Suppose the inflation rate is expected to be 7% next year, 5% the following year, and 3% thereafter. Assume that the real risk-free rate, r*, will remain at 2% and that maturity risk premiums on Treasury securities rise from zero on very short-term bonds (those that mature in a few days) to 0.2% for 1-year securities. Furthermore, maturity risk premiums increase 0.2% for each year to maturity, up to a limit of 1.0% on 5-year or longer term T-bonds. a. Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year Treasury securities and plot the yield curve. b. Suppose a AAA-rated company (which is the highest bond rating a firm can have) had bonds with the same maturities as the Treasury bonds. Estimate and plot what you believe a AAA-rated company’s yield curve would look like on the same graph with the Treasury bond yield curve. (Hint: Think about the default risk premium on its long term versus its short-term bonds.) c. On the same graph, plot the approximate yield curve of a much riskier lower-rated company with a much higher risk of defaulting on its bonds.
> 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?
> Distinguish among beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a project being considered for inclusion in a firm’s capital budget.
> The Butler-Perkins Company (BPC) must decide between two mutually exclusive projects. Each costs $6,750 and has an expected life of 3 years. Annual project cash flows begin 1 year after the initial investment and are subject to the following probability
> Mississippi River Shipyards is considering replacing an 8-year-old riveting machine with a new one that will increase earnings before depreciation from $27,000 to $54,000 per year. The new machine will cost $82,500, and it will have an estimated life of
> The Dauten Toy Corporation uses an injection molding machine that was purchased 2 years ago. This machine is being depreciated on a straight-line basis, and it has 6 years of remaining life. Its current book value is $2,100, and it can be sold for $2,500
> In late 1980, the U.S. Commerce Department released new data showing inflation was 15%. At the time, the prime rate of interest was 21%, a record high. However, many investors expected the new Reagan administration to be more effective in controlling inf
> You must evaluate a proposal to buy a new milling machine. The base price is $108,000, and shipping and installation costs would add another $12,500. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The appli
> You must evaluate a proposed spectrometer for the R&D Department. The base price is $140,000, and it would cost another $30,000 to modify the equipment for special use by the firm. The equipment falls into the MACRS 3-year class and would be sold after 3
> Kristin is evaluating a capital budgeting project that should last 4 years. The project requires $800,000 of equipment. She is unsure what depreciation method to use in her analysis, straight-line or the 3-year MACRS accelerated method. Under straight-li
> Corcoran Consulting is deciding which of two computer systems to purchase. It can purchase state-of-the-art equipment (System A) for $20,000, which will generate cash flows of $6,000 at the end of each of the next 6 years. Alternatively, the company can
> The Chang Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has a book value and a market value of zero. However, the machine is in good working order and will last at least another
> Eisenhower Communications is trying to estimate the first-year net cash flow (at Year 1) for a proposed project. The financial staff has collected the following information on the project: The company has a 40% tax rate, and its WACC is 10%. a. What is
> Truman Industries is considering an expansion. The necessary equipment would be purchased for $9 million, and the expansion would require an additional $3 million investment in working capital. The tax rate is 40%. a. What is the initial investment outla
> The Bigbee Bottling Company is contemplating the replacement of one of its bottling machines with a newer and more efficient one. The old machine has a book value of $600,000 and a remaining useful life of 5 years. The firm does not expect to realize any
> The Erley Equipment Company purchased a machine 5 years ago at a cost of $90,000. The machine had an expected life of 10 years at the time of purchase, and it is being depreciated by the straight-line method by $9,000 per year. If the machine is not repl
> Holmes Manufacturing is considering a new machine that costs $250,000 and would reduce pretax manufacturing costs by $90,000 annually. Holmes would use the 3-year MACRS method to depreciate the machine, and management thinks the machine would have a valu
> Your firm, Agrico Products, is considering a tractor that would have a net cost of $36,000, would increase pretax operating cash flows before taking account of depreciation by $12,000 per year, and would be depreciated on a straight-line basis to zero ov
> A firm has two mutually exclusive investment projects to evaluate; both can be repeated indefinitely. The projects have the following cash flows: Projects X and Y are equally risky and may be repeated indefinitely. If the firm’s WACC i
> The Fernandez Company has an opportunity to invest in one of two mutually exclusive machines that will produce a product the company will need for the next 8 years. Machine A costs $10 million but will provide after-tax inflows of $4 million per year for
> Zappe Airlines is considering two alternative planes. Plane A has an expected life of 5 years, will cost $100 million, and will produce after-tax cash flows of $30 million per year. Plane B has a life of 10 years, will cost $132 million, and will produce
> Cotner Clothes Inc. is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: (a) Machine 190-3, which has a cost of $190,000, a 3-year expected life, and after-tax cash flows (labor savings and depreci
> Haley’s Graphic Designs Inc. is considering two mutually exclusive projects. Both projects require an initial investment of $10,000 and are typical average-risk projects for the firm. Project A has an expected life of 2 years with after-tax cash inflows
> Allied Food Products is considering expanding into the fruit juice business with a new fresh lemon juice product. Assume that you were recently hired as assistant to the director of capital budgeting and you must evaluate the new project. The lemon juic
> You must analyze a potential new product—a caulking compound that Cory Materials’ R&D people developed for use in the residential construction industry. Cory’s marketing manager thinks the company can sell 115,000 tubes per year for 3 years at a price of
> What is a mutually exclusive project? How should managers rank mutually exclusive projects?
> What are three potential flaws with the regular payback method? Does the discounted payback method correct all three flaws? Explain.
> A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond yields 6.4%, and a 10-year corporate bond yields 8.4%. The market expects that inflation will average 2.5% over the next 10 years (IP10 ¼ 2.5%). Assume that there is no maturity risk premiu
> How are project classifications used in the capital budgeting process?
> A firm has a $100 million capital budget. It is considering two projects, each costing $100 million. Project A has an IRR of 20%; has an NPV of $9 million; and will be terminated after 1 year at a profit of $20 million, resulting in an immediate increase
> What reinvestment rate assumptions are built into the NPV, IRR, and MIRR methods? Give an explanation (other than “because the text says so”) for your answer.
> Project X is very risky and has an NPV of $3 million. Project Y is very safe and has an NPV of $2.5 million. They are mutually exclusive, and project risk has been properly considered in the NPV analyses. Which project should be chosen? Explain.
> Why might it be rational for a small firm that does not have access to the capital markets to use the payback method rather than the NPV method?
> Discuss the following statement: If a firm has only independent projects, a constant WACC, and projects with normal cash flows, the NPV and IRR methods will always lead to identical capital budgeting decisions. What does this imply about the choice betwe
> If two mutually exclusive projects were being compared, would a high cost of capital favor the longer-term or the shorter-term project? Why? If the cost of capital declined, would that lead firms to invest more in longer-term projects or shorter-term pro
> An electric utility is considering a new power plant in northern Arizona. Power from the plant would be sold in the Phoenix area, where it is badly needed. Because the firm has received a permit, the plant would be legal; but it would cause some air poll
> A mining company is considering a new project. Because the mine has received a permit, the project would be legal; but it would cause significant harm to a nearby river. The firm could spend an additional $10 million at Year 0 to mitigate the environment
> A firm with a 14% WACC is evaluating two projects for this year’s capital budget. After-tax cash flows, including depreciation, are as follows: a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each project. b. Assuming
> Which fluctuate more—long-term or short-term interest rates? Why?
> Your division is considering two projects with the following net cash flows (in millions): a. What are the projects’ NPVs assuming the WACC is 5%? 10%? 15%? b. What are the projects’ IRRs at each of these WACCs? c. If
> Refer to Problem 11-1. What is the project’s discounted payback? Problem 11-1 Project K costs $52,125, its expected net cash inflows are $12,000 per year for 8 years, and its WACC is 12%.
> MIRR Refer to Problem 11-1. What is the project’s MIRR? Problem 11-1 Project K costs $52,125, its expected net cash inflows are $12,000 per year for 8 years, and its WACC is 12%.
> A project has the following cash flows: This project requires two outflows at Years 0 and 2, but the remaining cash flows are positive. Its WACC is 10%, and its MIRR is 14.14%. What is the Year 2 cash outflow? 1 2 4 + $196 + -$500 $202 -$X $350 $451
> Project X costs $1,000, and its cash flows are the same in Years 1 through 10. Its IRR is 12%, and its WACC is 10%. What is the project’s MIRR?
> A project has annual cash flows of $7,500 for the next 10 years and then $10,000 each year for the following 10 years. The IRR of this 20-year project is 10.98%. If the firm’s WACC is 9%, what is the project’s NPV?
> A mining company is deciding whether to open a strip mine, which costs $2 million. Net cash inflows of $13 million would occur at the end of Year 1. The land must be returned to its natural state at a cost of $12 million, payable at the end of Year 2. a.
> A store has 5 years remaining on its lease in a mall. Rent is $2,000 per month, 60 payments remain, and the next payment is due in 1 month. The mall’s owner plans to sell the property in a year and wants rent at that time to be high so that the property
> A company has a 12% WACC and is considering two mutually exclusive investments (that cannot be repeated) with the following net cash flows: a. What is each project’s NPV? b. What is each project’s IRR? c. What is each
> A company is considering two mutually exclusive expansion plans. Plan A requires a $40 million expenditure on a large-scale integrated plant that would provide expected cash flows of $6.4 million per year for 20 years. Plan B requires a $12 million expen
> Assume that the real risk-free rate is 2% and that the maturity risk premium is zero. If the 1-year bond yield is 5% and a 2-year bond (of similar risk) yields 7%, what is the 1-year interest rate that is expected for Year 2? What inflation rate is expec
> An oil drilling company must choose between two mutually exclusive extraction projects, and each costs $12 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $14.4 million. Under Plan B, cash flows would be
> K. Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC and LCC (for high and low capital costs,
> A company is analyzing two mutually exclusive projects, S and L, with the following cash flows: The company’s WACC is 10%. What is the IRR of the better project? (Hint: The better project may or may not be the one with the higher IRR.)
> Project S costs $15,000, and its expected cash flows would be $4,500 per year for 5 years. Mutually exclusive Project L costs $37,500, and its expected cash flows would be $11,100 per year for 5 years. If both projects have a WACC of 14%, which project w
> You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the esti
> Your division is considering two projects. Its WACC is 10%, and the projects’ after-tax cash flows (in millions of dollars) would be as follows: a. Calculate the projects’ NPVs, IRRs, MIRRs, regular paybacks, and disc
> The WACC is a weighted average of the costs of debt, preferred stock, and common equity. Would the WACC be different if the equity for the coming year came solely in the form of retained earnings versus some equity from the sale of new common stock? Wou
> Suppose a firm estimates its WACC to be 10%. Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? If not, what might be “reasonable” costs of capital for average-, high-, and low-risk projects?
> How should the capital structure weights used to calculate the WACC be determined?
> Suppose 2-year Treasury bonds yield 4.5%, while 1-year bonds yield 3%. r* is 1%, and the maturity risk premium is zero. a. Using the expectations theory, what is the yield on a 1-year bond 1 year from now? b. What is the expected inflation rate in Year 1
> Suppose a new and more liberal Congress and administration are elected. Their first order of business is to take away the independence of the Federal Reserve System and to force the Fed to greatly expand the money supply. What effect will this have: a. O
> Donna Jamison, a 2003 graduate of the University of Florida with 4 years of banking experience, was recently brought in as assistant to the chairperson of the board of D’Leon Inc., a small food producer that operates in north Florida an
> An investment will pay $100 at the end of each of the next 3 years, $200 at the end of Year 4, $300 at the end of Year 5, and $500 at the end of Year 6. If other investments of equal risk earn 8% annually, what is its present value? Its future value?
> What’s the future value of a 7%, 5-year ordinary annuity that pays $300 each year? If this was an annuity due, what would its future value be?
> Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For example, if one action increases a firm’s stock price from a current level of $20 to $25 in 6 months and then to $30 in 5 years but another action keeps the sto
> You have $42,180.53 in a brokerage account, and you plan to deposit an additional $5,000 at the end of every future year until your account totals $250,000. You expect to earn 12% annually on the account. How many years will it take to reach your goal?
> If you deposit $10,000 in a bank account that pays 10% interest annually, how much will be in your account after 5 years?
> A father is now planning a savings program to put his daughter through college. She is 13, she plans to enroll at the university in 5 years, and she should graduate in 4 years. Currently, the annual cost (for everything—food, clothing, tuition, books, tr
