Finance unit 6

Using a spreadsheet program like Excel, calculate the NPV and IRR of the following scenario:

•Cost (Year 0): 10,000.

•Year 1 Return: 3,000.

•Year 2 Return: 3,000.

•Year 3 Return: 5,000.

•Discount Rate: 10%.

Using a spreadsheet program like Excel, calculate the NPV and IRR of the following scenario:

•Cost (Year 0): 10,000.

•Year 1 Return: 3,000.

•Year 2 Return: 3,000.

•Year 3 Return: 5,000.

•Discount Rate: 10%.

Using a spreadsheet program like Excel, calculate the NPV and IRR of the following scenario:
•Cost (Year 0): 10,000.
•Year 1 Return: 3,000.
•Year 2 Return: 3,000.
•Year 3 Return: 5,000.
•Discount Rate: 10%.

·

C

o

mplete the following p

r

oblem

s

from your textbook:

·

Pages 378

–

38

1

:

1

0

–

1,

10

–

2

, 10

–

16

, an

d

10

–

20

.

·

Pages 443

–

444: 12

–

7 and 12

–

9.

·

Page 469: 13

–

5.

· 10-1

How would each of the following scenarios affect a firm’s cost of debt, r

d

(1

−

T)

; its

cost of equity, r

s

; and its

WACC

?

Indicate with a plus (+), a minus (

−

), or a zero (0)

whethe

r 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 tru

e.

Be prepared to justify your answer but

reco

gnize that several of the parts have no single correct answer. These questions are

designed to stimulate thought and discussion.

Effect on

rd(1 − T)

rs

WACC

a.

The corporate tax rate is lowere

d.

__

__

__

b.

The Federal Reserve tightens credit.

__

__

__

c.

The firm uses more debt; that is, it increases its debt ratio.

__

__

__

d.

The dividend payout ratio is increased.

__

__

__

e.

The firm doubles the amount of capital it raises during the year.

__

__

__

f.

The firm expands into a risky new area.

__

__

__

g.

The firm merges with another firm whose earnings are countercyclical both

to those of the first firm and to the stock market.

__

__

__

h.

The stock market falls drastically, and the firm’s stock price falls along

with the rest.

__

__

__

i.

Investors become more risk

–

averse.

__

__

__

j.

The firm is an electric utility with a large investment in nuclear plants.

Several states are considering a ban on nuclear power generation.

__

__

__

· 10-2

Assume that the risk

–

free rate increases, but the market risk premium

· 10-16

COST OF COMMON EQUITY

The Bouchard Company’s EPS was $6.50 in

2018, up from $4.42 in 2013. 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

D

0

= 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, r

s?
· 10-20

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 (1/1/19) selling for

$65.00 per share. The expected dividend at the end of the current year (12/31/19) is 55%

of the 2018 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%; Foust’s marginal tax rate is 40%, and its target capital structure is 40% debt and 60% equity.

· a. Calculate Foust’s after-tax cost of debt and common equity. Calculate the cost of equity as rs = D1/P0 + g.

· b. Find Foust’s WACC

· 12-7 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

12-9 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.

Challenging Problems 5-7

13-5 OPTIMAL CAPITAL BUDGET Hampton Manufacturing estimates that its WACC is 12.5%. The company is considering the following 7 investment projects:

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 I 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?

·

Complete the following problems from your textbook:

o

Pages 378
–
381: 10
–
1, 10
–
2, 10
–
16, and 10
–
20.

o

Pages 443
–
444: 12
–
7 and 12
–
9.

o

Page 469: 13
–
5.

·

10
–
1

How would each of the following scenarios affect a firm’s cost of debt, r
d
(1
–
T); its
cost of equity, r
s
; and its WACC? Indicate with a plus (+), a minus (
–
), or a zero (0)
whethe
r 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. Be prepared to justify your answer but

reco
gnize that several of the parts have no single correct answer. These questions are
designed to stimulate thought and discussion.

Effect on

r
d
(1
–

T)

r
s

WACC

a.

The corporate tax rate is lowered.

__

__

__

b.

The Federal Reserve tightens credit.

__

__

__

c.

The firm uses more debt; that is, it increases its debt ratio.

__

__

__

d.

The dividend payout ratio is increased.

__

__

__

e.

The firm doubles the amount of capital it raises during the year.

__

__

__

f.

The firm expands into a risky new area.

__

__

__

g.

The firm merges with another firm whose earnings are countercyclical both
to those of the first firm and to the stock market.

__

__

__

h.

The stock market falls drastically, and the firm’s stock price falls along
with the rest.

__

__

__

i.

Investors become more risk
–
averse.

__

__

__

j.

The firm is an electric utility with a large investment in nuclear plants.
Several states are considering a ban on nuclear power generation.

__

__

__

·

10
–
2

Assume that the risk
–
free rate increases, but the market risk premium

·

10
–
16

COST OF COMMON EQUITY

The Bouchard Company’s EPS was $6.50 in
2018, up from $4.42 in 2013. 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 D
0

= 0.4($6.50) = $2.60. Calculate the next expected dividend,
D
1
, assuming that the past growth rate continues.

·

c.

What is Bouchard’s cost of retained earnings, r
s
?

·

10
–
20

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 (1/1/19) selling for
$65.00 per share. The expected dividend at the end of the current year (12/31/19) is 55%

 Complete the following problems from your textbook:

o Pages 378–381: 10-1, 10-2, 10-16, and 10-20.

o Pages 443–444: 12-7 and 12-9.

o Page 469: 13-5.

 10-1 How would each of the following scenarios affect a firm’s cost of debt, r

d

(1 –

T); its

cost of equity, r
s

; 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. Be 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.

Effect on

r
d
(1 –

T)

r
s
WACC

a. The corporate tax rate is lowered.

__ __ __

b. The Federal Reserve tightens credit. __ __ __

c. The firm uses more debt; that is, it increases its debt ratio. __ __ __

d. The dividend payout ratio is increased. __ __ __

e. The firm doubles the amount of capital it raises during the year. __ __ __

f. The firm expands into a risky new area. __ __ __

g. The firm merges with another firm whose earnings are countercyclical both

to those of the first firm and to the stock market.

__ __ __

h. The stock market falls drastically, and the firm’s stock price falls along

with the rest.

__ __ __

i. Investors become more risk-averse. __ __ __

j. The firm is an electric utility with a large investment in nuclear plants.

Several states are considering a ban on nuclear power generation.

__ __ __

 10-2 Assume that the risk-free rate increases, but the market risk premium

 10-16 COST OF COMMON EQUITY The Bouchard Company’s EPS was $6.50 in

2018, up from $4.42 in 2013. 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 D

0

= 0.4($6.50) = $2.60. Calculate the next expected dividend,

D
1

, assuming that the past growth rate continues.

 c. What is Bouchard’s cost of retained earnings, r

s
?

 10-20 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 (1/1/19) selling for
$65.00 per share. The expected dividend at the end of the current year (12/31/19) is 55%