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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. 1 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. Answer provided here: 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. 2 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 3 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 4 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 your monthly payment? 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 5 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. 6 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. 7