Corp Fin FINAL Prep

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Two Reasons NPV Profiles Cross

*Size of CF *Timing of CF *If r is high, early CF is valuable, NPVs > NPVl *If r is low, early CF is not valuable, NPVs < NPVl

Factors of Business Risk

1) EBIT Equals to Sales (P*Q) Minus Costs (Total Costs = F + V*Q) 2) Uncertainty About Demand (q) 3) Uncertainty about prices (p) 4) Uncertainty about input costs (total costs) 5) Product and other types of liability 6) Degree of operating leverage (OL) -OL is the change in EBIT caused by a change in unit sales , the higher the proportion of fixed costs within a firms overall costs, the greater the operating leverage

Capital Structure Theories

1) Modigliani and Miller Theory (MM Theory) -Zero Tax -Corporate Tax -Corporate and Personal Tax 2) Trade off Theory 3) Pecking Order Theory 4) Windows of Opp

If a petrochemical firm that used oil as feedstock merged with an oil producer that had large oil reserves and a drilling subsidiary, this would be a vertical merger

Synergistic benefits can arise from a number of different sources, including operating economies of scale, financial economies, and increased managerial efficiency

The pecking order (signaling) theory states how financing should be raised. In order to avoid asymmetric information problems and misinterpretation of whether management is sending a signal on security overvaluation the firm's first rule is to: a. finance with internally generated funds. b. always issue debt then the market won't know when management thinks the security is overvalued. c. issue new equity first. d. issue debt first. e. None of the above.

Cummings Products is considering two mutually exclusive investments whose expected net cash flows are as follows: Year Project A Project B 0 -400 -650 1 -528 210 2 -219 210 3 -150 1,100 4 1100 210 5 820 210 6 990 210 7 -325 210 A) Construct an NPV profile for Project A & B B) What is each projects IRR? C) If each project's cost of capital were 10%, which project, if either, should be selected? If the cost of capital were 17%, what would be the proper choice? D) What is each project's MIRR at the cost of capital of 10%? At 17%? E) What is the crossover rate, and what is its significance?

A) r NPVa NPVb 0 1288 820 10 479 372 12 366 308 14.8 228 229 18 94 150 20.7 0 94 25.8 -150 0 30 -245 -62 B) IRRa = 20.7% ; IRRb = 25.8% C) At r = 10%, Project A has the greater NPV, specifically $478.83 as compared to Project B's NPV of $372.37. Thus, Project A would be selected. At r = 17%, Project B has an NPV of $173.70 which is higher than Project A's NPV of $133.76. Thus, choose Project B if r = 17% D) Here is the MIRR for Project A when r = 10%: PV costs = $400 + $528/(1.10)1 + $219/(1.10)2 + $150/(1.10)3 + $325/(1.10)7 = $1,340.47 TV inflows = $1,100(1.10)3 + $820(1.10)2 + $990(1.10)1 = $3,545.30. Now, MIRR is that discount rate which forces the PV of $3,545.30 in 7 years to equal $1,340.47: $1,340.47 = $3,545.30/(1 + MIRR)7 MIRRA = 14.91%. Here is the MIRR for Project B when r = 10%: PV costs = 600. TV of inflows: Financial calculator settings are N = 7, I/YR = 10, PV = 0, PMT = 210, and solve for FV = -1992.3059. Similarly, $650 = $1,992.31/(1 + MIRR)7 MIRRB = 17.35% At r = 17% MIRRA = 18.76% MIRRB = 21.03% E) To find the crossover rate, construct a Project ∆ which is the difference in the two projects' cash flows: IRR∆ = Crossover rate = 14.76%. Projects A and B are mutually exclusive, thus, only one of the projects can be chosen. As long as the cost of capital is greater than the crossover rate, both the NPV and IRR methods will lead to the same project selection. However, if the cost of capital is less than the crossover rate the two methods lead to different project selections—a conflict exists. When a conflict exists the NPV method must be used. Because of the sign changes and the size of the cash flows, Project ∆ has multiple IRRs. Thus, the IRR function for some calculators will not work (it will work, however, on a BAII Plus). The HP can be "tricked" into giving the roots by selecting an initial guess near one of the roots. After you have keyed Project Delta's cash flows into the CFj register of an HP-10B, you will see an "Error-Soln" message. Now enter 10 STO IRR/YR and the 14.76% IRR is found. Then enter 100 STO IRR/YR to obtain IRR = 246.02%. Similarly, Excel can also be used.

Your division is considering two investment projects, each of which requires an up-front expenditure of $25 million. You estimate that the cost of capital is 10% and that the investments will produce the following after-tax cash flows (in millions of dollars): Year A 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? B) What is the discounted payback period for each of the projects? C) If the two projects are independent and the cost of capital is 10%, which project or projects should the firm undertake? D) If the two projects are mutually exclusive and the cost of capital is 5%, which project should the firm undertake? E) If the two projects are mutually exclusive and the cost of capital is 15%, which project should the firm undertake? F) What is the crossover rate?

A) Payback A Period CF Cumulative 0 -25k -25k 1 5k -20k 2 10k -10k 3 15k 5k 4 20k 25k Paybacka = 2 + 10k/15k = 2.67 Years Payback B Period CF Cumulative 0 -25k -25k 1 20k -5k 2 10k 5k 3 8k 13k 4 6k 19k Paybackb = 1 + 5k/10k = 1.5 Years B) Discounted Payback A Per An CF Disc CF Cum 0 -25k -25k -25k 1 5k 4,545 -20,454 2 10k 8,264 -12,190 3 15k 11,269 -920.37 4 20k 13,660 12,739 Discounted PaybackA = 3 + 920.37/13,660.27 = 3.07 Years Discounted Payback B Per An CF Disc CF Cum 0 -25k -25k -25k 1 20k 18,181 -6,818 2 10k 8,264 1,446 3 8k 6,010 7,456 4 6k 4,098 11,554 Discounted Paybackb = 1 + 6,818/8,264 = 1.825 C) NPVa = 12,739 ; IRRa = 27.27% NPVb = 11,554 ; IRRb = 36.15% Both projects have positive NPVs, so both projects should be undertaken D) At a discount rate of 5%, NPVA = $18,243,813. At a discount rate of 5%, NPVB = $14,964,829. 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 = $8,207,071. At a discount rate of 15%, NPVB = $8,643,390. At a discount rate of 15%, Project B has the higher NPV; consequently, it should be accepted F) Year Change (A-B) 0 0 1 -15 2 0 3 7 4 14 IRR (Change) = Crossover Rate = 13.5254%

Additional Essay Questions Pulled Up on Microsoft Edge + Solutions

Operating Leverage Affect on Business Risk

As operating leverage increases, more sales are needed to cover the increased fixed costs. High levels of fixed costs increase business risk, which is the inherent uncertainty in the operation of the business. Operating leverage also increases forecasting risk.

Which of the following is NOT a real option? a. The option to expand production if the product is successful. b. The option to buy shares of stock if its price goes up. c. The option to expand into a new geographic region. d. The option to abandon a project. e. The option to switch the type of fuel used in an industrial furnace

B b is a financial option because the underlying asset is stock, a financial product. The other choices are real options)

Assume that you are comparing two mutually exclusive projects. Which of the following statements is most correct? a. The NPV and IRR rules will always lead to the same decision unless one or both of the projects are "non-normal" in the sense of having only one change of sign in the cash flow stream, i.e., one or more initial cash outflows (the investment) followed by a series of cash inflows. b. If a conflict exists between the NPV and the IRR, the conflict can always be eliminated by dropping the IRR and replacing it with the MIRR. c. There will be a meaningful (as opposed to irrelevant) conflict only if the projects' NPV profiles cross, and even then, only if the cost of capital is to the left of (or lower than) the discount rate at which the crossover occurs. d. Statements a, b, and c are true.

Crossover Rate

Crossover rate is the cost of capital at which the net present values of two projects are equal. It is the point at which the NPV profile of one project crosses over (intersects) the NPV profile of the other project.

The optimal capital structure will tend to include more debt for firms with: a. the highest depreciation deductions. b. the lowest marginal tax rate. c. substantial tax shields from other sources. d. lower probability of financial distress. e. less taxable income.

Which of the following statements is most correct? The modified IRR (MIRR) method: a. Always leads to the same ranking decision as NPV for independent projects. b. Overcomes the problem of multiple rates of return. c. Compounds cash flows at the cost of capital. d. Overcomes the problems of cash flow timing and project size that lead to criticism of the regular IRR method. e. Answers b and c are correct.

PS 2

A company's most recent free cash flow to equity was $100 and is expected to grow at 5% thereafter. The company's cost of equity is 10%. Its WACC is 8.72%. What is its current intrinsic value?

VEquity = FCFE (1+gL) / (rsl - gl) (100 (1+.05)) / (0.10 - .05) = 2100

Hamada's Equation

b= bU (1 + (1-T) (D/S))

The following cash flows are estimated for two mutually exclusive projects: Year CF (A) CF (B) 0 -100,000 -110,000 1 60,000 20,000 2 40,000 40,000 3 20,000 40,000 4 10,000 50,000 When is Project B more lucrative than Project A? (That is, over what range of costs of capital (r) does Project B have a higher NPV than Project A?) (Choose the best answer.) a. For all values of r less than 7.25%. b. Project B is always more profitable than Project A. c. Project A is always more profitable than Project B. d. For all values of r less than 6.57%. e. For all values of r greater than 6.57%.

D (First, solve for the crossover rate. If you subtract the cash flows (CFs) of Project A from the CFs of Project B, then the differential CFs are CF0 = -$10,000, CF1 = -$40,000, CF2 = 0, CF3 = $20,000, and CF4 = $40,000. Entering these CFs and solving for IRR/YR yields a crossover rate of 6.57%. Thus, if the cost of capital is 6.57%, then Projects A and B have the same NPV. If the cost of capital is less than 6.57%, then Project B has a higher NPV than Project A, since Project B's cash inflows come comparatively later in the project life. For lower discount rates, Project B's NPV is not penalized as much for having large cash inflows farther in the future than Project A)

Davis Corporation is faced with two independent investment opportunities. The corporation has an investment policy that requires acceptable projects to recover all costs within 3 years. The corporation uses the discounted payback method to assess potential projects and utilizes a discount rate of 10 percent. The cash flows for the two projects are: Year CF (A) CF (B) 0 -100,000 -80,000 1 40,000 50,000 2 40,000 20,000 3 40,000 30,000 4 30,000 0 Which investment project(s) does the company invest in? a. Project A only. b. Neither Project A nor Project B. c. Project A and Project B. d. Project B only

D (The sum of the PVs of the t = 1, t = 2, and t = 3 cash flows at t = 0 for Project A is $99,474.08. Thus, the discounted payback period of Project A exceeds 3 years and Project A is not acceptable. The PVs of the t = 1, t = 2, and t = 3 cash flows at t = 0 for Project B are $45,454.55, $16,528.93, and $22,539.44, respectively. These PVs sum to $84,522.92, which is greater than the cost of the project, indicating that the discounted payback period is less than 3 years. Thus, Project B will be undertaken)

Which of the following statements about valuing a firm using the APV approach is most CORRECT? a. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity. b. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt. c. The horizon value is calculated by discounting the expected earnings at the WACC. d. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC. e. None of the statements above is correct.

Which of the following statements is most CORRECT? a. The acquiring firm's required rate of return in most horizontal mergers will not be affected, because the 2 firms will have similar betas. b. Financial theory says that the choice of how to pay for a merger is really irrelevant because, although it may affect the firm's capital structure, it will not affect its overall required rate of return. c. The basic rationale for any financial merger is synergy and, thus, the estimation of pro forma cash flows is the single most important part of the analysis. d. In most mergers, the benefits of synergy and the premium the acquirer pays over the market price are summed and then divided equally between the shareholders of the acquiring and target firms. e. The primary rationale for most operating mergers is synergy

Which of the following statements is most correct? a. Since debt financing raises the firm's financial risk, raising a company's debt ratio will always increase the company's WACC. b. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce the company's WACC. c. Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company's WACC. d. Statements a and c are correct. e. None of the statements above is correct.

A consultant has collected the following information regarding Young Publishing: Tot Assets 3B Tax Rate 40% (EBIT) 800M Debt Ratio 0% Int Exp 0M WACC 10% Net Inc 480M M/B Ratio 1x Share Price 32 EPS=DPS 32 The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. If the company makes this change, what would be the total market value of the firm? (The answers are in millions.) a. $3,200 b. $3,600 c. $4,000 d. $4,200 e. $4,800

E 1) Find New WACC WACC = WeRs + Wd (1-T) Rd = (0.8(0.11) + (0.2(1-0.4)0.10) = .10 2) Find FCF (no growth, no investment in capital hence FCF = to NOPAT) FCF = NOPAT - Investment in Capital = EBIT (1-T) - 0 = 800 (1-.4) = 480M 3) Find new value of firm V = FCF/WACC-G = 480/.10 = 480B

Which of the following statements is false? As a firm increases its operating leverage for a given quantity of output, this a. changes its operating cost structure. b. increases its business risk. c. increases the standard deviation of its EBIT. d. increases the variability in earnings per share. e. decreases its financial leverage.

E An increase in the tax rate would lower the after-tax cost of debt relative to equity; therefore, this would encourage a company to raise its target debt ratio. An increase in the personal tax rate affects the firm's investors' interest (from debt) and dividend income (from equity). Since all of interest income is taxed but capital gains (from equity) receive preferential treatment (lower tax) this would cause the firm to lower its target debt ratio. An increase in a company's operating leverage would actually cause a firm to decrease its target debt ratio. Therefore, the correct choice is statement a

As the capital budgeting director for Chapel Hill Coffins Company, you are evaluating construction of a new plant. The plant has a net cost of $5 million in Year 0 (today), and it will provide net cash inflows of $1 million at the end of Year 1, $1.5 million at the end of Year 2, and $2 million at the end of Years 3 through 5. Within what range is the plant's IRR? a. 14 - 15% b. 15 - 16% c. 16 - 17% d. 17 - 18% e. 18 - 19%

E IRR = ? Financial Calculator Inputs : CF0 = -5 CF1 = 1 CF2 = 1.5 CF3 = 2 N = 3 Output : IRR = 18.37%

Your company has a cost of capital equal to 10%. If the following projects are mutually exclusive, and you only have the information that is provided, which should you accept? A B C E Payback (years) 1 5 2 5 IRR 18% 20% 20% 12% NPV (Millions) 40 75 35 100 A B C D. B & C E

E (For mutually exclusive projects, always take the one with the greatest NPV)

Which of the following is most correct? a. The NPV and IRR rules will always lead to the same decision in choosing between mutually exclusive projects, unless one or both of the projects are "non-normal" in the sense of having only one change of sign in the cash flow stream. b. The Modified Internal Rate of Return (MIRR) compounds cash outflows at the cost of capital. c. Conflicts between NPV and IRR rules arise in choosing between two mutually exclusive projects (that each have normal cash flows) when the cost of capital exceeds the crossover point (that is, the point at which the NPV profiles cross). d. The discounted payback method overcomes the problems that the payback method has with cash flows occurring after the payback period. e. None of the statements above is correct.

E (Statement e is correct; the other statements are false. IRR can lead to conflicting decisions with NPV even with normal cash flows if the projects are mutually exclusive. Cash outflows are discounted at the cost of capital with the MIRR method, while cash inflows are compounded at the cost of capital. Conflicts between NPV and IRR arise when the cost of capital is below the crossover point. The discounted payback method does correct the problem of ignoring the time value of money, but it still does not account for cash flows beyond the payback period)

Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of 15 percent. Both projects have a positive net present value. Which of the following statements is most correct? a. Project X must have a higher net present value than Project Y. b. If the two projects have the same WACC, Project X must have a higher net present value. c. Project X must have a shorter payback than Project Y. d. Both answers b and c are correct. e. None of the above answers is correct.

E (Statement e is correct; the other statements are incorrect. Statement a is incorrect; the two projects' NPV profiles could cross, consequently, a higher IRR doesn't guarantee a higher NPV. Statement b is incorrect; if the two projects' NPV profiles cross, Y could have a higher NPV. Statement c is incorrect; we don't have enough information)

Types of Mergers

Economists classify mergers into four types: (1) horizontal, (2) vertical, (3) congeneric, and (4) conglomerate. In a horizontal merger, one firm combines with another in its same line of business; the 2017 merger of Sherwin-Williams with Valspar (painting industry) is an example. A roll-up merger is a particular type of horizontal merger in which a firm purchases many small companies in the same industry and "rolls them up" to create a consolidated brand. This has happened in many businesses, including garbage collection (e.g., Waste Connections), used car sales (e.g., AutoNation), and even funeral homes (e.g. Services Corporation International)

Assuming that the total cash flows are equal, the NPV of a project whose cash flows accrue relatively rapidly is more sensitive to changes in the discount rate than is the NPV of a project whose cash flows come in more slowly

FALSE

Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT

FALSE

Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms' expected EBITs could actually be identical

FALSE

Given two mutually exclusive projects and a zero cost of capital, the payback method and NPV method of selecting investments will always lead to the same decision on which project to undertake.

FALSE

Normal Projects Q and R have the same NPV when the discount rate is zero. However, Project Q has larger early cash flows than R. Therefore, we know that at all discount rates greater than zero, Project R will have a greater NPV than Q.

FALSE

Projects L and S each have an initial cost of $10,000, followed by a series of positive cash inflows. Project L has total, undiscounted cash inflows of $16,000, while S has total undiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects have identical NPVs. Which project's NPV will be more sensitive to changes in the discount rate? (Hint: Projects with steeper NPV profiles are more sensitive to discount rate changes.) a. Project S. b. Project L. c. Both projects are equally sensitive to changes in the discount rate since their NPVs are equal at all costs of capital. d. Neither project is sensitive to changes in the discount rate, since both have NPV profiles which are horizontal. e. The solution cannot be determined unless the timing of the cash flows is known.

FALSE

The firm's business risk is largely determined by the financial characteristics of its industry

FALSE

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects which have different lives are being compared.

FALSE

A project has an up-front cost of $100,000. The project's WACC is 12 percent and its net present value is $10,000. Which of the following statements is most correct? a. The project should be rejected since its return is less than the WACC. b. The project's internal rate of return is greater than 12 percent. c. The project's modified internal rate of return is less than 12 percent. d. All of the above answers are correct. e. None of the above answers is correct.

FALSE (Statement b is correct; the other statements are incorrect. Statement a is incorrect; if the NPV > 0, then the return must be > 12%. Statement c is incorrect; if NPV > 0, then MIRR > WACC)

Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the same risk. Which of the following statements is most correct? a. If the WACC is 10 percent, both projects will have a positive NPV, and the NPV of Project B will exceed the NPV of Project A. b. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A. c. If the WACC is less than 18 percent, Project B will always have a shorter payback than Project A. d. If the WACC is greater than 18 percent, Project B will always have a shorter payback than Project A. e. If the WACC increases, the IRR of both projects will decline.

FALSE (The correct statement is b; the other statements are false. Since Project A's IRR is 15%, at a WACC of 15% NPVA = 0; however, Project B would still have a positive NPV. Given the information in a, we can't conclude which project's NPV is going to be greater. Since we are given no details about each project's cash flows we cannot conclude anything about payback. Finally, IRR is independent of the discount rate, i.e., IRR stays the same no matter what the WACC is)

The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also, the NPV of X is greater than the NPV of Y at the cost of capital. If the two projects are mutually exclusive, Project X should definitely be selected, and the investment made, provided we have confidence in the data. Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X.

FALSE (project X may have a negative NPV if r > IRR)

Friendly or Hostile Mergers

Friendly (The target's management will recommend to its stockholders that they agree to the merger. Generally, the stockholders are asked to tender (i.e., turn over) their shares to a designated financial institution, along with a signed power of attorney that transfers ownership of the shares to the acquiring firm. The target firm's stockholders then receive the specified payment, either common stock of the acquiring company (in which case the target company's stockholders become stockholders of the acquiring company), cash, bonds, or some mix of cash and securities. This is the usual process in a friendly merger. Microsoft's acquisition of LinkedIn in 2016 is an example of a friendly merger) -Target company management agrees to the merger and recommends that shareholders approve the deal Hostile (Often, however, the target company's management resists and the takeover attempt is called a hostile merger. If the acquiring company (often called a corporate raider) wishes to persist, it will make a tender offer directly to the target's shareholders asking them to tender their shares in exchange for the offered price. The target's managers will urge stockholders not to tender their shares, generally claiming that the offer is too low.) -management of target company resists the offer

IPO

Counts Accounting's beta is 1.15 and its tax rate is 40%. If it is financed with 20% debt, what is its unlevered beta?

If Wd = 0.2, then Wce = 1 - 0.2 = 0.8. So D/S = Wd/We = 0.2/0.8 bU = b (1 + (1-T)(D/S)) =1.15/(1 + (1 - .40)(0.2/0.8) = 1

Vertical

In a vertical merger, one company's products are used by the other company. The 2017 merger of Tecogen (a manufacturer of clean energy power generation systems for business facilities) and American DG Energy (which owns and manages on-site power generation systems) was a vertical merger. Congeneric means "allied in nature or action" *Company acquires another firm that is upstream or downstream for example (an automobile manufacturer acquires a steel producer)

EBIT =100 Int Exp = 10 T Rate = 40% Net Change in Debt = 12 Investment in Total Capital = 9 What is its FCF to equity?

Interest Tax Savings = Interest (T) 10(0.40) = 4 FCFE = FCF - Interest Expense + Interest Tax Savings + Net Change in Debt= 51 - 10 + 4 + 12 = 57

Pecking Order Signaling Theory

It can be shown that only the most overvalued firms have any incentive to issue equity. (Even if a moderately overpriced firm issues equity, investors will infer it is highly overpriced and cause the stock to fall more than it deserves.) Similar but less severe skepticism about debt issue. (Debt securities are less informationally sensitive: the fixed income nature; smaller information gap) The best way for managers to get out of this box is to finance projects out of retained earnings (internal cash) Rule #1: Firm will first use internal financing Rule #2: If internal financing is not available, firm will issue debt before issuing equity. Implications No target/optimal debt ratio (leverage). Profitable firms use less debt. Companies like financial slack (cash).

MM Theory : No Taxes

MM Assume : 1) no transactions costs (taxes or brokerage fees) 2) no restrictions or costs to short sales 3) individuals can borrow at the same rate as corporations 4) no bankruptcy costs 5) EBIT is not affected by the use of debt 6) no information asymmetry -Under these assumptions, MM prove that if the total CF to investors of Firm U & Firm L are equal, then the total values of Firm U & Firm L must be equal Vl = Vu -Because FCF and values of firms L and U are equal, their WACCs are equal -Therefore, cap structure is irrelevant

Trade off Theory

MM Theory ignores bankruptcy costs, which increase as more leverage is used *at low leverage levels, tax benefits outweigh bankruptcy costs *at high levels, bankruptcy costs outweigh tax benefits *an optimal capital structure exists that balances these costs and benefits

Pecking Order Theory : Managers vs Investors

Manager says: I want to issue stock only when it is overvalued. If our stock is selling at $50 per share, but I think it is actually worth $60, I will not issue stock. I would actually be giving new stockholders a gift but upset my current stockholders. But suppose our stock is selling at $70, now I will issue stock. If I can get some fools to buy our stock for $70, I will be making $10 for our current shareholders Investor says: Even with all my time and efforts, I can't possibly know what the managers know. So if a manager issues stock, his firm is likely overvalued beforehand. Managers know the firm's future prospects better than investors. Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.

Market Timing

Market timing is the act of moving investment money in or out of a financial market—or switching funds between asset classes—based on predictive methods. If investors can predict when the market will go up and down, they can make trades to turn that market move into a profit.

Davis Industries must choose between a gas-powered and an electric-powered forklift truck for moving materials in its factory. Because both forklifts perform the same function, the firm will choose only one. (They are mutually exclusive investments.) The electric-powered truck will cost more, but it will be less expensive to operate; it will cost $22,000, whereas the gas-powered truck will cost $17,500. The cost of capital that applies to both investments is 12%. The life for both types of truck is estimated to be 6 years, during which time the net cash flows for the electric-powered truck will be $6,290 per year, and those for the gas-powered truck will be $5,000 per year. Annual net cash flows include depreciation expenses. Calculate the NPV and IRR for each type of truck, and decide which to recommend.

NPVE = -$22,000 + $6,290 [(1/i) - (1/(i × (1 + i)n )] = -$22,000 + $6,290[(1/0.12) - (1/(0.12 × (1 + 0.12)6 )] = -$22,000 + $6,290(4.1114) = -$22,000 + $25,861 = $3,861 Financial calculator: Input the appropriate cash flows into the cash flow register, input I/YR = 12, and then solve for NPV = $3,861 Financial calculator: Input the appropriate cash flows into the cash flow register and then solve for IRR = 18% Gas-powered: NPVG = -$17,500 + $5,000[(1/i) - (1/(i × (1 + i)n )] = -$17,500 + $5,000[(1/0.12) - (1/(0.12 × (1 + 0.12)6 )] = -$17,500 + $5,000(4.1114) = -$17,500 + $20,557 = $3,057 Financial calculator: Input the appropriate cash flows into the cash flow register, input I/YR = 12, and then solve for NPV = $3,057 Financial calculator: Input the appropriate cash flows into the cash flow register and then solve for IRR = 17.97% ≈ 18% The firm should purchase the electric-powered forklift because it has a higher NPV than the gas-powered forklift. The company gets a high rate of return (18% > r = 12%) on a larger investment

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 30 million shares before the recap. What is P (the stock price after the recap)?

S = (1 - Wd) (Vop) = (1 - 1/3)(900) = 600M P = (S + (D - D0) / No = (600 + (300 - 0) / 30 = 30

Financial risk refers to the extra risk stockholders bear as a result of the use of debt as compared with the risk they would bear if no debt were used

TRUE

If Miller and Modigliani had considered the cost of bankruptcy, it is unlikely that they would have concluded that 100 percent debt financing is optimal for the firm

TRUE

NPV can be negative if IRR is positive

TRUE

The internal rate of return is that discount rate which equates the present value of the cash outflows (or costs) with the present value of the cash inflows

TRUE

The trade-off theory tells us that the capital structure decision involves a tradeoff between the costs of debt financing and the benefits of debt financing

TRUE

Which of the following statements is most correct? a. If a normal project's internal rate of return (IRR) exceeds the cost of capital, then the project's net present value (NPV) must be positive. b. If normal Project A has a higher IRR than normal Project B, then Project A must also 3 have a higher NPV. c. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the cost of capital. d. Answers a and c are correct. e. None of the answers above is correct.

TRUE (Statement a is correct; the other statements are false. If the projects are mutually exclusive, then project B may have a higher NPV even though Project A has a higher IRR. IRR is calculated assuming cash flows are reinvested at the IRR, not the cost of capital)

A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of the following independent projects should the company accept? a. Project A requires an up-front expenditure of $1,000,000 and generates a net present value of $3,200. b. Project B has a modified internal rate of return of 9.5 percent. 4 c. Project C requires an up-front expenditure of $1,000,000 and generates a positive internal rate of return of 9.7 percent. d. Project D has an internal rate of return of 9.5 percent. e. None of the projects above should be accepted

TRUE (This is the only project with either a positive NPV or an IRR that exceeds the cost of capital)

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 low interest rates and the tax shield. Its investment banker has indicated that the pre-tax cost of debt under various possible capital structures would be as follows: D-V E-V D-E PreTax Cost Debt 0 1 0 6% .2 .8 .25 7 .4 .6 .67 8 .6 .4 1.5 9 .8 .2 4 10 Pierce uses the CAPM to estimate its cost of common equity, rs and at the time of the analysis the risk-free rate is 5%, the market risk premium is 6%, and the company's tax rate is 40%. 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?

Tax Rate = 40% Rrf = 5% bU =0.8 rM - rRF = 6% 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) + (wce)(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 60% debt and 40% equity. At that capital structure, the firm's WACC is 8.89%.

Evidence Supporting and Contradicting Theories

Tax benefits are important- $1 debt adds about $0.10 to value. Supports Miller model with personal taxes. Bankruptcies are costly- costs can be up to 10% to 20% of firm value. Firms don't make quick corrections when stock price changes cause their debt ratios to change- doesn't support trade-off model. After big stock price run ups, debt-equity ratio (D/E) falls, but firms tend to issue equity instead of debt. *Inconsistent with trade-off model. *Inconsistent with pecking order. *Consistent with windows of opportunity. Many firms, especially those with growth options and asymmetric information problems, tend to maintain excess borrowing capacity

NPV Profiles

The NPV Profile is a graphical illustration of a project's NPV graphed as a function of various discount rates. The NPV values are graphed on the vertical or y-axis while the discount rates are graphed on the horizontal or x-axis Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opp. Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

Reserve Borrowing Capacity

The ability to borrow money at a reasonable cost when good investment opportunities arise . Firms often use less debt than specified by the MM optimal capital structure to ensure that they can obtain debt capital later if they need to.

Explain why the APV model is suited for situations in which the capital structure is changing during the forecast period

The appropriate discount rate reflects the risk of the cash flows. Thus, it is Conroy's unlevered cost of equity that should be used to discount the free cash flows and tax shields in years 1-5 and at the horizon. The horizon value should be calculated using Conroy's tax shields at the stable target capital structure, which are provided for Year 5. Since Conroy's beta = 1.3, its current cost of equity, rsL = 6% + 1.3(4.5%) = 11.85%. Since its percentage of debt is 25% and the rate on its debt is 9%, its unlevered cost of equity is rsu = wdrd + wsrsL =0.25(9%) + 0.75(11.85%) =11.14% Interest5= Debt4 (9.5%) = 22.27 (9.5%) = 2.116 TS5 - Interest5 (tax rate) = 2.116 (0.35%) = 0.7405 (must use post merger tax rate) In other years, the tax shield is equal to the interest expense multiplied by the tax rate TS1 = 1.2 (0.35) = .42, ts2 - .595, ts3 = 0.98, ts4 = 0.735 HVTS5 = TS6/(rsU -g) = TS5 (1+G) / (rsU -g) =.7405 (1.06) / (0.1114 - 0.06) = 15.28M Value of Tax Shields = 11.50M Unlevered Horizon Value is HVUL5 = FCF5 (1+g) / (rsU -g) 2.12(1.06) / (0.1115 - 0.06) =43.74M he value of operations is the sum of the interest tax shields and the unlevered value = 11.50 + 32.02 = $43.52 million. The value of the equity is the value of operations (plus any non-operating assets, which are zero in this case) less debt: Equity = 43.52 - 10.00 = $33.52 million. This is the maximum amount that Marston should pay for Conroy. Although not required for the value calculation, the WACC at the new capital structure can be calculated. At the new capital structure of 40 percent debt with a rate of 9.5 percent, the new levered cost of equity and WACC will be rsL = rsU + (rsU -rd) (D/S) 11.14% + (11.14% - 9.5%) (0.40/0.60) =12.23% WACC = wdrd (1-T) + wsrs =0.40 (9.5%) (1-0.35) + 0.60 (12.23%) =9.81%

Discounted Payback

The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money.

IRR

The internal rate of return (IRR) is a core component of capital budgeting and corporate finance. Businesses use it to determine which discount rate makes the present value of future after-tax cash flows equal to the initial cost of the capital investment.

Payback

The payback period is a method commonly used by investors, financial professionals, and corporations to calculate investment returns. It helps determine how long it takes to recover the initial costs associated with an investment. The payback period is the length of time it takes to recover the cost of an investment or the length of time an investor needs to reach a breakeven point. Shorter paybacks mean more attractive investments, while longer payback periods are less desirable.

Preemptive Bids

The preemptive bidding theory suggests that takeover premia are determined not only by actual, but also by potential competition. If entry into takeover contests is costly, an initial bidder may deter the entry of a rival by making a bid that signals a high enough valuation for the target

The profitability index (PI) is a measure of a project's or investment's attractiveness. The PI is calculated by dividing the present value of future expected cash flows by the initial investment amount in the project.

Affect of capital structure on stock price

The results indicate adding debt to overall capital inversely effects the share prices. The results are in tandem to Net Income Approach which portrays capital structure to influence firm value

Underinvestment

The underinvestment problem describes a conundrum whereby a company becomes so overleveraged that it can no longer make investments in growth opportunities. Economists recognize this situation as an agency problem that can arise between a firm's debt holders and equity shareholders.

Economic Reasons for Mergers (Synergy)

This is explained through the synergy effect. The market value of the joint venture exceeds the sum of the market values of the companies considered independently. The economic decisions of the company must tend to increase its market value, that is, to maximize the value of its shareholders

Signaling an Equity Issuance (Reason & Evidence)

To avoid Debt - The primary reason for issuing shares is to avoid debt. Stocks help companies in raising capital without taking any burden in the form of debt. Expansion of Funding - Companies often select strategic time for selling stocks. Principal among them is that equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business

Spin-Offs

(Parent companies typically retain at least 80% of the subsidiary's common stock to preserve their ability to file a consolidated tax return.) This type of transaction is called an equity carve-out (or partial public offering, or spin-out) *A spinoff is the creation of an independent company through the sale or distribution of new shares of an existing business or division of a parent company. The spun-off companies are expected to be worth more as independent entities than as parts of a larger business *Carve-out Vs Spinoff (A carve-out allows a company to capitalize on a business segment that may not be part of its core operations as it still retains an equity stake in the subsidiary. A carve-out is similar to a spin-off, however, a spin-off is when a parent company transfers shares to existing shareholders as opposed to new ones)

Breakup Value

*A firm's value of its assets are sold off in pieces *Some takeover specialists estimate a company's breakup value. A firm's value if its assets are sold off in pieces., which is the value of the individual parts of the firm if they were sold off separately. If this value is higher than the firm's current market value, then a takeover specialist could acquire the firm at or even above its current market value, sell it off in pieces, and earn a profit

LBO Concept

*A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company *The portion of the Purchase Price not funded by Debt will come from the PE Firm's Investors, which is called 'Sponsor Equity.' *The primary reason for using Debt (as opposed to investing more Equity) is to increase the potential for higher returns for the Private Equity firm's Investors.

Empirical Evidence on Who Gains in M&As

*A merger occurs when two firms join together to form one. The new firm will have an increased market share, which helps the firm gain economies of scale and become more profitable. The merger will also reduce competition and could lead to higher prices for consumers

How do real options change in cap budgeting decisions and create value

*A real option allows the management team to analyze and evaluate business opportunities and choose the right one. The concept of real options is based on the concept of financial options; thus, fundamental knowledge of financial options is crucial to understanding real options *Having options affords the freedom to make optimal choices in decisions, such as when and where to make a specific capital expenditure. Various management choices to make investments can give companies real options to take additional actions in the future, based on existing market conditions *Basically, these options are the opportunities that are part of the investment projects. And offer additional value to the usual capital budgeting decisions. Also, the real options enable businesses to change their cash flows, as well as risk profile to make the project more acceptable and profitable

Capital Budgetting

*Analysis of potential projects *Longterm decisions (large expenditures) *Important to firms future *Procedures (estimate CF, assess risk of CF, determine WACC, evaluate CF) *Well managed firm will go great lenghts to encourage good capital budgetting (not a costless operation) *Projects are independent (taking one project does not rule out the possibility or taking the other project) *Mutually exclusive (we can choose either, or we can reject both, but we cannot accept both projects)

Effect of Capital Structure on Stock Price and EPS

*As percent finance with debt increases 1) Cost of equity increases 2) WACC dips at first then increases 3) After tax cost of debt exponentially increases P * n0 = S + (D - D0) where P is the stock price before (and after) the repurchase (but after the capital structure change); n0 is the number of shares before the repurchase S is the value of total equity after repurchase D is the amount of debt after capital structure change D0 is the amount of debt before capital structure change

MM Theory : Corporate Taxes

*Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms (therefore, more CF goes to investors and less to taxes when leverage is used) *MM show the value of firm L is equal to the value of Firm U plus an additional amount due to tax shield (vL = vU + T*D) *If T = 40%, then every dollar of debt adds 40 cents of extra value to firm

Valuation of Target (when there is a permanent change in cap structure) : APV Method

*Defines the value of a levered firm as the sum of an unlevered firm's value plus the value of side effects due to leverage. The side effects often include the present value of annual tax savings each year and the present value of any expected financial distress costs

Tax Shields (Savings)

*Each year a levered company can deduct its interest expenses, so the value of the levered firm is equal to the value of the unlevered firm plus the gain from leverage, which is the present value of the interest tax savings, also known as the interest tax shield *The value of the tax shield is the present value of all of the interest tax savings (TS), discounted at the appropriate rate *If the company will always get to deduct interest expenses, then the tax shield has no risk and should be discounted at the risk-free rate. However, corporate debt is not riskless—firms do occasionally default on their loans if cash flows from operations are so low that the firm's value is less than the debt's value. Even if a company doesn't default on its debt, a company might not be able to use tax savings from interest deductions in the current year if it has a pre-tax operating loss. Therefore, the future tax savings are not risk free and hence should be discounted using a higher rate than the risk-free rate

How are real options different from financial options?

*Financial options have an underlying asset that is traded, usually a security like a stock *A real option has an underlying asset that is not a security, for example a project or a growth opportunity, and it isn't traded *The payoffs for financial options are specified in the contract *Real options are "found" or created inside of projects. Their payoffs can be varied

Crossover Rate

*Find CF differences between projects (L-S) *Enter these differences in CFLO register than press IRR

Free Cash Flow to Equity (FCFE)

*Free cash flow is the cash flow available for distribution to all investors. In contrast, free cash flow to equity (FCFE) is the cash flow available for distribution to common shareholders. Because FCFE is available for distribution only to shareholders, it should be discounted at the levered cost of equity, rsL. Therefore, the free cash flow to equity model, also called the equity residual model, discounts the projected FCFE at the cost of equity to determine the value of the equity *Because FCFE is the cash flow available for distribution to shareholders, it may be used to pay common dividends, repurchase stock, purchase financial assets, or some combination of these uses. In other words, the uses of FCFE include all those of FCF except for distributions to debtholders. Therefore, one way to calculate FCFE is to start with FCF and reduce it by the net after-tax distributions to debtholders *FCFE = NI - Investment in Total Net Operating Capital + Net Change in Debt

Carve-Outs (difference from spin-offs)

*IPO in which parents company creates a new publicly traded company from a subsidiary and sells some of the stock to the public (parents companies retain 80% + of the common stock to maintain control and to preserve their ability to file a consolidated tax return) *Carve-outs facilitate the evaluation of corporate growth opportunities on a line of business basis *Carve-out Vs Spinoff (A carve-out allows a company to capitalize on a business segment that may not be part of its core operations as it still retains an equity stake in the subsidiary. A carve-out is similar to a spin-off, however, a spin-off is when a parent company transfers shares to existing shareholders as opposed to new ones)

IRR Method

*IRR > WACC then projects rate of return is greater than its cost *If S and L are indendent accept both IRRs > WACC and IRRl > WACC *If S and L are mutually exclusive, accept S because IRRs > IRRl (NPV and IRR approaches agree with each other)

Asset Sales

*In an asset sale, a firm sells some or all of its actual assets, either tangible or intangible. The seller retains legal ownership of the company that has sold the assets but has no further recourse to the sold assets. The buyer assumes no liabilities in an asset sale

Some types of real options

*Investment timing options *Growth options (expansion of existing product line, new products, new geographic markets) *Abandonment Options (contraction, temporary suspension) *Flexibility options

Junk Bonds

*Junk bonds, or high-yield bonds, are risky investments that have higher rates of default but offer significantly higher returns. Unlike lower-risk, investment-grade bonds, junk bonds are not usually ideal for long-term investments, and can easily cause the investor to lose money if she's not careful *Junk bonds are less useful as a means of reducing taxes after the act *Single-A and triple-B bonds are also strong enough to be called investment-grade bonds, and they are the lowest-rated bonds that many banks and other institutional investors are permitted by law to hold. Double-B and lower bonds are speculative bonds and are often called junk bonds. These bonds have a significant probability of defaulting

Liquidation

*Liquidation in finance and economics is the process of bringing a business to an end and distributing its assets to claimants. It is an event that usually occurs when a company is insolvent, meaning it cannot pay its obligations when they are due.

Motivation for Divesting

*Managers often cite diversification as a reason for mergers. They contend that diversification helps stabilize a firm's earnings and thus benefits its owners. Stabilization of earnings is certainly beneficial to employees, suppliers, and customers, but its value to stockholders is less obvious. For example, shareholders could diversify by purchasing stock in both firms. Also, research shows that diversified conglomerates are worth significantly less than the sum of their individual parts. *The situation is different for the owner-manager of a closely held firm. To diversify, the owner must sell some of the firm's stock and use the proceeds for other investments. However, it is difficult to sell closely held stock, and any profits from the stock sale would be taxed as capital gains. Therefore, a merger might be the best way for an owner to diversify personal wealth

Windows of Opportunity

*Managers try to "time the market" when issuing securities. They issue equity when the market is "high" and after big stock price run ups. They issue debt when the stock market is "low" and when interest rates are "low." ("flight to quality") They issue short-term debt when the term structure (yield curve) is upward sloping and long-term debt when it is relatively flat.

Horizontal

*Merger between 2 companies in the same line of business (one firm combines with another in its same line of business) *Roll Up Merger (type if horizontal merger in which a firm purchases many small companies in the same industry and rolls them up to create a consolidated brand)

Diversification Discount

*Recent work suggests that shares of diversified firms sell at a discount, possibly because managerial self-interest makes it difficult or impossible to direct internal cash flows to their most profitable use

Waves (cashing out)

*The empirical observation that mergers tend to cluster in time, becoming frequent in some years and infrequent in other years *Subsequent waves, in our opinions, are driven primarily by economic conditions. Figure 26-1 shows the value of worldwide mergers as a percentage of the world stock market capitalization. Not surprisingly, increased merger activity tends to occur in periods of high economic growth and technological innovation, while decreases are driven by the same forces that lead to recessions

3 DCF Valuation Approaches 1) Corporate FCF Valuation 2) APV Approach 3) FCFE Model

*The most general approach to analyzing capital structure effects is the adjusted present value approach (APV), which expresses the levered value of a company as the combination of its unlevered value and the value of side effects due to leverage *MM stated that the primary benefit of debt stems from the tax deductibility of interest payments. The present value of the tax savings due to interest expense deductibility is called the interest tax shield. If we ignore other side effects, the value of an unlevered firm is (VL = VU + VTax Shield) *The compressed adjusted present value (CAPV) model incorporates nonconstant growth and assumes that the tax savings should be discounted at the unlevered cost of equity *The levered cost of equity and the levered beta are different in the compressed APV model than in the MM and Hamada models. In the compressed APV model 1) The FCFF valuation approach estimates the value of the firm as the present value of future FCFF discounted at the weighted average cost of capital -The HV of TWTR FCF as of 2023 can be calculated using the constant growth formula -The value ops is the PV of CF in the forecast period plus the PV of HV 2) APV is the NPV of a project or company if financed solely by equity plus the present value of financing benefits. APV shows an investor the benefit of tax shields from tax-deductible interest payments. It is best used for leverage transactions, such as leveraged buyouts, but is more of an academic calculation *requires estimate of twitters unlevered cost of equity (using cap structure, levered $ equity, $ debt) provides unlevered $ equity 3) What Is Free Cash Flow to Equity (FCFE)? Free cash flow to equity is a measure of how much cash is available to the equity shareholders of a company after all expenses, reinvestment, and debt are paid. FCFE is a measure of equity capital usage *The free cash flow to equity (FCFE) model discounts the cash flows available for distribution to common shareholders using the levered cost of equity, resulting in the intrinsic value of equity. It is also called the equity residual model

Market Multiple Methods

*The multiples approach is a valuation theory based on the idea that similar assets sell at similar prices. It assumes that the type of ratio used in comparing firms, such as operating margins or cash flows, is the same across similar firms

Long Run Performance of IPOs (stock and operating performances)

*The results show that the three year equally weighted cumulative adjusted returns average -16.5%. The magnitude of this underperformance is consistent with most reported studies in different developed and emerging markets *Some researchers have found that IPOs underperform marginally or have no abnormal performance in the long run; thus, they do not reject the market efficiency hypothesis in the long run. Others have reported that IPOs overperform or do not underperform in the long- run market

Unlevered Cost of Equity

*The value of an unlevered firm without any nonoperating assets is the present value of its free cash flows (FCF) discounted at the weighted average cost of capital (WACC). For an unlevered firm, the WACC is the unlevered cost of equity: WACC=rsU. As we saw in the free cash flow corporate valuation model from Chapter 8, this present value is

IPO Relation to Underpricing

*Underpricing is the practice of listing an initial public offering (IPO) at a price below its real value in the stock market. When a new stock closes its first day of trading above the set IPO price, the stock is considered to have been underpriced

Levered Cost of Equity

*With considerable algebra, the levered cost of equity (rsL) can be expressed in terms of (1) the unlevered cost of equity, (2) the capital structure weights (wd is the percentage of the firm financed with debt and ws is the percentage financed with common stock), (3) the cost of debt (rd), and (4) the discount rate for the tax shield

Conglomerate

*a congeneric merger involves related enterprises but not producers of the same product (horizontal) and not firms in a producer-supplier relationship (vertical). Verizon's acquisition of Yahoo! is an example. A conglomerate merger occurs when unrelated enterprises combine. *Involves firms that are interrelated but do not have identical lines of business

Weaknesses of Payback

*ignores the TVM *ignores CFs occurring after the payback period

Strengths of Payback

*provides an indication of projects risk and liquidity *easy to calculate and understand

Effects of Debt on WACC

1) Additional debt increases cost of equity -Debt holders have a prioritized claim on cash flows relative to stockholders -Debt holders (fixed claim increases risk of stockholders residual claim) -Cost of stock (r) goes up 2) Additional debt reduces taxes a company pays -Interest payment is tax deductible -Reduces after-tax cost of capital 3) Additional debt increases risk of bankruptcy (causes pre-tax cost of debt) -rd increases 4) Adding debt increases percent percent of firm financed with low-cost debt (Wd) and decreases percent financed with high-cost equity (Wce) 5) Net effect on WACC = uncertain

Effects of Debt on FCF

1) Additional debt increases probability of bankruptcy -Direct costs (legal fees) -Indirect costs (lost costumers, reduction in productivity of managers and line workers, reduction in trade credit) offered by suppliers 2) Impact of Indirect Costs -NOPAT goes down due to lost costumers and drop in productivity -Require more net operating working capital leading to lower efficiency 3) Additional debt can affect the behavior of managers *(reduction in agency costs so managers are less likely to waste FCF on perquisties or non value adding acquisitions) -Increases in agency costs

Business Risk vs Financial Risk

1) Business risk is the risk a firms shareholders would face even if the firm has no debt *arises from uncertainty in firms business and cash flows *Business risk focusses on EBIT (op income) 2) Financial risk is the additional risk placed on shareholders as a result of using debt *greater the use of debt the higher the financial risk on shareholders *financial risk focusses on net income

LBO Typical Procedure

1) Calculate Purchase Price 2) Determine Debt & Equity Funding 3) Project Cash Flows 4) Calculate Exit Sale Value 5) Work to Exit Owner Value 6) Assess Investor Returns (IRR)

Estimating Optimal Capital Structure

1) Estimate $ of Debt 2) Estimate $ of Equity 3) Calculate WACC 4) Calculate Firm Value 5) Deduct the Value of Debt to Find Value of Shareholder's Wealth *Capital structure theories imply that beta changes with leverage *bU is the beta of a firm when it has no debt or unlevered beta)

3 Valuation Approaches (dont worry about this one)

1) Income Approach *The income approach is applied using the valuation technique of a discounted cash flow (DCF) analysis, which requires (1) estimating future cash flows for a certain discrete projection period; (2) estimating the terminal value, if appropriate; and (3) discounting those amounts to present value at a rate of return that considers the relative risk of the cash flows and the time value of money. Terminal value represents the present value at the end of the discrete projection period of all subsequent cash flows to the end of the life of the asset or into perpetuity if the asset has an indefinite life *The income approach converts future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. When the income approach is used, the fair value measurement reflects current market expectations about those future amounts. *Income approaches are used to measure the value of liabilities, intangible assets, businesses (e.g., for purposes of computing an internal rate of return, or to measure the fair value of an NCI or previously held equity interest when the price is not observable), and financial instruments when those assets are not traded in an active market 2) Market Approach *The market approach is often used as the primary valuation approach for financial assets and liabilities when observable inputs of identical or comparable instruments are available *The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business *The market approach is also used commonly for real estate when comparable transactions and prices are available, and can be used to value a business or elements of equity (e.g., NCI). The market approach may also be used as a secondary approach to evaluate and support the conclusions derived using an income approach 3) Cost Approach *The cost approach assumes that the fair value would not exceed what it would cost a market participant to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence *The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost) *This approach assumes that a market participant buyer would not pay more for an asset than the amount for which it could replace the service capacity of that asset. Obsolescence includes "physical deterioration, functional (technological) obsolescence, and economic (external) obsolescence." Therefore, in using a replacement cost approach, a reporting entity would need to consider the impact of product improvements. The cost approach is typically used to value assets that can be easily replaced, such as property, plant, and equipment

MM Theory Corporate and Personal Taxes

1) Personal taxes lessen the advantage of corporate debt -the income from bond is generally interest, which is taxed at rates going up to 35% -the income from stocks is generally from dividends and partly from capital gains. long-term capital gains are taxed at a rate of 15%, and this tax deferred until the stock is sold and gain realized 2) Use of debt financing remains advantageous, but benefits are less than under only corporate taxes

In a merger with true synergies, the post-merger value exceeds the sum of the separate companies' pre-merger values

Leveraged buyouts (LBOs) occur when a firm's managers, generally backed by private equity groups, try to gain control of a publicly owned company by buying out the public shareholders using large amounts of borrowed money

The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt

The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers

Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20 percent debt and 80 percent equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6 percent and the market risk premium, rM - rRF, is 5 percent. Currently the company's cost of equity, which is based on the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon's estimated cost of equity if it were to change its capital structure to 50 percent debt and 50 percent equity? a. 14.35% b. 30.00% c. 14.72% d. 15.60% e. 13.64%

A Facts given: rs = 12%; D/E = 0.25; rRF = 6%; RPM = 5%; T = 40%. 1) Find the firm's current levered beta using the CAPM : rs = rrf + rpm (b) 12% = 6% + 5% (b) b = 1.2 2) Find the firm's unlevered beta using the Hamada equation : b = bu (1 + (1-T) (D/E)) 1.2 = bu (1+ (0.6) (0.25)) 1.2 = 1.15bu 1.0435 = bu 3) Find the new levered beta given the new capital structure using the Hamada equation b = bu (1 + (1-T) (D/E)) b = 1.0435 (1 + (0.6) (1)) b = 1.6696 4) Find the firms new cost of equity given its new beta and the CAPM rs = rrf + rpm (b) rs = 6% + 5% (1.6696( rs = 14.35%

Which of the following events is likely to encourage a company to raise its target debt ratio? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. An increase in the company's operating leverage. d. Statements a and c are correct. e. All of the statements above are correct.

A Statement a is false; if you are to the left of the firm's optimal capital structure on the WACC curve, raising a company's debt ratio will actually decrease the firm's WACC. Statement b is false; if you are to the right of the firm's optimal capital structure on the WACC curve, raising a company's debt ratio will actually increase the firm's WACC. Statement c is false; as you increase the firm's debt ratio the cost of debt will increase because you're using more debt. Because you're using more debt the cost of equity increases because the firm's financial risk has increased. From statements a and b you can see that whether the WACC is increased depends on where you are on the WACC curve relative to the firm's optimal capital structure. Therefore, the correct answer is statement e

Affect of capital structure on shareholders wealth

A company's capital structure — essentially, its blend of equity and debt financing — is a significant factor in valuing the business. The relative levels of equity and debt affect risk and cash flow and, therefore, the amount an investor would be willing to pay for the company or for an interest in it.

What is a real option

A real options exist when managers can influence the size and risk of a projects cash flows by taking different actions during the projects life in response to changing market conditions *Recognizing real options in a project ALWAYS makes the project more attractive (ex-ante profitable) *Real options is a DYNAMIC capital budgeting method, allowing decision makers to change the future cash flows as conditions change. This is in sharp contrast to NPV/IRR, which are STATIC capital budgeting methods, for which we take the size and risk of future cash flows as given

The Pinkerton Publishing Company is considering two mutually exclusive expansion plans. Plan A calls for the expenditure of $50 million on a large-scale, integrated plant that will provide an expected cash flow stream of $8 million per year for 20 years. Plan B calls for the expenditure of $15 million to build a somewhat less efficient, more labor-intensive plant that has an expected cash flow stream of $3.4 million per year for 20 years. The firm's cost of capital is 10%. a) Calculate each project's NPV & IRR b) Set up a Project Δ by showing the cash flows that will exist if the firm goes with the large plant rather than the smaller plant. What are the NPV and the IRR for this Project Δ? c) Graph the NPV profiles for Plan A, Plan B, and Project Δ.

A) N = 20 I = 10 PV = ? PMT = 8M FV = 0 NPVa = 68,108,510 - 50,000,000 = 18,108,510 N = 20 I = 10 PV = ? PMT = 34M FV = 0 NPVb = 28,946,117 - 15,000,000 = 13,946,117 N = 20 I = ? PV = -50M PMT = 8M FV = 0 IRRa = 15.03% N = 20 I = ? PV = 15M PMT = 34M FV = 0 IRRb = 22.26% b) If the company takes Plan A rather than B, its cash flows will be (in millions of dollars):

This problem provides an example of real options. One advantage of using staged financing in the venture capital industry is that the venture capitalists (VCs) do not have to provide all of their capital to the firms they fund at once and can have the option not to provide further funding as more information becomes available. Consider a young start-up company that needs $200 million from a VC to fund a project. Both the firm and the VC will receive further information about the viability/profitability of the project only in one year (after the project has been tested). If the news is good after the above testing period (1 year), they know that the project will succeed in another 5 years from then and return $400 million dollars. If the news is bad after the testing period (1 year), they know that the project will fail in another 5 years from then and return only $10 million. The cost of capital is 10%. The probability of having good news in one year is 50%. A) If the VC does not have the option of staging its financing and has to provide all the needed capital ($200 million) today, should it go ahead and invest? Why or why not? B) Now assume that the VC has the option of staging its investment: it only has to invest half of the total amount ($100 million) today and can decide whether to provide the rest of funding ($100 million) in one year, depending on whether the news is good or bad. In this scenario, should the VC go ahead and invest in the company (i.e., provide the first round of financing of $100 million)? Why or why not?

A) ) If the VC cannot stage its financing (i.e., does not have the option of abandoning the project after learning more information), it has to make a single-round investment today, and its payoff looks like: Invest Up Front (-200) cf = +4-- in 5 years (good) cf = + 1- in 5 years (bad) Since r = 10%, the expected NPV under single-round financing =-200 +50%*400/[(1+10%)^6] + 50%*10/[(1+10%)^6] = -$84.28 million. Since it is negative, the VC should NOT invest in the project. B) If the VC can now stage its financing (i.e., has the option of abandoning the project after learning more information), its payoff looks like: GOOD NEWS cf = +400 in 5 years INVEST 100 dont invest cf = 0 BAD NEWS cf = +10 in 5 years invest $100 dont invest cf = 0 In this case, after one year, the VC will invest another $100 million if the news is good (because investing generates a positive return while abandoning generates 0) and will abandon the project if the news is bad (because investing generates a negative return while abandoning generates 0). Thus, the expected NPV = -100 + 0.5 * (400/(1+10%)^5 - 100)/(1+10%) + 0.5 * 0/(1+10%) = $ -32.56 million. Since it is still negative, the VC should NOT go ahead and make the first-stage investment today. Note that although the expected NPV is still negative, it has gone up in the case of staged financing, which illustrates the value of having the real options (in this case the option of abandoning the project as more information comes in).

Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero-growth firm and pays out all of its earnings as dividends. The firm's EBIT is $14.933 million, and it faces a 40% federal-plus-state tax rate. The market risk premium is 4%, and the risk-free rate is 6%. BEA is considering increasing its debt level to a capital structure with 40% debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 9%. BEA has a beta of 1.0. A) What is BEA's unlevered beta? Use market value D/S (which is the same as wd/ws) when unlevering. B) What are BEA's new beta and cost of equity if it has 40% debt? C) What are BEA's WACC and total value of the firm with 40% debt?

A) BEA's unlevered beta is bU = b/(1 + (1-T)(D/S)) = 1/(1+(1-.4)(20/80)) = .870 B) b = bU (1+(1-T)(D/S)) at 40% debt : bL = 0.87 (1 + 0.6 (40%/60%)) = 1.218 rs = 6 + 1.218 (4) = 10.872% C) WACC = WdRd (1-t) + WceRs (0.4)(9%)(1-.04) + (0.6)(10.872%) = 8.683% V = FCF/WACC = EBIT(1-T)/WACC = (14.933)(1-.4)/.08683 = 103.188M

The Ewert Exploration Company is considering two mutually exclusive plans for extracting oil on property for which it has mineral rights. Both plans call for the expenditure of $10 million to drill development wells. Under Plan A, all the oil will be extracted in 1 year, producing a cash flow at t=1 of $12 million; under Plan B, cash flows will be $1.75 million per year for 20 years A) What are the annual incremental cash flows that will be available to Ewert Exploration if it undertakes Plan B rather than Plan A? (Hint: Subtract Plan A's flows from B's.) B) If the company accepts Plan A and then invests the extra cash generated at the end of Year 1, what rate of return (reinvestment rate) would cause the cash flows from reinvestment to equal the cash flows from Plan B? C) Suppose a firm's cost of capital is 10%. Is it logical to assume that the firm would take on all available independent projects (of average risk) with returns greater than 10%? Further, if all available projects with returns greater than 10% have been taken, would this mean that cash flows from past investments would have an opportunity cost of only 10% because all the firm could do with these cash flows would be to replace money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project's cash flows? D) Construct NPV profiles for Plans A and B, identify each project's IRR, and indicate the crossover rate.

A) If the firm goes with Plan B, it will forgo $10,250,000 in Year 1, but will receive $1,750,000 per year in Years 2-20. Year B A In CF 0 (10M) (10M) 0 1 1.75M 12M (10.25M) 2-20 1.75B 0 1.75M B) If the firm could invest the incremental $10,250,000 at a return of 16.07%, it would receive cash flows of $1,750,000. If we set up an amortization schedule, we would find that payments of $1,750,000 per year for 19 years would amortize a loan of $10,250,000 at 16.0665%. Financial Calculator N = 19 I = ? PV = -10.25M PMT = 1.75M FV = 0 I = 16.0665 C) Yes, assuming (1) equal risk among projects, and (2) that the cost of capital is a constant and does not vary with the amount of capital raised. D) See graph. If the cost of capital is less than 16.07%, then Plan B should be accepted; if r > 16.07%, then Plan A is preferred.

A spin-off is a type of divestiture in which the assets of a division are sold to another firm

Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated

Since managers' central goal is to maximize stock price, managerial control issues do not interfere with mergers that would benefit the target firm's stockholders

The distribution of synergistic gains between the stockholders of 2 merged firms is almost always based strictly on their respective market values before the announcement of the merger

Which of the following statements is most CORRECT? a. If a company that produces military equipment merges with a company that manages a chain of motels, this is an example of a horizontal merger. b. A defensive merger is one where the firm's managers decide to merge with another firm to avoid or lessen the possibility of being acquired through a hostile takeover. c. Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition. d. None of the statements above is correct. e. Answers a and c are correct.

Your assistant has just completed an analysis of two mutually exclusive projects. You must now take her report to a board of directors meeting and present the alternatives for the board's consideration. To help you with your presentation, your assistant also constructed a graph with NPV profiles for the two projects. However, she forgot to label the profiles, so you do not know which line applies to which project. Of the following statements regarding the profiles, which one is most reasonable? a. If the two projects have the same investment cost, and if their NPV profiles cross once in the upper right quadrant, at a discount rate of 40 percent, this suggests that a NPV versus IRR conflict is not likely to exist. b. If the two projects' NPV profiles cross once, in the upper left quadrant, at a discount rate of minus 10 percent, then there will probably not be a NPV versus IRR conflict, irrespective of the relative sizes of the two projects, in any meaningful, practical sense (that is, a conflict which will affect the actual investment decision). c. If one of the projects has a NPV profile which crosses the X-axis twice, hence the project appears to have two IRRs, your assistant must have made a mistake. d. Whenever a conflict between NPV and IRR exist, then, if the two projects have the same initial cost, the one with the steeper NPV profile probably has less rapid cash flows.

Florida Phosphate is considering a project which involves opening a new mine at a cost of $10,000,000 at t = 0. The project is expected to have operating cash flows of $5,000,000 at the end of each of the next 4 years. However, the facility will have to be repaired at a cost of $6,000,000 at the end of the second year. Thus, at the end of Year 2 there will be a $5,000,000 operating cash inflow and an outflow of -$6,000,000 for repairs. The company's cost of capital is 15 percent. What is the difference between the project's MIRR and its regular IRR? a. 0.00% b. 0.51% c. 3.40% d. 9.65% e. 13.78%

B 1) Calculate IRR by inputting this CF0 = -10,000,000 CF1 = 5,000,000 CF2 = -1,000,000 CF3-4 = 5,000,000 Solve for IRR = 13.78% 2) Calculate MIRR Calculate PV of Outflows CF0 = -10,000,000 CF1 = 0 CF2 = -1,000,000 I = 15% Solve for NPV = -10,756,143.67 B) Calculate FV of inflows CF = 0 CF1 = 5,000,000 CF2 = 0 CF3-4 = 5,000,000 I = 15%, NPV = 10,494,173.48 FV (10,494,173.478) (1.15)^4 = 18,354,375 C) Calculate MIRR N = 4 PV = -10,756,143.67 PMT = 0 FV = 18,354,375 Solve for I = 14.29% Calculate Difference Between Projects MIRR and Its IRR (MIRR - IRR) = 14.29% - 13.78% = 0.51%

Dabney Electronics currently has no debt. Its operating income is $20 million and its tax rate is 40 percent. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40 percent debt and 60 percent equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10 percent. What would its stock price be if it changes to the new capital structure? a. $40 b. $48 c. $52 d. $54 e. $60

B 1) Find new value of firm after recaptialization (bc growth is 0, FCF is equal to NOPAT) V = FCF/WACC = NOPAT/WACC = EBIT (1-T)/WACC = 20 (1-.4)/.1 = 120M 2) Find new value of equity and debt after recapitalization S = We V = .6 (120) =72M D = Wd V = .4(120) = 48M 3) Find new price per share after recapitalization P = (S + (D-D0)) /No = 72 + (48-0) /2.5 = 48

USE LAST QUESTION What is the value of Dustvac's equity to Magiclean? (Round your answer to the closest thousand dollars.) a. $16,019,000 b. $17,111,000 c. $18,916,000 d. $22,111,000 e. $22,916,000

B Because the cash flows are all discounted at the same rate, we don't need to separately calculate the unlevered value of operations and the value of the tax shield. We can simply enter the sum of the tax shields and free cash flows and their horizon values for each year into the financial calculator: CF0 = 0 CF1 = 4,000,000 NJ = 3 CF2 = 19,000,000 I = 11.29 Output: PVInflows = $22,111,708 = Vops Value of equity = Vops - Debt = $22.111 - $5 = $17.111 million Alternately, some students will calculate separately the unlevered value of operations and the value of the tax shield: Inputs: CF0 = 0; CF1 = 3,000,000; Nj = 3; CF2 = 13,000,000; I/YR = 11.29 Output: PVInflows = $15,768,917 = Value of unlevered operations CF0 = 0 CF1 = 1,000,000 NJ =3 CF2 = 6,000,000 I = 11.29 PVInflows = 6,342,792 = Value of Tax Shield Adding these together gives the value of operations above, and subtracting the debt gives the value of equity above.

The term "equity carve-out" refers to the situation where a firm's managers give themselves the right to purchase new stock at a price far below the going market price. Since this dilutes the value of the public stockholders, it "carves out" some of their value

B False. An equity carve-out occurs when there is only a partial public offering. In other words, the public is sold equity in a wholly owned subsidiary but the parent retains full control of the subsidiary by retaining the majority of the subsidiary's common stock

Houston Inc. is considering a project which involves building a new refrigerated warehouse which will cost $7,000,000 at t = 0 and which is expected to have operating cash flows of $500,000 at the end of each of the next 20 years. However, repairs which will cost $1,000,000 must be incurred at the end of the 10th year. Thus, at the end of Year 10 there will be a $500,000 operating cash inflow and an outflow of -$1,000,000 for repairs. If Houston's cost of capital is 12 percent, what is the project's MIRR? (Hint: Think carefully about the MIRR equation and the treatment of cash outflows.) a. 7.75% b. 8.29% c. 9.81% d. 11.45% e. 12.33%

B R = 12% Calculation of PV of Outlofws : CF0 = -7000 CF 1-9 = 0 CF10 = -1000 I = 12 Solve for NPV = -7,231.97 Calculation of TV of Inflows : N = 20 I = 12 PV = 0 PMT = 500 Solve for TF = TV = 36,026.22 N = 20 PV = -7,322 PMT = 0 FV = 36,026 Solve for I = MIRR = 8.29% Note IRR = 2.52% and NPV = -3587.251 (Both Consistent with MIRR less than WACC = 12%)

Scott Corporation's new project calls for an investment of $10,000. It has an estimated life of 10 years. The IRR has been calculated to be 15 percent. If cash flows are evenly distributed and the tax rate is 40 percent, what is the annual before-tax cash flow each year? (Assume depreciation is a negligible amount.) a. $1,993 b. $3,321 c. $1,500 d. $4,983 e. $5,019

B IRR : 15% Financial Calculator Input : N = 10 I = 15 PV = -10,000 Output : PMT = 1,992.52 Before Tax Cash Flow 1,992.52/.06 = 3,320.87

Martin Fillmore is a big football star who has been offered contracts by two different teams. The payments (in millions of dollars) he receives under the two contracts are listed below: Year CF (A) CF (B) 0 8 2.5 1 4 4 2 4 4 3 4 8 4 4 8 Fillmore is committed to accepting the contract which provides him with the highest net present value (NPV). At what discount rate would he be indifferent between the two contracts? a. 10.85% b. 11.35% c. 16.49% d. 19.67% e. 21.03%

B (First, find the differential CFs by subtracting Team A CFs from Team B CFs (or vice versa). Enter these into the cash flow register; then solve to find IRR/YR to get the discount rate for which he is indifferent between the two contracts, 11.35%)

Shannon Industries is considering a project which has the following cash flows: Year Cash Flow 0 ? Year Cash Flow 0 ? 1 2,000 2 3,000 3 3,000 4 1,500 The project has a payback of 2.5 years. The firm's cost of capital is 12 percent. What is the project's net present value NPV? a. $ 577.68 b. $ 765.91 c. $1,049.80 d. $2,761.32 e. $3,765.91

B (First, find the missing t = 0 cash flow. If payback = 2.5 years, this implies t = 0 cash flow must be -$2,000 - $3,000 + (0.5)$3,000 = - $6,500) NPV = -6,500 + 2,000/1.12 + 3,000/(1.12)^2 + 3,000/(1.12)^3 + 1,500/(1.12)^4 = 765.91

Which of the following statements is correct? a. Because discounted payback takes account of the cost of capital, a project's discounted payback is normally shorter than its regular payback. b. The NPV and IRR methods use the same basic equation, but in the NPV method the discount rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set equal to zero and the discount rate is found. c. If the cost of capital is less than the crossover rate for two mutually exclusive projects' NPV profiles, a NPV/IRR conflict will not occur. d. If you are choosing between two projects which have the same life, and if their NPV profiles cross, then the smaller project will probably be the one with the steeper NPV profile. e. If the cost of capital is relatively high, this will favor larger, longer-term projects over smaller, shorter-term alternatives because it is good to earn high rates on larger amounts over longer periods.

B (This statement reflects exactly the difference between the NPV and IRR methods)

Uptown Interior Designs is an all equity firm that has 40,000 shares of stock outstanding. The company has decided to borrow $1 million to buy out the shares of a deceased stockholder who holds 2,500 shares. What is the total value of this firm if you ignore taxes? a. $15.5 million b. $15.6 million c. $16.0 million d. $16.8 million e. $17.2 million

Which of the following statements is most correct? a. When dealing with independent projects, discounted payback (using a payback requirement of 3 or less years), NPV, IRR, and modified IRR always lead to the same accept/reject decisions for a given project. b. When dealing with mutually exclusive projects, the NPV and modified IRR methods always rank projects the same, but those rankings can conflict with rankings produced by the discounted payback and the regular IRR methods. c. Multiple rates of return are possible with the regular IRR method but not with the modified IRR method, and this fact is one reason given by the textbook for favoring MIRR (or modified IRR) over IRR. d. Statements a, b, and c are false. e. Statements a and c are true.

Michigan Mattress Company is considering the purchase of land and the construction of a new plant. The land, which would be bought immediately (at t = 0), has a cost of $100,000 and the building, which would be erected at the end of the first year (t = 1), would cost $500,000. It is estimated that the firm's after-tax cash flow will be increased by $100,000 starting at the end of the second year, and that this incremental flow would increase at a 10 percent rate annually over the next 10 years. What is the approximate payback period? a. 2 years b. 4 years c. 6 years d. 8 years e. 10 years

C Payback = 5 + 135.9/146.41 = 5.928 (6_ Years

Company A and Company B have the same total assets, operating income (EBIT), tax rate, interest rate (cost of debt, rd), and business risk. Company A, however, has a much higher debt ratio than Company B. Company A's basic earning power (BEP) exceeds its cost of debt financing (rd). Which of the following statements is most correct? a. Company A has a higher return on assets (ROA) than Company B. b. Company A has a higher times interest earned (TIE) ratio than Company B. c. Company A has a higher return on equity (ROE) than Company B, and its risk, as measured by the standard deviation of ROE, is also higher than Company B's. d. Statements b and c are correct. e. All of the statements above are correct.

C Statement a is false; A's net income is lower than B's due to higher interest expense, but its assets are equal to B's, so A's ROA must be lower than B's ROA. Statement b is false; A has the same EBIT as B, but higher interest payments than B; therefore, A's TIE is lower than B's. Statement c is correct

USE LAST QUESTION What discount rate should you use to discount Dustvac's free cash flows and interest tax savings? a. 10.01% b. 10.06% c. 11.29% d. 11.44% e. 13.49%

C The correct discount rate is the unlevered cost of equity. The levered cost of equity is 6% + 1.36(4%) = 11.44%, the percent of debt is $5/($5 + $10) = 0.333. The rate on the debt is 11%. The unlevered cost of equity is wd*rd + ws*rsL = 0.333(11%) + 0.667(11.44%) = 11.29%.

Magiclean Corporation is considering the acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02, and both it and Dustvac face a 40% tax rate. Magiclean's capital structure is 40% debt and 60% equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next 4 years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. New debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%. What Dustvac's pre-merger WACC? a. 9.02% b. 9.50% c. 9.83% d. 10.01% e. 11.29%

C The pre-merger weight of debt is $5/($5 + $10) = 0.333 The pre-merger required rate of return on equity is 6% + 1.36(4%) = 11.44%. WACC = wdrd(1 - T) + wSrS = 0.333(11%)(1 - 0.40) + 0.667(11.44%) = 9.83%.

Blazer Inc. is thinking of acquiring Laker Company. Blazer expects Laker's NOPAT to be $9 million the first year, with no net new investment in operating capital and no interest expense. For the second year, Laker is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year, Laker will need $10 million of net new investment in operating capital. Laker's marginal tax rate is 40%. After the second year, the free cash flows and the tax shields from Laker to Blazer will both grow at a constant rate of 4%. Blazer has determined that Laker's cost of equity is 17.5%, and Laker currently has no debt outstanding. Assume that all cash flows occur at the end of the year, Blazer must pay $45 million to acquire Laker. What it the NPV of the proposed acquisition? Note that you must first calculate the value to Blazer of Laker's equity. a. $ 45.0 million b. $ 68.2 million c. $ 69.8 million d. $113.2 million e. $133.0 million

C Unlevered cost of equity is 17.5%. All CF are discounted at this rate Vops = $9/(1.175) + $148/(1.175)^2 = $114.8 = V equity since there is no debt. NPV is 114.8 - 45 = 69.8M

Great Subs Inc., a regional sandwich chain, is considering purchasing a smaller chain, Eastern Pizza, which is currently financed using 20% debt at a cost of 8%. Great Subs' analysts project that the merger will result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Eastern's pre-merger beta is 2.0, and its postmerger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%. What is the appropriate rate for use in discounting the free cash flows and the interest tax savings? a. 12.0% b. 13.9% c. 14.4% d. 16.0% e. 16.9%

C rSL = 8% + 2 (4%) = 16% ; rsU = .20(8%) + 0.80 (16%) = 14.4%

Project A has an internal rate of return of 18 percent, while Project B has an internal rate of return of 16 percent. However, if the company's cost of capital (WACC) is 12 percent, Project B has a higher net present value. Which of the following statements is most correct? a. The crossover rate for the two projects is less than 12 percent. b. Assuming the timing of the two projects is the same, Project A is probably of larger scale (initial investment cost) than Project B. c. Assuming that the two projects have the same scale (initial investment cost), Project A probably has a faster payback than Project B. d. Answers a and b are correct. e. Answers b and c are correct.

C (Draw out the NPV profiles of these two projects. As B's NPV declines more rapidly with an increase in discount rates, this implies that more of the cash flows are coming later on. Therefore, Project A has a faster payback than Project B)

Which of the following statements is most correct? a. The MIRR method will always arrive at the same conclusion as the NPV method. b. The MIRR method can overcome the multiple IRR problem, while the NPV method cannot. c. The MIRR method uses a more reasonable assumption about reinvestment rates than the IRR method. d. Statements a and c are correct. e. All of the above statements are correct.

C (Statement c is correct; the other statements are false. MIRR and NPV can conflict for mutually exclusive projects if the projects differ in size. NPV does not suffer from the multiple IRR problem)

Which one of the following is an example of a "flexibility" option? a. A company has an option to invest in a project today or to wait a year. b. A company has an option to close down an operation if it turns out to be unprofitable. c. A company agrees to pay more to build a plant in order to be able to change the plant's inputs and/or outputs at a later date if conditions change. d. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date. e. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly commercial.

C (Statements a, b, c, and d are all examples of different types of real options. A flexibility option permits the firm to alter operations depending on how conditions change during the life of the project. Typically, either inputs or outputs, or both, can be changed. Statement a is an example of an investment timing option, while statement b is an example of an abandonment option. Statement c is an example of a flexibility option, statement d is an example of a growth option, and statement e is not really a real option at all. Therefore, statement c is the correct choice)

Which of the following statements is most CORRECT? a. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers. b. The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed. 3 c. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger. d. Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what's probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm. e. None of the answers above is correct

Elephant Books sells paperback books for $7 each. The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1. Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even? a. $600,000 b. $466,667 c. $333,333 d. $200,000 e. None of the above

D $7(200,000) - $5(200,000) - F = 0 F = $400,000. $7(200,000) - $4(200,000) - F = 0; F = $600,000 $600,000 - $400,000 = $200,000.

Dunbar Hardware, a national hardware chain, is considering purchasing a smaller chain, Eastern Hardware. Dunbar's analysts project that the merger will let Eastern produce incremental free cash flows and interest tax savings with a combined present value of $72.52 million, and they have determined that the appropriate discount rate for valuing Eastern is 16%. Eastern has 4 million shares outstanding and no debt. Eastern's current price is $16.25. What is the maximum price per share that Dunbar should offer? a. $16.25 b. $16.97 c. $17.42 d. $18.13 e. $34.38

D 75.52M/4M = 18.13

Aaron Athletics is trying to determine its optimal capital structure. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table % Fin % Fin D-Equity Bond Pre-Tax D No D Ratio Rating Cost Debt .10 .90 .11 AA 7% .20 .80 .25 A 7.2 .30 .70 .43 A 8 .40 .60 .67 BB 8.8 .50 .50 1 B 9.6 The company's tax rate, T, is 40 percent. The company uses the CAPM to estimate its cost of common equity, rs. The risk-free rate is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," bU, equals 1.0.) On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure? a. wc = 0.9; wd = 0.1; WACC = 14.96% b. wc = 0.8; wd = 0.2; WACC = 10.96% c. wc = 0.7; wd = 0.3; WACC = 7.83% d. wc = 0.6; wd = 0.4; WACC = 10.15% e. wc = 0.5; wd = 0.5; WACC = 10.18%

D rRF = 5% ; rm- rrf = 6% rs = rrf + (rm-rrf) WACC = rd x wd x (1 - T) rs x wc You need to use the D/E ratio given for each capital structure to find the levered beta using the Hamada equation. Then, use each of these betas with the CAPM to find the rs for that capital structure. Use this rs and rd for each capital structure to find the WACC. The optimal capital structure is the one that minimizes the WACC. rs = rRF + (rM - rRF)b = 5% + 6%(1.0667) = 11.40%. The weights are given at 0.9 and 0.1 for equity and debt, respectively, and the rd for that capital structure is given as 7 percent. WACC = rd wd (1 - T) + rs wc = 7% 0.1 (1 - 0.4) + 11.40% 0.9 = 10.68%. Do the same calculation for each of the capital structures and find each WACC. The optimal capital structure is the one that minimizes the WACC, which is 10.15%. Therefore, the optimal capital structure is 40% debt and 60% equity.

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