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After graduating from Ohio State University with a degree in Finance, Kate Myers took a position as a stock broker with Merrill Lynch in Cleveland. Although she had several college loans to make payments on, her goal was to set aside funds for the next eight years in order to make a down payment on a house. After considering the various suburbs of Cleveland, Kate chose Lakewood as her desired future residency. Based on median house price data, she learned that a three-bedroom, two-bath house currently costs $98,000. To avoid paying Private Mortgage Insurance (PMI), Kate wanted to make a down payment of 20%. Because it will be eight years before Kate buys a house, the $98,000 price will surely not be the same in the future. To estimate the rate at which the median house price will increase, she considered the historical price appreciation in Lakewood. In the past, homes appreciated by nearly 4% per annum. Kate was satisfied with this estimation. Merrill Lynch provides several opportunities for Kate to invest the funds that will be devoted to the purchase of her future home. She feels that a balanced account containing stocks, bonds, and government securities would realistically achieve an annual rate of return of 8%. 1. Taking into consideration the fact that the $98,000 home price will grow at 4% per year, what will be the future median home selling price in Lakewood in eight years? What amount will Kate Myers have to accumulate as a down payment if she does decide to buy a house in Lakewood? 2. Based on your answer from number 1, how much will have to be deposited into the Merrill Lynch account (which earns 8% per year) at the end of each month to accumulate the required down payment? 3. If Kate decides to make end-of-the-year deposits into the Merrill Lynch account, how much would these deposits be? Why is this amount greater than twelve times the monthly payment amount? 4. If homes in Lakewood appreciate by 6% per annum over the next eight years instead of the assumed 4%, how much would Kate have to deposit at the end of each month to make the down payment? What if the appreciation is only 2% per year? 5. If Kate decided to deposit her down payment funds in less risky certificates of deposit (CDs) earning only 4%, how much would she have to deposit at the end of each month to make the down payment? What if she pursued a more risky investment of growth stocks that have an expected return of 12%?

Greg and Debra Quilici own a four bedroom home in an affluent neighborhood just north of San Francisco, California. Greg is a partner in the family owned commercial painting business. Debra now stays home with their child, Brady, who is age 5. Until recently, the Quilicis have felt very comfortable with their financial position. After visiting Lawrence Krause, a family financial planner, the couple became concerned that they were spending too much and not putting enough funds aside for both their child's future education needs and their own retirement. Greg earns $85,000 per year, but with the rising costs of education, their past contribution efforts have left them short of their financial goals. To estimate the amount of money the Quilicis need to begin putting away for future security some general information was obtained by their financial planner. The couple felt that the amount of money they currently contribute to their Koegh plan would be sufficient for their retirement needs. What they had not accounted for was Brady's education. Greg is an alumni of Stanford University, a private school with an extremely high tuition of approximately $20,000 per year. Debra graduated from the University of North Carolina at Chapel Hill. The tuition expense there is only $2,500 per year. When Brady turns 18, the couple wishes to send him to either of these exceptional universities. They have a slight preference for the much more local Stanford University. The problem, however, is that with the rate at which tuition is increasing the Quilicis are not sure they can raise enough money. To assist in the calculations, assume the tuition at both universities will increase at an annual rate of 5%. Living expenses are currently estimated at $6,000 per year at both schools. This expense is expected to grow at only 3% per year. Further assume the Quilicis can deposit their money into a growth oriented mutual fund at Neuberger & Berman Management, Inc., which has historically earned a 12% return per annum (1% per month). The couple wishes to have a pre-determined monthly amount automatically drafted from their checking account. When Brady starts college they will slowly liquidate the account by making an annual payment to Brady to cover tuition and living expenses at the beginning of each year for the four years he will be in college. 1. How much will be the tuition and living expenses per year when Brady is ready to attend? Give an answer for each university. 2. Once Brady starts college what will his total expenses be in each of his four years? Again, give an answer for each university. 3. How much money will Greg and Debra have to deposit per month to allow Brady to attend Stanford University? How much money will have to be deposited per month to allow Brady to attend the University of North Carolina? (HINT: To answer this question you need to consider the costs of ALL four years.)

4. What if the Quilicis feel the Neuberger & Berman mutual fund will only yield 10%. How much will have to be deposited per month in order for Brady to attend each college? 5. What is the relationship between the amount that must be deposited monthly by the parents and the future increases in both tuition and living expenses?

It is December 31, 2007 and Camille Henley, age 35, is in the process of reviewing her retirement savings and planning for her retirement at age 60. She currently has $55,000 saved (which includes the deposit she just made today) and she invests $2,000 per year (at the end of the year) in a retirement account that earns about 10% annually. She has decided that she is comfortable living on $40,000 per year (in today's dollars) and she thinks she can continue to live on that amount, as long as it is adjusted annually for inflation. Inflation is expected to average 2.86% per year for the foreseeable future. After researching information on average life expectancy for females of her background, her plan will assume she lives to age 88. She will withdraw the amount needed for each year during retirement at the beginning of the year. So, on December 31 at age 60, she will make her last deposit of $2,000 and the following day (January 1) she will withdraw her first installment for retirement. 1. If Camille continues on her current plan, will she be able to accomplish it? 2. How would the situation change if Camille were to start placing her $2,000 annual savings into her retirement account on January 1st of each year rather than December 31 of each year? Assume the investment still pays interest at the end of the year. 3. If Camille resumes making her deposits at the end of the year, how much would she have to save each year to accomplish her objective? 4. Assume that Camille continues with her current plan. What interest rate would she have to earn on her investment to make it work? 5. If Camille wishes to leave $50,000 perpetuity to her alma mater, starting one year from the year she turns 88, how much extra money would she need to have on December 31 of the year she turns 88? Assume the investment will earn 10%. 6. Rework question 5, assuming that Camille wants the university investment to grow by 5% per year.

KajunKorp currently has 1,500,000 shares of common stock outstanding with a $0.75 par value. The firm issued all 1,500,000 shares via an initial public offering at $11.26 per share. The firm's total common equity balance is $528,649,000 and the firm has no Treasury Stock. Determine the following balances: Common stock, $0.75 par: Additional paid-in capital: Retained earnings: Also, KajunKorp estimates that it will need $12,000,000 in additional financing to support new projects in the upcoming year. The firm's current debt ratio is 30% and it wishes to maintain that percentage. KajunKorp expects to generate EBIT of $6,429,000 and it currently has $10,000,000 in outstanding long-term debt with a

coupon rate of 7%. Any new debt issued will have the same coupon rate. KajunKorp's tax rate is 35% and the firm currently pays a dividend of $0.10 per share: however, they would like to increase the dividend to $0.11 per share. Determine how much the firm expects to generate in retained earnings during the upcoming year and how many new shares (if any) of common stock KajunKorp will need to issue at the current stock price of $11.26 to finance the equity portion of the additional financing.

Hasbro, Inc., is a multinational parent company who is in the primary business of designing, manufacturing, and marketing toys, games, puzzles, etc. Their subsidiary companies include such household names as Parker Brothers, Milton Bradley, Tonka, Kenner, and Playschool. These companies produce some of the most easily recognized products in the world: Monopoly, Mr. Potato Head, G.I. Joe, The Game of Life, Scrabble, Lincoln Logs, Twister, Operation, Yahtzee, Candy Land, Pictionary, Trivial Pursuit, and Scattergories, to name a few. Hasbro is currently trying to pick-up ground in the doll market by directly competing with Mattel's Barbie, a front runner in the doll market segment for decades. To do so, Hasbro has proposed the sale of their own teenage doll, Maxie. To produce Maxie, Hasbro must acquire several new pieces of equipment. As part of the production process, Hasbro currently occupies certain manufacturing facilities and sales offices and uses certain equipment under various operating leases. Now that they need to acquire more machinery, they must decide whether to buy or lease the new equipment. Hasbro can purchase the machinery for $30,000 by financing over a five year period at 8% interest. The corresponding annual payment would be $7,514. Buying the machinery has an advantage in that the machine can be depreciated using the MACRS five year recovery system. Depreciation rates are given below. Table 1 % that can Year be depreciated 1 2 3 4 5 20 32 19 12 12

The drawback to purchasing the machinery, however, is that the maintenance duties are borne by the owner. To maintain the machinery will cost Hasbro $1,000 each year for five years. If Hasbro decides to lease the machinery, they will have to pay the lessor $7,000 per year for the next five years. As with most operating leases, the lessor will pay

for all maintenance necessary. At the end of the five year period, Hasbro will have the option to buy the machinery at a cost of $6,000. The tax rate for Hasbro is 40%. 1. Find the after-tax cash flows associated with the lease payments. Assume Hasbro will agree to purchase the machinery at the end of the five year period for the agreed upon $6,000. 2. If the machinery is purchased, the interest paid from financing it is tax deductible. Since this is the case, find the amount of interest paid each year. 3. Depreciation is also tax deductible if the machinery is purchased. Calculate the depreciation expenses over the five year period. 4. Knowing that depreciation, interest expenses, and maintenance costs are tax deductible, calculate the total tax shield associated with purchasing the machinery. 5. What are the total net after-tax cash outflows associated with purchasing the machinery? 6. Using your answers from questions 1 and 5, should Hasbro lease or buy the machinery? (i.e. What is the present value of the costs associated with both options?) 7. In general, what are the advantages and disadvantages to leasing? 8. In question 1, we assumed Hasbro would purchase the machinery for $6,000 at the end of the five year lease period. In practice, Hasbro will want to wait the full five years before they make that decision. What will their decision be based on at that time? That is, if Hasbro decides to lease the machinery, what factors will determine their decision of whether or not to buy the machinery at the end of the lease?

A few years ago when the stock market was reaching new highs every day, investors were pouring more and more money into the capital markets. This free flow of funds encouraged small firms to go public before they were ready. More directly, many of these firms had limited track records, and in several cases, no track record at all. Still, with such a hot IPO market, these premature public offerings had been extremely successful; the majority of these firms had no problem fully subscribing their shares. The market capitalization of was over $22.9 million. Yet in their SEC statement it read, "The company is not currently engaged in any substantial business activity and has no plans to engage in any such activity in the foreseeable future." How is it that a firm with no business operations had come to command such a market capitalization? began under the name The mission of this firm was to perform bad debt collections for doctors. Finding this to be a not so profitable venture, the firm shifted gears. Recognizing that the IPO process is a lengthy and expensive one, they saw value in the fact that they were already a publicly held corporation. As such, they could identify private companies who wished to go public, but didn't want to put the necessary time and effort into the process. The game plan was to merge with the other firm and have that be their line of business.

This practice of making it up as you go along seemed not only to be a necessary course of action, but an attractive one as well. The trick appears to be keeping yourself "new." is certainly keeping itself open to possibilities. As stated in their SEC statement, "The company does not intend to restrict its search (for a partner) to any particular business or industryhigh tech, natural resources, manufacturing, R&D, communications, transportations, insurance, brokerage, finance, and all medical related industries." That pretty much covers it. With "extremely limited assets" and "no source of revenue," one wonders how long can continue to command a stock price above zero before investors stop believing in possibilities and start demanding performance. Questions 1. How is it that a company with little to no track record can successfully go public? 2. How can a firm with no revenue have a positive stock price? 3. Why would a privately held firm generating significant profits consider merging with a publicly held firm who seems to be without direction and who is operating at a loss? 4. How long can a corporation with no revenue and no immediate plans to generate revenue expect to have their stock price supported by the market?


Computerized Business Systems (CBS) transforms manual accounting and inventory systems into computerized, more efficient, systems. Many of their customers describe the transition as an overnight evolution from the dark ages to the 21st century. Manual systems are far too cumbersome with respects to both time and inventory control. CBS's computerized inventory systems, for example, allow every item in inventory, no matter how small, to be tracked at all points throughout the production process. Replenishing stock becomes an automatic process because the CBS system alerts the manager when supplies reach a pre-programmed level. Vicky Pagel has been a financial analyst with CBS for over five years. Although she normally does not get involved with sales, her most recent assignment was to assist Jack Ingram, a new sales representative. Jack is in the process of trying to sell a CBS system to Corbin Mills, a firm that does not know how to determine accurately its weighted average cost of capital (WACC). Corbin Mills, therefore, cannot determine whether the net present value (NPV) of the CBS system is positive or negative. To calculate Corbin Mills' WACC, Vicky first needed to gather information on the firm's cost of raising funds from various sources. As she proceeded with the analysis, she learned that Corbin Mills could issue 20-year corporate bonds at a coupon rate of 9%. As a result of current interest rates, the bonds could be sold for $1,005 each. These bonds have floatation costs of $35 per bond, pay interest semiannually, and have a par value of $1,000. A corporate tax rate of 40% applies.

Corbin Mills can raise additional funds through either retained earnings or new issues of common stock. Their common stock is currently selling for $68.25 per share. The most recent dividend paid was in the amount of $2.25. Corbin's dividends have previously grown at a rate of 4%, but this growth rate is expected to jump to 10% the year after and continue at this rate to infinity. If the firm wanted to sell new shares of common stock, after underpricing and floatation costs, they could do so for $62.75 per share. A final source from which funds could be raised is via preferred stock. $100-par preferred stock can be issued at an 11% annual dividend rate. After floatation costs, the preferred stock would sell for $95.50 per share. The final set of information needed to calculate the WACC is the proportion of total funds that each asset class represents. This information is given in Table 1. In performing the NPV calculation, net after-tax cash flows must be known. These cash flows are given in Table 2. All variables such as improvements in efficiency, employee training costs, and salvage value are already incorporated in the cash flows. Put yourself in Vicky Pagel's position, and develop the WACC calculation that will be used in evaluating projects for Corbin Mills. Next, demonstrate whether the NPV for the proposed CBS system is positive or negative. The following questions will lead you step-by-step to complete the analysis. To perform this type of analysis you are implicitly making several assumptions. Since Jack will be the only one involved in communicating with Corbin Mills, he must completely understand all of the assumptions and calculations that will be made throughout the analysis. For this reason, the analysis must be clear as well as technically correct. Table 1 contains the market and book values of each asset class. Table 2 shows the after-tax cash flows associated with the CBS system. Use these tables to answer the questions which follow. Table 1 Asset Class Long-term Debt Preferred Stock Common Stock Book Value Market Value Target Ratio $35,000,000 $33,400,000 $5,000,000 $7,000,000 $40,000,000 $42,000,000 Table 2 Year After-tax net cash flow 0 11 -$480,000 $10,000 1-10 $80,000 35% 5% 40% 20%

Retained Earnings $10,000,000 $10,000,000

1. What is the firm's cost of preferred stock? Is this the same as the after-tax cost of preferred stock? 2. What is the firm's cost of long-term debt? Is this the same as the after-tax cost of long-term debt? 3. What is the firm's cost of retained earnings? Is this the same as the after-tax cost of retained earnings? 4. What is the firm's cost of new common stock? Is this the same as the aftertax cost of new common stock? 5. Using market values, what is Corbin Mill's WACC? 6. Using book values, what is Corbin Mill's WACC? 7. Using target ratios, what is Corbin Mill's WACC? Explain why the target ratio will not always be maintained by a firm. 8. Which weights, market, book, or target, should be used in this analysis? Explain. 9. Would Corbin Mills be better off with the new CBS system (i.e. What is the NPV of the proposed system?)? Does the answer to this question depend upon which weight is used to calculate the WACC? Explain.


Durango Cereal Company is considering adding a new kind of cereal to its product lineone geared toward children and the other toward adults. The company is currently at full capacity and will have to invest a large sum in machinery and production space. However, given the nature of cereal production, the investments in machinery will be more costly for the children cereal (Poofy Puffs) than for the adult cereal (Filling Fiber). The expected cash flows for both cereals are: Year 0 1 2 3 4 Poofy Puffs -$24,890,000 12,950,000 10,923,000 8,231,000 7,242,000 Filling Fiber -$13,500,000 7,230,000 8,100,000 8,629,000 5,238,900

Also, the expected net income figures for the two cereals are: Year 1 2 3 4 Poofy Puffs $6,727,500 4,700,500 2,008,500 7,242,000 Filling Fiber $3,855,000 4,725,000 5,254,000 1,863,900

The average book value for the Poofy Puffs project is $12,445,000, while the average book value for Filling Fiber is $6,750,000. Management requires a minimum return of 15% in order for the project to be acceptable from an accounting rate of return perspective. The discount rate for projects of this level of risk is 10%. Management requires projects with this type of risk to have a minimum payback of 1.75 years. Assuming the projects are independent and ignoring the issue of scale, what should Durango Cereal Company do? Include calculations for the payback method, the discounted pay-back method, accounting rate of return, net present value,

internal rate of return, and profitability index in your analysis. Which project should the company consider, if any?

The airline industry is extremely cyclical. That is, when the economy does well, so too do airlines. In recent years, the airline industry has found itself with too many seats and too few passengers. Some experts point to the past deregulation of the industry while others argue that technological advances such as teleconferencing are responsible. Several airlines such as Continental, America West, Eastern, and Trans World Airlines, have filed for Chapter 11 Bankruptcy. Some have fully recovered, while others have been forced to liquidate. Narrowing profit margins have prompted airlines to develop creative survival tactics. Southwest Airlines has successfully found its niche in the industry by providing direct flight service to less traveled routes such as those to and from smaller cities. Since these routes do not generate nearly as much revenue as major city routes, Southwest has found ways to reduce its costs. Costs are reduced by following a no frills policy that the travelers refer to as "peanut flights." This means that instead of serving costly meals (the quality of which passengers have historically complained about anyway), Southwest serves just a bag of peanuts and a soft drink. With the recent success of short, direct flights, Southwest is considering the purchase of one such additional route. Before an airline applies to the federal government for a new route, a lengthy analysis is performed to determine the feasibility of the route. Expenses to consider include airport costs such as gate and landing fees and labor costs such as local baggage handlers and maintenance workers. Many times the airline will provide its own employees to load and unload luggage or to provide upkeep for their planes, but in the case of Southwest, they have so many small cities to service that the outsourcing of these jobs is not uncommon. Table 1 provides a summary of the after-tax cash flows associated with the acquiring of an additional small route. All costs and revenues are reflected by the following numbers. Table 1 Projected Net Cash flows (in Millions of Dollars) Year Net Cash flow 0 1 2 3 4 5 6 7 -$20.8 $4.5 $6.3 $5.2 $3.9 $2.1 $1.3 $0.5

1. What is the project's NPV assuming Southwest has a discount rate of 10%? How do we interpret the NPV? 2. What is the project's IRR? How is this measure different from the NPV? What is the interpretation of this number? 3. Calculate the project's Payback Period. 4. Assuming that Southwest has a required payback period of 5 years and a hurdle rate of 10%, should Southwest accept the additional route? Based on the project's NPV, should it be accepted? If conflicting conclusions occur, which criteria would you follow? 5. When will conflicts likely occur among the three criteria? 6. Calculate the project's Modified Internal Rate of Return (MIRR). What critical assumption does the MIRR make that differentiates it from the IRR? 7. Where does the value of MIRR fall relative to the discount rate and IRR?

Acclaim Entertainment, Inc. is a mass marketer of interactive entertainment software whose games can be played on such well known video game systems as Nintendo and Sega. Some of their more successful games include Mortal Kombat I and II, NBA Jam I and II, Maximum Carnage, Virtual Bart (Simpson), and NFL Quarterback. Acclaim has also obtained licenses from True Lies, Batman Forever, and Spiderman. The interactive entertainment industry is characterized by rapid technological change and as such, no single hardware system has achieved long-term dominance. Accordingly, Acclaim focuses its production efforts on the development of software for the hardware systems that dominate the interactive entertainment market at a given point in time or in the very near future. Presently, Acclaim has licensing agreements with three industry leaders: Sony Computer Entertainment of America (SCE), Nintendo, and Sega. Acclaim is currently in the design/production stage of a new version of Mortal Kombat. Since the previous versions of the game were extremely successful, Acclaim is not greatly concerned with the acceptance of the game by the general public. It is concerned, however, with the hardware platform that should be chosen to distribute the game. Since licensing agreements are extremely short term, Acclaim wonders which of the three hardware companies should carry Mortal Kombat. For example, the licensing agreement with SCE expires in December two years from now. The Nintendo agreement expires in December of this year and the Sega contract expires in December of next year. While these contracts expire and have traditionally been renewed every few years, there is no guarantee they will be successfully renewed or extended in the future. A further consideration involves the costs charged by each company. SCE, Nintendo, and Sega charge their licensees a fixed amount per unit based on chip configuration, memory capacity, and market price. This charge covers manufacturing, printing and packaging of the unit, as well as a royalty for the use of their respective names, proprietary information and technology. Furthermore,

these charges are subject to adjustment at the discretion of SCE, Nintendo, and Sega. To offset the expenses of licensing fees, Acclaim must speculate on the ability of the three hardware platforms to access enough end-users to make their games profitable. Nintendo and Sega hold a grater share of the market, but SCE charges lower licensing fees. In general, the product life cycle in the interactive software business is from one month up to eighteen months with the majority of sales occurring within the first three months after introduction. Although titles older than eighteen months may still be available for sale, Acclaim generally actively markets only its ten to fifteen most recently released titles. Mortal Kombat represents somewhat of an exception to the rule. Being one of the most successful products, Mortal Kombat's most feared competitor will be the prospect of the next version of Mortal Kombat. There has currently been no discussion of the number of games that will be produced in the series. Acclaim's management has assembled the following projected net cash flows associated with the distribution of Mortal Kombat. These net cash flows reflect all licensing fees, productions costs, advertising expenditures, revenues, etc. Table 1 Time Net cash flow (in millions) (end of year) SCE Nintendo Sega 0 1 2 3 4 -$40 $34 $10 $5 $1 -$40 $44 $16 -$40 $41 $18 $4

1. What is the Payback Period for Mortal Kombat when marketed under the three different hardware companies? Assuming a required payback period of 1 year, which company would you allow to carry the new product? 2. Assuming a discount rate of 10%, what is the Net Present Value (NPV) under each system? Under which system, if any, would you be willing produce Mortal Kombat? 3. What are the Internal Rates of Return (IRR) under each marketer? Which marketer(s) has/have acceptable IRRs? 4. Thus far we have assumed that Mortal Kombat will be marketed through only one hardware system. Under this assumption, the projects are mutually exclusive. If we explore the possibility of allowing more than one company to market Mortal Kombat, which company(ies) would you allow to market the product? Base your answer on the three criteria from the above questions. 5. Mortal Kombat will have a different life span depending on the hardware system Acclaim chooses. Since the lives of the three projects are not equal, can a comparison truly be made based on conventional NPV measures? Calculate the Annualized Net Present Value (ANPV) for each of the three

alternatives. Based on ANPV, which marketer would you choose to sell the product through if the projects were mutually exclusive? What if they were independent?

When most people hear the name Philip Morris, they think of tobacco, or more specifically, Marlboro cigarettes. What most people do not realized is that the food products Philip Morris markets generate more sales revenue for the firm. Recognizable brand names include Kraft, Post, Maxwell House, and Entenmann's. Philip Morris is considering the introduction of two new products. The first product is a new breakfast cereal called Post Blueberry Morning. Post is an established name in the cereal market with a market share of 16.7%. Getting shelf space is extremely difficult and costly for most new products because grocery stores traditionally charge slotting fees. Slotting fees are fixed amounts that companies must pay to gain ideal shelf locations for their products. Post, however, feels less pressure from grocery stores because of the consumer demand for their products. With the consumer preference for Post brand cereal, Philip Morris feels that introducing Post Blueberry Morning will be a low risk venture. The second new product Philip Morris is considering the introduction of is a Gourmet Hazel Nut coffee that will be sold under the Maxwell House family of products. Maxwell House is also established in its market, but the coffee industry itself is more risky than the high profit margin breakfast cereal market. Coffee profits are strongly affected by the general swings in the commodity's price due to uncontrollable factors such as weather. From month to month the price of coffee fluctuates making profits from coffee sales fluctuate as well. In performing a capital budgeting analysis, Philip Morris recognizes that these two products should not be considered to be of equal risk. Therefore, traditional net present value analysis should not be used to decide which product, if any, to produce. To help the company decide how to handle the perspective investments, their finance department forecasted the projects' expected net cash flows. Both projects have an expected life of seven years. Table 1 shows the projected net cash flows associated with both projects. Table 1 Year 0 1 2 3 4 5 Net cash flow Net cash flow Gourmet Hazel Nut Post Blueberry Morning -$4,000,000 $1,000,000 $1,200,000 $750,000 $950,000 $880,000 -$2,500,000 $803,000 $521,000 $235,000 $400,000 $498,000

6 7

$500,000 $206,000

$612,000 $519,000

Since the two projects have dissimilar risks, the finance department felt it would be appropriate to indicate how certain they were about their estimates of the net cash flows associated with each project. These certainty equivalents are shown in Table 2.

Table 2
Year 0 1 2 3 4 5 6 7 C.E. Net cash flow Gourmet Hazel Nut Post Blueberry Morning 1.00 .80 .70 .60 .50 .40 .30 .20 1.00 .95 .90 .85 .80 .75 .70 .65

The appropriate discount rate for an average risk project for Philip Morris is 10%. They feel that because the Gourmet Hazel Nut project is more risky than average, a risk-adjusted discount rate of 12% should be used. Finally, the risk-free rate of return is currently 5%. 1. If you assume the two projects are of equal risk, what is the net present value (NPV) of each project? Because the projects are independent, which project(s) would you accept? 2. Because the Gourmet Hazel Nut project is more risky, calculate its NPV using the Risk-Adjusted Discount Rate (RADR). 3. Using the certainty equivalents method, calculate the projects' NPV. Does your accept/reject decision change? 4. Explain the concept of certainty equivalents. Start with a definition and then explain fully. 5. How do certainty equivalents adjust cash flows for risk and time. How does this adjustment compare to the way RADRs treat risk and time?


Florida Power & Light (FP&L) is the primary subsidiary of Florida Power & Light Group, representing 97% of their operating revenues. FP&L is a utility company that supplies electric service throughout most of Florida's eastern seaboard. Their service area contains 27,605 square miles which translates into approximately 3.4 million customers. Of these 3.4 million customers, as a percentage of operating

income, roughly 55% comes from residential customers, 35% from commercial, 4% from industrial, and the remaining 6% from other sources. Paul Seiler, a senior contracts agent in the nuclear division at FP&L's Turkey Point Plant in Florida City, Florida, is debating on whether to renew or replace the commercial nuclear reactor's reactimeter. A reactimeter is a vital component of the nuclear power generating process. The core of a nuclear reactor must be maintained at a certain temperature and must possess a particular chemical composition. Any deviation from this sensitive optimal mix will result in the sub-optimization of the plant and a corresponding waste of energy. The reactimeter is a computer with accompanying software that is used to monitor the requisite characteristics of the Reactor Coolant System (RCS) and make minor adjustments as needed. Alternative 1: In order to determine whether the reactimeter should be renewed or replaced, Paul had to gather some financial information. If the current computer system is upgraded and new software is purchased, the cost will be $80,000. An additional $5,000 will be required to have the system installed and calibrated for accuracy. The renewed computer system will have a useful life of just five years and will be depreciated in compliance with the MACRS five year recovery system. Depreciation rates for years one through five are .20, .32, .19, .12, and .12, respectively. Only the purchase cost of $80,000 will be depreciable, not the installation cost. At the end of the five year period, the renewed machine can be sold for $5,000 before taxes. The renewed machine would also result in an increase in net working capital of $20,000. Net profits resulting from an increase in operational efficiency for each year will be as follows: Table 1 Year Net increase in profits 1 2 3 4 5 Alternative 2: The new system will also have a five year life and will be depreciated in compliance with the MACRS five year recovery system. The fully depreciable cost of the new system will be $100,000. Installation costs will be an additional $5,000. At the end of the five year period, the renewed machine can be sold for $10,000 before taxes. Implementing the new machine would result in an increase in net working capital of $15,000. If FP&L decides to replace the old system with a new reactimeter, the resulting net profits will be: $650,000 $425,000 $317,000 $220,000 $129,000

Table 2 Year Net increase in profits 1 2 3 4 5 $350,000 $350,000 $350,000 $350,000 $350,000

If a new system is purchased, the old system can be salvaged for $10,000. Finally, FP&L has a 40% corporate tax rate. 1. What is the initial investment associated with both alternatives? 2. Calculate the net after-tax operating cash inflows associated with both alternatives. 3. Calculate the year 5 cash flow associated with the sale of the computer for both alternatives. That is, remember to consider that both computer systems can be sold at the end of the fifth year. 4. Using a discount rate of 10%, calculate the present value of both alternatives. Which alternative should Paul choose? 5. What are some of the qualitative factors to consider when making a decision between the two alternatives? 6. Based on your answers from questions 4 and 5, has your decision changed concerning which alternative is preferred?

Jaedan Industries has the following account balances as of December 31, 2007. The firm's dividend payout ratio is 25% and the tax rate is 34%. The firm's stock price on December 31,2006 was $42.89 and on December 31, 2007is $56.82. Construct an income statement, balance sheet, statement of retained earnings, and statement of cash flows for 2007. Also determine the firm's cash flows and calculate the liquidity, activity, debt, profitability, and market ratios tor Jaedan Industries. Perform a DuPont analysis and compare the firm to the industry ratios. Highlight any financial strengths and weaknesses that Jaedan Industries may have. Sales $42,000,000 Cost of goods sold (COGS) 63% Portion of COGS that represent purchases 75% Selling, general, and administrative expenses. $1,621,000 Depreciation $800,000 Interest rate on short- and long-term debt 10% Cash balance $3,689,000 Accounts receivable $5,423,000 Marketable securities $1,836,000 Inventory $4,118,000 Fixed assets $14,811,000 Accumulated depreciation (does not include depreciation for 2007)$5,160,000 Accounts payable $3,136,000 Notes payable $706,000

Accruals $500,000 Long-term bonds outstanding $3,046,000 Preferred stock (at par) $100,000 Retained earnings (does not include retained earnings for 2007) $1,628,819 Common stock (at par) $4,000,000 Paid-in capital in excess of par $4,500,000 Tax rate 34% Dividend payout ratio (common stock) 25% Dividends on preferred stock 8% of par Number of shares of common stock outstanding 1million Terms of trade on accounts receivable 35 days Terms of trade on accounts payable 45 days To aid in your calculations, the financial statements from 2006 are included below:


Bracelet Blanks. Inc. (BB) generated $ 43,803,000 in sales (all on credit) during 2007. Cost of goods sold was 57% of that total. Accounts receivable totaled $3,240,222, inventory totaled $842,020, and accounts payable totaled $1,826,070. 1. Calculate EB's current cash conversion cycle. 2. BB currently uses 3,000 ingots of aluminum each year to manufacture bracelet blanks. The order cost including shipping is $5,000 per order, and carrying costs are $75 per unit per year. Determine the economic order quantity (EOQ), the amount of safety stock, and the reorder point for aluminum ingots assuming there is a one-week lead time and the firm would like a safety stock of 3 percent. 3. Also, in an attempt to boost sales, the firm is considering relaxing its credit standards by extending more credit to small firms. BB charges $1.50 per unit. Variable costs are $0.5126 per unit and fixed costs are $10,000,000 per year. The relaxation of credit standards is expected to result in a 3.8% increase in sales (the firm has sufficient excess capacity to handle the increase), and an increase in the average collection period of 3 days. They also expect bad debts to rise from the current level of 0% to 0.5% of sales.

Assuming BB requires a 13% return on investments of this type, should the firm relax its credit standards? 4. Additionally, BB currently offers its credit customers terms of net 30. However, it is considering changing the terms to 2/10 net 30 in an attempt to reduce the amount of time it takes to collect its accounts receivables. The firm believes this change alone will decrease the average collection period by 5 days. BB also expects 63% of its customers will elect to pay within the discount period and that the increased attractiveness of the terms will increase sales by 1% a year. It is not expected that bad debts will change from the current level of 0% as result of this change in terms. BB's opportunity cost of funds invested in accounts receivable is 10%. Should the firm offer the cash discount? Evaluate this scenario separately from the one described in question 3.

Foah's Designs sells precious metal jewelry throughout the western half of the United States. It is based in Yakima, Washington and currently all customers mail their payments to the Yakima office. The average amount of float is 6.5 days. The firm is considering implementing a lockbox system in Los Angeles. Total annual sales that are expected to be routed to the Los Angeles lock-box are $68,000,000, with an average check amount of $1,300. The lockbox system would be administered by California State Bank, which will charge a $0.25 fee per check and an annual fixed charge of $10,000. Foah's Designs has a cost of capital of 12% per year, and the lockbox is expected to reduce float to 4 days. However, there is some chance that the lockbox will only reduce float to 5 days. The firm must also decide between using EDT or wire transfers when transferring funds between California State Bank and their local bank, Yakima State Bank. Using the wire transfer method would cost $20 per transfer while the EDT method would cost only $1.50 per transfer. However, the wire transfer method would result in the funds arriving at Yakima State Bank one day sooner. Foah's Designs is also faced with a decision concerning its accounts payable. Foah's purchases its inventory from Jewellery Findings, Inc. on credit. Jewelry Findings' terms of trade are 3/15 net 45 and Foah's Designs normally pays after exactly 45 days. However, it has been considering accessing a line of credit from Yakima State Bank to pay its accounts payable after exactly 15 days instead. The commitment fee on the unused portion of the credit line is 0.3%, and the interest rate on the loan from Yakima Stare Bank is 8.9%. There are no compensating balance requirements. Use a 365-day year. 1. Should Foah's Designs implement the lockbox system? 2. If Foah's Designs plans to transfer money on a weekly basis (every Tuesday) from California State Bank to Yakima Stare Bank, which transfer method should it use, assuming it could earn 0.5% on its funds in Yakima State Bank over and above what it earns from California State Bank? 3. Assuming Foahs Designs has a line of credit of $2,000,000 and its accounts payable average $1,417,000 determine whether the firm should

continuing paying Jewellery Findings. Inc. after 45 days or if it should begin accessing the line of credit from Yakima State Bank.

Brewing beer has always been the core business of Anheuser-Busch Companies, Inc. The industry leader since 1957, Anheuser-Busch currently owns 45% of the domestic beer market. This represents annual sales of 88.5 million barrels of beer. Market share has grown so much that Anheuser-Busch now has a larger portion of the market than their next four largest competitors combined. International sales are no different. Anheuser-Busch International remains the leading exporter of beer from the United States with sales in more than 65 countries. Microbreweries, or microbrews for short, have been gaining attention in recent years. Microbrews are defined as breweries that produce less than 15,000 barrels a year. The strength of microbrews is their philosophy that beer should be of the highest quality. Microbrews are only made with malted barley, hops, water, and yeast, the only four ingredients found in the purist German beers. Mass bottled beers usually add rice and corn to minimize costs. The drawback of microbrews is their cost. The more expensive ingredients make microbrews cost an average of 60% more than mass bottled beers. Beer is not like wine which gets better with age. Instead, it is a food that should be consumed as soon after production as possible. As such, beer pubs or microbrews that produce beer on the premises, are the hottest new trend with an average of four new pubs popping up every week. Sales have grown an average of 40% per year. This figure is extremely impressive when one considers that the beer market as a whole is shrinking. Even with this success, microbrew sales represent only two percent of the $50 billion dollar beer market. In their relentless pursuit to continue to dominate all sectors of the beer market, Anheuser-Busch has tapped into the microbrewing trend. They have recently bought a stake in the Seattle based Red Hook Ale micro-brewery. The new products introduced into the regional and mainstream specialty beer segment include Red Wolf, Elk Mountain Red, Elk Mountain Amber Ale, and Elephant Red. Since microbrews are typically produced regionally, Anheuser-Busch is developing regional manufacturers and distributors. As such, they must decide on the best way to handle their short-term cash needs for purchasing inventory in these small plants. Anheuser-Busch has decided to use the Baumol model to determine the level of cash to keep on hand versus the amount to keep in marketable securities. Anheuser-Busch can earn 7% if they keep their funds in marketable securities. Every time they convert their marketable securities to cash, it costs them $25. Finally, they anticipate their total cash outlays over the next year to be $2,000,000. 1. Using the Baumol Model, what is the economic conversion quantity (ECQ) that will maximize the firm's value given their short-term cash

2. 3. 4. 5.

needs? Why is it important for a business to correctly determine their ECQ? Based on your answer from question 1, how many times will AnheuserBusch convert marketable securities into cash per year? What is the average cash balance the firm will hold throughout the year, assuming the cash outflows will occur on a consistent or smooth basis? What is the total cost associated with managing these short-term funds? How can you be sure this is the optimal ECQ? In the above analysis, we have not considered a level of safety stock. Why is safety stock so important? What primary factor will determine the amount of safety stock for each specific firm?

Pepsi is a multinational company who operates within three primary industry segments: beverages, snack foods, and restaurants. The primary products sold in the beverage segment include Pepsi, Diet Pepsi, 7UP, and Mountain Dew. Frito-Lay represents the domestic snack food business, while PepsiCo's restaurant segment consists primarily of Taco Bell, Pizza Hut, and Kentucky Fried Chicken (KFC). Pepsi also engages in several joint ventures around the world, each within one of the three industry segments. Because Pepsi is such a large manufacturer and distributor, they spend millions of dollars each year on salaries trying to keep track of orders, payments, and receipts for each of their three lines of business. Todd Rovelstad, a manager in Financial Services at Pepsi's Phoenix plant, has discovered a way to reduce the time required to log orders, payments, and receipts. His idea is simple, yet innovative. Todd uses bar codes to sort paperwork. Just as bar codes are used in a grocery store to identify each item and its price, Todd can use bar codes to identify where orders are sent to and from, the product that is being referred to, and the amount of the product to be bought, sold, or shipped. This idea has several positive attributes. First, the Pepsi employees will be able to do their logging up to four times faster than they are able to under the current system. Today, receipts for payment are left stacked until a processor can get to them. This also allows employees to concentrate more on other ways in which the company can save money. Second, the accuracy rate under the bar code system is 99.99%. While keying in codes is relatively accurate also, Pepsi has been experiencing problems because their workers are putting in too much over time and fatigue has increased the error rate. Todd did not stop at bar codes for processing accounts receivables. He also saw the usefulness of bar codes for mail. The post office now sorts mail electronically by bar codes for those letters that have them. Pepsi can use coded envelopes to speed up the return time when its customers pay for shipments. These funds can then be deposited into PepsiCo's account much sooner than they currently can be. Even though interest is earned on only one to two additional days, when considering the size of Pepsi, this will translates into big savings.

Pepsi wants to determine just how much these new programs will save the company. To determine the amount, they have disclosed the following information concerning the operating cycle. Pepsi's average payment period is 29 days. Their average age of inventory is 42 days. And the average collection period is 39 days. Pepsi feels that with the new system in place, it can speed up the average collection period by 12 days. This figure reflects the fact that the employees will not only receive the payments earlier, but more importantly, they will be able to start processing the receipts much sooner than they are currently able to do. The average age of the inventory and average payment period are assumed to remain unchanged. Pepsi currently spends $28,000,000 per year on its operating cycle investments. Funds used for financing the operating cycle cost 12% per annum. Todd feels the additional annual cost of $50,000 will be sufficient to pay for the added hardware necessary to use bar codes. This expense does not take into consideration the additional salary expenses that will be avoided due to a reduction in overtime costs. 1. Calculate Pepsi's current operating cycle, cash conversion cycle, and need for short-term financing of the cash conversion cycle (i.e. What is Pepsi's negotiated financing need?). Calculate the operating cycle, cash conversion cycle, and need for short-term financing of the cash conversion cycle if Pepsi decides to implement the use of bar codes. If the bar codes are used in the future, what will be the annual savings stemming specifically from the cash conversion cycle financing reduction? Considering the annual costs associated with implementing the bar code system, should Pepsi change their logging systems? Assume the cost of implementing the bar code system exceeds the savings in reduction of short-term financing needs. Should Pepsi decide not to change systems? Discuss. Define the cash conversion cycle and explain why it is so important. Do you think cash conversion cycles should be different for different industries (HINT - consider a manufacturer versus a retailer). What are the three ways to speed up the cash conversion cycle?


3. 4. 5.



Mass media news programs have made travelers aware, via hidden video cameras, of how common it is for hotel employees and outsiders posing as hotel guests to gain access to your room and steal your valuables right off the night stand. Of course, by the time you find out something is missing there is no way to figure out who did it. And housekeeping never seems to keep track of who cleaned your room. To combat this problem, most hospitality establishments provide, at a nominal fee, an in-room safe that can only be accessed by the guest and the top manager of the hotel. Inn-Room Safe is a manufacturer and wholesaler of the most popular and secure in-room safes on the market, the "Interchangeable Lock Block." Inn-Room

specializes by manufacturing and distributing only this one product which comes in four different sizes to fit almost all hotel spaces. Currently, Inn-Room provides shipping credit terms of net 30 days to top qualifying customers and those paying by bank wire transfer. For other, less credit worthy customers, net terms of 10 and 15 days are required. Inn-Room does not allow for a discount for early accounts receivable collections. Recognizing that sales volume should increase and that bad debt expenses should decrease, Inn-Room is considering offering a 2% discount to those hotels who pay for shipments within 10 days. Today, Inn-Room's average collection period is 23 days. With the proposed discount offering, this number is expected to reduce to 14 days. Bad debt expense is expected to decrease from 0.8% to 0.5%. Inn-Room now sells 1,700 safes on credit at an average price of $234 and a variable cost of $157 per unit. After the discount, Inn-Room forecasts that sales will increase by 7% and that 70% of all credit sales will be by hotels that take the 2% discount. Finally, Inn-Room's required rate of return on a similar risk investment is 12% under both account receivable options. 1. 2. 3. 4. If Inn-Room decides to implement the newly proposed discount, what will be the additional profit contribution from an increase in sales? If Inn-Room decides to implement the newly proposed discount, what will be the cost of the marginal investment in accounts receivable? If Inn-Room decides to implement the newly proposed discount, what will be the marginal benefit of reducing the bad debt expense? If Inn-Room decides to implement the newly proposed discount, what will be the marginal cost of paying the cash discount to early paying customers? If Inn-Room decides to implement the newly proposed discount, what will be the net profit from implementing the proposed plan? What additional factors should Inn-Room consider when making such an important decision?

5. 6.

Home Depot, the largest home improvement retailer in the world, is on the cutting edge of retail innovations. Much of their quick and steady rise to success is attributed to their approach to creating new customers and cultivating future customers. Through an idea called Home Depot University, adults take a four week comprehensive course in home improvement techniques which, of course, illustrate how the products sold by Home Depot can be used to enhance and modernize homes. The potential of kids as customers has not slipped their attention either. A program, known as "Our Kids Workshops," teaches children not only safety and creativity, but also plants a loyalty seed for the future. Another means by which Home Depot has differentiated themselves from their competition is by marketing what are called proprietary brands. This simply means that the product lines are only offered at Home Depot. Once customers adopt the product, they cannot buy it elsewhere. This is a way for Home Depot to protect

their customer base from discount retailers who compete purely on price and drive down profit margins. One of Home Depot's proprietary brands is RIDGID who produce everything from power tools to wet/dry vacuums and air filtration systems. When Home Depot buys products from RIDGID, they use credit and have 45 days to make full payment on these accounts payable. However, if Home Depot wants to take advantage of RIDGID's 2% cash discount offer, they must pay within 15 days. To simplify record keeping, RIDGID uses the end-of-month (EOM) method when determining the beginning of the credit period. This simply means that any sales made throughout the month will have a starting credit period beginning on the first day of the next month. For example, Home Depot recently purchased a shipment of stationary bench-top power tools from RIDGID on December 23. Since RIDGID follows the EOM method, Home Depot's credit period does not start until January 1. If Home Depot wishes to take the 2% cash discount offered, they must make full payment by January 15. If not, they must pay the entire amount by February 14. 1. 2. Calculate the exact cost of giving up the discount. Home Depot's risk-free required rate of return is currently 7%. The firm's Weighted Average Cost of Capital (WACC) is 13.4%. Finally, the rate at which the company can borrow from a bank is 9.7%. Should Home Depot take the cash discount or should they wait until the full credit period is up? On which of the above three figures did you base your comparison? Explain. Calculate the approximate cost of giving up the discount. Perform a sensitivity analysis using both the actual and the approximation formulas with cash discounts of 1%, 2%, and 3% and credit periods of 30 days, 45 days, and 60 days. What is the relationship between these two variables and the error yielded by the approximation formula? Perform a sensitivity analysis using both the actual and the approximation formulas with cash discounts of 1%, 2%, and 3% and credit periods of 30 days, 45 days, and 60 days. What is the relationship between these two variables and the error yielded by the approximation formula?

3. 4.



Sunil Mehra, a resident of Chandigarh, is an unemployed commerce graduate, aged 26 years. He does have some experience of working as an assistant in a tourist bus service. He is now thinking of floating a tourist bus service himself. The project requires an estimated cost of Rs 3,00,000 i.e. Rs 2,00,000 as cost of bus chassis and Rs.1,00,000 as cost of deluxe body with 50 seats. Sunil's father has promised him to contribute Rs 1,00,000 as equity capital on his behalf. His father would like him to earn at least an after-tax return of 13 per cent on equity capital. The remaining amount of Rs 2,00,000 will be borrowed by him from a nationalized bank. PROJECT IDEA Chandigarh, where Sunil lives, is situated at about 250 km Northwest of Delhi on the national Highway No. 1, which runs between Delhi to Wagah International Border. The city is so beautifully planned by Mr LeCarbusier, a well-known French architect, that it is known as the City Beautiful. Chandigarh is surrounded by historical places as well as good picnic spots and hill stations. To its north are Shimla and the Pinjore gardens where the Pandavas were said to have lived during their exile. To the north west is Anandpur Sahib where the ninth Sikh Guru, Guru Teg Bahadur, was cremated, and also the Bhakra Nangal Dam. To its west are industrial towns of Ludhiana and Jullunder, and also the famous Golden Temple at Amritsar; and beyond that is the Wagah International Border where the Sounding of the Last Post is an attraction for tourists. To the south of Chandigarh is the famous old city of Patiala with its wonderful museum of old weapons, and to its east is the popular Karna Lake which is a great picnic spot. With all these attractions in and around Chandigarh, there is a very good potential to run a tourist bus service. At present there is hardly any good tourist bus service. Train services are available, but they are time-consuming as well as inconvenient. All this prompted Sunil Mehra to think of starting a tourist bus service based in Chandigarh. He has done some market survey. He is convinced that there are no good services at Chandigarh to cater to the touring needs of the upper class people, who are prepared to pay for a good tourist service, if it is available. He has also contacted some of the hotels in and around Chandigarh and was assured support if he could run a good bus service. ESTIMATES OF THE PROJECT'S PROFITABILITY AND CASH FLOWS As stated earlier, the initial cost of the project is estimated as Rs 3,00,000. On the basis of the project's profitability and cash flow estimates, a nationalized bank has sanctioned a five-year term loan of Rs 2,00,000 at 15 per cent per annum (the bank's letter of approval is given in Annexure I). Exhibits I, II and III respectively give the estimates of operating costs, and profitability. In preparing the estimates, Sunil has assumed that in spite of good publicity and hard work, it will not be possible for him to operate the bus for more than 70 per cent of its occupancy. With sustained efforts and good contacts, that occupancy is expected to increase to 80 per cent in the second year and to 90 percent in the subsequent year. He hopes to run the bus for 25 days in a month

Further, he expects the bus to have a useful life of five years, after which it could be sold for Rs 1,00,000. Depreciation will be charged at 30 per cent per year on the vehicle's written down value. Fuel cost is the major item of variable cost. It is expected to increase at 10 percent per year due to change in diesel price. Repairs are semi/fixed costs (they have been assumed as variable cost in Exhibit I); they are expected to increase with increased occupancy over the years. Tax, insurance and rent are assumed to remain constant because of the reduction in insurance premium owing to depreciated value of the vehicle, offset by increase in road tax and rent. Miscellaneous expenses for office rent and furniture include Rs 5,000 per year. Revenue is calculated assuming Rs 350 per running km. In spite of the increase in the fuel cost, the rate is assumed to remain constant during the project's life because of the expected competition from other bus operators. Bank interest is payable at 15 per cent per year, taking into account the monthly repayments. It is estimated that Sunil will be paying tax approximately at 25 cent per annum. Exhibit II and III show the detailed estimates of the project's before-and-after-tax profitability. The project earns an average rate of return of 18.2 per cent before tax and a 13.6 per cent after taxwhich is slightly higher than the minimum required rate of return on equity capital. Sunil has also prepared estimates of net cash flows (Exhibit IV). His estimates show that after repaying the installments of the term loan and allowing an average 3 per cent dividend on equity capital, he will have a total cash surplus of Rs 53,400 at the end of the project's life. This amount would be much more if the project's aftertax salvage value is also included.

As a management consultant for Sunderson Consulting, you have been retained by Whims & Fancy to compute their cost of capital. You are surprised to learn that they never bothered to determine this for themselves. They have been using 15% in their capital budgeting analysis but did not know if this was correct. You gather the following information: (figures in 000) Current liabilities Rs.200 10% Debentures 400 8% Long-term debt 1,000

12% Preference shares Retained earnings Equity shares Total liabilities and equity

100 400 1,200 Rs. 3,300

Debentures currently sell for Rs. 105. They have a par value of Rs. 100 and have a 15-year maturity. Preference shares have a face value of Rs. 10 but are currently selling at Rs. 35. The preference shares were issued 5 years ago and were redeemable at the end of 7 years. The current price of the equity shares is Rs. 20. Its next dividend is expected to be Rs. 1.75 and its expected growth rate is 3%. Equity shares can be currently sold at a premium of 5% but an underwriting fee of 5% of the issue price will have to be incurred. The firm's tax rate is 40%. Compute the WACC from the above data.

Your family owns a popular restaurant off campus. The firm is a corporation with stock that has been publicly distributed. You are talking to your parents one night and learn that the business is totally debt free. When you mention that you had learned in your finance class that borrowing money can often increase firm value, your family looks skeptical. They argue that if they borrowed money, they would have to pay interest to a bank. This would reduce their income and should lower firm value. a. Without using any numbers, discuss the concept of leverage and how it affects return on investment. b. Distinguish between operating leverage and financial leverage. c. Discuss how increased debt can increase firm value. Your family is mildly interested, but still thinks the firm would be better off debt free. When they realize you are starting to get annoyed, they offer to let you "run the numbers." You begin by contacting the bank and find that it is eager to lend the firm money. The firm is currently capitalized with 200,000 shared outstanding at Rs. 20 per share. Using data provided by the bank for the cost of debt and the Internet for cost of equity for firms similar to your family's with varying levels of debt, you prepare the following chart:
Debt/Equity Ratio 0% 25 50 75 100 Cost of Debt -8% 10 14 20 Cost of Equity 16% 17.5 19 25 28

Earnings before interest and taxes are expected to be Rs. 8, 00,000. The tax rate is 40%. d. Compute the net income for each level of debt listed above. (Hints: Total assets = Share price x Number of shares. Equity = Total assets - Debt. Debt = Total assets x Debt - equity ratio.)

e. Compute the return on equity (Net income/Total equity). f. Compute the WACC. Discuss which level of financing results in the highest ROE. Should debt be used to finance the firm?

During the last few years, Pramod Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Pradeep Agarwal, the financial vice-president. Your first task is to estimate Pramods cost of capital. Agarwal has provided data that he believes is relevant to your task. (1) The firm's tax rate is 40% (2) The current price of Pramods 12 percent coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is Rs. 1,153.72. (Par value is Rs. 1,000)New bonds would be privately placed with no flotation costs. (3) The current price of the firm's 10 percent, Rs. 100 par value, quarterly dividend, perpetual preferred stock is Rs. 113.10. Pramod would incur a flotation cost of Rs. 2.00 per share on a new issue. (4) Pramods' common stock is currently selling at Rs. 50 per share. Its last dividend (Do) was Rs. 4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. (5) Pramods target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common Compute the WACC from the above data.

Assume you have just been hired as a business manager of Pizza Palace, a pizza restaurant located adjacent to campus. The company's EBIT was Rs.5,00,000 last year, and since the university's enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, Pizza Palace plans to pay out all earnings as dividends. The management group owns about 50 percent of the stock and the stock is traded in the over-the-counter market. The firm is currently financed with all equity; it has 100,000 shares outstanding; and Po = Rs. 20 per share. When you took your MBA corporate finance course, your instructor stated that most firm's owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different debt levels (Rs. In 000)
Amount Borrowed 0 250 500

0% 10% 11%

750 1000

13% 16%

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Pizza Palace is in the 40% state-plus-federal tax bracket. Should debt be used to finance the firm?

You have just graduated from the MBA program of a large university, and one of your favorite courses was "Today's Entrepreneurs." In fact, you enjoyed it so much you have decided you want to "be your own boss." While you were in the master's program, your grandfather died and left you Rs. 3,00,000 to do with as you please. You are not an inventor, and you do not have a trade skill, which you can market; however you have decided that you would like to purchase at least one established franchise in the fast food area, maybe two (if profitable). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is three years. After three years you will sell off your investment and go on to something else. You have narrowed your selection down to two choices (1) Franchise L: Lisa's Soups, Salads and Stuff and (2) Franchise S: Sam's Wonderful Fried Chicken. The net cash flows shown below include the price you would receive for selling the franchise in Year 3 and the forecast of how each franchise will do over the threeyear period. Franchise L's cash flows will start off slowly, but will increase rather quickly as people become more health conscious, while Franchise S's cash flows will start off high but will trail off as more chicken competitors enter the marketplace and as people become more health conscious and avoid fried foods. Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for you to invest in both franchises. You see these franchises as perfect complements to one another: you could attract both the lunch and dinner crowds and the health conscious and not so health conscious crowds without the franchises directly competing against one another. Expected after-tax Net Cash Flows (CFAT) (Rs. 000) Franchise Franchise S L (100) (100) 70 10 50 60 20 80

Year (t) 0 1 2 3

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. You made subjective risk assessments of each project, and then concluded that both franchises have risk characteristics that require a return of 10%. You must now determine whether one or both of the projects should be accepted. Analyze using all the methods of capital budgeting.

VAYU Limited, a highly profitable company, is engaged in the manufacture of power intensive products. As part of its diversification plans, the company proposes to put up a windmill to generate electricity. The details of the scheme are as follows: a. Cost of windmill Rs. 300 lakhs b. Cost of land Rs. 15 lakhs c. Subsidy from State Govt. to be received at the end of the first year of installation Rs. 15 lakhs d. Cost of electricity will be Rs. 2.25 per unit in year 1. This will increase by Re. 0.25 per unit every year till year 7. After that it will increase by Re. 0.50 per unit. e. Maintenance cost will be Rs. 4 lakhs in year 1 and the same will increase by Rs. 2 lakhs every year. f. Estimated life 10 years. g. Cost of capital 15% h. Residual value of windmill will be nil. However the land value will go up to Rs. 60 lakhs (net of taxes), at the end of year 10. i. Depreciation will be 100% of the cost of the windmill in year 1 (accounted for at the end of year 1) and the same will be allowed for tax purposes. j. As windmills are expected to work based on wind velocity, the efficiency is expected to be an average 30%. Gross electricity generated at this level will be 25 lakh unit per annum. 4% of this electricity generated will be committed free to the state electricity board as per the agreement. k. Tax rate is 50%. What are your recommendations?

You have recently gone to work for a development/construction firm. This company does contract and bid construction work as well as real estate development. You work on the development side helping to select projects that will be profitable. The development company is organized as a separate entity from the construction firm. This requires that both firms be independently profitable. The company founder, Anthony Colaco, is primarily responsible for identifying development opportunities. Once an opportunity is identified, Colaco turns it over to his staff for analysis. Anthony began as a carpenter and has built the firm into a multi-million-rupee enterprise mostly based on good intuition and street smarts. He has no college education. Last week Anthony called the staff of the development firm together to discuss his latest idea. He would like to build a new strip mall on a corner of property near the university. He visualizes a group of tenants that would service the needs of college students. He directed you to let him know if the project was feasible. Your first step was to collect cost and revenue estimates. The proposed mall is a duplicate of one built last year for Rs.3,750,000 with minor cosmetic changes. The mall will have 30,000 square feet, all of which can be leased. You contact the owner of the property and find it can be purchased for Rs.500,000. The revenues are more difficult to estimate. You decide the most practical approach is to assume the mall will lease for Rs.2.75 per square foot per month. The mall will take about 10 months to build and you think the mall will be 10% leased by the end of the first year. You will get 10% of the possible revenues for 2

months. Thus, the first year revenues will be computed as Rs.16,500 (30,000 x Rs.2.75 x 10% x 2). You project to get about 60% of the possible revenues during the second year (i.e. 30,000 x Rs.2.75 x 12 x 60%). This will rise to 90% by the end of the third year. During the fourth year you project the mall to be fully leased. It is the intent of the company to sell the property once it is fully leased. You think it reasonable to project a sale by the end of the fifth year for Rs.150 per square foot (net of tax) You decide a 15% discount accurately reflects the firm's cost of capital. Should the project be accepted?

Before Nations Bank was bought by Bank of America, Tina Brown was considering the purchase of Nations Bank's common stock. Given Nations Bank's recent merger with the Southeastern powerhouse, Bank South, and talks of penetration into the Florida market via a takeover of Barnett Bank, Tina felt Nations Bank would be a solid "buy and hold" as it continued to increase its market share through aggressive growth by acquisition. While Tina was convinced she wanted to own Nations Bank, with all the price volatility surrounding the recent speculations, she was not sure if the price was above or below the stock's intrinsic value. She decided to derive the price of Nations Bank's common stock by using the Gordon Growth Model (Constant Growth Model). To use the Gordon Growth Model, Tina had to first calculate Nations Bank's required rate of return on their common stock. The risk free rate, as proxied by the yield on a three month Treasury Bill, was 6%. The return on the market, as proxied by the return on the Standard and Poor's 500 (S&P 500), was 10%. Nations Bank had a beta of 1.75. Past dividend payments also had to be known. Tina was not sure how far back into the future she should go to retrieve the dividend payment information, so she arbitrarily stopped in 1987. Between 1987 and 1990, Nations Bank seemed to have very different payout amounts. Not fully understanding the reasons behind these differences, Tina decided to consider two periods for analysis: from 1987-1995 and from 1990-1995. The dividend information that Tina recovered is shown below in Table 1.

Table 1 Year 1994 $1.88 1993 $1.64 1992 $1.51 1991 $1.48 1990 $1.42 Dividends 1995 $2.00 ($1.00 through June 1995)

1989 $1.10 1988 $0.94 1987 $0.86 1. Using the Capital Asset Pricing Model (CAPM), what was Nations Bank's required rate of return on common stock? 2. Consider the first time period from 1987-1995. Use the Gordon Growth Model to determine the price of Nations Bank's common stock. 3. Consider the second time period from 1990-1995. Use the Gordon Growth Model to determine the price of Nations Bank's common stock 4. The answers for questions 2 and 3 are very different. What does this indicate, in general, about the Gordon Growth Model? (Hint--The observed market price of Nations Bank's common stock is $70.25.) 5. What effect does the stock's required rate of return have on the calculation of its stock price when using the Gordon Growth Model? 6. If you felt that Nations Bank's last year dividend of $2.00 was going to be paid in that constant amount throughout the remainder of the company's life (i.e. zero growth), what would be the value of the stock today? 7. Based on your response to question 6, what is the relationship between the present value of a dividend paid one year from now, a dividend paid ten years from now and a dividend paid one hundred years from now?