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All Textbook Solutions for Fundamentals of Financial Management, Concise Edition (MindTap Course List)
5DQ6DQThe required return on equity, rs, is the final input needed to estimate intrinsic value. For our purposes, you can assume a number (say, 9% or 10%) or you can use the CAPM to calculate an estimate of the cost of equity, using the data available on the Internet (For more details, look at the Taking a Closer Look exercise for Chapter 8.) Having decided on your best estimates for D1, rs, and g, you can calculate XOMs intrinsic value. Be careful to make sure that the long-run growth rate is less than the required rate of return. How does this estimate compare with the current stock price? Does your preliminary analysis suggest that XOM is undervalued or overvalued? Explain.8DQ9DQ10DQFor a stock to be in equilibrium, what two conditions must hold?If a stock is not in equilibrium, explain how financial markets adjust to bring it into equilibrium.RATES OF RETURN AND EQUILIBRIUM Stock Cs beta coefficient is bC = 0.4, and Stock Ds is bD = 0.5. (Stock Ds beta is negative, indicating that its return rises when returns on most other stocks fall. There are very few negative beta stocks, although collection agency stocks are sometimes cited as an example.) a. If the risk-free rate is 7% and the required rate of return on an average stock is 11%, what are the required rates of return on Stocks C and D? b. For Stock C, suppose the current price, P0, is 25.00; the next expected dividend, D1 is 1.50; and the stocks expected constant growth rate is 4%. Is the stock in equilibrium? Explain and describe what will happen if the stock is not in equilibrium.2P3PHow would each of the following scenarios affect a firms cost of debt, rd( 1 T); its cost of equity, rs; and its WACC? Indicate with a plus (+), a minus (), or a zero (0) whether the factor would raise, lower, or have an indeterminate effect on the item in question. Assume for each answer that other things are held constant, even though in some instances this would probably not be true. Bo prepared to justify your answer but recognize that several of the parts have no single correct answer. These questions are designed to stimulate thought and discussion.Assume that the risk-free rate increases, but the market risk premium remains constant. What impact would this have on the cost of debt? What impact would it have on the cost of equity?How should the capital structure weights used to calculate the WACC be determined?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?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? Would the calculated WACC depend in any way on the size of the capital budget? How might dividend policy affect the WACC?AFTER-TAX COST OF DEBT The Holmes Companys currently outstanding bonds have an 8% coupon and a 10% yield to maturity. Holmes believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 40%, what is Holmes after-tax cost of debt?COST OF PREFERRED STOCK Torch Industries can issue perpetual preferred stock at a price of 57.00 a share. The stock would pay a constant annual dividend of 56.00 a share. What is the company's cost of preferred stock, rp?COST OF COMMON EQUITY Pearson Motors has a target capital structure of 30% debt and 70% common equity, with no preferred stock. The yield to maturity on the companys outstanding bonds is 9%, and its tax rate is 40%. Pearsons CFO estimates that the companys WACC is 10.50%. What is Pearsons cost of common equity?COST OF EQUITY WITH AND WITHOUT FLOTATION Jarett Sonss common stock currently trades at 30.00 a share. It is expected to pay an annual dividend of 1.00 a share at the end of the year [D1 = 1.00], and the constant growth rate is 4% a year. a. What is the companys cost of common equity if all of its equity comes from retained earnings? b. If the company issued new stock, it would incur a 10% flotation cost. What would be the cost of equity from new stock?PROJECT SELECTION Midwest Water Works estimates that its WACC is 10.5%. The company is considering the following capital budgeting projects: Project Size Rate of Return A 1 million. 12.0% B 2 million 11.5 c 2 million 11.2 D 2 million 11.0 E 1 million 10.7 F 1 million 10.3 G 1 million 10.2 Assume that each of these projects is just as risky as the firms existing assets and that the firm may accept all the projects or only some of them Which set of projects should be accepted? Explain.COST OF COMMON EQUITY The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 6% per year. Callahans common stock currently sells for 22.00 per share; its last dividend was 2.00; and it will pay a 2.12 dividend at the end of the current year. a. Using the DCF approach, what is its cost of common equity? b. If the firm's beta is 1-2, the risk-free rate is 6%, and the average return on the market is 13%, what will be the firm's cost of common equity using the CAPM approach? c. If the firms bonds earn a return of 11%, based on the bond-yield-plus-risk-premium approach, what will be rs? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. d. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahans cost of common equity?COST OF COMMON EQUITY WITH AND WITHOUT FLOTATION The Evanec Companys next expected dividend, D1 is 3.18; its growth rate is 6%; and its common stock now sells for 36.00. New stock (external equity) can be sold to net 32.40 per share. a. What is Evanecs cost of retained earnings, rs? b. What is Evanecs percentage flotation cost, F? c. c What is Evanecs cost of new common stock, re?COST OF COMMON EQUITY AND WACC Palencia Paints Corporation has a target capital structure of 35% debt and 65% common equity, with no preferred stock. Its before-tax cost of debt is 8%, and its marginal tax rate is 40%. The current stock price is P0 = 22.00. The last dividend was D0 2.25, and it is expected to grow at a 5% constant rate. What is its cost of common equity and its WACC?WACC The Paulson Companys year-end balance sheet is shown below. Its cost of common equity is 14%, its before-tax cost of debt is 10%, and its marginal tax rate is 40%. Assume that the firms long-term debt sells at par value. The firms total debt, which is the sum of the companys short-term debt and long-term debt, equals 1,167. The firm has 576 shares of common stock outstanding that sell for 4.00 per share. Calculate Paulsons WACC using market-value weights.WACC Olsen Outfitters Inc. believes that its optimal capital structure consists of 55% common equity and 45% debt, and its tax rate is 40%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have 4 million of retained earnings with a cost of rs = 11%. New common stock in an amount up to 8 million would have a cost of re = 12-5%. Furthermore, Olsen can raise up to 4 million of debt at an interest rate of rd = 9% and an additional 5 million of debt at rd = 13%. The CFO estimates that a proposed expansion would require an investment of 8.2 million. What is the WACC for the last dollar raised to complete the expansion?WACC AND PERCENTAGE OF DEBT FINANCING Hook Industriess capital structure consists solely of debt and common equity. It can issue debt at rd = 11%, and its common stock currently pays a 2.00 dividend per share (D0 =2.00). The stocks price is currently 24.75, its dividend is expected to grow at a constant rate of 7% per year, its tax rate is 35%, and its WACC is 13.95%. What percentage of the company's capital structure consists of debt?WACC Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 9% as long as it finances at its target capital structure, which calls for 35% debt and 65% common equity. Its last dividend (D0) was 2.20, its expected constant growth rate is 6%, and its common stock sells for 26. EEC's tax rate is 40%. Two projects are available: Project A has a rate of return of 12%. and Project Bs return is 11%. These two projects are equally risky and about as risky as the firms existing assets. a. What is its cost of common equity? b. What is the WACC? c. Which projects should Empire accept?13PCOST OF PREFERRED STOCK INCLUDING FLOTATION Travis Industries plans to issue perpetual preferred stock with an 11.00 dividend. The stock is currently selling for 108.50, but flotation costs will be 5% of the market price, so the net price will be 103.08 per share. What is the cost of the preferred stock, including flotation?WACC AND COST OF COMMON EQUITY Kahn Inc. has a target capital structure of 60% common equity and 40% debt to fund its 10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 13%, a before-tax cost of debt of 10%, and a tax rate of 40%. The company's retained earnings are adequate to provide the common equity portion of its capital budget. Its expected dividend next year (D1) is 3, and the current stock price is 35. a. What is the companys expected growth rate? b. If the firms net income is expected to be 1.1 billion, what portion of its net income is the firm expected to pay out as dividends? (Hint: Refer to Equation 9.4 in Chapter 9.)COST OF COMMON EQUITY The Bouchard Companys EPS was 6.50 in 2016, up from 4.42 in 2011. The company pays out 40% of its earnings as dividends, and its common stock sells for 36.00. a. Calculate the past growth rate in earnings. (Hint: This is a 5-year growth period.) b. The last dividend was D0 = 0 4(6.50) = 2.60. Calculate the next expected dividend, D1, assuming that the past growth rate continues. c. What is Bouchard's cost of retained earnings, rs?CALCULATION OF g AND EPS Sidman Productss common stock currently sells for 60.00 a share. The firm is expected to earn 5.40 per share this year and to pay a year-end dividend of 3.60, and it finances only with common equity. a. If investors require a 9% return, what is the expected growth rate? b. If Sidman reinvests retained earnings in projects whose average return is equal to the stocks expected rate of return, what will be next year's EPS? (Hint: Refer to Equation 9.4 in Chapter 9.)WACC AND OPTIMAL CAPITAL BUDGET Adamson Corporation is considering four average-risk projects with the following costs and rates of return: Project Cost Expected Kate of Return 1 2,000 16.00% 2 3,000 15.00 3 5,000 13.75 4 2,000 12.30 The company estimates that it can issue debt at a rate of rd = 10%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of 5.00 per year at 50.00 per share. Also, its common stock currently sells for 38.00 per share; the next expected dividend, D1, is 4.25, and the dividend is expected to grow at a constant rate of 5% per year. The target capital structure consists of 75% common stock, 15% debt, and 10% preferred stock. a. What is the cost of each of the capital components? b. What is Adamson's WACC? c. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept?ADJUSTING COST OF CAPITAL FOR RISK Ziege Systems is considering the following independent projects for the coming year: Zieges WACC is 10%, but it adjusts for risk by adding 2% to the WACC for high-risk projects and subtracting 2% for low-risk projects. a. Which projects should Ziege accept if it faces no capital constraints? b. If Ziege can only invest a total of 13 million, which projects should it accept, and what would be the dollar size of its capital budget? c. Suppose Ziege can raise additional funds beyond the 13 million, but each new increment (or partial increment) of 5 million of new capital will cause the WACC to increase by 1%. Assuming that Ziege uses the same method of risk adjustment, which projects should it now accept, and what would be the dollar size of its capital budget?WACC The following table gives Foust Company's earnings per share for the last 10 years. The common stock, 7.8 million shares outstanding, is now (1/1/17) selling for 65.00 per share. The expected dividend at the end of the current year (12/31/17) is 55% of the 2016 EPS. Because investors expect past trends to continue, g may be based on the historical earnings growth rate. (Note that 9 years of growth are reflected in the 10 years of data.) The current interest rate on new debt is 9%; Fousts marginal tax rate is 40%; and its target capital structure is 40% debt and 60% equity. a. Calculate Fousts after-tax cost of debt and common equity. Calculate the cost of equity as rs = D1/P0 + g. b. Find Foust's WACC.CALCULATING THE WACC Here is the condensed 2016 balance sheet for Skye Computer Company (in thousands of dollars): 2016 Current assets 2,000 Net fixed assets 3,000 Total assets 5,000 Accounts payable and accruals 900 Short-term debt 100 Long-term debt 1,100 Preferred stock (10,000 shares) 250 Common stock (50,000 shares) 1.300 Retained earnings 1,350 Total common equity 52,650 Total liabilities and equity 5,000 Skyes earnings per share last year were 3.20. The common stock sells for 55.00, Last year's dividend (Do) was 2.10, and a flotation cost of 10% would be required to sell new common stock. Security analysts are projecting that the common dividend will grow at an annual rate of 9%. Skye's preferred stock pays a dividend of 3.30 per share, and its preferred stock sells for 30.00 per share. The firm's before-tax cost of debt is 10%, and its marginal tax rate is 35%. The firms currently outstanding 10% annual coupon rate, long-term debt sells at par value. The market risk premium is 5%, the risk-free rate is 6%, and Skyes beta is 1.516. The firms total debt, which is the sum of the companys short-term debt and Long-term debt, equals 1.2 million. a. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock, the cost of equity from retained earnings, and the cost of newly issued common stock. Use the DCF method to find the cost of common equity. b. Now calculate the cost of common equity from retained earnings, using the CAPM method. c. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between rc and rs. as determined by the DCF method, and add that differential to the CAPM value for rs) d. If Skye continues to use the same market-value capital structure, what is the firms WACC assuming that (1) it uses only retained earnings for equity? (2) If it expands so rapidly that it must issue new common stock?COLEMAN TECHNOLOGIES INC. COST OF CAPITAL Coleman Technologies is considering a major expansion program that has been proposed by the companys information technology group. Before proceeding with the expansion, the company must estimate its cost of capital. Suppose you are an assistant to Jerry Lehman, the financial vice president. Your first task is to estimate Colemans cost of capital. Lehman has provided you with the following data, which he believes may be relevant to your task. The firms tax rate is 40%. The current price of Colemans 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity, is 1,153.72. Coleman does not use short-term, interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost. The current price of the firms 10%, 100.00 par value, quarterly dividend, perpetual preferred stock is 111.10. Colemans common stock is currently selling for 50.00 per share. Its last dividend (D0) was 4.19, and dividends are expected to grow at a constant annual rate of 5% in the foreseeable future. Colemans beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4%. Colemans target capital structure is 30% debt. 10% preferred stock, and 60% common equity. To structure the task somewhat. Lehman has asked you to answer the following questions. a. 1. What sources of capital should be included when you estimate Coleman's WACC? 2. Should the component costs be figured on a before-tax or an after-tax basis? 3. Should the costs be historical (embedded) costs or new (marginal) costs? b. What is the market interest rate on Colemans debt and its component cost of debt? c. 1. What is the firm's cost of preferred stock? 2. Coleman's preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on the debt. Docs this suggest that you have made a mistake? (Hint: Think about taxes.) d. 1. Why is there a cost associated with retained earnings? 2. What is Colemans estimated cost of common equity using the CAPM approach? e. What is the estimated cost of common equity using the DCF approach? f. What is the bond-yield-plus-risk-premium estimate for Coleman's cost of common equity? g. What is your final estimate for rs? h. Explain in words why new common stock has a higher cost than retained earnings. i. 1. What are two approaches that can be Used to adjust for flotation costs? 2. Coleman estimates that if it issues new common stock, the flotation cost will be 15%. Coleman incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, considering the flotation cost? j. What is Colemans overall, or weighted average, cost of capital (WACC)? Ignore flotation costs. k. What factors influence Colemans composite WACC? l. Should the company use the composite WACC as the hurdle rate for each of its projects? Explain.As a first step, we need to estimate what percentage of MMMs capital comes from debt, preferred stock, and common equity. This information can be found on the firms latest annual balance sheet. (As of year end 2014, MMM had no preferred stock.) Total debt includes all interest-bearing debt and is the sum of short-term debt and long-term debt. a. Recall that the weights used in the WACC are based on the companys target capital structure. If we assume that the company wants to maintain the same mix of capital that it currently has on its balance sheet, what weights should you use to estimate the WACC for MMM? b. Find MMMs market capitalization, which is the market value of its common equity. Using the sum of its short-term debt and long-term debt from the balance sheet (we assume that the market value of its debt equals its book value) and its market capitalization, recalculate the firms debt and common equity weights to be used in the WACC equation. These weights are approximations of market-value weights. Be sure not to include accruals in the debt calculation.2DQNext, we need to calculate MMMs cost of debt. We can use different approaches to estimate it One approach is to take the companys interest expense and divide it by total debt (which is the sum of short-term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in todays market (i.e., if MMMs outstanding bonds are trading at dose to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the companys annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Finally, you can also go to Morningstar.com, which will provide yield to maturity information on the firms various bond issues. A longer-term issues YTM could provide an estimate of the firms current cost of debt to be used in the WACC calculation. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMMs tax rate (which has averaged around 30% in recent years). What is your estimate of MMMs after-tax cost of debt?How are project classifications used in the capital budgeting process?2QWhy is the NFV of a relatively long-term project (one for which a high percentage of its cash flows occurs in the distant future) more sensitive to changes in the WACC than that of a short-term project?4QIf 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 projects? Would a decline (or an increase) in the WACC cause changes in the IRR ranking of mutually exclusive projects? Explain.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 between IRR and NPV? If each of the assumptions were changed (one by one), how would your answer change?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?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 property considered in the NPV analyses. Which project should be chosen? Explain.What reinvestment rate assumptions are built into the NPV, IRR, and MIRR methods? Give an explanation for your answer.A firm has a 100 million capital budget. It is considering two projects, each costing 100 million. Project A has an IRR of 20% and an NPV of 9 million; it will be terminated after 1 year at a profit of 20 million, resulting in an immediate increase in EPS. Project B, which cannot be postponed, has an IRR of 30% and an NPV of 50 million. However, the firms short-run EPS will be reduced if it accepts Project B because no revenues will be generated for several years. a. Should the short-run effects on EPS influence the choice between the two projects? b. How might situations like this influence a firms decision to use payback?NPV Project L costs 65,000, its expected cash inflows are 12,000 per year for 9 years, and its WACC is 9%. What is the projects NPV?IRR Refer to problem 11-1. What is the projects IRR?MIRR Refer to problem 11-1. What is the projects MIRR?4PDISCOUNTED PAYBACK Refer to problem 11-1. What is the projects discounted payback?NPV Your division is considering two projects with the following 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 the WACC was 5% and A and B were mutually exclusive, which project would you choose? What if the WACC was 10%? 15%? (Hint: The crossover rate is 7.81%.)CAPITAL BUDGETING CRITERIA A firm with a 14% WACC is evaluating two projects for this years capital budget. After-tax cash flows, including depredation, are as follows: a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each project. b. Assuming the projects are independent, which one(s) would you recommend? c. If the projects are mutually exclusive, which would you recommend? d. Notice that the projects have the same cash flow timing pattern. Why is there a conflict between NPV and IRR?8PCAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS 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 pollution. The company could spend an additional 40 million at Year 0 to mitigate the environmental problem, but it would not be required to do so. The plant without mitigation would cost 240 million, and the expected cash inflows would be 80 million per year for 5 years. If the firm does invest in mitigation, the annual inflows would be 84 million. Unemployment in the area where the plant would be built is high, and the plant would provide about 350 good jobs. The risk-adjusted WACC is 17%. a. Calculate the NPV and IRR with and without mitigation. b. How should the environmental effects be dealt with when evaluating this project? c. Should this project be undertaken? If so, should the firm do the mitigation? Why or why not?CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS A firm with a WACC of 10% is considering the following mutually exclusive projects: Which project would you recommend? Explain.CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS Project S costs 17,000, and its expected cash flows would be 5,000 per year for 5 years. Mutually exclusive Project L costs 30,000, and its expected cash flows would be 8,750 per year for 5 years. If both projects have a WACC of 12%, which project would you recommend? Explain.12P13PCHOOSING MANDATORY PROJECTS ON THE BASIS OF LEAST COST 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, respectively). HCC has a high capital cost but relatively low operating costs, while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the units are shown here. Kims WACC is 7%. a. Which unit would you recommend? Explain. b. If Kims controller wanted to know the IRRs of the two projects, what would you tell him? c. If the WACC rose to 15% would this affect your recommendation? Explain your answer and the reason this result occurred.NPV PROFILES: TIMING DIFFERENCES 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 2.1 million per year for 20 years. The firms WACC is 12%. a. Construct NPV profiles for Plans A and B, identify each projects IRR, and show the approximate crossover rate. b. Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 12%? If all available projects with returns greater than 12% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 12% because all the company can do with these cash flows is to replace money that has a cost of 12%? Does this imply that the WACC is the correct reinvestment rate assumption for a projects cash flows? Why or why not?NPV PROFILES: SCALE DIFFERENCES 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 expenditure to build a somewhat less efficient, more labor-intensive plant with expected cash flows of 2.72 million per year for 20 years. The firms WACC is 10%. a. Calculate each projects NPV and IRR. b. Graph the NPV profiles for Plan A and Plan B and approximate the crossover rate. c. Calculate the crossover rate where the two projects NPVs are equal. d. Why is NPV better than IRR for making capital budgeting decisions that add to shareholder value?CAPITAL BUDGETING CRITERIA A company has an 11% WACC and is considering two mutually exclusive investments (that cannot be repeated) with the following cash flows: a. What is each projects NPV? b. What is cach projects IRR? c. What is each projects M1RR? (Hint: Consider Period 7 as the end of Project Bs life.) d. From your answers to parts a, b, and c, which project would be selected? If the WACC was 18%, which project would be selected? e. Construct NPV profiles for Projects A and B. f. Calculate the crossover rate where the two projects NPVs are equal. g. What is each projects MIRR at a WACC of 18%?NPV AND IRR 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 malls owner plans to sell the property in a year and wants rent at that time to be high so that the property will appear more valuable. Therefore, the store has been offered a great deal (owners words) on a new 5-year lease. The new lease calls for no rent for 9 months, then payments of 2,600 per month for the next 51 months. The lease cannot be broken, and the stores WACC is 12% (or 1% per month). a. Should the new lease be accepted? (Hint Make sure you use 1% per month.) b. If the store owner decided to bargain with the malls owner over the new lease payment, what new lease payment would make the store owner indifferent between the new and old leases? (Hint: Find FV of the old leases original cost at t = 9; then treat this as the PV of a 51-period annuity whose payments represent the rent during months 10 to 60.) c. The store owner is not sure of the 12% WACCit could be higher or lower. At what nominal WACC would the store owner be indifferent between the two leases? (Hint: Calculate the differences between the two payment streams; then find its IRR.)19P20P21PMIRR 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?CAPITAL BUDGETING CRITERIA 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 discounted paybacks. b. If the two projects are independent, which project(s) should be chosen? c. If the two projects are mutually exclusive and the WACC is 10%, which project(s) should be chosen? d. Plot NPV profiles for the two projects. Identify the projects IRRs on the graph. e. If the WACC was 5%, would this change your recommendation if the projects were mutually exclusive? If the WACC was 15%, would this change your recommendation? Explain your answers. f. The crossover rate is 13.5252%. Explain what this rate is and how it affects the choice between mutually exclusive projects. g. Is it possible for conflicts to exist between the NPV and the IRR when independent projects are being evaluated? Explain your answer. h. Now look at the regular and discounted paybacks. Which project looks better when judged by the paybacks? i. If the payback was the only method a firm used to accept or reject projects, what payback should it choose as the cutoff point, that is, reject projects if their paybacks are not below the chosen cutoff? Is your selected cutoff based on some economic criteria, or is it more or less arbitrary? Are the cutoff criteria equally arbitrary when firms use the NPV and/or the IRR as the criteria? Explain. j. Define the MIRR. Whats the difference between the IRR and the MIRR, and which generally gives a better idea of the rate of return on the investment in a project? Explain. k. Why do most academics and financial executives regard the NPV as being the single best criterion and better than the IRR? Why do companies still calculate IRRs?BASICS OF CAPITAL BUDGETING You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler AG, Ford, Toyota, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firms ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because Allied is planning to introduce entirely new models after 3 years. Here are the projects after-tax cash flows (in thousands of dollars): Depredation, salvage values, net operating working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firms average project Allieds WACC is 10%. You must determine whether one or both of the projects should be accepted. a. What is capital budgeting? Are there any similarities between a firms capital budgeting decisions and an individuals investment decisions? b. What is the difference between independent and mutually exclusive projects? Between projects with normal and nonnormal cash flows? c. 1. Define the term net present value (NPV). What is each projects NPV? 2. What is the rationale behind the NPV method? According to NPV, which project(s) should be accepted if they are independent? Mutually exclusive? 3. Would the NPVs change if the WACC changed? Explain. d. 1. Define the term internal rate of return (IRR). What is each projects IRR? 2. How is the IRR on a project related to the YTM on a bond? 3. What is the logic behind the IRR method? According to IRR, which project(s) should be accepted if they are independent? Mutually exclusive? 4. Would the projects IRRs change if the WACC changed? e. 1. Draw NPV profiles for Projects L and S. At what discount rate do the profiles cross? 2. Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which project(s) should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any WACC less than 23.6%? f. 1. What is the underlying cause of ranking conflicts between NPV and IRR? 2. What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict? 3. Which method is best? Why? g. 1. Define the term modified IRR (MIRR). Find the MIRKs for Projects L and S. 2. What are the MIRRs advantages and disadvantages as compared to the NPV? h. 1. What is the payback period? Find the paybacks for Projects L and S. 2. What is the rationale for the payback method? According to the payback criterion, which project(s) should be accepted if the firms maximum acceptable payback is 2 years, if Projects L and S are independent? If Projects L and S are mutually exclusive? 3. What is the difference between the regular and discounted payback methods? 4. What are the two main disadvantages of discounted payback? Is the payback method useful in capital budgeting decisions? Explain. i. As a separate project (Project P), the firm is considering sponsoring a pavilion at the upcoming Worlds Fair. The pavilion would cost 800,000, and it is expected to result in 5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and 5 million of costs, to demolish the site and return it to its original condition. Thus, Project Ps expected cash flows (in millions of dollars) look like this: The project is estimated to be of average risk, so its WACC is 10%. 1. What is Project Ps NPV? What is its IRR? Its MIRR? 2. Draw Project Ps NPV profile. Does Project P have normal or nonnormal cash flows? Should this project be accepted? Explain.1Q2QExplain why net operating working capital is included in a capital budgeting analysis and how it is recovered at the end a project's life.Why are interest charges not deducted when a project's cash flows for use in a capital budgeting analysis are calculated?5QWhat are some differences in the analysis for a replacement project versus that for a new expansion project?Distinguish among beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a project being considered for inclusion in the capital budget.8Q9QIf 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 and thus not be cost-effective? What involvement would nonfinancial people such as those in marketing, accounting, and production have in the analysis?11QREQUIRED INVESTMENT Tannen Industries is considering an expansion. The necessary equipment would be purchased for 18 million, and the expansion would require an additional 2 million investment in net operating working capital. The tax rate is 40%. a. What is the initial investment outlay? b. The company spent and expensed 20,000 on research related to the project last year. Would this change your answer? Explain. c. The company plans to use a building that it owns to house the project. The building could be sold for 1 million after taxes and real estate commissions. How would that fact affect your answer?PROJECT CASH FLOW Colsen Communications is trying to estimate the first-year cash flow (at Year 1) for a proposed project. The financial staff has collected the following information on the project: Sales revenues 15 million Operating costs (excluding depreciation) 10.5 million Depreciation 3 million Interest expense 3 million The company has a 40% tax rate, and its WACC is 11%. a. What is the project's cash flow for the first year (t = 1)? b. If this project would cannibalize other projects by 1.5 million of cash flow before taxes per year, how would this change your answer to part a? c. Ignore part b. If the tax rate dropped to 30%, how would that change your answer to part a?3PREPLACEMENT ANALYSIS The Oviedo 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 10 years. The proposed replacement machine will perform the operation so much more efficiently that Oviedo's engineers estimate that it will produce after-tax cash flows (labor savings and depredation) of 8,000 per year. The new machine will cost 45,000 delivered and installed, and its economic life is estimated to be 10 years. It has zero salvage value. The firm's WACC is 10%, and its marginal tax rate is 35%. Should Oviedo buy the new machine?OPTIMAL CAPTTAL BUDGET Marble Construction estimates that its WACC is 10% if equity comes from retained earnings. However, if the company issues new stock to raise new equity, it estimates that its WACC will rise to 10.8%. The company believes that it will exhaust its retained earnings at 2,500,000 of capital due to the number of highly profitable projects available to the firm and its limited earnings. The company is considering the following seven investment projects: Project Size IRR A 650,000 14.0% B 1,050,000 13.5 C 1,000,000 11.2 D 1,200,000 11.0 E 500,000 10.7 F 650,000 10.3 G 700,000 10.2 Assume that each of these projects is independent and that each is just as risky as the firm's existing assets. Which set of projects should be accepted, and what is the firm's optimal capital budget?DEPRECIATION METHODS Charlene is evaluating a capital budgeting project that should last for 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-line depreciation, the cost of the equipment would be depreciated evenly over its 4-year life (ignore the half-year convention, for the straight-line method). The applicable MACRS depreciation rates are 33%, 45%, 15%, and 7%, as discussed in Appendix 12A. The company's WACC is 8%, and its tax rate is 35%. a. What would the depreciation expense be each year under each method? b. Which depreciation method would produce the higher NPV, and how much higher would it be?SCENARIO ANALYSIS Huang Industries is considering a proposed project whose estimated NPV is 12 million. This estimate assumes that economic conditions will be average. However, the CFO realizes that conditions could be better or worse, so she performed a scenario analysis and obtained these results: Economic Scenario Probability of Outcome NPV Recession 0.05 (70 million) Below average 0.20 (25 million) Average 0.50 12 million Above average 0.20 20 million Boom 0.05 30 million Calculate the project's expected NPV, standard deviation, and coefficient of variation.NEW PROJECT ANALYSIS You must evaluate the purchase of a proposed spectrometer for the RD 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 years for 60,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%, as discussed in Appendix 12A. The equipment would require an 8,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm 50,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 35%. a. What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow? b. What are the project's annual cash flows in Years 1, 2, and 3? c. If the WACC is 9%, should the spectrometer be purchased? Explain.NEW PROJECT ANALYSIS You must evaluate a proposal to buy a new milling machine. The base price is 135,000, and shipping and installation costs would add another 8,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for 94,500. The applicable depreciation rates are 33%, 45%, 15%, and 7% as discussed in Appendix 12A. The machine would require a 5,000 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by 52,000 per year. The marginal tax rate is 35%, and the WACC is 8%. Also, the firm spent 4,500 last year investigating the feasibility of using the machine. a. How should the 4,500 spent last year be handled? b. What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? c. What are the project's annual cash flows during Years 1, 2, and 3? d. Should the machine be purchased? Explain your answer.REPLACEMENT ANALYSIS The Dauten Toy Corporation currently 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 at this time. Thus, the annual depreciation expense is 2,100/6 = 350 per year. If the old machine not replaced, it can be sold for 500 at the end of its useful life. Dauten is offered a replacement machine which has a cost of 8,000, an estimated useful life of 6 years, and an estimated salvage value of 800. This machine falls into the MACRS 5-year class so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The replacement machine would permit an output expansion, so sales would rise by 1,000 per year; even so, the new machine's much greater efficiency would cause operating expenses to decline by 1,500 per year. The new machine would require that inventories be increased by 2,000, but accounts payable would simultaneously increase by 500. Dauten's marginal federal-plus-state tax rate is 40%, and its WACC is 11%. Should it replace the old machine?REPLACEMENT ANALYSIS St. Johns River Shipyards is considering the replacement of an 8-year-old riveting machine with a new one that will increase earnings before depreciation from 24,000 to 46,000 per year. The new machine will cost 80,000; and it will have an estimated life of 8 years and no salvage value. The new machine will be depreciated over its 5-year MACRS recovery period, so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The applicable corporate tax rate is 40%, and the firm's WACC is 10%. The old machine has been fully depreciated and has no salvage value. Should the old riveting machine be replaced by the new one? Explain your answer.PROJECT RISK ANALYSIS 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 distributions: BPC has decided to evaluate the riskier project at 12% and the less-risky project at 10%. a. What is each project's exported annual cash flow? Project B's standard deviation (B) is 5,798, and its coefficient of variation (CVB) is 0.76. What are the values of A and CVA? b. Based on the risk-adjusted NPVs, which project should BPC choose? c. If you knew that Project B's cash flows were negatively correlated with the firm's other cash flows, but Project A's cash flows were positively correlated, how might this affect the decision? If Project B's cash flows were negatively correlated with gross domestic product (GDP), while A's cash flows were positively correlated, would that influence your risk assessment?SCENARIO ANALYSIS Your firm, Agrico Products, is considering a tractor that would have a 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 over 5 years at the rate of 7,200 per year beginning the first year. (Thus, annual cash flows would be 12,000 before taxes plus the tax savings that result from 7,200 of depreciation.) The managers disagree about whether the tractor would last 5 years. The controller insists that she knows of tractors that have lasted only 4 years. The treasurer agrees with the controller, but he argues that most tractors do give 5 years of service. The service manager then states that some last for as long as 8 years. Given this discussion, the CFO asks you to prepare a scenario analysis to determine the importance of the tractor's life on the NPV. Use a 40% marginal federal-plus-state tax rate, a zero salvage value, and a 10% WACC. Assuming each of the indicated lives has the same probability of occurring (probability = 1/3), what is the tractor's expected NPV? (Hint: Use the 5-year straight-line depreciation for all analyses, and ignore the MACRS half-year convention for this problem.)NEW PROJECT ANALYSIS 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 value of 23,000 at the end of its 5-year operating life. The applicable depreciation rates are 33%, 45%, 15%, and 7%, as discussed in Appendix 12A. Net operating working capital would increase by 25,000 initially, but it would be recovered at the end of the project's 5-year life. Holmes's marginal tax rate is 40%, and a 10% WACC is appropriate for the project. a. Calculate the project's NPV, IRR, MIRR, and payback. b. Assume management is unsure about the 90,000 cost savingsthis figure could deviate by as much as plus or minus 20%. What would the NPV be under each of these situations? c. Suppose the CFO wants you to do a scenario analysis with different values for the cost savings, the machine's salvage value, and the net operating working capital (NOWC) requirement. She asks you to use the following probabilities and values in the scenario analysis: Calculate the project's expected NPV, its standard deviation, and its coefficient of variation. Would you recommend that the project be accepted? Why or why not?REPLACEMENT ANALYSIS The Darlington Equipment Company purchased a machine 5 years ago at a cost of 85,000. 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 8,500 per year. If the machine is not replaced, it can be sold for 15,000 at the end of its useful life. A new machine can be purchased for 170,000, including installation costs. During its 5-year life, it will reduce cash operating expenses by 40,000 per year. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worthless. MACRS depreciation will be used, and the machine will be depreciated over its 3-year class life rather than its 5-year economic life; so the applicable depreciation rates are 33%, 45%, 15%, and 7%. The old machine can be sold today for 55,000. The firm's tax rate is 40%. The appropriate WACC is 9%. a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0? b. What are the incremental cash flows that will occur at the end of Years 1 through 5? c. What is the NPV of this project? Should Darlington replace the old machine? Explain.REPLACEMENT ANALYSIS 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 return from scrapping the old machine in 5 years, but it can sell it now to another firm in the industry for 265,000. The old machine is being depreciated by 120,000 per year, using the straight-line method. The new machine has a purchase price of 1,175,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of 145,000. The applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected to economize on electric power usage, labor, and repair costs, as well as to reduce the number of defective bottles. In total, an annual savings of 255,000 will be realized if the new machine is installed. The company's marginal tax rate is 35% and it has a 12% WACC. a. What initial cash outlay is required for the new machine? b. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made. c. What are the incremental cash flows in Years 1 through 5? d. Should the firm purchase the new machine? Support your answer. e. In general, how would each of the following factors affect the investment decision, and how should each be treated? 1. The expected life of the existing machine decreases. 2. The WACC is not constant, but is increasing as Bigbee adds more projects into its capital budget for the year.ABANDONMENT OPTION The Sorensen Supplies Company recently purchased a new delivery truck. The new truck costs 22,500; and it is expected to generate after-tax cash flows, including depreciation, of 5,875 per year. The truck has a 5-year expected life. The expected year-end abandonment values (salvage values after tax adjustments) for the truck are given here. The company's WACC is 9%. Year Annual After-Tax Cash Flow Abandonment Value 1 (22,500 2 5,875 17,000 3 5,875 15,000 4 5,875 9,000 5 5,875 4,750 6 5,875 0 a. Should the firm operate the truck until the end of its 5-year physical life; if not, what is the truck's optimal economic life? b. Would the introduction of abandonment values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project? Explain.OPTIMAL CAPITAL BUDGET Hampton Manufacturing estimates that its WACC is 125%. The company is considering the following seven investment projects: Project Size IRR A 750,000 14.0% B 1,250,000 13.5 C 1,250,000 13.2 D 1,250,000 13.0 E 750,000 12.7 F 750,000 12.3 G 750,000 12.2 a. Assume that each of these projects is independent and that each is just as risky as the firm's existing assets. Which set of projects should be accepted, and what is the firm's optimal capital budget? b. Now assume that Projects C and D are mutually exclusive. Project D has an NPV of 400,000, whereas Project C has an NPV of 350,000. Which set of projects should be accepted, and what is the firm's optimal capital budget? c. Ignore Part b and assume that each of the projects is independent but that management decides to incorporate project risk differentials. Management judges Projects B, C, D, and E to have average risk; Project A to have high risk; and Projects F and G to have low risk. The company adds 2% to the WACC of those projects that are significantly more risky than average, and it subtracts 2% from the WACC of those projects that are substantially less risky than average. Which set of projects should be accepted, and what is the firm's optimal capital budget?NEW PROJECT ANALYSIS You must analyze a potential new producta caulking compound that Cory Materials' RD people developed for use in the residential construction industry. Cory's marketing manager thinks the company can sell 115,000 tubes per year at a price of 3.25 each for 3 years, after which the product will be obsolete. The required equipment would cost 150,000, plus another 25,000 for shipping and installation. Current assets (receivables and inventories) would increase by 35,000, while current liabilities (accounts payable and accruals) would rise by 15,000. Variable cost per unit is 1.95, fixed costs (exclusive of depreciation) would be 70,000 per year, and fixed assets would be depreciated under MACRS with a 3-year life. (Refer to Appendix 12A for MACRS depreciation rates.) When production ceases after 3 years, the equipment should have a market value of 15,000. Cory's tax rate is 40%, and it uses a 10% WACC for average-risk projects. a. Find the required Year 0 investment and the project's annual cash flows. Then calculate the project's NFV, IRR, MIRR, and payback. Assume at this point that the project is of average risk. b. Suppose you now learn that RD costs for the new product were 30,000 and that those costs were incurred and expensed for tax purposes last year. How would this affect your estimate of NPV and the other profitability measures? c. If the new project would reduce cash flows from Cory's other projects and if the new project would be housed in an empty building that Cory owns and could sell, how would those factors affect the project's NPV? d. Are this project's cash flows likely to be positively or negatively corrected with returns on Cory's other projects and with the economy, and should this matter in your analysis? Explain. e. Spreadsheet assignment: at instructor's option Construct a spreadsheet that calculates the cash flows, NFV, IRR, payback, and MIRR. f. The CEO expressed concern that some of the base-case inputs for the caulking compound might be too optimistic or too pessimistic, and he wants to know how the NPV would be affected if these six variables were 20% above or 20% below the base-case levels: unit sales, sales price, variable cost, fixed costs, WACC, and equipment cost. Hold other things constant you consider each variable and construct a sensitivity graph to illustrate your results. g. Do a scenario analysis based on the assumption that there is a 25% probability that each of the six variables itemized in part f will turn out to have their best-case values as calculated in part f, a 50% probability that all will have their base-case values, and a 25% probability that all will have their worst-case values. The other variables remain at base-case levels. Calculate the expected NPV, the standard deviation of NPV, and the coefficient of variation. h. Does Cory's management use the risk-adjusted discount rate to adjust for project risk? Explain.INTEGRATED CASE ALLIED FOOD PRODUCTS CAPITAL BUDGETING AND CASH FLOW ESTIMATION 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 juice would be produced in an unused building adjacent to Allied's Fort Myers plant; Allied owns the building, which is fully depreciated. The required equipment would cost 200,000, plus on additional 40,000 for shipping and installation. In addition, inventories would rise by 25,000, while accounts payable would increase by 5,000. All of these costs would be incurred at t = 0. By a special ruling, the machinery could be depreciated under the MACRS system as 3-year property. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The project is expected to operate for 4 years, at which time it will be terminated. The cash inflows are assumed to begin 1 year after the project is undertaken, or at t = 1, and to continue out to t = 4. At the end of the project's life (t = 4), the equipment is expected to have a salvage value of 25,000. Unit sales are expected to total 100,000 units per year, and the expected sales price is 2.00 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Allied's tax rate is 40%, and its WACC is 10%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied's other assets. You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected. To guide you in your analysis, your boss gave you the following set of tasks/ questions: a. Allied has a standard form that is used in the capital budgeting process. (See Table IC 12.1.) Part of the table has been completed, but you must replace the blanks with the missing numbers. Complete the table using the following steps: 1. Fill in the blanks under Year 0 for the initial investment outlays: CAPEX and NOWC. 2. Complete the table for unit sales, sales price, total revenues, and operating costs excluding depreciation. 3. Complete the depreciation data. 4. Complete the table down to after-tax operating income and then down to the project's operating cash flows, EBIT(1 T) + DEP. 5. Fill in the blanks under Year 4 for the terminal cash flows and complete the project free cash flow line. Discuss the recovery of net operating working capital. What would have happened if the machinery had been sold for less than its book value? b. 1. Allied uses debt in its capital structure, so some of the money used to finance the project will be debt. Given this fact, should the projected cash flows be revised to show projected interest charges? Explain. 2. Suppose you learned that Allied had spent 50,000 to renovate the building last year, expensing these costs. Should this cost be reflected in the analysis? Explain. 3. Suppose you learned that Allied could lease its building to another party and earn 25,000 per year. Should that fact be reflected in the analysis? If so, how? 4. Assume that the lemon juice project would take profitable sales away from Allied's fresh orange juice business. Should that fact be reflected in your analysis? If so, how? c. Disregard all the assumptions made in part b and assume there is no alternative use for the building over the next 4 years. Now calculate the project's NPV, IRR, MIRR, and payback. Do these indicators suggest that the project should be accepted? Explain. Allied's Lemon Juice Project (in Thousands) TABLE IC 12.1 TABLE IC 12.2 Allied's Lemon Juice Project Considering 5% Inflation (in Thousands) d. If this project had been a replacement rather than an expansion project, how would the analysis have changed? Think about the changes that would have to occur in the cash flow table. e. 1. What three levels, or types, of project risk are normally considered? 2. Which type is most relevant? 3. Which type is easiest to measure? 4. Are the three types of risk generally highly correlated? f. 1. What is sensitivity analysis? 2. How would you perform a sensitivity analysis on the unit sales, salvage value, and WACC for the project? Assume that each of these variables deviates from its base-case, or expected, value by plus or minus 10%, 20%, and 30%. Explain how you would calculate the NPV, IRR, MIRR, and payback for each ease; but don't do the analysis unless your instructor asks you to. 3. What is the primary weakness of sensitivity analysis? What are its primary advantages? Work out quantitative answers to the remaining questions only if your instructor asks you to. Also note that it will take a long time to do the calculations unless you are using an Excel model. g. Assume that inflation is expected to average 5% over the next 4 years and that this expectation is reflected in the WACC. Moreover, inflation is expected to increase revenues and variable costs by this same 5%. Does it appear that inflation has been dealt with properly in the initial analysis to this point? If not, what should be done and how would the required adjustment affect the decision? h. The expected cash flows, considering inflation (in thousands of dollars), are given in Table IC 12.2. Allied's WACC is 10%. Assume that you are confident about the estimates of all the variables that affect the cash flows except unit sales. If product acceptance is poor, sales would be only 75,000 units a year, while a strong consumer response would produce sales of 125,000 units. In either case, cash costs would still amount to 60% of revenues. You believe that there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case). Provide numbers only if you are using a computer model. 1. What is the worst-case NPV? The best-case NPV? 2. Use the worst-case, most likely case (or base-case), and best-case NPVs with their probabilities of occurrence, to find the project's expected NPV, standard deviation, and coefficient of variation. i. Assume that Allied's average project has a coefficient of variation (CV) in the range of 1.25 to 1.75. Would the lemon juice project be classified as high risk, average risk, or low risk? What type of risk is being measured here? j. Based on common sense, how highly correlated do you think the project would be with the firm's other assets? (Give a correlation coefficient or range of coefficients, based on your judgment.) k. How would the correlation coefficient and the previously calculated combine to affect the project's contribution to corporate, or within-firm, risk? Explain. l. Based on your judgment, what do you think the project's correlation coefficient would be with respect to the general economy and thus with returns on the market? How would correlation with the economy affect the project's market risk? m. Allied typically adds or subtracts 3% to its WACC to adjust for risk. After adjusting for risk, should the lemon juice project be accepted? Should any subjective risk factors be considered before the final decision is made? Explain. n. In recent months, Allieds group has begun to focus on real option analysis. 1. What is real option analysis? 2. What are some examples of projects with embedded real options?Changes in sales cause changes in profits. Would the profit change associated with sales changes be larger or smaller if a firm increased its operating leverage? Explain your answer.Would each of the following increase, decrease, or have an indeterminant effect on a firm's break-even point (unit sales)? a. The sales price increases with no change in unit costs. b. An increase in fixed costs is accompanied by a decrease in variable costs. c. A new firm decides to use MACRS depreciation for both book and tax purposes rather than the straight-line depreciation method. d. Variable labor costs decline; other things are held constant.Discuss the following statement: All else equal, firms with relatively stable sales are able to carry relatively high debt ratios. Is the statement true or false? Why?4QWhich of the following would likely encourage a firm to increase the debt in its capital structure? a. The corporate tax rate increases. b. The personal tax rate increases. c. Due to market changes, the firm's assets become less liquid. d. Changes in the bankruptcy code make bankruptcy less costly to the firm. e. The firm's sales and earnings become more volatile.6QWhy is EBIT generally considered independent of financial leverage? Why might EBIT actually be affected by financial leverage at high debt levels?Is the debt level that maximizes a firm's expected EPS the same as the debt level that maximizes its stock price? Explain.If a firm goes from zero debt to successively higher levels of debt, why would you expect its stock price to rise first, then hit a peak, and then begin to decline?10Q11QBREAK-EVEN ANALYSIS A company's fixed operating costs are 430,000, its variable costs are 2.95 per unit and the products sales price is 4.50. What is the company's break-even point; that is, at what unit sales volume will its income equal its costs?OPTIMAL CAPITAL STRUCTURE Terrell Trucking Company is in the process of setting its target capital structure. The CFO believes that the optimal debt-to-capital ratio is somewhere between 20% and 50%, and her staff has compiled the following projections for EPS and the stock price at various debt levels: Debt/Capital Ratio Projected EPS Projected Stock Price 20% 3.10 34.25 30 3.55 36.00 40 3.70 35.50 50 3.55 34.00 Assuming that the firm uses only debt and common equity, what is Terrell's optimal capital structure? At what debt-to-capital ratio is the company's WACC minimized?RISK ANALYSIS a. Given the following information, calculate the expected value for Firm C's EPS. Data for Firms A and B are as follows: E(EPSA) = 5.10, A = 3 61, E(EPSB) = 4.20, and B = 2.96. b. You are given that c = 4.11. Discuss the relative riskiness of the three firms' earnings.4PFINANCIAL LEVERAGE EFFECTS Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has 20 million in invested capital, has 4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 50% and pays 12% interest on its debt, whereas LL has a 30% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure. a. Calculate the return on invested capital (ROIC) for each firm. b. Calculate the return on equity (ROE) for each firm. c. Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to- capital ratio from 30% to 60% even though that would increase LL's interest rate on all debt to 15%. Calculate the new ROE for LL.6PFINANCIAL LEVERAGE EFFECTS The Neal Company wants to estimate next year's return on equity (ROE) under different financial leverage ratios. Neal's total capital is 14 million, it currently uses only common equity, it has no future plans to use preferred stock in its capital structure, and its federal-plus-state tax rate is 40%. The CFO has estimated next year's EBIT for three possible states of the world: 4.2 million with a 0.2 probability, 2.8 million with a 0.5 probability, and 700,000 with a 0.3 probability. Calculate Neal's expected ROE, standard deviation, and coefficient of variation for each of the following debt-to-capital ratios; then evaluate the results: Debt/Capital Ratio Interest Rate 0% 10 9% 50 11 60 14HAMADA EQUATION Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 25% debt and 75% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 4%; the market risk premium, RPm, is 5%; and the firm's tax rate is 40%. Currently, SSC's cost of equity is 12%, which is determined by the CAPM. What would be SSC's estimated cost of equity if it changed its capital structure to 40% debt and 60% equity?RECAPITALIZATION Tartan Industries currently has total capital equal to 4 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of 1 million, and distributes 40% of its earnings as dividends. Net income is expected to grow at a constant rate of 3% per year, 200,000 shares of stock are outstanding, and the current WACC is 12.30%. The company is considering a recapitalization where it will issue 2 million in debt and use the proceeds to repurchase stock. Investment bankers have estimated that if the company goes through with the recapitalization, its before-tax cost of debt will be 10% and its cost of equity will rise to 15.5%. a. What is the stock's current price per share (before the recapitalization)? b. Assuming that the company maintains the same payout ratio, what will be its stock price following the recapitalization? Assume that shares are repurchased at the price calculated in part a.BREAKEVEN AND OPERATING LEVERAGE 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 firm has the higher operating leverage at any given level of sales? Explain. c. At what sales level, in units, do both firms earn the same operating profit? Firm A Firm BRECAPITALIZATION Currently, Forever flowers Inc. has a capital structure consisting of 25% debt and 75% equity. Forever's debt currently has a 7% yield to maturity. The risk-free rate (rRF) is 6%, and the market risk premium (rM - rRF) is 7%. Using the CAPM, Forever estimates that its cost of equity is currently 14.5%. The company has a 40% tax rate. a. What is Forever's current WACC? b. What is the current beta on Forever's common stock? c. What would Forever's beta be if the company had no debt in its capital structure? (That is, what is Forever's unlevered beta, bU?) Forever's financial staff is considering changing its capital structure to 40% debt and 60% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 10.5%. The proposed change will have no effect on the company's tax rate. d. What would be the company's new cost of equity if it adopted the proposed change in capital structure? e. What would be the company's new WACC if it adopted the proposed change in capital structure? f. Based on your answer to part e, would you advise Forever to adopt the proposed change in capital structure? Explain.BREAKEVEN AND LEVERAGE Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for 28.80 per set, and this year's sales are expected to be 450,000 units. Variable production costs for the expected sales under present production methods are estimated at 10,200,000, and fixed production (operating) costs at present are 1,560,000. WCC has 4,800,000 of debt outstanding at an interest rate of 8%. There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax bracket. The company is considering investing 7,200,000 in new equipment. Sales would not increase, but variable costs per unit would decline by 20%. Also, fixed operating costs would increase from 1,560,000 to 1,800,000. WCC could raise the required capital by borrowing 7,200,000 at 10% or by selling 240,000 additional shares of common stock at 30 per share. a. What would be WCC's EPS (1) under the old production process, (2) under the new process if it uses debt, and (3) under the new process if it uses common stock? b. At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it with debt or with stock? (Hint: V = variable cost per unit = 8,160,000/450,000, and EPS = [(PQ VQ F I)(I T)]/N. Set EPSstock = EPSDebt and solve for Q.] c. At what unit sales level would EPS = 0 under the three production/financing setupsthat is, under the old plan, the new plan with debt financing, and the new plan with stock financing? (Hint: Note that Vold = 10,200,000/450,000, and use the hints for part b, setting the EPS equation equal to zero.) d. On the basis of the analysis in parts a through c, and given that operating leverage is lower under the new setup, which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume that there is a fairly high probability of sales falling as low as 250,000 units. Determine EPSDept and EPSStock at that sales level to help assess the riskiness of the two financing plans.FINANCING ALTERNATIVES The Severn Company plans to raise a net amount of 270 million to finance new equipment in early 2017. Two alternatives are being considered: Common stock may be sold to net 60 per share, or bonds yielding 12% may be issued. The balance sheet and income statement of the Severn Company prior to financing are as follows: The Severn Company: Balance Sheet as of December 31, 2016 (Millions of Dollars) The Severn Company: Income Statement for Year Ended December 31, 2016 (Millions of Dollars) Sales 2,475.00 Operating costs 2,227.50 Earnings before interest and taxes (10%) 247.50 Interest on short-term debt 15.00 Interest on long-term debt 69.75 Earnings before taxes 162.75 Federal-plus-state taxes (40%) 65.10 Net income 97.65 The probability distribution for annual sales is as follows: The probability distribution for annual sales is as follows: Probability Annual Sales (Millions of Dollars) 0.30 2,250 0.40 2,700 0.30 3,150 Assuming that EBIT equals 10% of sales, calculate earnings per share (EPS) under the debt financing and the stock financing alternatives at each possible sales level. Then calculate expected EPS and eps under both debt and stock financing alternatives. Also calculate the debt-to-capital ratio and the times-interest-earned (TIE) ratio at the expected sales level under each alternative. The old debt will remain outstanding. Which financing method do you recommend? (Hint: Notes payable should be included in both the numerator and the denominator of the debt-to-capital ratio.]WACC AND OPTIMAL CAPITAL STRUCTURE 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 staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firm's debt cost at different debt levels: Elliott uses the CAPM to estimate its cost of common equity, rs, and estimates that the risk-free rate is 5%, the market risk premium is 6%, and its tax rate is 40%. Elliott estimates that if it had no debt, its unlevered beta, bU, would be 1.2. a. What is the firm's optimal capital structure, and what would be its WACC at the optimal capital structure? b. If Elliott's managers anticipate that the company's business risk will increase in the future, what effect would this likely have on the firm's target capital structure? c. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on Elliott's target capital structure? d. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus (1) the debt/capital ratio and (2) the debt/equity ratio.CAMPUS DELI INC. OPTIMAL CAPITAL STRUCTURE 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. Because the university's enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, CD distributes all earnings as dividends. Invested capital is 2 million, and 80,000 shares are outstanding. The management group owns about 50% of the stock, which is traded in the over-the-counter market. CD currently has no debtit is an all-equity firmand its 80,000 shares outstanding sell at a price of 25 per share, which is also the book value. The firm's federal-plus-state tax rate is 40%. On the basis of statements made in your finance text, you believe that CD's shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea but to provide support for the suggestion. In today's market, the risk-free rate, rRF, is 6%, and the market risk premium, RPM, is 6%. CD's unlevered beta, bU, is 1.0. CD currently has no debt, so its cost of equity (and WACC) is 12%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to CD. You plan to complete your report by asking and then answering the following questions. a. 1. What is business risk? What factors influence a firm's business risk? 2. What is operating leverage, and how does it affect a firm's business risk? 3. What is the firm's return on invested capital (ROIC)? b. 1. What do the terms financial leverage and financial risk mean? 2. How does financial risk differ from business risk? c. To develop an example that can be presented to CD's management as an illustration, consider two hypothetical firms: Firm U with zero debt financing and Firm L with 10,000 of 12% debt. Both firms have 20,000 in invested capital and a 40% federal-plus-state tax rate, they have the following EBIT probability distribution for next year: Probability EBIT 0.25 2,000 0.50 3,000 0.25 4,000 d. After speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars): Now consider the optimal capital structure for CD. 1. To begin, define the terms optimal capital structure and target capital structure. 2. Why does CD's bond rating and cost of debt depend on the amount of money borrowed? 3. Assume that shapes could be repurchased at the current market price of 25 per share. Calculate CD's expected EPS and TIE at debt levels of 0, 250,000, 500,000, 750,000, and 1,000,000. How many shares would remain after recapitalization under each scenario? 4. Using the Hamada equation, what is the cost of equity if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? 5. Considering only the levels of debt discussed, what is the capital structure that minimizes CD's WACC? 6. What would be the new stock price if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? Recall that the payout ratio is 100%, so g = 0. 7. Is EPS maximized at the debt level that maximizes share price? Why or why not? 8. Considering only the levels of debt discussed, what is CD's optimal capital structure? 9. What is the WACC at the optimal capital structure? e. Suppose you discovered that CD had more business risk than you originally estimated. Describe how this would affect the analysis. How would the analysis be affected if the firm had less business risk than originally estimated? Income Statements and Ratios TABLE IC 13.1 f. What are some factors a manager should consider when establishing his or her firm's target capital structure? g. Put labels on Figure IC 13.1 and then discuss the graph as you might use it to explain to your boss why CD might want to use some debt. h. How does the existence of asymmetric information and signaling affect capital structure? FIGURE IC 13.1 Relationship between Capital Structure and Stock PriceTo get an overall picture of each company's capital structure, it is helpful to look at a the Key Ratios screen and then select the Financial Health tab. Common size balance sheet data are provided over a 10-year period. What, if any, are the major trends that emerge when you're looking at those data? Do those companies tend to have relatively high or relatively low levels of debt? Do these companies have significant levels of current liabilities? Have their capital structures changed over time? Use online resources to work on this chapter's questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions. This chapter provides an overview of the effects of leverage and describes the process that firms use to determine their optimal capital structure. The chapter also indicates that capital structures tend to vary across industries and across countries. If you are interested in exploring these differences in more detail, the Morningstar website provides information about the capital structures of each of the companies it follows. The following discussion questions demonstrate how we can use this information to evaluate the capital structures for four restaurant companies: Cheesecake Factory (CAKE), Chipotle Mexican Grill (CMG), Ruby Tuesday (RT), and O'Charley's Inc. (CHUX).Repeat this procedure for the other three companies. Do you find similar capital structures for each of the four companies? Do you find that the capital structures have moved in the same direction over the past 5 years, or have the different companies changed their capital structures in different ways over the past 5 years? Use online resources to work on this chapter's questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions. This chapter provides an overview of the effects of leverage and describes the process that firms use to determine their optimal capital structure. The chapter also indicates that capital structures tend to vary across industries and across countries. If you are interested in exploring these differences in more detail, the Morningstar website provides information about the capital structures of each of the companies it follows. The following discussion questions demonstrate how we can use this information to evaluate the capital structures for four restaurant companies: Cheesecake Factory (CAKE), Chipotle Mexican Grill (CMG), Ruby Tuesday (RT), and O'Charley's Inc. (CHUX).1QThe 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 cash dividends during the same year. Discuss the meaning of those statements.Would it ever be rational for a firm to borrow money in order to pay cash dividends? Explain.Modigliani and Miller (MM), on the one hand, and Gordon and Lintner (GL), on the other hand, have expressed strong views regarding the effect of dividend policy on a firms cost of capital and value. a. In essence, what are MMs and GLs views regarding the effect of dividend policy on the cost of capital and stock prices? b. How could MM use the information content, or signaling, hypothesis to counter their opponents arguments? If you were debating MM, how would you counter them? c. How could MM use the clientele effect concept to counter their opponents arguments? If you were debating MM, how would you counter them?How would each of the following changes tend to affect aggregate (i.e., the average for all corporations) payout ratios, other things held constant? Explain your answers. a. An increase in the personal income tax rate b. A liberalization of depreciation for federal income tax purposesthat is, faster lax write-offs c. An increase in interest rates d. An increase in corporate profits e. A decline in investment opportunities f. Permission for corporations to deduct dividends for tax purposes as they now deduct interest expense g. A change in the Tax Code so that realized and unrealized long-term capital gains in any year are taxed at the same rate as ordinary incomeOne position expressed in the financial literature is that firms set their dividends as a residual after using income to support new investment. a. Explain what a residual dividend policy implies, illustrating your answer with a table showing how different investment opportunities can lead to different dividend payout ratios. b. Think back to Chapter 13 where we considered the relationship between capital structure and the cost of capital. If the WACC-versus-debt-ratio plot was shaped like a sharp V, would this have a different implication for the importance of setting dividends according to the residual policy than if the plot was shaped like a shallow bowl (a flattened U)?7QWhat is the difference between a stock dividend and a stock split? As a stockholder, would you prefer to see your company declare a 100% stock dividend or a two-for-one split? Assume that either action is feasible.Most firms like to have their stock selling at a high P/E ratio, and they also like to have extensive public ownership (many different shareholders). Explain how stock dividends or stock splits may help achieve those goals.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 in a companys stock and the companys stock splits two-for-one, you will own 200 shares in the company following the split. c. Some dividend reinvestment plaits increase the amount of equity capital available to the firm. d. The Tax Code encourages companies to pay a large percentage of their net income in the form of dividends. e. If your company has established a clientele of investors who prefer large dividends, the company is unlikely to adopt a residual dividend policy. f. If a firm follows a residual dividend policy, holding all else constant, its dividend payout will tend to rise whenever the firms investment opportunities improve.11QRESIDUAL DIVIDEND MODEL Altamonte Telecommunications has a target capital structure that consists of 45% debt and 55% equity, The company anticipates that its capital budget for the upcoming year will be 1,000,000. If Altamonte reports net income of 1,200,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio?2PSTOCK REPURCHASES Gamma Industries has net income of 3,800,000, and it has 1,490,000 shares of common stock outstanding. The companys stock currently trades at 67 a share. Gamma is considering a plan in which it will use available cash to repurchase 10% of its shares in the open market at the current 67 stock price. The repurchase is expected to have no effect on net income or the companys P/E ratio. What will be its stock price following the stock repurchase?STOCK SPLIT After a 5-for-1 stock split, Tyler Company paid a dividend of 1.15 per new share, which represents a 7% increase over last years pre-split dividend. What was last years dividend per share?5PRESIDUAL DIVIDEND MODEL Walsh Company is considering three independent projects, each of which requires a 4 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here: Project H (high risk): Cost of capital = 16% IRR = 19% Project M (medium risk): Cost of capital = 12% IRR = 13% Project L (low risk): Cost of capital = 9% IRR = 8% Note that the projects costs of capital vary because the projects have different levels of risk. The companys optimal capital structure calls for 40% debt and 60% common equity, and it expects to have net income of 7,500,000. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio?DIVIDENDS Brooks sporting Inc. is prepared to report the following 2016 income statement (shown in thousands of dollars). Sales 15,300 Operating costs including depreciation 12,240 EBIT 3,060 Interest 330 EBT 2,730 Taxes (40%) 1,092 Net income 1,638 Prior to reporting this income statement, the company wants to determine its annual dividend. The company has 320,000 shares of common stock outstanding, and its stock trades at 37 per share. a. The company had a 25% dividend payout ratio in 2015. If Brooks wants to maintain this payout ratio in 2016, what will be its per-share dividend in 2016? b. If the company maintains this 25% payout ratio, what will be the current dividend yield on the companys stock? c. The company reported net income of 1.35 million in 2015. Assume that the number of shares outstanding has remained constant. What was the companys per-share dividend in 2015? d. As an alternative to maintaining the same dividend payout ratio. Brooks is considering maintaining the same per-share dividend in 2016 that it paid in 2015. If it chooses this policy, what will be the companys dividend payout ratio in 2016? e. Assume that the company is interested in dramatically expanding its operations and that this expansion will require significant amounts of capital. The company would like to avoid transactions costs involved in issuing new equity. Given this scenario, would it make more sense for the company to maintain a constant dividend payout ratio or to maintain the same per-share dividend? Explain.8PALTERNATIVE DIVIDEND POLICIES In 2015, Keenan Company paid dividends totaling 3,600,000 on net income of 10.8 million. Note that 2015 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 10%. However, in 2016, earnings are exported to jump to 14.4 million and the firm expects to have profitable investment opportunities of 8.4 million. It is predicted that Keenan will not be able to maintain the 2016 level of earnings growth because the high 2016 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2016, the company will return to its previous 10% growth rate. Keenans target capital structure is 40% debt and 60% equity. a. Calculate Keenans total dividends for 2016 assuming that it follows each of the following policies: 1. Its 2016 dividend payment is set to force dividends to grow at the long-run growth rate in earnings. 2. It continues the 2015 dividend payout ratio. 3. It USOS a pure residual dividend policy (40% of the 8.4 million investment is financed with debt and 60% with common equity). 4. It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate? and the extra dividend being sot according to the residual dividend policy. a. b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed but justify your answer. b. Assume that investors expect Keenan to pay total dividends of 9,000,000 in 2016 and to have the dividend grow at 10% after 2016. The stocks total market value is 100 million. What is the companys cost of equity? c. What is Keenans long-run average return on equity? [Hint: g = Retention rate ROE = (1.0 Payout rate)(ROE)] d. Does a 2016 dividend of 9,000,000 seem reasonable in view of your answers to parts c and d? If not, should the dividend be higher or lower? Explain your answer.RESIDUAL DIVIDEND MODEL 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 expeet the dividend to remain constant for the next several years. The companys target capital structure is 60% equity and 40% debt, it has 1,000,000 shares of common equity outstanding, and its net Income is 8 million. The company forecasts that it will require 10 million to fund all of its profitable (i.e., positive NPV) projects for the upcoming year. a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget? b. If Buena Terra follows the residual dividend model, what will be the companys dividend per share and payout ratio for the upcoming year? c. If Buena Terra maintains its current 3.00 DPS for next year, how much retained earnings will be available for the firms capital budget? d. Can the company maintain its current capital structure, the 3.00 DPS, and a 10 million capital budget without having to raise new common stock? e. Suppose that Buena Terras management is firmly opposed to cutting the dividend; that is, it wants to maintain the 3.00 dividend for the next year. Also, assume that the company was committed to funding all profitable projects and was willing to issue more debt (along with the available retained earnings) to help finance the companys capital budget Assume that the resulting change in capital structure has a minimal effect on the companys composite cost of capital so that the capital budget remains at 10 million. What portion of this years capital budget would have to be financed with debt? f. Suppose once again that Buena Terras management wants to maintain the 3.00 DPS. In addition, the company wants to maintain its target capital structure (60% equity and 40% debt) and its 10 million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue to meet each of its objectives? g. Now consider the case where Buena Terras management wants to maintain the 3.00 DPS and its target capital structure, but it wants to avoid issuing new common stock. The company is willing to cut its capital budget to meet its other objectives. Assuming that the companys projects are divisible, what will be the companys capital budget for the next year? h. What actions can a firm that follows the residual dividend model take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?DIVIDEND POLICY Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous casting process. SSCs founders, Donald Brown and Margo Valencia, had been employed in the research department of a major integrated-steel company; but when that company decided against using the new process (which Brown and Valencia tad developed), they decided to strike out on their own. One advantage of the new process was that it required relatively little capital compared to the typical Steel company, so Brown and Valencia have been able to avoid issuing new stock and thus own all of the shares. However, SSC has now reached the stage in which outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital structure of 60% equity and 40% debt. Therefore, Brown and Valencia have decided to take the company public. Until now, Brown and Valencia have paid them-selves reasonable salaries but routinely reinvested all after tax comings in the firm; so the firms dividend policy has not been an issue. However, before talking with potential outside investors, they must decide on a dividend policy. Assume that you were recently hired by Arthur Adamson Company (AA), a national consulting firm, which has been asked to help SSC prepare for its public offering. Martha Millon, the senior AA consultant in your group, has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions: a. 1.What is meant by the term dividend polity? 2.Explain briefly the dividend irrelevance theory that was put forward by Modigliani and Miller. What were the key assumptions underlying their theory? 3.Why do some investors prefer high-dividend-paying stocks, while other investors prefer stocks that pay low or nonexistent dividends? b.Discuss (1) the information content, or signaling, hypothesis; (2) the clientele effect; (3) catering theory; and (4) their effects on dividend policy. c.1.Assume that SSC has an 800,000 capital budget planned for the coming year. You have determined that its present capital structure (60% equity and 40% debt) is optimal, and its net income is forecasted at 600,000. Use the residual dividend model to determine SSCs total dollar dividend and payout ratio. In the process, explain how the residual dividend model works. Then explain what would happen if expected net income was 400,000 or 800,000. 2.In general terms, how would a change in investment opportunities affect the payout ratio under the residual dividend model? 3.What are the advantages and disadvantages of the residual policy? (Hint: Dont neglect signaling and clientele effects.) d. Describe the series of steps that most firms lake in setting dividend policy in practice. e. What is a dividend reinvestment plan (DRIP), and how does it work? f.What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits? g.What are stock repurchases? Discuss the advantages and disadvantages of a firms repurchasing its own shares.1DQ2DQ3DQ4DQ5DQ6DQWhat are some pros and cons of holding high levels of current assets in relation to sales? Use the DuPont equation to help explain your answer.2QWhat are the two definitions of cash, and why do corporate treasurers often use the second definition?4QWhat are the four key factors in a firms credit policy? How would a relaxed policy differ from a restrictive policy? Give examples of how the four factors might differ between the two policies. How would the relaxed versus the restrictive policy affect sales? Profits?6QWhy is some trade credit called free while other credit is called costly? If a firm buys on terms of 2/10, net 30, pays at the end of the 30th day, and typically shows 300,000 of accounts payable on its balance sheet, would the entire 300,000 be free credit, would it be costly credit, or would some be free and some costly? Explain your answer. No calculations are necessary.Define each of the following loan terms, and explain how they are related to one another: the prime rate, the rate on commercial paper, the simple interest rate on a bank loan calling for interest to be paid monthly, and the rate on an installment loan based on add-on interest. If the stated rate on each of these loans was 4%, would they all have equal, effective annual rates? Explain.9QIndicate using a (+), (), or (0) whether each of the following events would probably cause accounts receivable (A/R), sales, and profits to increase, decrease, or be affected in an indeterminate manner:CASH CONVERSION CYCLE Parramore Corp has 12 million of sales, 3 million of inventories, 3.25 million of receivables, and 1.25 million of payables. Its cost of goods sold is 75% of sales, and it finances working capital with bank loans at an 8% rate. What is Parramores cash conversion cycle (CCC)? If Parramore could lower its inventories and receivables by 10% each and increase its payables by 10%, all without affecting sales or cost of goods sold, what would be the new CCC, how much cash would be freed up, and how would that affect pretax profits?2PCOST OF TRADE CREDIT AND BANK LOAM Lancaster Lumber buys 8 million of materials (net of discounts) on terms of 3/5, net 55; and it currently pays on the 5th day and takes discounts. Lancaster plans to expand, which will require additional financing. If Lancaster decides to forgo discounts, how much additional credit could it obtain, and what would be the nominal and effective cost of that credit? If the company could get the funds from a bank at a rate of 9%, interest paid monthly, based on a 365-day year, what would be the effective cost of the bank Loan? Should Lancaster use bank debt or additional trade credit? Explain.CASH CONVERSION CYCLE Zane Corporation has an inventory conversion period of 64 days, an average collection period of 28 days, and a payables deferral period of 41 days. a. What is the length of the cash conversion cycle? b. If Zanes annual sales are 2,578,235 and all sales are on credit, what is the investment in accounts receivable? c. How many times per year does Zane turn over its inventory? Assume that the cost of goods sold is 75% of sales. Use sales in the numerator to calculate the turnover ratio. d. e.RECEIVABLES INVESTMENT McEwan Industries sells on terms of 3/10, net 30. Total sales for the year are 1,921,000; 40% of the customers pay on the 10th day and take discounts, while the other 60% pay, on average, 70 days after their purchases. a. What is the days sales outstanding? b. What is the average amount of receivables? c. What is the percentage cost of trade credit to customers who take the discount? d. What is the percentage cost of trade credit to customers who do not take the discount and pay in 70 days? e. What would happen to McEwans accounts receivable if it toughened up on its collection policy with the result that all nondiscount customers paid on the 30th day? f. g.WORKING CAPITAL INVESTMENT Pasha Corporation produces motorcycle batteries. Pasha turns out 1,400 batteries a day at a cost of 7 per battery for materials and labor. It takes the firm 22 days to convert raw materials into a battery. Pasha allows its customers 40 days in which to pay for the batteries, and the firm generally pays its suppliers in 30 days. a. What is the length of Pashas cash conversion cycle? b. At a steady state in which Pasha produces 1,400 batteries a day, what amount of working capital must it finance? c. By what amount could Pasha reduce its working capital financing needs if it was able to stretch its payables deferral period to 33 days? d. Pashas management is trying to analyze the effect of a proposed new production process on its working capital investment. The new production process would allow Pasha to decrease its inventory conversion period to 17 days and to increase its daily production to 2,400 batteries. However, the new process would cause the cost of materials and labor to increase to 12. Assuming the change does not affect the average collection period (40 days) or the payables deferral period (30 days), what will be the length of its cash conversion cycle and its working capital financing requirement if the new production process is implemented?CASH CONVERSION CYCLE Chastain Corporation is trying to determine the effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash conversion cycle. Chastains 2016 sales (all on credit) were 121,000; its cost of goods sold is 80% of sales; and it earned a net profit of 2%, or 2,420. It turned over its inventory 7 times during the year, and its DSO was 37 days. The firm had fixed assets totaling 42,000. Chastains payables deferral period is 35 days. a. Calculate Chastains cash conversion cycle. b. Assuming Chastain holds negligible amounts of cash and marketable securities, calculate its total assets turnover and ROA. c. Suppose Chastains managers believe that the inventory turnover can be raised to 9.9 times. What would Chastains cash conversion cycle, total assets turnover, and ROA have been if the inventory turnover had been 9.9 for 2016? d. e.CURRENT ASSETS INVESTMENT POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately 2 million as a result of an asset expansion presently being undertaken. Fixed assets total 1 million, and the firm plans to maintain a 60% debt-to-assets ratio. Rentzs interest rate is currently 8% on both short- and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level are under consideration: (1) a restricted policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 12% of total sales, and the federal-plus- state tax rate is 40%. a. What is the expected return on equity under each current assets level? b. In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption? Why or why not? c. How would the firms risk be affected by the different policies? d. e.9PCASH BUDGETING Helen Bowers, owner of Helens Fashion Designs, is planning to request a line of credit from her bank. She has estimated the following sales forecasts for the firm for parts of 2016 and 2017. May 2016 180,000 June 180,000 July 360,000 August 540,000 September 720,000 October 360,000 November 360,000 December 90,000 January 2017 180,000 Estimates regarding payments obtained from the credit department are as follows: collected within the month of sale, 10%; collected the month following the sale. 75%; collected the second month following the sale, 15%. Payments for labor and raw materials are made the month after these services were provided. Here are the estimated costs of labor plus raw materials: May 2016 90,000 June 90,000 July 126,000 August 882,000 September 306,000 October 234,000 November 162,000 December 90,000 General and administrative salaries are approximately 27,000 a month. Lease payments under long-term leases are 9,000 a month. Depredation charges are 36,000 a month. Miscellaneous expenses are 2,700 a month. Income tax payments of 63,000 are due in September and December. A progress payment of 180,000 on a new design studio must be paid in October. Cash on hand on July 1 will be 132,000, and a minimum cash balance of 90,000 should be maintained throughout the cash budget period. a. Prepare a monthly cash budget for the last 6 months of 2016. b. Prepare monthly estimates of the required financing or excess fundsthat is, the amount of money Bowers will need to borrow or will have available to invest. c. Now suppose receipts from sales come in uniformly during the month (that is, cash receipts come in at the rate of 1/30 each day), but all outflows must be paid on the 5th. Will this affect the cash budget? That is, will the cash budget you prepared be valid under these assumptions? If not, what could be done to make a valid estimate of the peak financing requirements? No calculations are required, although if you prefer, you can use calculations to illustrate the effects. d. Bowers sales are seasonal; and her company produces on a seasonal basis, just ahead of sales. Without making any calculations, discuss how the companys current and debt ratios would vary during the year if ail financial requirements were met with short-term bank loans. Could changes in these ratios affect the firms ability to obtain bank credit? Explain.CASH BUDGETING Rework problem 15-10 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 dedined, this also would have an effect on the required loan. Do a sensitivity analysis that shows the effects of these two factors on the maximum loan requirement. 15-10 CASH BUDGETING Helen Bowers, owner of Helens Fashion Designs, is planning to request a line of credit from her bank. She has estimated the following sales forecasts for the firm for parts of 2016 and 2017. May 2016 180,000 June 180,000 July 360,000 August 540,000 September 720,000 October 360,000 November 360,000 December 90,000 January 2017 180,000 Estimates regarding payments obtained from the credit department are as follows: collected within the month of sale, 10%; collected the month following the sale. 75%; collected the second month following the sale, 15%. Payments for labor and raw materials are made the month after these services were provided. Here are the estimated costs of labor plus raw materials: May 2016 90,000 June 90,000 July 126,000 August 882,000 September 306,000 October 234,000 November 162,000 December 90,000 General and administrative salaries are approximately 27,000 a month. Lease payments under long-term leases are 9,000 a month. Depredation charges are 36,000 a month. Miscellaneous expenses are 2,700 a month. Income tax payments of 63,000 are due in September and December. A progress payment of 180,000 on a new design studio must be paid in October. Cash on hand on July 1 will be 132,000, and a minimum cash balance of 90,000 should be maintained throughout the cash budget period. a. Prepare a monthly cash budget for the last 6 months of 2016. b. Prepare monthly estimates of the required financing or excess fundsthat is, the amount of money Bowers will need to borrow or will have available to invest. c. Now suppose receipts from sales come in uniformly during the month (that is, cash receipts come in at the rate of 1/30 each day), but all outflows must be paid on the 5th. Will this affect the cash budget? That is, will the cash budget you prepared be valid under these assumptions? If not, what could be done to make a valid estimate of the peak financing requirements? No calculations are required, although if you prefer, you can use calculations to illustrate the effects. d. Bowers sales are seasonal; and her company produces on a seasonal basis, just ahead of sales. Without making any calculations, discuss how the companys current and debt ratios would vary during the year if ail financial requirements were met with short-term bank loans. Could changes in these ratios affect the firms ability to obtain bank credit? Explain. e. f. g. h.12IC1QAssume that an average firm in the office supply business has a 6% profit margin, a 40% total liabilities/assets ratio, a total assets turnover of 2 times, and a dividend payout ratio of 40%. Is it true that if such a firm is to have any sales growth (g 0), it will be forced to borrow or to sell common stock (that is, it will need some nonspontaneous external capital even if g is very small)? Explain.Would you agree that computerized corporate planning models were a fad during the 1990s but that because of a need for flexibility in corporate planning, they are no longer used by most firms? Explain.Certain liability and net worth items generally increase spontaneously with increases in sales. Put a check mark () next to those items that typically increase spontaneously. Accounts payable __________ Notes payable to banks __________ Accrued wages __________ Accrued taxes __________ Mortgage bonds __________ Common stock __________ Retained earnings __________Suppose a firm makes the following policy changes. If the change means that external nonspontaneous financial requirements (AFN) will increase, indicate this with a (+); indicate a decrease with a (); and indicate an indeterminate or negligible effect with a (0). Think in terms of the immediate short-run effect on funds requirements. a. The dividend payout ratio is increased. __________ b. Rather than produce computers in advance, a computer company decides to produce them only after an order has been received. __________ c. The firm decides to pay all suppliers on delivery, rather than after a 30-day delay, to take advantage of discounts for rapid payment. __________ d. The firm begins to sell on credit. (Previously, all sales had been on a cash basis.) __________ e.The firms profit margin is eroded by increased competition; sales are steady. __________ f. Advertising expenditures are stepped up. __________ g. A decision is made to substitute long-term mortgage bonds for short-term bank loans. __________ h. The firm begins to pay employees on a weekly basis. (Previously, it had paid employees at the end of each month.) __________AFN EQUATION Carlsbad Corporations sales are expected to increase from 5 million in 2016 to 6 million in 2017, or by 20%. Its assets totaled 3 million at the end of 2016. Carlsbad is at full capacity, so its assets must grow in proportion to projected sales. At the end of 2016, current liabilities are 1 million, consisting of 250,000 of accounts payable, 500,000 of notes payable, and 250,000 of accrued liabilities. Its profit margin is forecasted to be 3%, and the forecasted retention ratio is 30%. Use the AFN equation to forecast the additional funds Carlsbad will need for the coming year.AFN EQUATION Refer to problem 16-1. What additional funds would be needed if the companys year-end 2016 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 16-1? Is the companys capital intensity the same or different? Explain.AFN EQUATION Refer to problem 16-1 and assume that the company had 3 million in assets at the end of 2016. However, now assume that the company pays no dividends. Under these assumptions, what additional funds would be needed for the coming year? Why is this AFN different from the one you found in problem 16-1?PRO FORMA INCOME STATEMENT Austin Grocers recently reported the following 2016 income statement (in millions of dollars): Sales 700 Operating costs including depredation 500 EBIT 200 Interest 40 EBT 160 Taxes (40%) 64 Net income 96 Dividends 32 Addition to retained earnings 64 For the coming year, the company is forecasting a 25% increase in sales, and it expects that its year-end operating costs, including depredation, will equal 70% of sales. Austins tax rate, interest expense, and dividend payout ratio are all expected to remain constant. a. What is Austins projected 2017 net income? b. What is the expected growth rate in Austins dividends?EXCESS CAPACITY Williamson Industries has 7 billion in sales and 1.944 billion in fixed assets. Currently, the companys fixed assets are operating at 90% of capacity. a. What level of sales could Williamson Industries have obtained if it had been operating at full capacity? b. What is Williamsons target fixed assets/sales ratio? c. If Williamsons sales increase 15%, how large of an increase in fixed assets will the company need to meet its target fixed assets/sales ratio?REGRESSION AND INVENTORIES jasper Furnishings has 300 million in sales. The company expects that its sales will increase 12% this year. Jaspers CFO uses a simple linear regression to forecast the companys inventory level for a given level of projected sales. On the basis of recent history, the estimated relationship between inventories and sales (in millions of dollars) is as follows: Inventories=25+1.125(Sales) Given the estimated sales forecast and the estimated relationship between inventories and sales, what are your forecasts of the companys year-end inventory level and its inventory turnover ratio?PRO FORMA INCOME STATEMENT At the end of last year, Roberts Inc. reported the following income statement (in millions of dollars): Sales 3,000 Operating costs excluding depredation 2,450 EBITDA 550 Depredation 250 EBIT 300 Interest 125 EBT 175 Taxes (40%) 70 Net Income 105 Looking ahead to the following year, the companys CFO has assembled this information: Year-end sales are expected to be 10% higher than the 3 billion in sales generated last year. Year-end operating costs, excluding depreciation, are expected to equal 80% of year-end sales. Depredation is expected to increase at the same rate as sales. Interest costs are expected to remain unchanged. The tax rate is expected to remain at 40%. On the basis of that information, what will be the forecast for Roberts year-end net income?LONG-TERM FINANCING NEEDED At year-end 2016, total assets for Arrington Inc. were 1.8 million and accounts payable were 450,000. Sales, which in 2016 were 3.0 million, are expected to increase by 25% in 2017. Total assets and accounts payable are proportional to sales, and that relationship will be maintained; that is, they will grow at the same rate as sales. Arrington typically uses no current liabilities other than accounts payable. Common stock amounted to 500,000 in 2016, and retained earnings were 475,000. Arrington plans to sell new common stock in the amount of 130,000 The firms profit margin on sales is 5%; 35% of earnings will be retained. a. What were Arringtons total liabilities in 2016? b. How much new long-term debt financing will be needed in 2017? (Hint: AFN New stock New long-term debt)SALES INCREASE Paladin Furnishings generated 4 million in sales during 2016, and its year-end total assets were 3.2 million Also, at year-end 2016, current liabilities were 500,000, consisting of 200,000 of notes payable, 200,000 of accounts payable, and 100,000 of accrued liabilities. Looking ahead to 2017, the company estimates that its assets must increase by 0.80 for every 1.00 increase in sales. Paladins profit margin is 3%, and its retention ratio is 50%. How large of a sales increase can the company achieve without having to raise funds externally?REGRESSION AND RECEIVABLES Edwards Industries has 320 million in sales. The company expects that its sales will increase 12% this year. Edwards CFO uses a simple linear regression to forecast the companys receivables level for a given level of projected sales. On the basis of recent history, the estimated relationship between receivables and sales (in millions of dollars) is as follows: Receivables=9.25+0.07(Sales) Given the estimated sales forecast and the estimated relationship between receivables and sales, what are your forecasts of the companys year-end balance for receivables and its year-end days sales outstanding (DSO) ratio? Assume that DSO is calculated on the basis of a 365-day year.REGRESSION AND INVENTORIES Charlies Cycles Inc. has 110 million in sales. The company expects that its sales will increase 5% this year. Charlies CFO uses a simple linear regression to forecast the companys inventory level for a given level of projected sales. On the basis of recent history, the estimated relationship between inventories and sales (in millions of dollars) is as follows: Inventories=9+0.0875(Sales) Given the estimated sales forecast and the estimated relationship between inventories and sales, what are your forecasts of the companys year-end inventory level and its inventory turnover ratio?EXCESS CAPACITY Earleton Manufacturing Company has 3 billion in sales and 787,500,000 in fixed assets. Currently, the companys fixed assets are operating at 80% of capacity. a. What level of sales could Earleton have obtained if it had been operating at full capacity? b. What is Earletons target fixed assets/sales ratio? c. If Earletons sales increase 30%, how large of an increase in fixed assets will the company need to meet its target fixed assets/sales ratio?ADDITIONAL FUNDS NEEDED Morrissey Technologies Inc.s 2016 financial statements are shown here. Morrissey Technologies Inc.: Balance Sheet as of December 31, 2016 Morrissey Technologies Inc.: Income Statement for December 31, 2016 Sales 3,600,000 Operating costs including depredation 3,279,720 EBIT 320,280 Interest 20,280 EBT 300,000 Taxes (40%) 120,000 Net Income 180,000 Per Share Data: Common stock price 45.00 Earnings per share (EPS) 1.80 Dividends per share (DPS) 1.08 Suppose that in 2017, sales increase by 10% over 2016 sales. The firm currently has 100,000 shares outstanding. It expects to maintain its 2016 dividend payout ratio and believes that its assets should grow at the same rate as sales. The firm has no excess capacity. However, the firm would like to reduce its operating costs/sales ratio to 87.5% and increase its total liabilities-to-assets ratio to 30%. (It believes its liabilities-to-assets ratio currently is too low relative to the industry average.) The firm will raise 30% of the 2017 forecasted interest- bearing debt as notes payable, and it will issue long-term bonds for the remainder. The firm forecasts that its before-tax cost of debt (which includes both short- and long-term debt) is 12.5%. Assume that any common stock issuances or repurchases can be made at the firms current stock price of 45. a. Construct the forecasted financial statements assuming that these changes are made. What are the firms forecasted notes payable and long-term debt balances? What is the forecasted addition to retained earnings? b. If the profit margin remains at 5% and the dividend payout ratio remains at 60%, at what growth rate in sales will the additional financing requirements be exactly zero? In other words, what is the firms sustainable growth rate? (Hint: Set AFN equal to zero and solve for g.)EXCESS CAPACITY Krogh Lumbers 2016 financial statements are shown here. Krogh Lumber Balance Sheet as of December 31, 2016 (Thousands of Dollars) Krogh Lumben Income Statement for December 31, 2016 (Thousands of Dollars) Sales 36,000 Operating costs including depredation 30,783 Earnings before interest and taxes 5,217 Interest 1,017 Earnings before taxes 4,200 Taxes (40%) 1,680 Net income 2,520 Dividends (60%) 1,512 Addition to retained earnings 1,008 a. Assume that the company was operating at full capacity in 2016 with regard to all items except fixed assets; fixed assets in 2016 were being utilized to only 75% of capacity. By what percentage could 2017 sales increase over 2016 sales without the need for an increase in fixed assets? b. Now suppose 2017 sales increase by 25% over 2016 sales. Assume that Krogh cannot sell any fixed assets. All assets other than fixed assets will grow at the same rate as sales; however, after reviewing industry averages, the firm would like to reduce its operating costs/sales ratio to 82% and increase its total liabilities-to-assets ratio to 42%. The firm will maintain its 60% dividend payout ratio, and it currently has 1 million shares outstanding. The firm plans to raise 35% of its 2017 forecasted interest-bearing debt as notes payable, and it will issue bonds for the remainder. The firm forecasts that its before-tax cost of debt (which includes both short- and longterm debt) is 11%. Any stock issuances or repurchases will be made at the firms current stock price of 40. Develop Kroghs projected financial statements like those shown in Table 16.2. What are the balances of notes payable, bonds, common stock, and retained earnings?INTEGRATED CASE NEW WORLD CHEMICALS INC. FINANCIAL FORECASTING Sue Wilson, the new financial manager of New World Chemicals (NWC), a California producer of specialized chemicals for use in fruit orchards, must prepare a formal financial forecast for 2017. NWCs 2016 sales were 2 billion, and the marketing department is forecasting a 25% increase for 2017. Wilson thinks the company was operating at full capacity in 2016, but she is not sure. The first step in her forecast was to assume that key ratios would remain unchanged and that it would be business as usual at NWC. The 2016 financial statements, the 2017 initial forecast, and a ratio analysis for 2016 and the 2017 initial forecast are given in Table IC 16.1. Assume that you were recently hired as Wilsons assistant and that your first major task is to help her develop the formal financial forecast. She asks you to begin by answering the following questions. a. Assume (1) that NWC was operating at full capacity in 2016 with respect to all assets, (2) that all assets must grow at the same rate as sales, (3) that accounts payable and accrued liabilities also will grow at the same rate as sales, and (4) that the 2016 profit margin and dividend payout will be maintained. Under those conditions, what would the AFN equation predict the companys financial requirements to be for the coming year? b. Consultations with several key managers within NWC, including production, inventory, and receivable managers, have yielded some very useful information. 1. NWCs high DSO is largely due to one significant customer who battled through some hardships the past 2 years but who appears to be financially healthy again and is generating strong cash flow. As a result, NWCs accounts receivable manager expects the Firm to lower receivables enough for a calculated DSO of 34 days without adversely affecting sales. 2. NWC was operating slightly below capacity; but its forecasted growth will require a new facility, which is expected to increase NWCs net Fixed assets to 700 million. 3. A relatively new inventory management system (installed last year) has taken some time to catch on and to operate efficiently. NWCs inventory turnover improved slightly last year, but this year NWC expects even more improvement as inventories decrease and inventory turnover is expected to rise to 10. Incorporate that information into the 2017 initial forecast results, as these adjustments to the initial forecast represent the final forecast for 2017. (Hint: Total assets do not change from the initial forecast.) c. Calculate NWCs forecasted ratios based on its final forecast and compare them with the companys 2016 historical ratios, the 2017 initial forecast ratios, and the industry averages. How does NWC compare with the average firm in its industry, and is the companys financial position expected to improve during the coming year? Explain. d. Based on the final forecast, calculate NWCs free cash flow for 2017. How does this FCF differ from the FCF forecasted by NWCs initial business as usual forecast? e. Initially, some NWC managers questioned whether the new facility expansion was necessary, especially as it results in increasing net fixed assets from 500 million to 700 million (a 40% increase). However, after extensive discussions about NWC needing to position itself for future growth and being flexible and competitive in todays marketplace, NWCs top managers agreed that the expansion was necessary. Among the issues raised by opponents was that NWCs fixed assets were being operated at only 85% of capacity. Assuming that its fixed assets were operating at only 85% of capacity, by how much could sales have increased, both in dollar terms and in percentage terms, before NWC reached full capacity? f. How would changes in the following items affect the AFN: (1) the dividend payout ratio, (2) the profit margin, (3) the capital intensity ratio, and (4) NWC beginning to buy from its suppliers on terms that permit it to pay after 60 days rather than after 30 days? (Consider each item separately and hold all other things constant.) TABLE IC 16.1 Financial Statements and Other Data on NWC (Millions of Dollars) A. Balance Sheets 2016 2017E Cash and equivalents 20 25 Accounts receivable 240 300 Inventories 240 300 Total current assets 500 625 Net fixed assets 500 625 Total assets 1,000 1,250 Accounts payable and accrued liabilities 100 125 Notes payable 100 190 Total current liabilities 200 315 Long-term debt 100 190 Common stock 500 500 Retained earnings 200 245 Total liabilities and equity 1,000 1.250 B. Income Statements 2016 2017E Sales 2,000.00 2,500.00 Variable costs 1,200.00 1,500.00 Fixed costs 700.00 875.00 Earnings before interest and taxes (EBIT) 100.00 125.00 Interest 16.00 16.00 Earnings before taxes (EBT) 84.00 109.00 Taxes (40%) 33.60 43.60 Net income 50.40 65.40 Dividends (30%) 15.12 19.62 Addition to retained earnings 35.28 45.781DQ2DQForecast Earnings Growth Have analysts made any significant changes to their forecasted earnings for Abercrombie Fitch in the past few months? Explain.4DQHow has Abercrombies stock performed this year relative to the SP 500?Why do U.S. corporations build manufacturing plants abroad when they can build them at home?If the euro depredates against the U.S. dollar, can a dollar bay more or fewer euros as a result? Explain.3QShould firms require higher rates of return on foreign projects than on identical projects located at home? Explain.5Q6Q7Q1P2P3P4P5P6PCURRENCY APPRECIATION Suppose that 1 Danish krone could be purchased in the foreign exchange market today for 0.15. If the krone appreciated 4% tomorrow against the dollar, how many krones would a dollar buy tomorrow?8P9PINTEREST RATE PARITY Assume that interest rate parity holds. In the spot market 1 Japanese yen = 0.008055, while in the 90-day forward market 1 Japanese yen 0 008065. In Japan, 90-day risk-free securities yield 2%. What is the yield on 90-day risk-free securities in the United States?PURCHASING POWER PARITY in the spot market, 15.4 Mexican pesos can be exchanged for 1 U.S. dollar. A compact disc costs 8 in the United States, If purchasing power parity (PPP) holds, what should be the price of the same disc in Mexico?12PSPOT AND FORWARD RATES Arvin Australian Imports has agreed to purchase 15,000 eases of Australian wine for 4 million Australian dollars at todays spot rate. The firms financial manager, Sarah Vintnor, has noted the following current spot and forward rates: US. Dollar/Australian Dollar Australian Dollar/ U.S. Dollar Spot 0.7644 1.3062 30-day forward 0.7632 1.3103 90-day forward 0.7606 1.3148 180-day forward 0.7571 1.3209 On the same day, Vintnor agrees to purchase 15,000 more cases of wine in 3 months at the same price of 4 million Australian dollars. a. What is the price of the wine in U.S. dollars if it is purchased at todays spot rate? b. What is the cost in U.S. dollars of the second 15,000 eases if payment is made in 90 days and the spot rate at that time equals todays 90-day forward rate? c. If the exchange rate for the Australian dollar is 1.25 to 1 in 90 days, how much will Vintnor have to pay for the wine (in US. dollars)?14PRESULTS OF EXCHANGE RATE CHANGES Early in June 1983, it took 245 Japanese yen to equal 1. In June 2015, that exchange rate had fallen to 124 yen to 1. Assume that the price of a Japanese-manufactured automobile was 9,000 in June 1983 and that its price changes were in direct relation to exchange rates. a. Has the price, in dollars, of the automobile increased or decreased during the 32-year period because of changes in the exchange rate? b. What would the dollar price of the automobile be in June 2015, again assuming that the cars price changes only with exchange rates?FOREIGN INVESTMENT ANALYSIS After all foreign and U.S. taxes, a U.S. corporation expects to receive 2 pounds of dividends per share from a British subsidiary this year. The exchange rate at the end of the year is expected to be 1.53 per pound, and the pound is expected to depreciate 5% against the dollar each year for an indefinite period. The dividend (in pounds) is exported to grow at 10% a year indefinitely. The parent U.S. corporation owns 10 million shares of the subsidiary. What is the present value in dollars of its equity ownership of the subsidiary? Assume a cost of equity capital of 11% for the subsidiary.FOREIGN CAPITAL BUDGETING Sandrine Machinery is a Swiss multinational manufacturing company. Currently, Sandrines financial planners are considering undertaking a 1-year project in the United States. The projects expected dollar- denominated cash flows consist of an initial investment of 2,000 and a cash inflow the following year of 2,400. Sandrine estimates that its risk-adjusted cost of capital is 10%. Currently, 1 U.S. dollar will buy 0.94 Swiss franc. In addition, 1-year risk-free securities in the United States are yielding 3%, while similar securities in Switzerland are yielding 1.50%. a. If this project was instead undertaken by a similar U.S.-based company with the same risk-adjusted cost of capital, what would be the net present value and rate of return generated by this project? b. What is the expected forward exchange rate 1 year from now? c. If Sandrine undertakes the project, what is the net present value and rate of return of the project for Sandrine?MULTINATIONAL FINANCIAL MANAGEMENT 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 countries using several different foreign currencies. The matter is further complicated because Yohe often sells its products in other foreign countries. One product in particular, the SY-20 radio transmitter, draws Component X, Component Y, and Component Z (its principal components) from Switzerland, France, and the United Kingdom, respectively. Specifically, Component X costs 165 Swiss francs Component V costs 20 euros, and Component Z costs 105 British pounds. The largest market for the SY-20 is Japan, where the product sells for 50,000 Japanese yen. Naturally. Yohe is intimately concerned with economic conditions that could adversely affect dollar exchange rates. You will find Tables 17.1, 17.2, and 17.3 useful for completing this problem. a. How much in dollars docs it cost Yohe to produce the SY-20? What is the dollar sale price of the SY-20? b. What is the dollar profit that Yohe makes on the sale of the SY-20? What is the percentage profit? c. If the U.S. dollar was to weaken by 10% against all foreign currencies, what would be the dollar profit for the SY-20? d. If the U.S. dollar was to weaken by 10% only against the Japanese yen and remained constant relative to all other foreign currencies, what would be the dollar and percentage profits for the SY-20? e. Using the 180-day forward exchange information from Table 173, calculate the return on 1-year securities in Switzerland assuming the rate of return on 1-year securities in the United States is 4.9%. f. Assuming that purchasing power parity (PPP) holds, what would be the sale price of the SY-20 if it was sold in the United Kingdom rather than Japan?MULTINATIONAL FINANCIAL MANAGEMENT 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 Gavnor, wants to expand into the Pacific Rim. The first step is to set up sales subsidiaries in Japan and Australia, then to set up a production plant in Japan, and finally to distribute the product throughout the Pacific Kim. The firms financial manager, Ruth Schmidt, is enthusiastic about tho plan, but she worries about the implications of the foreign expansion on the firms financial management process. She has sked you, the firms most recently hired financial analyst, to develop a 1-hour tutorial package that explains the basics of multinational financial management. The tutorial will be presented at the next board of directors meeting. To get you started, Schmidt has given you the following list of questions. a. What is a multinational corporation? Why do firms expand into other countries? b. What are the five major factors that distinguish multinational financial management from financial management as practiced by a purely domestic firm? c. Consider the following illustrative exchange rates: U.5. Dollars Required to Buy One Unit of Foreign Currency Japanese yen 0.009 Australian dollar 0.650 1. Are these currency prices direct quotations or indirect quotations? 2. Calculate the indirect quotations for yen and Australian dollars. 3. What is a cross rate? Calculate the two cross rates between yen and Australian dollars. 4. Assume that Citrus Products can produce a liter of orange juice and ship it to Japan for 1.75. If the firm wants a 50% markup on the product, what should the orange juice sell for in Japan? 5. Now assume that Citrus Products begins producing the same liter of orange juice in Japan. The product costs 250 yen to produce and ship to Australia, where it can be sold for 6 Australian dollars. What is the US. dollar profit on the sale? 6. What is exchange rate risk? d. Briefly describe the current international monetary system. What are the different types of exchange rate systems? e. What is the difference between spot rates and forward rates? When is the forward rate at a premium to the spot rate? When is it at a discount? f. What is interest rate parity? Currently, you can exchange 1 yen for 0.0095 U.S. dollar in the 30-day forward market, and the risk-free rate on 30-day securities is 4% in both Japan and the United States. Docs interest rate parity hold? If not, which securities offer the highest expected return? g. What is purchasing power parity (PPP)? If grapefruit juice costs 2 a liter in the United States and purchasing power parity holds, what should be the price of grapefruit juice in Australia? h. What effect does relative inflation have on interest rates and exchange rates? i. 1. Briefly explain the three major types of international credit markets. 2. Briefly explain how ADKs work. j. What is the effect of multinational operations on capital budgeting decisions? k. To what extent do average capital structures vary across different countries?DISCUSSION QUESTIONS Recreate Table 17.1 for the following currencies: Australian dollar, British pound, Canadian dollar, Chinese yuan, Euro, Japanese yen, and Swiss franc. Be sure to show both the direct quotations and indirect quotations. TABLE 17.1 Sample Exchange Rates: Friday, May 29, 2015 Direct Quotation: U.S. Dollars Required to Buy One Unit of Foreign Currency (1) Indirect Quotation: Number of Units of Foreign Currency per U.S. Dollar (2) Australian dollar 0.7644 1.3082 Brazilian real 0.3145 3.1793 British pound 1.5290 0.6540 Canadian dollar 0.8030 1.2454 Chinese yuan 0.1613 6.2004 Danish krone 0.1473 6.788 EMU euro 1.0993 0.9097 Hungarian forint 0.00355404 281.37 Israeli shekel 0.2586 3.8673 Japanese yen 0.00806 124.14 Mexican peso 0.0650 15.3776 South African rand 0.0823 12.1557 Swedish krona 0.1174 8.5195 Swiss franc 1.0636 0.9402 Venezuelan bolivar fuerte 0.1587289 6.3001 Nate: Column 2 equals 1.0 divided by column 1. However, rounding differences do occur. Source: Adapted from The Wall Street Journal (online.wsj.com). June 1, 2015.2DQSome of the websites show graphs indicating how one currency has done relative to another currency. a. Over the past year, how has the pound performed against the dollar? Does the dollar buy more or less pounds today than it did 1 year ago? b. Over the past year, how has the dollar performed against the yen? Does the dollar buy more or less yen today than it did 1 year ago?4DQ