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QUIZ 1; BA340; 10:00; Fall 2004 Write your Name and SS# on the BACK of the page Optional: Select a 4-digit identification code (to post scores in public folder):________________________ On quantitative problems show all work... Credit is given for the method, not the answer. 1. (5 points) Briefly explain the connection between the following two concepts: i. The goal of corporate financial management should be to "maximize shareholder wealth". ii. Equity is both the residual claim and the claim with control over the operation of the corporation. Answer: Because equity is the residual claim, operating the corporation in a manner consistent with equity's interests is necessarily also consistent with other claimants' interests. If everyone else must be paid first, the equity claim is maximized only when other claims have been satisfied. 2. Use the following balance sheets and income statement for the Stellar Corp. to answer the next 2 questions: Balance Sheets 2002 Income Stmt. Assets 12/31/01 12-31-02 Liab & SH Equity 12-31-01 12-31-02 sales 1215 cash 200 225 accruals 65 70 -costs -850 A/R 85 90 A/P 270 290 -depr. -70 inventory 450 425 long-term debt 600 650 EBIT 295 gross FA 1750 1950 Equity -interest -85 -accum. depr. 800 870 paid-in capital 500 500 EBT 210 net FA 950 1080 retained earnings 250 310 -tax -60 total assets 1685 1820 total claims 1685 1820 NI 150 2a. (4 points) How much did Stellar pay in dividends during 2002? Answer: You need to use the "statement of RE" relation to solve this problem: REend = REstart + NI - DIV 310 = 250 + 150 - DIV DIV = 90 2b. (4 points) Find the "operating cash flow" for 2002 and (4 points) carefully explain what this number means. Answer: OCF = EBIT – tax + Depreciation = 295 – 60 + 70 = 305 Operating Cash Flow is the cash flow generated by the firm from producing and selling goods and services. It does not include interest expense because interest is a financing expense. Depreciation is added back because depreciation is a non-cash expense. 3. The Auk Corp purchased an asset on 12-31-03 for $50,000. The asset is being depreciated straight-line over 4 years. 3a. (4 points) Create a depreciation schedule that shows the depreciation and book value of the asset for each of the 4 years. Answer: time % depreciation $ depreciation book value 0 $50,000 1 25% $12,500 $37,500 2 25% $12,500 $25,000 3 25% $12,500 $12,500 4 25% $12,500 0 3b. (4 points) If the Auklet Corp sells the asset on 12-31-05 for $32,000, find the net, after-tax, cash effect (cash flow) from the sale. The tax rate is 30%. Answer: accounting profit = selling price - book value = MV - BV =32,000 - 25,000 = 7,000 tax = (accounting profit) (tax rate) = 7,000 (.3) = 2100 net cash effect = cash received from the sale - tax = 32,000 – 2,100 = $29,900 QUIZ 1; BA340; 12:00; Fall 2004 Write your Name and SS# on the BACK of the page Optional: Select a 4-digit identification code (to post scores in public folder):________________________ On quantitative problems show all work... Credit is given for the method, not the answer. 1. (5 points) Briefly distinguish between “financial intermediaries” and “financial markets”. Provide an example of a financial intermediary and an example of a financial market. Answer: In financial markets, investors (the suppliers of funds) purchase securities (claims) that have been issued by the “users of funds”. An example of a financial market is the New York Stock Exchange, where investors trade equity securities that have been issued by large corporations. In financial intermediaries, investors (the suppliers of funds) purchase the securities (claims) of the financial intermediary, not the securities of the ultimate user of the funds. The financial intermediary then channels the funds to the ultimate users of funds. An example of a financial intermediary is a commercial bank. 2. Use the following balance sheets and income statement to answer the next 3 questions: Balance Sheets 2002 Income Stmt. Assets 12/31/01 12-31-02 Liab & SH Equity 12-31-01 12-31-02 sales 1215 cash 200 225 accruals 65 70 -costs -850 A/R 85 90 A/P 270 290 -depr. -70 inventory 450 425 long-term debt 600 650 EBIT 295 gross FA 1750 1950 Equity -interest -85 -accum. depr. 800 870 paid-in capital 500 500 EBT 210 net FA 950 1080 retained earnings 250 310 -tax -60 total assets 1685 1820 total claims 1685 1820 NI 150 2a. (4 points) How much did Stellar pay in dividends during 2002? Answer: You need to use the "statement of RE" relation to solve this problem: REend = REstart + NI - DIV 310 = 250 + 150 - DIV DIV = 90 2b. (8 points) Find the “free cash flow” for 2002 and (4 points) carefully explain what this number means. Answer: FCF = OCF – NFAI – NCAI OCF = EBIT – tax + depreciation = 295 – 60 + 70 = 305 NFAI = gross FAend – gross FAstart = 1950 – 1750 = 200 NCAI = nWCend = nWCstart (ignoring “notes payable) = (CA – CL)end - (CA – CL)start = {(225 + 90 + 425) - (70 + 290)} – {(200 + 85 + 450) - (65 + 270)} = -20 FCF = 305 – 200 – (-20) = 125 Free cash flow measures the amount of cash flow available to the firm’s investors (the suppliers of financing). Free cash flow represents the cash remaining after the firm has met all other obligations, and after the firm has made all investments in assets. If positive, the firm has generated cash that is available to the firm’s suppliers of financing. 3. (4 points) Which of the following correctly describes the equity claim (as opposed to debt claims): (circle the letter corresponding to the correct answer.) a. Equity is the residual claim; has unlimited life; pays cash flows of “dividends”; dividends are “after-tax” b. Equity is the residual claim; has unlimited life; pays cash flows of “interest”; interest is “after-tax” c. Equity is a priority claim; has a fixed maturity; pays cash flows of “dividends”; dividends are “after-tax” d. Equity is a priority claim; has a fixed maturity; pays cash flows of “interest”; interest is “after-tax” Correct answer: a QUIZ 2; BA340; 10:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. (21 points) It is currently 12-31-04, and the Scaup Corp. has the following balance sheet: 12-31-2004 Balance Sheet Assets 12-31-04 12-31-05 Claims 12-31-04 12-31-05 cash 200 260 A/P 1,700 2,210 A/R 2,150 3,750 Notes payable 1,500 1,500 Inv. 2,250 3,000 L.T. debt 1,000 2,240 net FA 1,050 1,140 equity: (PIC) 550 550 equity: (RE) 900 1,650 total assets 5,650 8,150 total claims 5,650 8,150 Create a pro forma 12-31-2005 balance sheet for the Scaup Corp. based on the above balance sheet and the following information (round to the closest $1): Scaup is planning to expand its product line in 2005. The expansion is expected to have the following effects: total sales (all on credit) are expected to increase by 30% during 2005, to $15,000. the "inventory turnover ratio" will be 3.0. the average collection period will increase to 90 days. The Scaup Corp. is planning a $280 investment in fixed assets on 1-1-05. These assets will be depreciated straight- line to zero over 4 years. The depreciation on existing assets will be $120 in 2005. Scaup expects Notes payable (seasonal working capital bank loan) will remain at $1,500. Any additional external financing needed will come from long-term debt. Scaup does not plan to issue any new equity during 2005. Scaup plans to pay out $150 as dividends. Scaup has a "net profit margin" of 6%, and a gross profit margin of 40%. Answer: cash: Since no better information, use % of sales method: cash = (200)(1.30) = 260 A/R: ACP = A/R/(sales/360) = 90; A/R = 3,750 Inv.: inventory turnover = 3.0 = CGS/Inv = 9000/Inv; Inv = 3000 CGS is found from the gross profit margin: gross profit margin = .40 = (sales - CGS)/sales = (15,000-CGS)/15,000; CGS = 9,000 nFAend = nFAstart + purchases - depreciation = 1,050 + 280 - (280/4 + 120) = 1140 Total Assets = cash + A/R + Inv + nFA = 8,150 Total Claims = Total Assets = 8,150 A/P: Since no better information, use % of sales method: A/P = (1700)(1.30) = 2210 Note payable: constant at 1,500 Equity PIC: since no new issues of equity, stays constant at 1,650. Equity RE: REend = REstart + NI - DIV = 900 + (.06)(15,000) - 150 = 1,650 L.T. Debt: The plug: LTDebt = 8,150 - 1,650 - 550 - 1,500 - 2,210 = 2,240 2. (4 points) Briefly explain why the "inventory turnover" ratio for a company with highly seasonal sales may be misleading. How could you change the calculation of "inventory turnover" to minimize this problem? Answer: For a company with highly seasonal sales, the ending balance sheet "inventory" account may be much larger or smaller that the average or typical inventory during the year. The "inventory turnover" ratio will therefore be much smaller or larger than is actually the case. To minimize this problem, the "inventory turnover" ratio can be calculated using "average" inventory during the year where the average is calculated using, for example, monthly or quarterly ending inventories. QUIZ 2; BA340; 12:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. (21 points) It is currently 12-31-04, and the Scaup Corp. has the following balance sheet: 12-31-2004 Balance Sheet Assets 12-31-04 12-31-05 Claims 12-31-04 12-31-05 cash 200 260 A/P 1,700 2,210 A/R 2,150 3,750 Notes payable 1,500 1,500 Inv. 2,250 3,000 L.T. debt 1,000 2,240 net FA 1,050 1,140 equity: (PIC) 550 550 equity: (RE) 900 1,650 total assets 5,650 8,150 total claims 5,650 8,150 Create a pro forma 12-31-2005 balance sheet for the Scaup Corp. based on the above balance sheet and the following information (round to the closest $1): Scaup is planning to expand its product line in 2005. The expansion is expected to have the following effects: total sales (all on credit) are expected to increase by 30% during 2005, to $15,000. the "inventory turnover ratio" will be 3.0. the average collection period will increase to 90 days. The Scaup Corp. is planning a $280 investment in fixed assets on 1-1-05. These assets will be depreciated straight- line to zero over 4 years. The depreciation on existing assets will be $120 in 2005. Scaup expects Notes payable (seasonal working capital bank loan) will remain at $1,500. Any additional external financing needed will come from long-term debt. Scaup does not plan to issue any new equity during 2005. Scaup plans to pay out $150 as dividends. Scaup has a "net profit margin" of 6%, and a gross profit margin of 40%. Answer: cash: Since no better information, use % of sales method: cash = (200)(1.30) = 260 A/R: ACP = A/R/(sales/360) = 90; A/R = 3,750 Inv.: inventory turnover = 3.0 = CGS/Inv = 9000/Inv; Inv = 3000 CGS is found from the gross profit margin: gross profit margin = .40 = (sales - CGS)/sales = (15,000-CGS)/15,000; CGS = 9,000 nFAend = nFAstart + purchases - depreciation = 1,050 + 280 - (280/4 + 120) = 1140 Total Assets = cash + A/R + Inv + nFA = 8,150 Total Claims = Total Assets = 8,150 A/P: Since no better information, use % of sales method: A/P = (1700)(1.30) = 2210 Note payable: constant at 1,500 Equity PIC: since no new issues of equity, stays constant at 1,650. Equity RE: REend = REstart + NI - DIV = 900 + (.06)(15,000) - 150 = 1,650 L.T. Debt: The plug: LTDebt = 8,150 - 1,650 - 550 - 1,500 - 2,210 = 2,240 2. (4 points) In the context of analyzing a firm's performance using financial ratios, briefly explain what is meant by the terms "time-series" analysis and "cross-sectional" analysis. Answer: A "time-series" analysis compares ratios of the same company over a series of time periods. A "cross-sectional" analysis, compares the ratios of different companies in the same industry. QUIZ 3; BA340; 10:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. An investment has a current price of $1,200. The investment is expected to provide a single (risky) cash flow of $1,400 in one year. The required rate of return on the investment is 12%. 1a. (4 points) Find the value (today) of the investment and use the value to explain whether or not this is a good investment. Answer: Value = PV (future cash flows) = $1400 / (1.12) = $$1,250 Because value > current price, this is a good investment. 1b. (4 points) Find the expected rate of return on the investment and use the expected rate of return to explain whether or not this is a good investment. Answer: Expected rate of return: $1200 = $1400 / (1+k) 1, k = 16.67% Because expected rate of return > required rate of return, this is a good investment 2. (4 points) You buy an asset for $850, and sell it 3 months later for $865. Find the EAR (effective annual rate) on your investment. Answer: 3 month rate: 850 = 865/(1+k)1; k = .0176471 = 1.76471% EAR = {1+.0176471)}12/3 - 1 = .0724788 = 7.24788% 3. (4 points) You take out a $22,000 car loan that is to be paid back in 60 equal monthly payments at an APR of 8%. What is your monthly payment? Answer: $22,000 = (monthly payment) (PVIFA.08/12, 60) = (monthly payment) (49.318433) monthly payment = $446.08 4. (4 points) An asset is expected to provide the following cash flows: Years 1 through 28: $50 each year. Year 29: $1050 If the required rate of return is 6.0%, find the value of the asset. Answer: Value = PV(expected future CF) = $50(PVIFA6%, 28) + $1000(PVIF6%, 28) = $50(13.406164) + $1000(.195630) = $670.31+ $195.63 = $865.94 5. (5 points) Your financial planner offers you a retirement annuity that has a cost today of $50,000. The retirement annuity will pay you 30, equal, annual, annuity payments, each of which is $36,000. The first of these annuity payments will occur 20 years from today and the last will occur 49 years from today. Find the expected return (%) on this investment. You do not need to get a numerical answer, just set up the equation that solves for the expected return. Answer: $50,000 = $36,000(PVIFAk%, 30) (1/(1+k)19) QUIZ 3; BA340; 12:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. (4 points.) The required rate of return is 9%. Find the value of an asset that provides the following cash flows: year 1 year 2 year 3 year 4 $100 $300 $500 $1,200 Answer: Value = PV (future cash flows) = 100/(1.09) + 300/(1.09)2 + 500/(1.09)3 + 1,200/(1.09)4 2. You deposit $600 today in a bank account paying a stated interest rate of 5.5% APR, compounded monthly. 2a. (4 points) What will be your bank account balance at the end of 5 years? Answer: FV = 600 (1 + (.055/12))(5)(12) = (600)(1.3157038) = $789.42 2b. (4 points) What is the EAR (effective annual return) on this bank account? Answer: (1+EAR) = (1 + (.055/12))(12) ; EAR = .0564079 = 5.64079% 2c. (4 points) Briefly explain why the EAR is higher than the APR. Answer: The EAR recognizes the fact that when compounding more frequently than annually, you are earning more interest on interest. For example, in the second month, you are earning interest not only on the $600 that you have deposited, but also on the interest that you earned during the first month. In contrast, with annual compounding, you earn no interest on interest until the second year. 3. (4 points) The required rate of return is 6.0%. Find the value of an asset that provides the following estimated cash flows: (Use the annuity formula in finding your answer.) Years Expected future cash flows 1-17 $60 18 $1060 Answer: Value = PV (future cash flows) = 70 (PVIFA6%,18) + 1000(PVIF6%,18) = 60 (10.827603) + 1000 (.3503438) = 1000.00 4. (5 points) 2 years ago today, you purchased a bond for $925.00. Each year (1 year ago and today), you received interest payments of $60.00. If you sell the bond today for $1,050.00, what was your realized, annual rate of return (%) over the two year period? You do not need to get a numerical answer, just set up the equation that solves for the rate of return. Answer: 925.00 = 60.00/(1+k) + 60.00/(1+k) 2 + 1050/(1+k)2 QUIZ 4; BA340; 10:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. A portfolio contains 2 assets: $100 invested in asset A, and $500 invested in asset B Asset A: expected return (kA) = 8.0%; standard deviation (σA) = 12%; beta (βA) = 0.50 Asset B: expected return (kB) = 14.0%; standard deviation (σB) = 15% beta (βB) = 1.25 (Choose the one, best answer for the following multiple choice questions.) 1a. (4 points) the expected return (kP) of the portfolio is: a. kP < 12.5% Answer: b. 12.5% ≤ kP < 13.5% kP = 1/6(8.0%) + 5/6(14.0%) = 13.0% c. 13.5% ≤ kP < 14.5% d. 14.5% ≤ kP e. not enough information 1b. (4 points) the standard deviation (σP) of the portfolio is: a. σP < 11% Answer: portfolio standard deviation is not a b. 11% ≤ σP < 13% weighted average, so we do not have enough c. 13% ≤ σP < 15% information . d. 15% ≤ σP e. not enough information 1c. (4 points) the beta (βP) of the portfolio is: a. βP < .70 Answer: b. .70 ≤ βP < .90 βP = 1/6(0.50) + 5/6(1.25) = 1.125 c. .90 ≤ βP < 1.10 d. 1.10 ≤ βP e. not enough information 1d. (4 points) If the expected return on the market portfolio (k M) is 12%, find the risk-free rate of interest (RF). Answer: Use the CAPM: ki = RF + βi(kM - RF) 13% = RF + 1.125(12.0% - RF) = RF = 4.0% 2. (4 points) A large, well-diversified portfolio has the following possible outcomes for the coming year: State of the Economy Probability Return Good .30 25% Normal .40 10% Bad .30 -10% Find the expected return of this portfolio. Answer: kportfolio = .30(25%) + .40(10%) + .30(-10 %) = 8.5% 3. (5 points) Carefully explain the process used to estimate beta. Include a graph with your answer...label the axes. Answer: The beta for a stock can be estimated from a graph of the stock's historical returns (y-axis) versus stock market historical returns (x-axis). Beta is the slope of the "best-line" (a least-squares, linear regression line) drawn through these points. QUIZ 4; BA340; 12:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. The Redtail Corp. is currently evaluating a potential investment in fixed assets. The investment has a beta of 1.15. The (expected) market return (kM) is 10.0%, and the risk free rate (RF) is 2.5%. The investment has an initial cost of $800, and is expected to provide the following cash flows: Year 1 Year 2 $325 $550 1a. (3 points) Find the required rate of return on the investment. Answer: Required rates of return can be found using the CAPM: ki = RF + βi(kM - RF) = 2.5% + 1.15(10.0% - 2.5%) = 11.125% 1b. (3 points) Find the value of the investment, and (2 points) use the value to decide whether or not this is a good investment. Answer: Value = PV(expected future cash flows), evaluated at the required rate of return: Value = $325/(1+.11125)1 + $550/(1+.11125)2 = 292.46 + 445.39 = $737.85 Since the value of the investment ($737.85) is less than the cost of the investment ($800), this is not a good investment. 1c. (3 points) Write the equation that would solve to give the expected rate of return on the investment. (You do not need to get a numerical answer, just set-up the equation.), and (3 points) carefully explain whether the expected rate of return is greater than, equal to, or less than the required rate of return. Answer: Price = PV(CF), using the expected rate of return; $800 = $325/(1+k)1 + $550/(1+k)2 3 Because this is not a good investment, the expected rate of return must be less than the required rate of return. Alternatively, if the investment could be purchased at its value of $732.56, you would be expecting to earn exactly your required rate of return of 11.625%. Since the price is higher than the current price, your expected rate of return must be lower than 11.625%. 2. (5 points) Carefully explain why the CAPM is generally not a useful approach to estimate the required rate of return to use in evaluating an investment in fixed assets by a corporation. Answer: To use the CAPM, you need an estimate for beta. To estimate a beta, you need a time-series of historical returns with which to run a least squares regression. While a return history is readily available for publicly traded securities (such as common stock) it generally NOT available for real assets, such as the investment in fixed assets by corporations. 3. The return (%) of Goldeneye Goldfields Inc.’s common stock is uncorrelated to the stock market as a whole (the market portfolio). What (if anything) do you know about the following: (Briefly explain your answers.) 3a. (2 points) the beta of Goldeneye’s common stock? Answer: Since the asset’s returns are uncorrelated to the market portfolio, its beta must be 0. 3b. (2 points) the standard deviation of goldeneye’s common stock Answer: The standard deviation could be anything. There is not enough information in the problem to say anything about the stock’s standard deviation. 3c. (2 points) the required return of Goldeneye’s common stock? Answer: Since the beta is 0, the required return must be the risk-free rate. QUIZ 5; BA340; 10:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. The Widgeon Corp.’s bonds have the following characteristics: Coupon: 13.0%, paid annually Maturity: 24 years Par value: $1000.00 Current price: $931.65 1a. (3 points) Draw a time line showing the payments promised by the bonds. 1b. (5 points) Show that the YTM (yield to maturity, kd) of the bonds is 14.0%. Answer: B0 = C(PVIFAkd, n) 931.65 = $130(PVIFA13%,24) + $1000(PVIF13%,24) 1c. (2 points) Widgeon has another outstanding bond issue that has the same YTM as the above bonds (14%) If these other bonds have a par value of $1000 and a current market value of $1,000, what coupon do they have? Answer: Bonds sell at par value when the coupon rate equals the interest rate. So the coupon rate must also be 14% ($140) 2. (5 points) Identify and explain the conditions under which a corporation is most likely to "call" its outstanding bonds. Answer: A corporation is most likely to call its outstanding bonds when the market interest rate is less than the coupon rate on the existing, outstanding bonds. The corporation can then reissue the bonds at a lower coupon rate. 3. (4 points) Briefly describe the term "indenture". Answer: A debenture is a bond that does not have specific real assets backing the promised payments. 4. (6 points) Draw an example of an “upward sloping” yield curve. Label the axis(s). Identify and briefly explain two factors that affect the shape of the yield curve. Answer: X Axis: time to maturity Y Axis: interest rate Factors 1. Expectations for future interest rates: If the investors expect interest rates to increase, then the yield curve will be steeper. 2. Maturity premium: Because long-term debt securities have more interest rate risk, investors demand higher interest rates for longer term securities. 3. Supply and Demand: Changes in the supply and demand for loanable funds at different maturities will cause changes in market interest rates at different maturities. QUIZ 5; BA340; 12:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. The Widgeon Corp.’s bonds have the following characteristics: Coupon: 13.0%, paid annually Maturity: 24 years Par value: $1000.00 Current price: $931.65 1a. (3 points) Draw a time line showing the payments promised by the bonds. 1b. (5 points) Show that the YTM (yield to maturity, kd) of the bonds is 14.0%. Answer: B0 = C(PVIFAkd, n) 931.65 = $130(PVIFA13%,24) + $1000(PVIF13%,24) 1c. (2 points) Widgeon has another outstanding bond issue that has the same YTM as the above bonds (14%) If these other bonds have a par value of $1000 and a current market value of $1,000, what coupon do they have? Answer: Bonds sell at par value when the coupon rate equals the interest rate. So the coupon rate must also be 14% ($140) 2. (5 points) Briefly explain what is meant by a "convertible" bond. Answer: Some bonds give the bondholder the right to convert the bond to common stock. These bonds usually stipulate specific time periods, and conversion rates at which bonds may be converted. 3. (4 points) Briefly distinguish between "senior" and "subordinated" bonds. Answer: Senior bonds have higher priority, while subordinate bonds have lower priority. 4. (6 points) Draw an example of an “upward sloping” yield curve. Label the axis(s). Identify and briefly explain two factors that affect the shape of the yield curve. Answer: X Axis: time to maturity Y Axis: interest rate Factors 1. Expectations for future interest rates: If the investors expect interest rates to increase, then the yield curve will be steeper. 2. Maturity premium: Because long-term debt securities have more interest rate risk, investors demand higher interest rates for longer term securities. 3. Supply and Demand: Changes in the supply and demand for loanable funds at different maturities will cause changes in market interest rates at different maturities. QUIZ 6; BA340; 10:00 and 12:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. The common stock of the Bunting Corporation has a current market price of $28.50 per share. The common stock currently pays a yearly dividend of $3.50 per share, and this dividend is expected to stay constant in the future. 1a. (4 points) Find Bunting's "cost of common stock" (ks ; "investors’ required rate of return"). Answer: P0 = PV(expected future dividends) = DIV/ ks $28.50 = $3.50 / ks ; ks = 12.28% 1b. (5 points) In 1a, you found an expected rate of return: the discount rate that makes the present value of the future cash flows equal to the current price. Carefully explain why we usually assume that this discount rate is also investors' required rate of return. Answer: We rely on the "efficient market hypothesis"; in financial markets, price quickly converges to fundamental value. When price = value, expected returns must be equal to required returns: Value = CF(1)/(1+k) + CF(2)/(1+k)2 + CF(3)/(1+k)3 + ……. where k = required rate of return Price = CF(1)/(1+k) + CF(2)/(1+k)2 + CF(3)/(1+k)3 + ……. where k = expected rate of return 1c. (4 points) What other method could be used to estimate Bunting's “cost of common stock” (ks). Why does this other method often provide a better estimate of ks? Answer: the CAPM could also be used to estimate ks. Unlike preferred stock and bonds (for which the promised cash flows are known with certainty), the cash flows (dividends) from common stock are extremely difficult to estimate; common stock dividends are entirely at the discretion of management, and often vary with company performance. Remember, common stock is the residual claim. 2. (6 points) The common stock of the Krug Corp. does not currently pay dividends. It is expected that: 1) an initial dividend of $2.00 will be paid in two years; 2) the annual dividend will then grow at a rate of 25% for the next two years (years three, and four); and 3) after the fourth year, the annual dividend will grow at a constant rate of 3% per year, forever. If the current price of Krug common stock is $15.00, find "investors’ required rate of return", ks). (You do not need to get a numerical answer...just set-up the equation that would solve for ks.) Answer: year: 1 2 3 4 5 6 DIV: 0 $2.00 $2.00 (1.25) = $2.50 (1.25) = $3.125 (1.03) = g = 3% $2.50 $3.125 $3.21875 (forever) 15.00 = 2.00 / (1+ks)2 + 2.50 / (1+ks)3 + 3.125 / (1+ks)4 +[ (3.21875) / (ks - .03) ] [1 / (1+ks)4 ] 3. (6 points) A mutual fund manager finds that when a company reports earnings that are better than expected, the company's common stock tends to outperform the overall stock market over the next 90 days. Carefully explain whether or not this is a violation of the "efficient markets hypothesis". Answer: This is a direct violation of the efficient markets hypothesis. If this were true, then it is possible to identify and profit from incorrectly prices securities. The mutual fund manager could consistently beat the market simply by buying the stock of companies that report better than expected earnings. QUIZ 7; BA340; 10:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. (20 points.) The Myna Corp is analyzing the possible purchase of a $1,200,000 computer-based inventory and order management system. The system will be depreciated straight-line to zero over three years. The system has an expected life of five years, after which the system will be worthless. In each of the 5 years, the investment would save the company $500,000 in order processing costs. As a result of the investment, inventory would decline by $180,000, accounts receivable (A/R) would increase by $40,000, and accounts payable (A/P) would increase by $60,000. The changes in inventory, accounts receivable, and accounts payable would occur immediately The tax rate is 30% and the cost of capital is 12%. Find the net present value (NPV), the internal rate of return (IRR), and the profitability index (PI) of the investment. (You do not need to get numerical answers...just set-up the equations.) Answer: (all in (000) time 0 1 2 3 4 5 OCF 470 470 470 350 350 chg. in nWC +200 -200 net CI -1,200 total incr CF -1,000 470 470 470 350 150 Depr.(1-3) = 1,200/3 = 400 Depr.(4-5) = 0 Sales (1-5) = 0 Costs(1-5) = -500 OCF(1-3) = (S-C)(1-T) + DT = (0 - (-500))(.7) + 400(.3) = 470 OCF(4-5) = (S-C)(1-T) + DT = (0 - (-500))(.7) + 0(.3) = 350 nWC(0) = +180 - 40 + 60 = +200 nWC(5): reverse: -200 nCI(0) = -1,200 NPV = value - cost = 470/(1.12)1 + 470/(1.12)2 +470/(1.12)3 +350/(1.12)4 +150/(1.12)5 - 1,000 IRR: k that makes NPV = 0: 470/(1+IRR)1 + 470/(1+IRR)2 +470/(1+IRR)3 +350/(1+IRR)4 +150/(1+IRR)5 - 1,000 = 0 PI: value / cost: PI = [470/(1.12)1 + 470/(1.12)2 +470/(1.12)3 +350/(1.12)4 +150/(1.12)5]/ 1,000 2. (5 points) Carefully what is meant by the term "incidental effects" (or "side-effects") in a capital budgeting analysis. Answer: Incidental effects are effects on the firm's CF resulting from changes in the firm's existing operations. For example, if an investment project affects the sales of existing products, then these effects are incremental and should be included in the capital budgeting analysis. Incidental effects are often very important in strategic decisions, and are often difficult to estimate accurately. QUIZ 7; BA340; 12:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. (20 points.) The Myna Corp is analyzing the possible purchase of a $1,200,000 computer-based inventory and order management system. The system will be depreciated straight-line to zero over three years. The system has an expected life of five years, after which the system will be worthless. In each of the 5 years, the investment would save the company $500,000 in order processing costs. As a result of the investment, inventory would decline by $180,000, accounts receivable (A/R) would increase by $40,000, and accounts payable (A/P) would increase by $60,000. The changes in inventory, accounts receivable, and accounts payable would occur immediately The tax rate is 30% and the cost of capital is 12%. Find the net present value (NPV), the internal rate of return (IRR), and the profitability index (PI) of the investment. (You do not need to get numerical answers...just set-up the equations.) Answer: (all in (000) time 0 1 2 3 4 5 OCF 470 470 470 350 350 chg. in nWC +200 -200 net CI -1,200 total incr CF -1,000 470 470 470 350 150 Depr.(1-3) = 1,200/3 = 400 Depr.(4-5) = 0 Sales (1-5) = 0 Costs(1-5) = -500 OCF(1-3) = (S-C)(1-T) + DT = (0 - (-500))(.7) + 400(.3) = 470 OCF(4-5) = (S-C)(1-T) + DT = (0 - (-500))(.7) + 0(.3) = 350 nWC(0) = +180 - 40 + 60 = +200 nWC(5): reverse: -200 nCI(0) = -1,200 NPV = value - cost = 470/(1.12)1 + 470/(1.12)2 +470/(1.12)3 +350/(1.12)4 +150/(1.12)5 - 1,000 IRR: k that makes NPV = 0: 470/(1+IRR)1 + 470/(1+IRR)2 +470/(1+IRR)3 +350/(1+IRR)4 +150/(1+IRR)5 - 1,000 = 0 PI: value / cost: PI = [470/(1.12)1 + 470/(1.12)2 +470/(1.12)3 +350/(1.12)4 +150/(1.12)5]/ 1,000 2. (5 points) Carefully explain the economic significance of "net present value" (NPV). Answer: Net present value measures the value created by the investment. A positive NPV means that we have identified an investment that provides the suppliers of capital with more than their required rate of return. The NPV measures the value created by this additional rate of return. Because equity is the residual claim, this created value accrues to equity; consistent with the goal of financial management to maximize shareholder wealth. QUIZ 8; BA340; 10:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. (5 points) The Van Horne Construction Company is evaluating the possibility of purchasing a new D9 tractor for $125,000. It would replace a D8 tractor which would be sold for $12,000. The D8 has a book value of $8,000 and is being depreciated straight-line to zero at $2,000 per year. The D9 would be depreciated straight-line to zero over 5 years. The D9 would support increased billings of $25,000 per year since it could complete larger jobs more quickly than the smaller D8. Operating costs would be higher with the D9. Fuel and maintenance costs with the D8 are estimated to be $13,000 per year. Fuel and maintenance costs with the D9 would be about $18,000. Labor and other costs run about $18,000 per year with either tractor. Van Horne's tax rate is 30%. Find the "net capital investment" at time 0: (netCI(0); the net cash effect from buying and selling fixed assets at time 0). Answer: This will have three parts: the cost of the D9, the selling price (MV) of the D8, and the tax effect from selling the D8 at a value other than its book value: 1. Buy D9: -$125,000 2. Sell D8: +$12,000 3. Tax on sale of D8: accounting profit = MV - BV = $12,000 - $8,000 = $4,000 tax (to pay) = $4,000 (.30) = $1,200 net cash effect = -$125,000 + $12,000 - $1,200 = -$114,200 2. (20 points) The Sleet Corp. is evaluating the possibility of adding a new product to its existing product line. This expansion project would require an initial investment of $870, and would result in estimated future incremental cash flows of $100 per year, forever (a perpetuity). Sleet's tax rate is 30%. The risk of the expansion project is considered comparable to that of Snow's existing operations. Sleet's current (target) capital structure is summarized below: Equity: Common stock: 1,000,000 shares outstanding, Current market price: $4.00 per share; Annual dividends: expected dividend for next year: $0.50 per share; Dividends are expected to grow at 3% per year, forever. Debt: Bonds: 6,000 bonds outstanding; Par Value: $1,000; Annual coupon: 6%; Current market price: $908.92 per bond; Maturity: 15 years. 2a. (4 points) Draw a time line showing the cash flows expected from one of Sleet's bonds. Use those cash flows to show that Sleet's cost of debt (kd) is 7.0%. Answer: 908.92 = 60(PVIFA7.0%,15) + 1000(PVIF7.0%,15) 2b. (4 points) Draw a time line showing the cash flows expected from a share of Sleet's common equity. Use those cash flows to estimate Snow's cost of common equity (ks). Answer: P0 = (DIV(1))/( ks - g); $4.00 = $0.50/( ks - .03); ks = 15.5% 2c. (6 points) Find Sleet's WACC (weighted average cost of capital). Answer: Total MV common equity = 1,000,000($4) = $4,000,000 Total MV bonds = 6,000($908.82) = $5,452,920 Total capital = $4,000,000 + 5,452,920 = $9,452,920 wd = $5,452,920 / $9,452,920 = .58 ws = $4,000,000 / $9,452,920 = .42 WACC = wd kd(1-T) + wsks = (.58)(7.00%)(1-.30) + (.42)(15.5%) = 9.352%% 2d. (4 points) Find the IRR for the expansion project. Use the IRR to explain whether or not this is a good investment Answer: IRR: 870 = 100/IRR IRR = 11.49% Since the IRR > cost of capital of 9.352%, this is a good investment; NPV > 0 The investment creates value. 2e. (2 points) Briefly explain why the information, “The risk of the expansion project is considered comparable to that of Snow's existing operations” is necessary to do this problem. Answer: The WACC is the required rate of return on the firm’s existing assets. If the risk of the investment is different from the risk of existing assets, then it would be the wrong cost of capital for this analysis. QUIZ 8; BA340; 12:00; Fall 2004 Write your Name and SS# on the BACK of the page On quantitative problems show all work... Credit is given for the method, not the answer. 1. (5 points) The Van Horne Construction Company is evaluating the possibility of purchasing a new D9 tractor for $125,000. It would replace a D8 tractor which would be sold for $12,000. The D8 has a book value of $8,000 and is being depreciated straight-line to zero at $2,000 per year. The D9 would be depreciated straight-line to zero over 5 years. The D9 would support increased billings of $25,000 per year since it could complete larger jobs more quickly than the smaller D8. Operating costs would be higher with the D9. Fuel and maintenance costs with the D8 are estimated to be $13,000 per year. Fuel and maintenance costs with the D9 would be about $18,000. Labor and other costs run about $18,000 per year with either tractor. Van Horne's tax rate is 30%. Find the incremental operating cash flow during year two (OCF(2) ). Answer: Sell D8 and Buy D9 Keep D8 Incremental Depreciation (2) D9; Depr(2) = $25,000 D8; Depr(2) = $2,000 Depr(2) = $23,000 Sales (2) Sales(2) = $25,000 Costs (2) Costs(2) = $18,000 Costs(2) = $13,000 Costs(2) = $5,000 OCF = (S-C) (1-T) + DT =(25,000 - 5,000) (1-.3) + 23,000 (.30) = $20,900 2. (20 points) The Sleet Corp. is evaluating the possibility of adding a new product to its existing product line. This expansion project would require an initial investment of $870, and would result in estimated future incremental cash flows of $100 per year, forever (a perpetuity). Sleet's tax rate is 30%. The risk of the expansion project is considered comparable to that of Snow's existing operations. Sleet's current (target) capital structure is summarized below: Equity: Common stock: 1,000,000 shares outstanding, Current market price: $4.00 per share; Annual dividends: expected dividend for next year: $0.50 per share; Dividends are expected to grow at 3% per year, forever. Debt: Bonds: 6,000 bonds outstanding; Par Value: $1,000; Annual coupon: 6%; Current market price: $908.92 per bond; Maturity: 15 years. 2a. (4 points) Draw a time line showing the cash flows expected from one of Sleet's bonds. Use those cash flows to show that Sleet's cost of debt (kd) is 7.0%. Answer: 908.92 = 60(PVIFA7.0%,15) + 1000(PVIF7.0%,15) 2b. (4 points) Draw a time line showing the cash flows expected from a share of Sleet's common equity. Use those cash flows to estimate Snow's cost of common equity (ks). Answer: P0 = (DIV(1))/( ks - g); $4.00 = $0.50/( ks - .03); ks = 15.5% 2c. (6 points) Find Sleet's WACC (weighted average cost of capital). Answer: Total MV common equity = 1,000,000($4) = $4,000,000 Total MV bonds = 6,000($908.82) = $5,452,920 Total capital = $4,000,000 + 5,452,920 = $9,452,920 wd = $5,452,920 / $9,452,920 = .58 ws = $4,000,000 / $9,452,920 = .42 WACC = wd kd(1-T) + wsks = (.58)(7.00%)(1-.30) + (.42)(15.5%) = 9.352%% 2d. (4 points) Find the IRR for the investment. Use the IRR to explain whether or not this is a good investment. Answer: IRR: 870 = 100/IRR IRR = 11.49% Since the IRR > cost of capital of 9.352%, this is a good investment; NPV > 0 The investment creates value. 2e. (2 points) Briefly explain why the information, “The risk of the expansion project is considered comparable to that of Snow's existing operations” is necessary to do this problem. Answer: The WACC is the required rate of return on the firm’s existing assets. If the risk of the investment is different from the risk of existing assets, then it would be the wrong cost of capital for this analysis.