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**Professor Y. Peter Chung
**

Solution to Homework A

Cha 8

19.

a.

**NPV for each of the two projects, at various discount rates, is tabulated below.
**

NPVA = –$20,000 + [$8,000 annuity factor (r%, 3 years)]

= –$20,000 +

NPVB =

Discount Rate

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

$20,000

NPVA

$4,000

3,071

2,201

1,384

617

–105

–785

–1,427

–2,033

–2,606

–3,148

1

1

3

r r (1 r )

$8,000

$25,000

(1 r )3

NPVB

$5,000

3,558

2,225

990

–154

–1,217

–2,205

–3,126

–3,984

–4,784

–5,532

**From the NPV profile, it can be seen that Project A is preferred over Project B if
**

the discount rate is above 4%. At 4% and below, Project B has the higher NPV.

b.

IRRA = discount rate (r), which is the solution to the following equation:

67%.66 1.000 $25.000 b.04 18.61 –37. Therefore: Standard deviation = 529.000 3 r r (1 r ) r = IRRA = 9.23 28.48 23. find IRRA = 9.77 5.72% Using a financial calculator. Recall that the IRR is the discount rate that makes NPV equal to zero: (– Investment) + (PV of cash flows discounted at IRR) = 0 $80.20 17. PMT = 0.42 529.10 0.05 Solving.91 601.000) + 0. 34. The variance (the average squared deviation from the mean) was 529.647. 1 1 $20.60 0. compute i.1125 = 11.000 0 IRR 0.16 Total Average T-Bill Return 4.30 –2. compute i.000 (1 r )3 = 0 IRRB = 7.05 = 0.000 $5.35 7. PMT = 8. a.37 Squared Deviation 53. n = 3.30 17.25% Cha 11 9. Cash flow at end of year $5.72 –42. c. FV = 25. we find that: IRR = ($5. 05 Present value = NPV = –$80.97 0. n = 3.000 IRRB = discount rate (r).000 $100.805.70% $8.33 3.000 = $20.000 + $100.67 7. Year 2006 2007 2008 2009 2010 b.48.000/$80.83 28.12 Risk Premium Deviation from Mean 10. which is the solution to the following equation: $20. 10 0 .92 178.000 Discount rate – growth rate 0 . a.38 1.86 2.72% as follows: Enter PV = (–)20.70% as follows: Enter PV = (–)20. FV = 0. Stock Market Return 15. Find IRRB = 7.01% .80 4.50 24.95 –38.48 The average risk premium was 3.53 13.

16. the value of the firm is: P0 cash flow $10.2% Therefore.82 r 0.000 $121.4 (11% – 4%) = 6.6 (11% – 4%)] = 8. a. the discount rate should be: rf + (rm – rf) = 4% + [0. If the true beta is actually 0. The discount rate is: rf + (rm – rf) = 4% + 0.058.082 .33) 2 963.33) 2 (48 9. Escapist Films: $0 ($18 $25) 28% $ 25 Boom: $1 ($ 26 $25) 8% $25 Normal: $3 ($34 $25) 48% $ 25 Recession: r ( 28) 8 48 9.366 3 3 Variance = 3 Standard deviation = = 48.33% 3 1 1 1 (28 9.64% Cha 12 6. the value of the firm would be: cash flow $10.8% Therefore.068 b.33) 2 (8 9.951.04% Portfolio rate of return: Boom: (28 + 210)/2 = 91% Normal: (8 + 18)/2 = 13% Recession: (48 –100)/2 = –26% Expected return = 26% 1 1 1 (91 26) 2 (13 26) 2 ( 26 26) 2 2.56 3 3 Variance = 3 Standard deviation = = 31.000 P0 $147. The expected cash flows from the firm are in the form of a perpetuity.22 r 0.6.

152) .2% Therefore: NPV = –$100 + [$15 annuity factor (15.0% 4.75 7%) = 9.22 = $25.25% 4% + (1. Its expected return is greater than the required return given its risk.107.0 IRR NPV 14% 6% 18% 7% 20% + + 0 + + The appropriate discount rate for the project is: r = rf + (rm – rf) = 4% + 1.951.75% 7. Expected return = 16% The security is underpriced.75 1. Figure shown below.058.0% 18.6 13.4 1.75 Cost of Capital (from CAPM) 4% + (0.152 0.2% 1.152 (1.60 Required return = rf + (rm – rf) = 6% + [1.0% 6.2%. you would overvalue the firm by: $147.0 0. 12. Cost of Capital 11.25 (13% – 6%)] = 14. Beta 0.29 10 0.4 (12% – 4%) = 15.0 0.75 7%) = 16.By underestimating beta.82 – $121. 10 years)] = –$100 + $15 1 1 $25.8% 15.0 2.25% r SML 11% 7% = market risk premium 4% beta 0 Beta 1.

90 1.2)] = 0.15 8 0.07 0. c. We can use the CAPM to derive the cost of capital for these firms: r = rf + (rm – rf) = 5% + ( 7%) Beta 1.15(1.15 0. With a par value of $1.87% $641.06) (1. a.10 law firm) = (0. r = rf + (rm – rf) = 5% + [(–0.000 and a coupon rate of 8%.59 Cisco Apple Hershey Coca-Cola 29.15) PV $70 b.06 0. 21.08% 7.06 (1. the bond will sell for: $1. We calculate the yield to maturity based on these expectations by solving the following equation for r: 1 1 $800 8 8 r r (1 r ) (1 r ) r = 12.01 for the bond. a. Portfolio beta = (0.0) + [0.10 (.000 1 1 $641. The investors pay $641.01 8 1.03 9 9 0.44 . 1 1 $1.You should reject the project. the bondholder receives $80 per year.13% a.065.06) PV $80 18.73% 9.07) PV $80 If the yield to maturity is 6%.000 $1.000 1 1 $1.90 market) + (0.07) (1.54% 15.2) (15% – 5%)] = 3% b.88 Cha 6 11. b.01 $70 . The coupon rate must be 7% because the bonds were issued at face value with a yield to maturity of 7%.39 .07 (1.136. Cost of Capital 13.22 1. They expect to receive the promised coupons plus $800 at maturity. Now the price is: $1.15 9 9 0.

87%.74% 15. enter n = 10. then compute i = 12. compute PV = $938.30 5% (1 – 0.83%.77 million The 10% coupon bond sells for 94% of par value and has a yield to maturity of 10. The rate on Buildwell’s debt is 5%.14 (1.86% of face value. Therefore. with a tax rate of 40%.75 P0 $1 $2 $3 $39.06 P3 = ($3 1. PV = ()641.000. The 9% coupon bond has a yield to maturity of 10% and sells for 93. i = 10%.14) (1. FV = 800. DIV1 = $1 DIV2 = $2 DIV3 = $3 g = 0.83% $940 $100 .90 8%) = 11.10 PV $90 Using a financial calculator.9386 $20 million = $18.06) = $39.Using a financial calculator. the market value of the issue is: 0. The cost of equity capital is the required rate of return on equity.70 11.000 1 1 $938.10 0.40)] + [0.55 10 10 0.27 2 1.06)/(0.2%] = 8.01. as shown below: $1.14)3 Cha 13 8. PMT = 90. enter n = 8. PMT = 70.10) 1.14 – 0.55. is: D E WACC rdebt (1 TC ) requity V V = [0. Cha 7 42.75 $31.2% The weighted-average cost of capital.000 15 15 r r (1 r ) (1 r ) r = 10.10(1. which can be calculated from the CAPM as follows: 4% + (0. a. as shown below: 1 1 $1. FV = 1.

Therefore.08 $40) = $1. interest t ax shield $236.35) 10. 28.12 The total value of the firm falls by $14 – $4.35 debt = 0.08 (1.50 10.08) $1. If the company plans to maintain its current debt level indefinitely. 5 years) 1 1 $4.000 (1 0.10 The value of the firm increases by the present value of the interest tax shield: 0.08 0. 40 120 WACC 8% (1 0.47 5 0.50 18.35 $50. The after-tax cost of debt is (1 – 0.6 million.47.83% 10. Its annual interest tax shield is 0. PV = ()940.83%.35 (0. The total value of the firm = $160.5 million r 0.500 r 0. Therefore.35 interest expense = 0.12 PV tax shield = $1. (See Chapter 6. Cha 16 21. FV = 1.00 – $9.53 = $150.77 23. PV tax shield = 0.000 = $17. a.53. PMT = 100.6 million $2.35 $40 = $14 b.50 10% 18. then we can find the present value of the stream of tax savings using the no-growth valuation model.500 . b.80%. V EBIT (1 Tc ) $25. Home Depot’s interest expense is given in Table 3-3 as $676 million.12 annuity factor (8%.957.55% 160 160 c. the present value of the perpetuity of tax savings is: PV 23.77 23. the weighted-average before-tax cost of debt is: 18.46% = 6.35) 15% 12.) The discount rate for the tax shield is 8%. enter n = 15. The market value of the issue is 0.47 = $9.94 $25 million = $23.35) $162. Annual tax shield = 0.46% b.35 $676 = $236. compute i = 10.50 million.77 23.000.Using a financial calculator.08 a.

6 1.125 0.100 0.100 0.100 0.100 0.125 0.100 0.8 0.153 0.100 0.545 0.091 0.1 0.4 1.079.100 0.286 0.160 0.444 0.100 0.143 0.135 0.000.175 0.167 0.125 0.125 0. 37.125 0.The expected cost of bankruptcy is 0.714 requity 0.125 0.100 0.100 0. WACC and rdebt do not change.100 0.6 0.100 0.133 0.125 0. In the absence of taxes.100 0.165 0.180 0.100 0. Alpha Corp is more profitable and is therefore able to rely to a greater extent on internal finance (retained earnings) as a source of capital.10)3 = $45.125 0.125 rdebt 0.178 0.5 1.100 0.125 0.706 0.375 0.100 0.231 0.125 0. It will therefore have less dependence on debt and have the lower debt ratio.100 0.697 0.128 0.140 0.333 0.125 0.8 1.130 0.100 0.185 0.125 0.125 0.125 0.3 1. Since this is greater than the present value of the potential tax shield.100 . c.615 0. 29.630 0.1 2.688 0.655 0.145 0.125 0.158 0.100 0.125 0.125 0.583 0.474 0.125 0.173 0.125 0.125 0.148 0. the firm should not issue the debt. Debt-Equity Ratio D/(D + E) 0 0.125 0.155 0.2 2.125 0.600 0.2 1.412 0.3 0. a.4 2.000/(1.7 0.565 0.5 0.100 0.3 2.170 0.125 0.000 = $60.100 0. The present value of this cost is $60.100 0.150 0.125 0.188 WACC 0.125 0.4 0.000 0.7 1.1 1.100 0.643 0.2 0. The requity increases with increased leverage.9 1 1.500 0.138 0.125 0.183 0.9 2 2.5 0.667 0.30 $200.168 0.100 0.524 0.163 0.677 0.100 0.

7 1.100 0.100 0.140 0. When the corporate tax rate is 35%. The announcement of an increase in Growler Corporation’s regular dividend would have the greatest impact on stock price.100 0.180 0.677 0.2 0.5 1.375 0.100 0.286 0.3 1.165 0.100 0.9 2 2.2 1.135 0.100 0.655 0.583 0.145 0.125 0.103 0.188 0.100 0.1 2.102 0.111 0.103 0.b.183 0.3 2.113 0. Dividend increases are typically good news for investors as they signal manager’s confidence in the future cash flow from operations of the firm.231 0.160 0.412 0.1 0.143 0.125 0.333 0.155 0.128 0.101 0.108 0.697 0.100 0.148 0.100 0.100 0.100 0.000 0.474 0.7 0.100 0.170 0. the WACC cost declines with increases in leverage.545 0.100 0. The optimal capital structure seems to be 100% debt financing.630 0.5 0.101 0.643 0.133 0.444 0.105 0.105 0.109 0.100 0.091 0.6 1.100 0.185 0.130 0.163 0. Debt-Equity Ratio D/(D + E) 0 0.100 0.3 0.100 0.100 0.103 0.117 0.167 0.4 1.565 0.100 requity WACC rdebt c. and investors realize that these programs and special dividends probably won’t be repeated.138 0.100 0.2 2.115 0.100 0.4 0.107 0.104 0.100 0.4 2.158 0.524 0. .6 0.100 0.8 0.600 0.5 0.153 0.8 1.150 0.175 0.119 0.714 0.102 0.122 0.101 0.108 0.1 1.667 0.9 1 1. A share repurchase will have no effect on price per share. What is not considered in the optimal capital structure seemingly implied by part (c) is the increased risk associated with higher debt levels—rdebt will increase with the debtequity ratio.688 0.100 0. Cha 17 13.168 0.112 0.500 0.100 0.100 0.615 0.100 0.706 0.173 0.178 0.106 0.100 0.

8) P0 (dividend 0.5) ($ 5 0.5) + (capital gain 0.08 P0 ($ 5 0.950% b. The pension fund pays no taxes.50% The after-tax proceeds equal [dividend (1 – 0. not payout policy. a firm’s overall cash flows are the same regardless of payouts as dividends or repurchases. so dividends are stable and capital gains less predictable.08 Using this formula for each stock. The risk in the firm is determined by the variability in cash flows.8) 0.500% 7.70) = 10.5) ($10 0. The increase in stock prices reflects the positive information contained in the dividend increase. 20.5) ($ 0 0. not as a reflection of investors’ preferences for high dividend payout ratios.19. The individual pays 15% taxes on dividends and 10% taxes on capital gains.08 Notice that a larger proportion of before-tax returns paid in the form of dividends results in a lower stock price. a. However. we find: Stock A: Stock B: Stock C: P0 ($0 0. The stock-price increase can be interpreted as a reflection of a new assessment of the firm’s prospects.25 0.8) $81.8) $100 0.5) (capital gain 0.50 0.75% 8. Therefore.8) $62.08 P0 = (dividend 0. the after-tax rate of return for each investor equals: dividend (1 dividend tax) capital gains (1 capital gains rate) price We can use this formula to construct the following table of after-tax returns: Stock Pension Investor Corporation A B C 10. As long as investment policy and borrowing are held constant. 21. .00% 6. Managers can stabilize dividends and cannot control stock prices.5% of dividend income.5)] + [capital gain (1 – 0. the risks of the firm are unchanged by its payout policy. If these proceeds are to provide an 8% after-tax return.08 P0 ($10 0. Individual 9.2)].725% 8. a. The corporation pays taxes equal to 35% of capital gains income and 35% (1 – 0.00% 10.00% 8. then: 0.00% 10.

It also equals gains from the merger. Cha 21 6. a. minus the cost of the stock purchase. b. c. Immense will have to pay $25 million to Sleepy. $6.125 million. The current value of Sleepy is $20 million. and Immense believes it can increase the value by $5 million. 10.125 million. A firm cannot change the outcomes of its investment policy by changing its payout policy.000.000. the NPV of the merger to Acquiring will be zero.08 = $6. This equals the decrease in the value of the stock held by Velcro’s original shareholders.000. This is the increase in the value of the stock held by Pogo shareholders. The merged company will have a total value of: $20 million + $10 million + $6. The cost of the offer is $14 million – $10 million = $4 million.000 $40 = $400.000 $20 = $100. therefore.25 million (from cost savings) = $36.000 Takeover Target: Value = 5.b. 9. NPV = $6. The cost of the stock alternative is $8. At a price of $25 per share.25 million.000.000 Gain from merger = $25.25 million a. c. Thus.25 million – $4 million = $2. So Immense would have to pay the full value of the target firm under the improved management. Again. a. Acquiring can pay up to $25 per share for Target.000/0. The causation in this statement is reversed: Safer companies pay more generous dividends because their forecast cash flows are more predictable. If Acquiring pays this amount. 8.25 million. NPV = –$1. the risks of the firm are unchanged by its payout policy.000.125 million. The present value of the $500. . This is the gain from the merger.000 The merger gain per share of Takeover Target is $25 million/5 million shares = $5. Premerger data: Acquiring: Value = 10.875 million. $8.25 million Since the Pogo shareholders own half of the firm.000 annual savings is $500. $5 above the current price. their stock is now worth $18. b.

and the price of SCC shares rises to reflect the NPV of the merger.800 = $52.000 + 800 = 3.00 = $150. SCC value = 3. SCC will sell for its original price plus the per-share NPV of the merger: $50 + ($10.50 to the tender price of $20.000 – $5. The deal is just barely acceptable for shareholders of Immense and clearly attractive for Sleepy's shareholders. which represents a 6.000/3.40 2. SDP shareholders capture an extra part of the merger gains from SCC shareholders. a percentage gain of $2.50) 2.000 (Merger gain) $200.890 This is less than the $10. There could not be a friendly takeover on this basis. c. Therefore. Because SDP shareholders receive stock in SCC.000/3.50/$17.63 3. Cost of merger to SCC = ($20 – $17. b.1429 = 14. NPV = price gain per share original shares outstanding = $2.000) = $53.000 NPV from part (a). Shares issued to acquire SDP = 0.50 = $ 35.000 Merger gain = $ 15.000 = $7.the deal would be a zero-NPV proposition for Immense.63 Notice that SCC sells for a lower post-merger price than it did in part (b).000 (SDP) + 15. If Sleepy tries to get $28 a share. 12.000 = $10.000 $17.50 = 0.000 NPV = gain – cost = $15. it can be accomplished on a friendly basis. d.000 = 800 shares Value of merged firm: $150.000 Shares outstanding = 3.000 (SCC) + 35.000 SDP value = 2.000 b. .33.800 Price = $200.000 = $5.000 a. the deal will have negative NPV to Immense shareholders. despite the fact that the terms of the merger seemed equivalent.000 $50.29%.66% gain The price of SDP will increase from $17.

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