A negatively-signed AFN value represents

a surplus of internally generated funds that can be invested in physical or financial assets or paid out as additional dividends.

include in the analysis? a The new project is expected to reduce sales revenue for one of the company's other product lines. b 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. c Bumbly spent nearly $1.1 million in market research to develop new product ideas. d Many of the new sales from this project will be made on credit, causing accounts receivable to increase. e The factory that the project will use could be used for another project that is expected to have a slightly positive net present value (NPV). f The new project is likely to have a negative impact on the company's existing related products. g The project will use some raw materials that the firm has in its inventory and can sell at a certain price. h Bumbly invested in research and development to come up with this new product. i Most of the purchases for this project will be made using cash, causing cash in the company to decrease.

a,b,d,e A project that launches a new product can impact the firm's cash flows if customers substitute the new product for the firm's existing products. This negative effect on the firm's cash flows is referred to as cannibalization and should be included as a decrease to the cash flows expected from the new product. The used equipment does not have an explicit cost for the firm, but because a used-equipment dealer is willing to buy the equipment, there is an implicit cost. The firm is forgoing cash flows from the equipment's sale, which is an opportunity cost. If the factory could be used for another project, then there is another opportunity cost associated with this project. Money previously spent 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. Sunk costs should not be included in the analysis. If new sales are made on credit, accounts receivable will increase. As a result, even though the firm will generate a lot of new sales revenue, some of it will be tied up in working capital (accounts receivable) rather than being received as cash immediately. If the purchases for the project are made using cash, the company's cash will decrease and lead to changes in current assets. These changes in NWC should be included in the project analysis.

a. Describes a firm's market segments, product lines, sales and marketing strategies, production processes, and logistics, as well as projected timeline and list of who is responsible for each task. AND Provides a forecast of a firm's free cash flows, usually for the next five years, with greater specificity for the first year and less detail for each succeeding year. b. Describes how a firm will allocate its forecasted free cash flow. AND Forecasts the additional sources of monies required to fund the company's sales, marketing, and production processes. c. Describes specific targets for the mix of debt and equity used to finance a firm d. Sets forth specific targets for cash for cash distributions to the firm's shareholders.

a. operating plan b. financial plan c. capital structure d. dividend policy

If projects are mutually exclusive, only one project can be chosen. The internal rate of return (IRR) and the net present value (NPV) methods will not always choose the same project. If the crossover rate on the NPV profile is below the horizontal axis, the methods will _____ agree. 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 ____ agree.

always, always If the crossover rate on the NPV profile is below the horizontal axis, the project with the higher NPV is the same as the project that has the higher IRR (horizontal intercept), so the NPV method and the IRR method will always agree in this case. 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 weighted average cost of capital, 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.

You are the most creative analyst for Saltwater Logistics Corp., and your admirers want to see you work your analytical magic once more. 2016 Actual Results 2017 Initial Forecast Net sales $20,000 $24,000 Cost of goods sold (16,000) (19,200) Gross profit $4,000 $4,800 Fixed operating costs except depreciation (1,000) (1,200) Depreciation (400) (480) Earnings before interest and taxes $2,600 $3,120 Interest (400) (400) Earnings before taxes $2,200 $2,720 Taxes (880) (1,088) Net income $1,320 1,632 Common dividends (712.8) (712.8) Addition to retained earnings $607.2 $919.2 Earnings per share $66 $81.6 Dividends per share $35.64 $35.64 Number of common shares (millions) 20.0 20.0 Which of the following are assumptions made by the initial income statement forecast? a. Saltwater Logistics Corp. will be issuing additional debt in the coming year. b. The forecasted increase in net sales is 20%. c. The cost of sales percentage for Saltwater Logistics Corp. will decrease due to economies of scale. d. No excess capacity currently exists. e. Saltwater Logistics Corp. will be issuing additional shares of common stock in the coming year. f. Spontaneously generated funds will sufficiently cover any financing needs.

b, d, f explanation: The forecasted percentage increase in sales is determined by dividing the difference between the forecasted sales and the actual current sales by the actual current sales: $24,000−$20,000/$20,000=20%. This is the percentage by which Saltwater Logistics Corp. predicts its net sales will grow in the coming year. Because, in the long run, both variable and fixed operating costs increase proportionately with sales, you can discern that the company is currently operating at full capacity It will need to increase its capacity to meet future sales forecasts. You can also assume that no additional external financing will be required to facilitate the increased level of sales, which you can see from the lack of movement in both interest expense and common dividends distributed. This assumes that spontaneously generated funds are sufficient to cover any increases in capacity.

The new project is expected to reduce sales revenue for one of the company's other product lines.

cannibalization

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

cannibalization

Many of the new sales from this project will be made on credit, causing accounts receivable to increase.

change in NWC

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. Which of the following are examples of a capital budgeting project? Check all that apply. I Alexander Enterprises Inc.'s investment in employee education and training programs II Cambridge Equipment Co.'s $25,000 investment in short-term marketable securities III Collins Construction Co.'s investment in a research and development program

i, III 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. Therefore, Alexander Enterprises Inc.'s investment in employee education and training programs constitutes a capital budgeting project, as does Collins Construction Co.'s investment in a research and development program. 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 last beyond one year or one operating cycle. Therefore, Cambridge Equipment Co.'s $25,000 investment in short-term marketable securities does not constitute a capital budgeting project.

When there is a conflict, a key to resolving this it is the assumed reinvestment rate. The IRR calculation assumes that intermediate cash flows are reinvested at the ___________ , and the NPV calculation implicitly assumes that the rate at which cash flows can be reinvested is the __________ .

internal rate of return, required rate of return 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.

Anusha is a risk analyst. She is conducting a sensitivity analysis to evaluate the riskiness of a new project that her company is considering investing in. Her risk analysis report includes the sensitivity curve shown on the graph. This curve implies that the project is not very sensitive to changes in cost of capital. The project's NPV is likely to stay _______ if the cost of capital increases to 15%.

positive The steeper the slope of the sensitivity curve, the more sensitive the expected value is to the independent variable. In this case, the expected value is the NPV, and the independent variable is cost of capital. The sensitivity curve of the NPV cost of capital is not very steep. This implies that the project is not very sensitive to changes in cost of capital. The project's NPV is likely to stay positive and decrease slightly if the cost of capital increases to 15%.

LL Incorporated's currently outstanding 10% coupon bonds have a yield to maturity of 7.8%. LL believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 25%, what is LL's after-tax cost of debt? Round your answer to one decimal place.

rd(1 - T) = 0.078(0.75) = 5.9% after tax cost of debt

When there is a conflict, a key to resolving this it is the assumed reinvestment rate. The NPV calculation implicitly assumes that intermediate cash flows are reinvested at the__________ , and the IRR calculation assumes that the rate at which cash flows can be reinvested is the _________ .

required rate of return, internal rate of return 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.

Different techniques for analyzing project risk require different input variables and assumptions. The procedure in which one of the elements (or variables) affecting a project's expected value is changed to study its effect on the expected value is called _______ analysis.

sensitivity Sensitivity analysis is a risk analysis technique that identifies changes in the expected net present value (NPV) or expected rate of return as individual variables in the model are changed one at a time. Because cash flows and other assumptions are estimates of future events, it's helpful to change the variables by certain percentage points above and below the estimates to determine the sensitivity (riskiness) of the variable to the expected value. In this technique, to study its effect on the expected value, you change only one input variable at a time. When the results are plotted on a graph, a steep slope indicates high risk. The decision maker can review several what-if situations by analyzing the effect of different variables on the expected value. Scenario analysis, on the other hand, analyzes the effect of changes in a set of variables on the expected value.