Financial management

Texas Transport has five possible investment projects for the coming year. Each project is indivisible. They are: Project Investment (million) IRR A $ 6 18% B $10 15% C $ 9 20% D $ 4 12% E $ 3 24% The firm's weighted marginal cost of capital schedule is 12 percent for up to $6 million of investment; 16 percent for between $6 million and $18 million of investment; and above $18 million the weighted cost of capital is 18 percent. The optimal capital budget is

$0-6M IRR must be > 12% $6-18M IRR must be > 16% $18M+ IRR must be > 18% So, A C and E meet these requirements. Capital budget should be $18M

Baxter Inc. has a target capital structure of 30% debt, 15% preferred stock, and 55% common equity. The company's after-tax cost of debt is 7%, its cost of preferred stock is 11%, its cost of retained earnings is 15%, and its cost of new common stock is 16%. The company stock has a beta of 1.5 and the company's marginal tax rate is 35%. What is the company's weighted average cost of capital if retained earnings are used to fund the common equity portion?

(30%*7%)+(15%*11%)+(55%*15%) = 12.00%

uppose a U.S. importer purchases an Italian product today but will not pay for it for 90 days. The cost of the product today is 35,000 euros. The spot exchange rate today is .6233 euros per dollar. The importer creates a forward-market hedge. The 90-day forward rate is .6100 euros per dollar. The amount the U.S. importer will pay in 90 days is

1 / 0.6100 = 1.639344262 1.639344262 * 35,000 =57377

Suppose the current exchange rates are 1.3215 dollars per euro, and 84.19 yen per dollar. What is the current exchange rate between yen and euros?

1 / 84.19 = 0.118778952 1 / 1.3215 = 0.7567158532 0.118778952 * 07567158532 =0.0089881916 1 / 0.0089881916 = 111.257

You are in charge of one division of Yeti Surplus Inc. Your division is subject to capital rationing. Your division has 4 indivisible projects available, detailed as follows: Project Initial Outlay IRR NPV 1 2 million 18% 2,500,000 2 1 million 15% 950,000 3 1 million 10% 600,000 4 3 million 9% 2,000,000 If you must select projects subject to a budget constraint of 5 million dollars, which set of projects should be accepted so as to maximize firm value?

1 and 4 because they make the highest NPV

The spot exchange rate is 1.57 dollars per pound. The 30-day forward exchange rate is .6211 pounds per dollar. Therefore, pounds in the forward market are selling at a ________ to the current spot rate.

1/.6211 = 1.610046691 1.610046691 - 1.57 = 0.04 .04 Premium

A bottle of German wine costs $21 euros in Berlin. According to the purchasing power parity theory, what would the bottle sell for in New York if it costs the New York company $1.25 per bottle to transport the wine to the United States? Assume the exchange rate is $1.32 per euro.

21 * 1.32 = 27.72 27.72 + 1.25 = 28.97

DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the net present value of this project?

350,000 / (1.08)^1 + 325,000 / (1.08)^2 + 150,000 / (1.08)^3 + 180,000/(1.08)^4 = 854089.4003 854089.4003 - 750,000 = 104,089.4003

The 90-day forward exchange rate is .01073033 dollars per yen. If this forward rate represents a per year premium of 2.5% from the current spot rate, what is the current spot exchange rate?

365 / 90 = 4.055555556 .025 / 4.055555556 = .0061643836 1 - 0.0061643836 = 0.9938356164 0.9938356164 * 0.0173033 = 0.0106641841

Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's equivalent annual annuity?

450,000/(1.1125)^1 + 270,000/(1.1125)^2 + 270,000/(1.1125)^3 + 270,000/(1.1125)^4 + 200,000/(1.1125)^5 = 1112369.058 - 920,000 = 192369.0578 EAA = (NPV / (1 - (1+discount rate) ^ - life of project ) / discount rate ) Discount rate = .1125 Life of project = 5 NPV = 192369.0578 1-(1.1125)^-5 =.4131867632 4131867632 / .1125 = 3.672771228 192369.0578 / 3.672771228 = 52377.08691 52377.08691

Which of the following should NOT be considered when calculating a firm's WACC?

After-tax cost of accounts payable

The direct quote in New York is .015 dollar per Pakistani Rupee. The direct quote in Pakistan is 60 rupees per dollar. This imbalance in rates can be corrected by arbitrage. A trader will ________ rupees in New York and ________ rupees in Pakistan, causing the direct quote in New York to ________.

Buy; Sell; Increase

DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the internal rate of return of this project?

CF = -750,000 Cfo1 = 350,000 Cfo2 = 325,000 Cfo3 = 150,000 Cfo4 = 180,000 IRR > CPT 15.13%

Due to changes in regulatory requirements, the transactions costs associated with selling corporate securities increased by $1 per share. This change will:

Cause the cost of capital to increase

In general, which of the following rankings, from highest to lowest cost, is most accurate?

Cost of new common stock, cost of retained earnings, cost of preferred stock, cost of debt.

Johnson Production Company paid a dividend yesterday of $3.50 per share. The dividend is expected to grow at a constant rate of 10% per year. The price of KayCee's common stock today is $40 per share. If KayCee decides to issue new common stock, flotation costs will equal $4.00 per share. KayCee's marginal tax rate is 35%. Based on the above information, the cost of retained earnings is

D1 = 3.5 * 1.10 = 3.85 Pcs = 40 G = 0.10 (3.85 / 40 ) + 0.10 = 19.63%

Sentry Manufacturing paid a dividend yesterday of $5 per share (D0 = $5). The dividend is expected to grow at a constant rate of 8% per year. The price of Sentry Manufacturing's stock today is $29 per share. If Sentry Manufacturing decides to issue new common stock, flotation costs will equal $2.50 per share. Sentry Manufacturing's marginal tax rate is 35%. Based on the above information, the cost of new common stock is

D1 = 5.4 Flotation costs = 2.5 NPCS = 29 - 2.5 = 26.5 G = 0.08 (5.4 / 26.5) + 0.08 = 28.38%

JPR Company is financed 75 percent by equity and 25 percent by debt. If the firm expects to earn $30 million in net income next year and retain 40% of it, how large can the capital budget be before common stock must be sold?

First, you need to calculate your expected addition to retained earnings next year which equals the Net Income * Retention Rate. In this case, $30 million * 40% or $12.0 million is the projected increase in retained earnings. Second, since your capital structure is financed by 75% equity, we know that the $12.0 million will represent 75% of the new funds available for investment in your Capital Budget, so we can divide the $12.0 million by 0.75 to arrive at a Capital Budget of $16.0 million (if we assume that we are going to use all of the addition to retained earnings to finance investment or growth, and that is a valid assumption if you consider the growth factor from Chapter 8 that we use in the Dividend Valuation model). Thus we will need $3.0 million in additional debt financing to complete the Capital budget.

IMXP Corp. enters into a 30-day forward exchange contract to buy 113,540,000 yen for $100,000. Which of the following statements is true concerning this transaction?

IMXP will pay $100,000 and receive 113,540,000 yen 30 days from now.

Which of the following is true regarding the correct price of the forward contract?

If the quote is less than the computed price, the forward contract is undervalued. If the quote is greater than the computed price, the forward contract is overvalued.

Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. The firm's required rate of return for these projects is 10%. The net present value for Project A is

Net present value for Project A = -95000 + 65000/1.1 + 75000/1.1^2 Net present value for Project A = $ 26074

Interstate Appliance Inc. is considering the following 3 mutually exclusive projects. Projected cash flows for these ventures are as follows: Plan A Plan B Plan C Initial Initial Initial Outlay=$3,600,000 Outlay=$6,000,000 Outlay=$3,500,000 Cash Flow: Cash Flow: Cash Flow: Yr 1=$ -0- Yr 1=$4,000,000 Yr 1=$2,000,000 Yr 2= -0- Yr 2= 3,000,000 Yr 2= -0- Yr 3= -0- Yr 3= 2,000,000 Yr 3=2,000,000 Yr 4= -0- Yr 4= -0- Yr 4=2,000,000 Yr 5=$7,000,000 Yr 5= -0- Yr 5=2,000,000 If Interstate Appliance has a 12% cost of capital, what decision should be made regarding the projects above?

Plan C because 2M + 2M + 2M + 2M = 8M 8M - 3,500,000 = the most amount of $

A corporate investment manager needs to invest $1,000,000 for the next 6 months. The current nominal rate of interest in the United States is 5%, while the nominal rate of interest in Argentina is 8%. Which of the following statements is MOST correct?

The manager may decide to invest the funds in the United States due to the international Fisher effect, which suggests inflation in Argentina may make the extra interest income worth less in one year.

CrochetCo is considering an investment in a project which would require an initial outlay of $350,000 and produce expected cash flows in years 1-5 of $95,450 per year. You have determined that the current after-tax cost of the firm's capital (required rate of return) for each source of financing is as follows: Cost of Long-Term Debt 7% Cost of Preferred Stock 11% Cost of Common Stock 15% long-term debt currently makes up 25% of the capital structure, preferred stock 15%, and common stock 60%. What is the net present value of this project?

WACC = Weight of Debt *Cost of Long-Term Debt: + Weight of preferred stock*Cost of Preferred Stock + Weight of common stock*Cost of Common Stock WACC = 25%*7 + 15%*11 + 60%*15 WACC = 12.40% Net present value of this project = Annual Cash flow*PVIFA(rate,nper) - Initial Investment Net present value of this project = 95450*PVIFA(12.40%,5) - 350000 Net present value of this project = 95450*3.56933953 - 350000 Net present value of this project = - $ 9306.54

Valley Flights, Inc. has a capital structure made up of 40% debt and 60% equity and a tax rate of 30%. A new issue of $1,000 par bonds maturing in 20 years can be issued with a coupon of 9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity available for investment at this time, but can issue new common stock at a price of $45. The next expected dividend on the stock is $2.70. The dividend for the firm is expected to grow at a constant annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00 per share. The company has the following independent investment projects available: Project Initial Outlay IRR 1 $100,000 10% 2 $ 10,000 8.5% 3 $ 50,000 12.5% Which of the above projects should the company take on?

We need to compute WACC to compare the projects. Cost of debt FV = 1000 N = 20 PV = 1098.18 Pmt = 1000x9% = 90 We can use value of bond formula to copmute YTM: PV = Pmt(1-(1+r)^-n) + FV(1+r)^-n 1,098.18 = ( 90(1-(1+r)^-20) / r ) + 1,000x(1+r)^-20 Solving for r, we get: r=8% thus YTM is 8% Cost of debt kd = YTMx(1 - tax rate) = 8%(1-0.30) =5.60% Cost of equity p=45 d1=2.70 G=5% F=7 Cost of equity Ke = D1/(p-f) + g =2.70/(45-7) + 0.05 =12.11% WACC = Ke xWe + Kd x Wd =12.11% x 0.60 + 5.60% x0.40 =9.51% if IRR is greater than WACC, then only we can choose that project. We have projects 1 and 3 with IRR greater than 9.51%, so they should be selected.

A corporate bond has a face value of $1,000 and a coupon rate of 5%. The bond matures in 15 years and has a current market price of $925. If the corporation sells more bonds it will incur flotation costs of $25 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt capital?

YTM = [Interest + [Face value -price]/years ] /[(face value+price)/2] = [ 50 + (1000 -(925 -25) )/15 ] / [(1000+925 -25)/2 = [50 + (1000- 900 )/15 ] / [1900/2] = [50 + 100/15 ]/ 950 = 50 +6.67 / 950 = 56.67 / 950 = 5.96 After tax cost of debt = 5.96 (1- .35) = 5.96 *.65 = 3.88 (approx 3.92

Suppose the 360-day forward exchange rate is 1.657 dollars per British Pound, and the current spot rate is 1.625 dollars per British Pound. If the 360-day interest rate in the United States is 5% and the 360-day interest rate in Great Britain is 3%, is the market in equilibrium according to the interest rate parity theory?

Yes, because the forward premium on the pound (2%) is exactly offset by the lower interest rate in Great Britain.

Exchange rate risk

arises from the fact that the spot exchange rate on a future date is a random variable.

All of the following are examples of political risk for a U.S. company investing in a foreign country EXCEPT

government requirements that ownership must be limited to U.S. citizens.

The capital budgeting manager for XYZ Corporation, a very profitable high technology company, completed her analysis of Project A assuming 5-year depreciation. Her accountant reviews the analysis and changes the depreciation method to 3-year depreciation. This change will

increase the present value of the NCFs.

Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4. The project is expected to generate equal annual cash flows over the next ten years. The required return for this project is 16%. What is project LMK's internal rate of return?

initial outlay = $500,000 PI = 1+npv/Initial putlay = Pv(future cash flows)/initial outlay since cash flows are equal in nature PV(future cash flows) = 500,000*1.4 = 700,000 now equal cash flows each year =PMT(0.16,10,-700000) = $144,830.76 so irr=(-500000,144830.76,144830.76,144830.76,144830.76,144830.76,144830.76,144830.76,144830.76,144830.76,144830.76) = 26.12%

Project W requires a net investment of $1,000,000 and has a payback period of 5.6 years. You analyze Project W and decide that Year 1 free cash flow is $100,000 too low, and Year 3 free cash flow is $100,000 too high. After making the necessary adjustments

the IRR of Project W will increase.

Which of the following causes a firm's cost of capital (WACC) to differ from an investor's required rate of return on the company's common stock?

the incurrence of flotation costs when new securities are issued