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```									       Lab 6 Problems
1.      The Connecticut Computer Company has the following selected financial results.

10% Debt        40% Debt         75% Debt
Debt                             \$ 10,000
Equity                             90,000
Total Capital                    \$100,000

Shares @ \$5                         18,000

EBIT                               \$18,000
Interest ( 15%)                      1,500
EBT                                \$16,500
Tax (40%)                            6,600
EAT                                \$ 9,900

ROE
EPS
The company is considering a capital restructuring to increase leverage from its present level of
10% of capital.
a. Calculate Connecticut’s ROE and EPS under its current capital structure.
b. Restate the financial statement line items shown, the number of shares outstanding, ROE, and EPS if
Connecticut borrows money and uses it to retire stock until its capital structure is 40% debt
assuming EBIT remains unchanged and the stock continues to sell at its book value. (Develop
the second column of the chart shown.)
c. Recalculate same figures assuming Connecticut continues to restructure until its capital structure is
75% debt. (Develop the third column of the chart.)
d. How is increasing leverage affecting financial performance? What overall effect might the changes
have on the market price of Connecticut’s stock? Why? (Words only. Hint: consider the move
from 10% to 40% and that from 40% to 75% separately.)

Answers are provided here for part d and the remaining questions. The point of this selection of
questions is to illustrate financial risk:

d. Increasing leverage is improving financial performance as measured by ROE and EPS. As
debt increases, earnings, equity, and the number of shares outstanding all decrease. However,
since equity decreases fastest the ratios ROE (EAT/Equity) and EPS (EAT/Shares) get larger.
The increase in debt from 10% to 40% of capital is likely to increase stock price, because
investors will react favorably to the improvement in ratios. In this leverage range debt is not
excessively high, so the positive effect of the improving ratios will probably overcome the
negative effect of increasing risk.
The move from 40% to 75% debt, on the other hand, is likely to be perceived by
investors as making the company uncomfortably risky. At higher leverage levels the negative
effect on investors of increased risk usually overwhelms the positive effect of improving
performance ratios, and the net result is a decline in stock price.

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2.      Reconsider the Connecticut Computer Company of problem 1 assuming the firm has
experienced some difficulties, and its EBIT has fallen to \$8,000.

a. Reconstruct the three-column chart developed in problem 1 assuming Connecticut’s
EBIT remains at \$8,000.
b. Interpret the result in terms of stock price and the advisability of restructuring capital
under these conditions.
c. Could these results have been predicted more easily? Use the ROCE or BEP concept
to come to the same conclusion.

10% Debt          40% Debt         75% Debt
Debt                              \$ 10,000          \$ 40,000         \$ 75,000
Equity                              90,000            60,000           25,000
Total Capital                     \$100,000          \$100,000         \$100,000

Shares @ \$5                          18,000           12,000             5,000

EBIT                                 \$8,000           \$8,000           \$ 8,000
Interest ( 15%)                       1,500            6,000            11,250
EBT                                  \$6,500           \$2,000          (\$ 3,250)
Tax (40%)                             2,600              800                  -
EAT                                 \$ 3,900           \$1,200          (\$ 3,250)

ROE                                     4.3%             2.0%         (13.0%)
EPS                                     \$.22             \$.10           (\$.65)

b. Stock price would almost certainly decline as a result of restructuring. Increased debt is
causing a deterioration of financial performance measured by ROE and EPS as well as increasing
risk. Both of these have negative effects on investors’ attitudes. Under these conditions (a low
EBIT) it would virtually never be advisable to exchange equity for debt.

c. Leverage is not advisable if the return on capital employed, ROCE, is less than the after tax
cost of debt. Currently Connecticut’s ROCE is
ROCE = EBIT(1  T) / (Debt + Equity)
= \$8,000(1  .4) / \$100,000
= \$4,800 / \$100,000
= 4.8%
Its after tax cost of debt is
15%(1 – T) = 15%(1  .4) = 9%
Hence at an EBIT of \$8,000, Connecticut’s ROCE is less than its after tax cost of debt and we
would not expect adding leverage to do the firm any good.

3.      Assume Connecticut Computer Company of the last two problems is earning an EBIT of
\$15,000. Once again, calculate the chart showing the implication of adding more leverage.
Verbally rationalize the result.

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SOLUTION:
10% Debt         40% Debt         75% Debt
Debt                             \$ 10,000         \$ 40,000         \$ 75,000
Equity                             90,000           60,000           25,000
Total Capital                    \$100,000         \$100,000         \$100,000

Shares @ \$5                         18,000          12,000               5,000

EBIT                               \$15,000          \$15,000          \$15,000
Interest ( 15%)                       1,500            6,000          11,250
EBT                                 \$13,500           \$9,000         \$ 3,750
Tax (40%)                             5,400            3,600           1,500
EAT                                \$ 8,100           \$ 5,400         \$ 2,250

ROE                                    9.0%            9.0%               9.0%
EPS                                    \$.45            \$.45               \$.45

Leverage has no effect on financial performance, but it still adds risk hence the effect on
stock price would probably be negative.
At an EBIT of \$15,000 the ROCE and the after tax cost of debt are both 9%. Trading
equity for debt or vice versa makes no difference on performance, because the firm is earning on
capital exactly what it pays for the use of additional debt funds. I.e., there’s no “leverage.” The
risk effect, however, is still there because as the firm adds more debt it must pay more interest
making its profit margin narrower. This will probably drive the stock’s price down in the absence
of a counteracting favorable change in ratios.

Time Value of Money Problems

Several of the choices in the list of multiple choices assume that the problem is being worked by
using tables rather than a calculator. In AGEC 424 you are expected to use a calculator and you
are expected to list your calculator inputs and outputs, which constitutes “showing your work.”
So, some of your answers will be a little different than the key due to the rounding involved when
using time value of money tables.

Timelines and listing calculator inputs and outputs will be emphasized in lab.

Multiple Choice Problems.
1. How much must be invested today to have \$1,000 in two years if the interest rate is 5%?
a. \$909.09
b. \$900.00
c. \$907.00
d. \$950.00

2. Find the present value of \$100 to be received at the end of two years if the discount rate is
12% compounded monthly.
a. \$66.50
b. \$78.76
c. \$68.80
d. \$91.80
e. \$79.75

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3. What is the rate of return on an investment if you lend \$1,000 and are repaid \$1,254.70 two
years later?
a. 12%
b. 25%
c. 6%
d. 18%
e. 4%
4. Determine how much \$1,000 deposited in a savings account paying 8% compounded
annually will be worth after 5 years.
a. \$5,526
b. \$784
c. \$1,400
d. \$1,469
5. At an effective interest rate of 12%, a single sum invested today will double itself in
approximately:
a. 8 years.
b. 12 years.
c. 6 years.
d. insufficient data to determine answer.

6. Your bank balance is exactly \$10,000. Three years ago you deposited \$7,938 and have not
touched the account since. What annually compounded rate of interest has the bank been
paying?
a. 8.65%
b. 26.00%
c. 8.00%
d. 6.87%
7. Which of the following interest rates will come closest to doubling invested money in five
years?
a. 13%
b. 14%
c. 15%
d. 16%
8. \$3,947 deposited four years ago has grown to \$5,000. What semiannually compounded rate
of interest has the bank been paying?
a. 5.26%
b. 6.00%
c. 3.00%
d. 6.67%

9. Using an annual interest rate of 9%, how long will it take a deposit of \$1,000 to grow to
\$3,000, assuming no additional deposits are made?
a. 8.04 years
b. 10.00 years
c. 11.11 years
d. 12.75 years
e. 13.50 years

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10. If you invest the \$10,000 you receive at graduation (age 22) in a mutual fund which averages
a 12% annual return, how much will you have at retirement in 40 years?
a. \$909,090
b. \$930,510
c. \$783,879
d. \$510,285
11. Assume that you have just won “\$5,000,000” in the lottery and will receive \$250,000 per
year for the next 20 years. How much is your prize worth today if the interest rate is 8%?
a. \$1,072,731
b. \$2,454,525
c. \$2,185,219
d. \$1,165,250

12. Ralph has decided to put \$2,400 a year (at the end of each year) into an IRA over his 40 year
working life and then retire. What will Ralph have at retirement if the account earns 10
percent compounded annually?
a. \$394,786
b. \$ 23,470
c. \$1,062,223
d. \$810,917

13. If you were to borrow \$10,000 over five years at 12% compounded monthly, what would be
a. \$122.44
b. \$222.44
c. \$168.38
d. \$187.28

14. Five years after an accident, you received \$100,000 to pay the medical expenses incurred at
the time of the accident. What is the present value (at the time of the accident) of the
payment? Assume interest rates are 9%.
a. \$153,900
b. \$68,100
c. \$65,000
d. \$70,800
15. You purchased a piece of property for \$30,000 nine years ago and sold it today for \$83,190.
What was the annual rate of return on your investment?
a. 12%
b. 11%
c. 10%
d. 9%
16. What is the most you should pay to receive the following cash flows if you require a return of
12 percent?
Year 1                   \$5,000
Year 2                   \$8,000
Year 3                 \$12,000
Year 4-10              \$15,000

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a.   \$58,580
b.   \$104,135
c.   \$68,105
d.   none of the above

17. Designs Now is opening a showcase office to display and sell it’s computer designed poster
art. Designs expects cash flows to be \$120,000 in the first year, \$180,000 in the second year,
\$240,000 in the third year. If Designs uses 11 percent as its discount rate, what is the present
value of the cash flows?
a. \$429,720
b. \$457,620
c. \$456,000
d. \$424,820
18. You have borrowed \$130,000 to buy a new motor home. Your loan is to be repaid over 15
years at 8% compounded monthly. Calculate the principal paid to the bank in month 2 of the
loan.
a. \$242.67
b. \$378.19
c. \$413.61
d. \$581.25

19. First Bank offers you a car loan at an annual interest rate of 10% compounded monthly. What
effective annual interest rate is the bank charging you?
a. 10.38%
b. 10.42%
c. 10.45%
d. 10.47%
20. Your monthly statement from your bank credit card shows that the monthly rate of interest is
1.5%. What is the effective annual rate of interest you are being charged on your credit card?
a. 18.00%
b. 18.64%
c. 19.56%
d. 29.74%
21. Jim Luster wants to have saved enough money by the time he is 65 to invest it and earn a
\$60,000 annual income for the rest of his life. He wants to be able to leave that same amount
to his heirs, no matter how long he lives. If he can earn 8% on invested money, how much
does he need to have accumulated by the time he is 65?
a. \$480,000
b. \$600,000
c. \$750,000
d. \$900,000
e. Cannot be determined based on the information given.

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22. You want to purchase a beach house for \$220,000 funding as much of the cost as possible
with a home mortgage loan. Banks are currently offering standard thirty year mortgages at
8% (monthly compounding). Unfortunately, you can only afford payments of \$1,500 per
month. How much cash will you need for a down payment in order to buy the home? (Round
to the nearest dollar)
a. \$11,142
b. \$13,778
c. \$15,575
d. \$17,457

23. A perpetuity has a cash flow of \$20 and a discount rate of 10%. What is the value of the
perpetuity?
a. \$22
b. \$500
c. \$200
d. none of the above

24. You want to purchase a boat that costs \$40,000. You want to finance as much of the purchase
as possible with a 5-year bank loan at 12% compounded monthly, but can only afford loan
payments of \$750 per month. How much will you need as a down payment to buy the boat?
(Round to the nearest dollar)
a. \$3,523
b. \$4,637
c. \$5,147
d. \$6,284

Perpetual Annuities:
1. Find the PV of a perpetual (ordinary) annuity of \$200 per year. Draw a time line. Assume a
5% discount rate.
2. Same as #1 except the first payment is today (an annuity due).
3. Same as #1 except the first payment is 10 years from today. This is a two step problem.

Problems from the Book:
33.     Merritt Manufacturing needs to accumulate \$20 million to retire a bond issue that
matures in 13 years. The firm’s manufacturing division can contribute \$100,000 per quarter to an
account that will pay 8%, compounded quarterly. How much will the remaining divisions have to
contribute every month to a second account that pays 6% compounded monthly in order to reach
the \$20 million goal?

34.     Carol Pasca just had her fifth birthday. As a birthday present, her uncle promised to
contribute \$300 per month to her education fund until she turns 18 and starts college. Carol’s
parents estimate college will cost \$2,500 per month for four years, but don’t think they’ll be able
to save anything toward it for five years. How much will Carol’s parents need to contribute to the
fund each month starting on her tenth birthday to pay for her college education? Assume the fund
earns 6% compounded monthly.

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