As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was found to be 20% versus a project required return of 12%. The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 10% interest rate, with payments to be made at the end of each year. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at the end of each year. The loom falls in the MACRS 5-year class, and Tanner-Woods’s marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 20%, 32%, 19%, 12%, 11%, and 6%. United Automation Inc., maker of the loom, has offered to lease the loom to Tanner- Woods for $70,000 upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has an expected life of 8 years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $42,500. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or owning the proposed loom for more than that period. a. Should the loom be leased or purchased? b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pretax discount rate is 15%. What would be the effect of a salvage value risk adjustment on the decision? c. The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use the loom after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.) Answer a. 0 1 2 3 4 | | | | | Net purchase price (250,000) Depr’n tax savingsa 20,000 32,000 19,000 12,000 Maintenance (AT) (12,000) (12,000) (12,000) (12,000) Salvage value 42,500 Net cash flow (250,000) 8,000 20,000 7,000 42,500 PV cost of owning at 6% = -$185,112. Notes: 1. There is no tax associated with the loom’s salvage value since salvage value equals book value. 2. The appropriate discount rate is the after-tax cost of debt = rd(1 – T) = 10%(1 – 0.4) = 6%. a Depreciation tax savings are calculated as follows: MACRS Allowance *Depreciation End of Year Depreciation Year Factor Expense Book Value Tax Savings 1 0.20 $50,000 $200,000 $20,000 2 0.32 80,000 120,000 32,000 3 0.19 47,500 72,500 19,000 4 0.12 30,000 42,500 12,000 *Note that the loom’s depreciable basis is $250,000. The cost of leasing can be placed on a time line as follows: 0 1 2 3 4 | | | | | Lease payment (AT) -42,000 -42,000 -42,000 -42,000 -42,000 PV at 6% = -$187,534. Thus, the present value of the cost of owning is $187,534 – $185,112 = $2,422 less than the present value of the cost of leasing. Tanner-Woods Textile should purchase the loom. b. Here we merely discount all cash flows in the cost of owning analysis at 6% except the salvage value cash flow, which we discount at 9%, the after-tax discount rate [15%(1 – 0.4)]: 0 1 2 3 4 | | | | | ($250,000) PVs of all other cash flows 7,547 @ 6% 17,800 5,877 0 30,108 @ 9% $42,500 NPV = (188,668) When differential risk is considered, the cost of owning is now higher than the $187,534 cost of leasing; thus, the firm should lease the loom. c. This merely shifts the salvage value cash flow from the cost of owning analysis to the cost of leasing analysis. If Tanner-Woods Textile needed the loom after four years, it would have it if the loom were purchased, but would have to buy it if the loom were leased. The decision would remain the same. If differential salvage value risk is not considered, the loom should be purchased. In fact, the advantage to purchasing would be exactly the same.
> Assume that it is now January 1, 2009. Wayne-Martin Electric Inc. (WME) has developed a solar panel capable of generating 200% more electricity than any other solar panel currently on the market. As a result, WME is expected to experience a 15% annual gr
> a. Given the following graphs, calculate the total fixed costs, variable costs per unit, and sales price for Firm A. Firm B’s fixed costs are $120,000, its variable costs per unit are $4, and its sales price is $8 per unit. b. Which fir
> A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a yield of 8%. Assume that the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the corporate bond?
> Assume that today is December 31, 2008, and that the following information applies to Vermeil Airlines: ● After-tax operating income [EBIT(1 – T)] for 2009 is expected to be $500 million. ● The depreciation expense for 2009 is expected to be $100 million
> Welch Company is considering three independent projects, each of which requires a $5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here: Note that the projects’ cos
> You plan to invest in the Kish Hedge Fund, which has total capital of $500 million invested in five stocks: Kish’s beta coefficient can be found as a weighted average of its stocks’ betas. The risk-free rate is 6%, an
> Last year Clark Company issued a 10-year, 12% semiannual coupon bond at its par value of $1,000. Currently, the bond can be called in 4 years at a price of $1,060 and it sells for $1,100. a. What are the bond’s nominal yield to maturity and its nominal y
> What’s the difference between a call for sinking fund purposes and a refunding call?
> What are the key factors on which external financing depends, as indicated in the AFN equation?
> A company’s 5-year bonds are yielding 7.75% per year. Treasury bonds with the same maturity are yielding 5.2% per year, and the real risk-free rate (r*) is 2.3%. The average inflation premium is 2.5%; and the maturity risk premium is estimated to be 0.1
> At the end of last year, Roberts Inc. reported the following income statement (in millions of dollars): Looking ahead to the following year, the company’s CFO has assembled this information: ● Year-end sales are expec
> Walter Industries has $5 billion in sales and $1.7 billion in fixed assets. Currently, the company’s fixed assets are operating at 90% of capacity. a. What level of sales could Walter Industries have obtained if it had been operating at full capacity? b.
> Austin Grocers recently reported the following 2008 income statement (in millions of dollars): This year the company is forecasting a 25% increase in sales; and it expects that its year-end operating costs, including depreciation, will equal 70% of sale
> Refer to Problem 17-1. What additional funds would be needed if the company’s year-end 2008 assets had been $4 million? Assume that all other numbers are the same. Why is this AFN different from the one you found in Problem 17-1? Is the company’s “capita
> Companies often have to increase their initial investment costs to obtain real options. Why might this be so, and how could a firm decide if it was worth the cost to obtain a given real option?
> Microtech Corporation is expanding rapidly and currently needs to retain all of its earnings; hence, it does not pay dividends. However, investors expect Microtech to begin paying dividends, beginning with a dividend of $1.00 coming 3 years from today. T
> Primrose Corp has $15 million of sales, $2 million of inventories, $3 million of receivables, and $1 million of payables. Its cost of goods sold is 80% of sales, and it finances working capital with bank loans at an 8% rate. What is Primrose’s cash conve
> McDowell Industries sells on terms of 3/10, net 30. Total sales for the year are $912,500; 40% of the customers pay on the 10th day and take discounts, while the other 60% pay, on average, 40 days after their purchases. a. What is the days’ sales outstan
> Dan Barnes, financial manager of Ski Equipment Inc. (SKI), is excited, but apprehensive. The company’s founder recently sold his 51% controlling block of stock to Kent Koren, who is a big fan of EVA (Economic Value Added). EVA is found
> Digital Inc. is considering production of a new cell phone. The project will require an investment of $20 million. If the phone is well-received, the project will produce cash flows of $10 million a year for 3 years; but if the market does not like the p
> Rework Problem 16-10 using a spreadsheet model. After completing Parts a through d, respond to the following: If Bowers’ customers began to pay late, collections would slow down, thus increasing the required loan amount. If sales declin
> Indicate whether each of the following actions will increase or decrease a bond’s yield to maturity: a. The bond’s price increases. b. The bond is downgraded by the rating agencies. c. A change in the bankruptcy code makes it more difficult for bondhold
> The cost of retained earnings is less than the cost of new outside equity capital. Consequently, it is totally irrational for a firm to sell a new issue of stock and to pay dividends during the same year. Discuss the meaning of those statements.
> Discuss the pros and cons of having the directors formally announce what a firm’s dividend policy will be in the future.
> Indicate whether the following statements are true or false. If the statement is false, explain why. a. If a firm repurchases its stock in the open market, the shareholders who tender the stock are subject to capital gains taxes. b. If you own 100 shares
> Suppose you won the lottery and had two options: (1) Receiving $0.5 million or (2)Taking a gamble in which at the flip of a coin you receive $1 million if a head comes up but receive zero if a tail comes up. a. What is the expected value of the gamble?
> Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $3.00 dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain constant for the next several years. The company’s
> One alleged advantage of leasing voiced in the past was that it kept liabilities off the balance sheet, thus making it possible for a firm to obtain more leverage than it otherwise could have. This raised the question of whether the lease obligation and
> Distinguish between operating leases and financial leases. Would a firm be more likely to finance a fleet of trucks or a manufacturing plant with an operating lease? Explain.
> One often finds that a company’s bonds have a higher yield than its preferred stock even though an investor considers the bonds to be less risky than the preferred. What causes this yield differential?
> Kaufman Enterprises has bonds outstanding with a $1,000 face value and 10 years left until maturity. They have an 11% annual coupon payment, and their current price is $1,175. The bonds may be called in 5 years at 109% of face value (Call price = $1,090)
> Suppose interest rates on Treasury bonds rose from 5% to 9% as a result of higher interest rates in Europe. What effect would this have on the price of an average company’s common stock?
> You are told that one corporation just issued $100 million of preferred stock and another purchased $100 million of preferred stock as an investment. You are also told that one firm has an effective tax rate of 20%, whereas the other is in the 35% bracke
> For purposes of measuring a firm’s leverage, should preferred stock be classified as debt or equity? Does it matter if the classification is being made (a) By the firm’s management, (b) By creditors, or (c) By equity investors?
> Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales were $1,100,000 last year, variable costs were 60% of sales, and fixed costs were $40,000. Therefore, EBIT totaled $400,000. Beca
> Suppose a company simultaneously issues $50 million of convertible bonds with a coupon rate of 9% and $50 million of pure bonds with a coupon rate of 12%. Both bonds have the same maturity. Does the fact that the convertible issue has the lower coupon ra
> a. How would a firm’s decision to pay out a higher percentage of its earnings as dividends affect each of the following? (1) The value of its long-term warrants (2) The likelihood that its convertible bonds will be converted (3) The likelihood that its w
> What effect does the expected growth rate of a firm’s stock price (subsequent to issue) have on its ability to raise additional funds through (a) Convertibles and (b) Warrants?
> Suppose Congress changed the tax laws in a way that (1) Permitted equipment to be depreciated over a shorter period, (2) Lowered corporate tax rates, and (3) Reinstated the investment tax credit. Discuss how each of these changes would affect the rela
> Suppose there were no IRS restrictions on what constitutes a valid lease. Explain in a manner that a legislator might understand why some restrictions should be imposed.
> Pogue Industries Inc. has warrants outstanding that permit its holders to purchase 1 share of stock per warrant at a price of $21. (Refer to Chapter 18 for Parts a, b, and c.) a. Calculate the exercise value of Pogue’s warrants if the common stock sells
> Morris-Meyer Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking firm that represents a group of investors believes that it ca
> Two textile companies, McDaniel-Edwards Manufacturing and Jordan-Hocking Mills, began operations with identical balance sheets. A year later both required additional manufacturing capacity at a cost of $200,000. McDaniel-Edwards obtained a 5-year, $200,0
> Look back at Table 7-4 and examine United Parcel Service and Telecom Italia Capital bonds that mature in 2013. a. If these companies were to sell new $1,000 par value long-term bonds, approximately what coupon interest rate would they have to set if they
> Gregg Company recently issued two types of bonds. The first issue consisted of 20-year straight (no warrants attached) bonds with an 8% annual coupon. The second issue consisted of 20-year bonds with a 6% annual coupon with warrants attached. Both bonds
> Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. Its treasury
> Connors Construction needs a piece of equipment that can be leased or purchased. The equipment costs $100. One option is to borrow $100 from the local bank and use the money to buy the equipment. The other option is to lease the equipment. If Connors cho
> O’Brien Computers Inc. needs to raise $35 million to begin producing a new microcomputer. O’Brien’s straight, nonconvertible debentures currently yield 12%. Its stock sells for $38 per share, the last dividend was $2.46, and the expected growth rate is a
> The Howe Computer Company has grown rapidly during the past 5 years. Recently, its commercial bank urged the company to consider increasing its permanent financing. Its bank loan under a line of credit has risen to $150,000, carrying a 10% interest rate,
> In the summer of 2008, the Hadaway Company was planning to finance an expansion with a convertible security. They considered a convertible debenture but feared the burden of fixed interest charges if the common stock did not rise enough to make conversio
> Martha Millon, financial manager of Fish & Chips Inc., is facing a dilemma. The firm was founded 5 years ago to develop a new fast-food concept; and although Fish & Chips has done well, the firm’s founder and chairman believes that an industry shake-out
> Martha Millon, financial manager for Fish & Chips Inc., has been asked to perform a lease versus- buy analysis on a new computer system. The computer costs $1,200,000; and if it is purchased, Fish & Chips could obtain a term loan for the full amount at a
> Storm Software wants to issue $100 million in new capital to fund new opportunities. If Storm raised the $100 million of new capital in a straight-debt 20-year bond offering, Storm would have to offer an annual coupon rate of 12%. However, Storm’s advise
> Use the spreadsheet model to rework Parts a and b of Problem 20-8. Then answer the following question. c. Accepting that the corporate WACC should be used equally to discount all anticipated cash flows, at what cost of capital would the firm be indiffere
> Last year Joan purchased a $1,000 face value corporate bond with an 11% annual coupon rate and a 10-year maturity. At the time of the purchase, it had an expected yield to maturity of 9.79%. If Joan sold the bond today for $1,060.49, what rate of return
> Would a failure to recognize growth options tend to cause a firm’s actual capital budget to be above or below the optimal level? Would your answer be the same for abandonment, timing, and flexibility options? Explain.
> Should firms require higher rates of return on foreign projects than on identical projects located at home? Explain.
> What is a Eurodollar? If a French citizen deposits $10,000 in Chase Manhattan Bank in New York, have Eurodollars been created? What if the deposit is made in Barclay’s Bank in London? Chase Manhattan’s Paris branch? Does the existence of the Eurodollar m
> Why might purchasing power parity fail to hold?
> Does interest rate parity imply that interest rates are the same in all countries?
> Six-month T-bills have a nominal rate of 7%, while default-free Japanese bonds that mature in 6 months have a nominal rate of 5.5%. In the spot exchange market, 1 yen equals $0.009. If interest rate parity holds, what is the 6–month forward exchange rate
> A currency trader observes that in the spot exchange market, 1 U.S. dollar can be exchanged for 3.50 Israeli shekels or for 104.00 Japanese yen. What is the cross exchange rate between the yen and the shekel; that is, how many yen would you receive for e
> Solitaire Machinery is a Swiss multinational manufacturing company. Currently, Solitaire’s financial planners are considering undertaking a 1-year project in the United States. The project’s expected dollar-denominated cash flows consist of an initial in
> After all foreign and U.S. taxes, a U.S. corporation expects to receive 3 pounds of dividends per share from a British subsidiary this year. The exchange rate at the end of the year is expected to be $2 per pound, and the pound is expected to depreciate
> You are the vice president of International InfoXchange, headquartered in Chicago, Illinois. All shareholders of the firm live in the United States. Earlier this month you obtained a loan of 5 million Canadian dollars from a bank in Toronto to finance th
> Chamberlain Canadian Imports has agreed to purchase 15,000 cases of Canadian beer for 4 million Canadian dollars at today’s spot rate. The firm’s financial manager, James Churchill, has noted the following current spot
> Explain in general terms what each of the following real options is and how it could change projects’ NPVs and their corresponding risk relative to what would have been estimated if the options had not been considered. a. abandonment b. timing c. growth
> You are considering a 10-year, $1,000 par value bond. Its coupon rate is 9%, and interest is paid semiannually. If you require an “effective” annual interest rate (not a nominal rate) of 8.16%, how much should you be willing to pay for the bond?
> Assume that interest rate parity holds and that 90-day risk-free securities yield 5% in the United States and 5.3% in Britain. In the spot market, 1 pound ¼ $2. a. Is the 90-day forward rate trading at a premium or a discount relative to the spot rate? b
> Assume that interest rate parity holds. In both the spot market and the 90-day forward market, 1 Japanese yen = 0.0086 dollar. And 90-day risk-free securities yield 4.6% in Japan. What is the yield on 90-day risk-free securities in the United States?
> Use the foreign exchange section of a current issue of The Wall Street Journal to look up the three currencies in Problem 19-8. What is the current exchange rate between Swedish kronas and pounds? Data from Problem 19-8 Suppose the exchange rate between
> Use the foreign exchange section of a current issue of The Wall Street Journal to look up the six currencies in Problem 19-5. a. What is the current exchange rate for changing dollars into 1,000 units of pounds, Canadian dollars, euros, yen, Mexican peso
> Table 19-1 lists foreign exchange rates for May 26, 2008. On that day, how many dollars would be required to purchase 1,000 units of each of the following: British pounds, Canadian dollars, EMU euros, Japanese yen, Mexican pesos, and Swedish kronas? Tabl
> Citrus Products Inc. is a medium-sized producer of citrus juice drinks with groves in Indian River County, Florida. Until now, the company has confined its operations and sales to the United States; but its CEO, George Gaynor, wants to expand into the Pa
> Yohe Telecommunications is a multinational corporation that produces and distributes telecommunications technology. Although its corporate headquarters are located in Maitland, Florida, Yohe usually buys its raw materials in several different foreign cou
> Discuss some of the techniques available to reduce risk exposure.
> Why do options typically sell at prices higher than their exercise values?
> What is a post-audit, why do firms use them, and what problems can arise when they are used?
> List seven reasons risk management might increase the value of a firm.
> Bond X is non callable and has 20 years to maturity, a 9% annual coupon, and a $1,000 par value. Your required return on Bond X is 10%; and if you buy it, you plan to hold it for 5 years. You (and the market) have expectations that in 5 years, the yield
> Give two reasons stockholders might be indifferent between owning the stock of a firm with volatile cash flows and the stock of a firm with stable cash flows.
> How can swaps be used to reduce the risks associated with debt contracts?
> Explain how the futures markets can be used to reduce interest rate and input price risk.
> Assume that you have been given the following information on Purcell Industries: Using the Black-Scholes Option Pricing Model, what is the value of the option? Current stock price = $15 Exercise price of option = $15 Time to maturity of option = 6 m
> Which of the following events are likely to increase the market value of a call option on a common stock? Explain. a. An increase in the stock’s price b. An increase in the volatility of the stock price c. An increase in the risk-free rate d. A decrease
> Stewart Enterprises’ current stock price is $60 per share. Call options for this stock exist that permit the holder to purchase one share at an exercise price of $50. These options will expire at the end of 1 year, at which time Stewart’s stock will be s
> Audrey is considering an investment in Morgan Communications, whose stock currently sells for $60. A put option on Morgan’s stock, with an exercise price of $55, has a market value of $3.06. Meanwhile, a call option on the stock with the same exercise pr
> The Zinn Company plans to issue $20,000,000 of 10-year bonds in December to help finance a new research and development laboratory. It is now August, and the current cost of debt to the high-risk biotech company is 11%. However, the firmâ€
> How might a firm’s corporate WACC be affected by the size of its capital budget?
> 21st Century Educational Products (21st Century) is a rapidly growing software company; and consistent with its growth, it has a relatively large capital budget. While most of the company’s projects are fairly easy to evaluate, a handfu
> Bankers’ Services Inc. (BSI) is considering a project that has a cost of $10 million and an expected life of 3 years. There is a 30% probability of good conditions, in which case the project will provide a cash flow of $9 million at the end of each year
> What are some differences in the analysis for a replacement project versus that for a new expansion project?
> Most firms generate cash inflows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows and then using them in the analysis? If we do not, are our results biased? If so,
> Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term or a short term basis? Why?
> Explain why working capital is included in a capital budgeting analysis and how it is recovered at the end of a project’s life.
> Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included. Give an example of each.
> What is a “replacement chain?” When and how should replacement chains be used in capital budgeting?
> If you were the CFO of a company that had to decide on hundreds of potential projects every year, would you want to use sensitivity analysis and scenario analysis as described in the chapter or would the amount of arithmetic required take too much time a
> Define (a) Sensitivity analysis, (b) Scenario analysis, and (c) Simulation analysis. If GE was considering two projects (one for $500 million to develop a satellite communications system and the other for a $30,000 new truck) on which project would th
> In theory, market risk should be the only “relevant” risk. However, companies focus as much on stand-alone risk as on market risk. What are the reasons for the focus on stand-alone risk?
