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# Quiz 2: Spring 1998

a.
Revenues 15000000
- Production Cost 3000000
- Payroll 2000000
- Depreciation 6250000 ! This includes depreciation on sunk cost, since this acctg
- Allocated Advertising 1375000 ! This is based on allocation, again because this is a incom
Operating Income 2375000
- Taxes 950000
Operating Income after taxes 1425000

b.
Initial Investment = 30000000 ! Includes capitalized market testing expen
Ending Salvage Value = 5000000 ! Assumes market testing expenses are not amortized
Average Book Value = 17500000 ! If market testing not capitalized, this will be 15,000,000

Return on Capital = 8.14% ! If market testing not capitalized, this would be 12%
(If you ignore the sunk costs, the return on capital is 12%)
Depending upon your definition of starting and ending book value, and whether you included working capital,
averages ranged from \$ 13.5 million to \$ 18 million. I gave full credit for all of the alternatives
c.
The most direct way to do this is to do the operating income from scratch, using only incremental amounts
Revenues 15000000
- Production Cost 3000000
- Payroll 2000000
- Depreciation 5000000 ! The depreciation on testing is not increme
Operating Income 2500000
- Taxes 1000000
Operating Income after taxes 1500000
+ Depreciation 5000000
ATCF 6500000
You can also get there from the operating income in part a.
Operating Income after taxes 1425000
+ Depreciation 6250000
ATCF 7675000
- Tax Benefit from Sunk Deprec'n 500000 ! This is the Depreciation on Testing Expense * Tax Rate
- Additional Adv. Cost (1-t) 675000 ! (\$2.5 million - 1.375 million) * (1-t)
ATCF 6500000
d.
Year 0 1 2 3 4
Investment in Equipment \$25,000,000
Investment in Working Capital \$1,500,000
ATCF \$6,500,000 \$6,500,000 \$6,500,000 \$6,500,000
Salvage Value \$6,500,000
Total ATCF (\$26,500,000) \$6,500,000 \$6,500,000 \$6,500,000 \$13,000,000
PV of Total ATCF (\$26,500,000) \$5,772,647 \$5,126,684 \$4,553,006 \$8,087,044
Cost of Capital = 12.60% ! Use the beta of software firms (and assumed an equity risk premium of 5.5%;
pre-2000 quizzes, it was not given but had to be estimated)
NPV = (\$2,960,620)
IRR = 7.71%

Salvage Value includes \$ 5 million from equipment and \$1.5 million from working capital.

## Quiz 2: Spring 1999

Problem 1 Alternatively,
Revenues 250 Revenues 250
- COGS 100 - COGS 100
- Deprecn 40 - Deprecn 50
- Variable OH 20 - Overhead 50
EBIT 90 EBIT 50
- Taxes 27 - Taxes 15
EBIT (1-t) 63 EBIT (1-t) 35
+ Deprecn 40 + Incr Deprecn 47 ! Only the after-tax portion of incr deprecn added back
- Cap Maint. 25 + Non-incr OH 21 ! Non-incremental portion (1 - tax rate)
- Chg in WC 20 - Chg in WC 20
ATCF 58 - Cap Maint 25
= ATCF 58
Problem 2
Annual cost of lease = 750 (APV,10%,6) = \$172.21
Annual cost of buying = 1200 (APV,8%,15) = \$140.20
Annual after-tax maintenance cost = \$32.01
Annual maintenance cost (pre-tax) = \$53.35

Problem 3
Cost of Equity = 5% + 1.8 (5.5%) = 0.149
NPV of project = -400 + 80 (PVA< 14.9%,5) = (\$131.19)

## Terminal Value needed to justify difference = 131.19*1.149^5 = \$262.73

Number of years the project would have to continue:
n PV of \$ 80 million
5 268.808578
6 303.575786
The project will have to last 5 years beyond the fifth year for the project to have a positive NPV.

## Alternatively, you could set up the equation

- 400 + 80 (PV of Annuity, 14.9%, n) and solve for n
n is approximately 10 years, yielding the same answer that the previous approach provided.

## Quiz 2B: Spring 1999

Problem 1
1 2 3 4 5
Existing 70% 0.77 0.847 0.9317 1.02487
New 20% 0.22 0.242 0.2662 0.29282
Total 90% 99% 109% 120% 132%

## Cost of system \$ 40.00 \$ 38.00 \$ 36.10 \$ 34.30 \$ 32.58

After-tax \$ 24.00 \$ 22.80 \$ 21.66 \$ 20.58 \$ 19.55
PV \$ 21.82 \$ 18.84 \$ 16.27 \$ 14.05 \$ 12.14
Opportunity Cost = 16.27 - 12.14 = \$ 4.14 ! Assumed that systems get replaced in year in which capacity runs out

Problem 2
! I am assuming that \$13 million is the expected payment next year. If I had assumed that it was last year's amount, I would have used 13 (1.05) in the solution
PV of 13 million(1-t) growing at 5% a year for 5 years = \$ (32.37)
Equivalent annual cost of leasing = 32.37*(APV, 10%, 5 years) = \$ (8.54) which would give me an answer of 33.89.

## NPV of second option = -40 + 10*0.4*(PVA,10%, 4 years) = \$ (27.32)

Equivalent annual cost = \$ (8.62)

## NPV of third option = -24

Equivalent annual cost = \$ (7.57)

Problem 3
NPV of cashflows for first 3 years = 10/1.12 + 15/1.12^2 + 20/1.12^3 = \$ 35.12
If initial investment is \$ 120 million
PV of terminal value has to be = 120 - 35.12 \$ 84.88
Terminal value has to be = 84.88 (1.12^3) = \$ 119.25
20(1+g)/(.12-g) = 119.25
Solving for g,
g = ( .12*119.25-20)/(20+119.25) = -4.09% ! Growth rate has to be negative (and it can be)

## Quiz 2: Spring 2000

Problem 1
Market Value of Equity = 250 * 20 = 5000
Market Value of Debt
Interest bearing debt = \$ 1,000
PV of Operating Leases= \$ 1,230 ! PV of \$ 300 million at 7% for 5 years
Total \$ 2,230
Debt to Equity Ratio = (2230/5000) = 44.60%
Debt to Capital Ratio = (2230/7230) = 30.84%

## Beta for this project = 1.05 (1 + (1-.4) (.446) = 1.33

Cost of Equity for this project = 6.5% + 1.33 (6%) = 14.48%
Cost of Capital for this project = 14.48% (.6916) + 7% (1-.4)(.3084) = 11.31%

1. Used unlevered beta to compute cost of equity (-1 point): Would have given you a cost of equity which is too low
2. Used firm's beta to compute cost of equity for the project (-1 point)
3. Did not consider operating leases at all, or just took one year's lease commitment (-1 point)
4. Computed the present value of operating leases using after-tax cost of debt (-1/2 point)
5. In computing cost of capital, used pre-tax cost of debt (-1/2 point)
6. Reported cost of equity as the cost of capital (-1.5 points)

Problem 2
EBIT (1-t) 100 Alternatively, EBIT = 100/(1-.4) = 166.666667
+ Depreciation 50 + Total G& A = 240
+ Fixed G&A (1-t) 108 - Variable G& A = 60
Cash Flow 258 Correct EBIT = 346.666667
EBIT (1-t) = 208
+ Depreciation 50
Cash Flow = 258

Problem 3
Current usage Database Total Usage Cost of Usage PV
1 66.00% 30% 96.00% \$ -
2 72.60% 30% 102.60% \$ 5.20 \$ 4.38
3 79.86% 30% 109.86% \$ 19.72 \$ 15.23
4 87.85% 30% 117.85% \$ 35.69 \$ 25.29
5 96.63% 30% 126.63% \$ 53.26 \$ 34.62
Present Value of Costs associated with excess capacity = \$ 79.51
Present Value of Benefits = PV of \$ 25 million a year for 5 years= \$ 97.24
NPV of Project = \$ 17.74

Spring 2001
1. Estimating Incremental after-tax cash flows
1 2 3 4 5
Investment Cash Flows
Investment (\$1,000) \$250
Working Capital (\$180) \$180
Operating Cash Flows
Revenues \$1,800 \$1,800 \$1,800 \$1,800 \$1,800
EBITDA \$450 \$450 \$450 \$450 \$450
Incremnetal S,G&A \$20 \$20 \$20 \$20 \$20
Depreciation \$150 \$150 \$150 \$150 \$150
EBIT \$280 \$280 \$280 \$280 \$280
EBIT(1-t) \$168 \$168 \$168 \$168 \$168
+ Depreciation \$150 \$150 \$150 \$150 \$150
Cash flow \$318 \$318 \$318 \$318 \$318
Effect of the computer purchase: Spend \$ 200 (1-.4) = - \$ 120 in year 2
Save \$200 (1-.4) in year 5
Incremental cash flow in year 2 = 198
Incremental cash flow in year 5 = 438

2. NPV of project
Initial investment = 1180
Salvage Value = 430
Opportunity Cost = -\$24.66 ! Cost of buying the computer earlier rather than later (-120/1.1^2 + 120/1.1^5)
NPV = -1180 + 318 (PVA, 10%,5 years) + 430 /1.1^5 -24.66= \$267.80

## 3. Effect of changing depreciation r=

Straight line Depreciation = \$150.00 10%
Tax benefit each year = \$60.00
PV of tax benefit = \$227.45
Accelerated Depreciation 1 2 3 4 5
Depreciation \$300.00 \$190.00 \$104.00 \$78.00 \$78.00
Tax Savings \$120.00 \$76.00 \$41.60 \$31.20 \$31.20
PV \$109.09 \$62.81 \$31.25 \$21.31 \$19.37 \$243.84
Effect on NPV = \$243.84 - \$ 227.45 = \$16.39

## 4. With infinite life

(I will assume that cap ex = depreciation, with infinite life)
Cash flow each year = 168
NPV =-1180+168/.1 - 24.66 = \$475.34 ! You would get the same answer if you put this in year 5 and then discounted
and added it back to the present value of cash flows over the first 5 years.
(Technicially,there will be other computer purchases further down the road, but the item seems small enough to ignore)

Spring 2002
Problem 1
a. Book value of debt = 750
Annual interest expenses = 40
Maturity of the debt = 5
Market interest rate = 7.20%
Market value of debt = \$692.90

## b. Unlevered beta = 0.8

Market value of equity = 2000
D/E ratio = 0.3464516628
levered beta = 0.9662967981
Cost of equity = 10.20%

## c. Cost of equity = 10.20%

After-tax cost of debt = 4.32%
Debt Ratio = 25.73%
Cost of capital = 8.68%

Problem 2
Effect of Working capital
Increase in initial investment = -250 ! 10% of revenues
Increase in salvage value = 250 ! Recover 100% at end
NPV effect = - 250 + 250/1.12^3 = -72.054938047

Effect of expensing
Tax benefit shown in analysis = 1200 ! Shown today
Depreciation each year = 1000
Tax benefit each year = 400
PV of tax benefits over 3 years = 960.73250729
Difference in PV = -239.26749271

## Corrected NPV = -\$61.32

Spring 2003
Problem 1
a. Cost of capital calculation Common Errors
Levered beta for software = 1.725 ! Use software company beta: 1.5 (1 + (1-.4)(200/800)) 1. Forgot to lever beta: -0.5
Cost of equity = 11.90% 2. Math error in levering beta: -0.5
After-tax cost of debt 4.20% ! (5% +2%) (1-.4) 3. Wrong cost of debt: -0.5
Cost of capital = 10.36% ! 11.9% (.8) + 7% (1-.4) (.2) 4. Forgot (1-t) in cost of debt: -0.5

b. Incremental cashflows
0 1 2 3 4
Initial investment -5

Revenues 6 6 6 6
- Operating Expenses 3.6 3.6 3.6 3.6
- Depreciation 1 1 1 1 ! No deprecn from sunk investment
EBIT 1.4 1.4 1.4 1.4
- Taxes 0.56 0.56 0.56 0.56 Any error in incr CF statement: 1 point off
EBIT (1-t) 0.84 0.84 0.84 0.84 1. Forgot taxes
+ Depreciation 1 1 1 1 2. Forgot to add back depreciation
Cashflow after taxes 1.84 1.84 1.84 1.84 3. Did strange things with allocated G&A

Salvage Value 1

Cashflow to firm -5 1.84 1.84 1.84 2.84 Forgot salvage value: -0.5
PV -5 1.6672707503 1.5107563884 1.3689347485 1.9145714252 Errors in NPV calculation: -0.5
c. NPV = \$1.46

Problem 2
Levered beta for computers= 1.035 This project is not a software project. You have to revert back to the unlevered beta of computer businesses: -1
Cost of equity = 9.1400%
Cost of capital = 8.15% You cannot compare the NPVs of two mutually exclusive projects with different lives: -1
Using IRR and profitability indices are only partial solutions to this problem.
NPV for 8 year project = \$3.43
Equivalent annuity = \$0.60

## Computer expansion is a better investment since the annuity of the PV is greater.

Spring 2004
Problem 1
Levered beta for project = 1.265 ! 1.10 (1 +(1-.4)*(20/80)): Use the marginal tax rate and the unlevered beta of educational service companies
Cost of equity = 10.10% Common Errors
Cost of capital = 8.80% ! 10.10(.8)+6%(1-.4)(.2) 1. Used company's beta instead of educational service beta (-1)
2. Forgot to lever educational service beta (-1)
Problem 2 3. Used effective tax rate (-1/2)
Year 0 Year 1-3 Year 3 4. Used wrong debt to equity ratio or wrong debt to capital ratio (-1/2)
Revenues \$10.00
EBITDA & G&A \$3.00
- Depreciation \$1.50 Common Errors
- Incremental G&A \$0.50 1. Started with revenues instead of EVBITA & G&A (-1)
- Incremental cleaning expenses \$0.15 2. Used allocated G&A instead of incremental and did not correct (-1)
EBIT \$0.85 3. Showed change in working capital each year instead of only in year 0 (-1)
- Taxes \$0.34 4. Used effective tax rate (-1/2)
After tax operating income \$0.51 5. Used wrong depreciation number (-1/2)
+ Depreciation \$1.50
- Change in WC \$0.00
After-tax Cashflow \$2.01

## Capital expenditure -\$7.50 \$3.00

Investment in working capital -\$1.00 \$1.00
-\$8.50 \$4.00
Problem 3
Net Present Value = -\$0.29 ! -8.5 + 2.01(PV of annuity, 3 years, 8.80%) + 4 (PV of FV, 3 years, 8.80%) ! Forgot to salvage working capital or fixed assets . (-1/2)
Forgot initial investment (-1/2)
Problem 4 Mechanical errors (-1/2)
After-tax cashflow starting in yr 4= \$0.51 ! Assume capital maintenance will be equal to depreciation in perpetuity
Terminal value = \$5.80 Common Errors
1. Used CF from part 2 without adjusting for any capital maintenance (-1)
Net present value = \$1.11 ! Use 5.11 as terminal value instead of salvage of 4.00 2. Too little capital maintenance. If your capital maintenance is set < depreciation, you
will have a problem since you will run out of book value to depreciate (-1/2 to -1 point)
The more precise answer 3. Discounted back terminal value 4 years instead of 3. You use year 4 cashflow to get
After-tax cashflow starting in yr 1= \$0.51 ! Assumes that you can't wait until year 4 to start capital mainte terminal value, it is in year 3. (-1/2 point)
PV of cashflows = \$5.80 4. Also counted salvage value (-1)
NPV of project = -\$2.70
(If you decide to make this a perpetual project, you should start investing in capital maintenance right away and not wait until year 4)

Spring 2005
Problem 1 Common Errors
Revenues 28 1. Computing the cashflow after interest expenses (Usin
- Operating Expenses 12 the tax benefit from interest. (The cost of capital already
- Allocated G&A 4 3. Using actual taxes paid of \$ 1.2 million instead of re
EBIT 7
- Interest Expenses 3 ! -1 point for subtracting out interest expenses or using
EBT 4 !-1 point for not correctly dealing with G&A expenses
- Taxes 1.2
Net Income 2.8

Revenues 28
- Operating Expenses 12
- Depreciation 5
- Incremental G&A 1
EBIT 10
Taxes 3
EBIT (1-t) 7
+ Depreciation 5
FCFF 12
There is a book value of \$ 10 million at the end of the project. If this i
NPV = \$7.80 NPV = \$11.02

Problem 2
a. NPV of liquor license = -65.91379608 ! The initital investment is a capital expense. You cannot
is no need to depreciate. If you did depreciate, I still gav
b. Annual cashflow needed to c 19.6631104923 ! Your cashflows from the restaurant have to have a NPV o
Revenue needed 32.7718508205 give you this present value is computed. Dividing by 0.6
! -65.91 = PMT (PVA, 15%,5 years)
Problem 3
Cost of equity = 11.00%
NPV of option 1 = 416.473833532 ! Used riskless rate since cashflow is guaranteed ! You cannot compare NPVs when projects have different lives, as these do.
Annual benefit = 96.1949596257 ! Converted into annuity You have to either replicate or convert into annuities.
! -1.5 points for not using annuity
NPV of option 2 = 484.312053407 ! Used cost of equity=5% + 1.5*4% = 11% ! -1 point for using risk adjusted discount rate to discount first option
Annual benefit = 74.5972713595 ! Converted back into annuity ! -1 point for not computing risk adjusted rate right

## Option 1 is better since it provides the higher annualized benefit.

Spring 2007
Interest bearing debt = \$300.00 1. Ignored leases altogether: -1
PV of lease commitments= \$216.47 2. Took nominsl value of leases: -1
Total debt outstanding = \$516.47 3. Computed present value of leases using wrong r: -0.
Equity = \$2,000.00 4. Used book value for debt or equity: -1
D/E Ratio = 25.82% 5. Error in levering beta: -0.5
Levered Beta = 0.9240 6. Error in CAPM equation: -0.5

## Cost of equity = 8.62%

1. Forgot to after-tax debt : -0.5
Cost of capital = 7.47% ! 8.62% (2000/2516.47) + 5% (1-.4)(516/47/2516.47) 2. Weights don't add up to one: -0.5
3. Math errors: -0.5
Problem 2
0 Yrs 1-5 Salvage
Investment in facility 500000 100000
Investment in Inventory 50000 50000

## Revenues 1000000 Part a.

- Food cost 500000 1. Subtracted change in working capital every year: -1
- Employee Expenses 200000 2. Error in computing depreciation: -0.5
- Advertising 40000 3. Used revenues for restaurant instead of service: -1
- Depreciation 80000 4. Forgot to add back depreciation: -0.5
Operating Income 180000
Taxes 72000
After-tax Operating Income 108000
+ Depreciation 80000
Cash flow to firm 188000 1. Ignored working capital in salvage with no tax effect: -0.5
2. Forgot working capital in initial investment: -0.5
NPV= \$154,781.67 ! -550000+ 188000 (PV of annuity, 15%,5)+ PV of Salvage 3. Errors in computation: -0.5

## c. Accounting for lost sales

Revenues lost in restaurant 200000 1. Forgot expenses associated with revenues: -0.5
- Variable costs 100000 2. Forgot taxes: -0.5
Operating Income 100000 3. Other errors: -0.5
Taxes 40000
After-tax Operating Income 60000 I gave full credit for two alternative interpretations
1. Using the after-tax operating margin for the restaur
PV of Cashflows from lost sales = \$201,129 2. Keeping variable costs fixed (the problem was a litt
Spring 2008
Problem 1
Rental revenue 100000 Math error: -.5
Maintenance cost & property taxes 20000 Added back maintenance: -.5
Depreciation 40000 Double counted tax benefits on maintenance: -.5
Operating income 40000
Taxes 16000
Income after taxes 24000
+ Depreciation 40000
After-tax cashflow 64000

b.
House price today = 1000000 ! Bt renting the house, you get a positive
NPV. Netting this out against the current
Cost of renovation 200000 ! Negative cash price gives you the PV of the future price
PV of after-tax cashflows (rental) = \$242,610.35 ! Positive cash flow
PV of future house price = \$957,389.65 Did not net out renovation cost: -1 point
FV of house price = \$1,541,885.60 Forgot to take future value: -1 point
House has to sell for more thanthis value for the rental option to be be Sundry errors: -.5 point each

Problem 2
NPV computed by analyst = \$10.00 ! Computed tax benefits incorrectly: -.5
- PV of depreciation over next 5 yea \$31.94 ! \$ 20 m (.4) (P ! Forgot salvage: -.5 to -1 point
+PV of depreciation over next 10 y \$24.16 ! 8 m (.4) (PV o ! PV incorrect: -.5 to -1 point
+PV of salvage value \$4.63 ! Salvage value discounted
Correct NPV = \$6.85

Problem 3
PV of investing in year 2 \$2,391,581.63 ! Did not convert to annuity: -1.5 points
PV of investing in year 5 \$1,702,280.57 ! Did not take PV difference: -1 point
Cost of using excess capacity = \$689,301.07 ! Math errors: -.5 point each
Annual revenues needed to break e \$191,218.82

Spring 2009
Step 1: Compute debt ratios
Pre-tax cost of debt = 5% ! Did not compute PV o leases: -1 point
Annual lease commitment = 100 Used after-tax cost of cdebt as discount rate: -0.5 point
Number of years of lease commitm \$646.32 Did not use the right beta: -1 point
Market Value of Equity = 2500 Did not lever beta: -0.5 point
Debt to Equity Ratio = 0.2585285104 Wrong cost of debt: -0.5 point
Debt to Capital Ratio = 0.2054212584 Did not compute after-tax cost of debt : -0.5 point
Step 2: Compute beta and cost of equity Math errors: -0.5 point
Unlevered beta for services = 0.8
Levered beta for services = 0.924093685
Cost of equity = 8.54%
Step 3: Compute cost of capital
Cost of equity = 8.54%
After-tax cost of debt = 3.00% ! Pre-tax cost (1- marginal tax rate)
Cost of capital = 7.41%

Problem 2
0 1 2 3
Investment in fixed assets 250 ! Did not adjust for fixed G&A: -1 point
Invvestment in Working Capital \$22.50 Did not tax adjust the G&A: -0.5 point
Revenues \$225 \$300 \$450 Used total working capital instead of change: -0.5 to -1 point
- Depreciatiion \$75 \$50 \$25 Forgot salvage value of WC: -0.5 point
- Other Operating Expenses \$100 \$125 \$175 Forgot salvage value of fixed assets : -0.5 poiint
- Allocated G&A \$25 \$25 \$25 did not compute NPV: -1 point
Pre-tax Operating Income \$25 \$100 \$225
- Taxes \$10.0 \$40.0 \$90.0
After-tax Operating Income \$15.0 \$60.0 \$135.0
+ Deprecistion \$75 \$50 \$25
+ Fixed G&A (1-t) \$15.0 \$15.0 \$15.0
- Change in Working Capital 7.5 15 0
Salvage of WC \$45.00
Salvage of Fixed Assets \$100
After-tax Cash Flow -\$272.50 \$97.50 \$110.00 \$320.00
PV at cost of capital -\$273 \$89 \$91 \$240
NPV = \$147.47

Problem 3
1 2 3 4 5
Cash flows from long term offer \$36,000 \$36,000 \$36,000 \$36,000 \$36,000 ! See below. Any PV errors; -0.5 points
Cash flow foregone (on reuglaro wor \$0 \$0 \$60,000 \$60,000 \$60,000
Incremental Cash flow \$36,000 \$36,000 -\$24,000 -\$24,000 -\$24,000
PV of cash flows \$31,304 \$27,221 -\$15,780 -\$13,722 -\$11,932
Present value of cash flows = \$17,091

## Alternatively, you could do the following:

Cashflows under status quo 75000 75000 150000 150000 150000
Present value 65217.39130435 56710.775047 98627.434865 85762.986839 74576.5102947
Total 380895.0983501
Cashflows under Long term offer \$111,000 \$111,000 \$126,000 \$126,000 \$126,000
Present value \$96,521.74 \$83,931.95 \$82,847.05 \$72,040.91 \$62,644.27
Total \$397,985.91
Difference in present values \$17,090.81

Spring 2010
Problem 1 ! PV of leases computed at wrong rate: -1 pt
Current market value of equity = \$1,000.00 ! Math errors in PV: -0.5 pt
Present value of leases = \$266.91 ! 50 (PV of annuity, 4 yrs, 5%) + 40 (PV of annuity, 3 years, 5%) (PF, 4 years, 5%)
Debt to capital ratio = 21.07% ! PV of leases/ (PV of leases + Market value of equity)
Cost of capital = 8.53% ! 10% (.7865) + 5% (1-.4) (.2135) ! Wrong cost of equity or debt: -0.5 pt

Problem 2
Opportunity cost of server = \$1,554 ! After tax cost of server = 10000 (1-.4) (Expensed, not capitalize ! No tax benefit: -0.5 point
! 6000/1.15^2-6000/1.15^5 ! No netting out of savings: -0.5 pt
( I gave full credit if you did not show the
Now Yrs 1-5 savings in year 5 and stayed consistent all
Initial cost -25000 the way through)
Server opportunity cost -\$1,554

## Advertising revenue 30000 ! Error in computing cash flow: -1 point

Annual operating cost 15000 ! Did not who server cost in NPV: -0.5 pt
Depreciation 5000 ! Did not count initial investment: -0.5 pt
Operating income 10000 ! Math errors: -0.5 pt each
Taxes 4000
After-tax operating income 6000
+ Depreciation 5000
After-tax cash flow 11000

Net present value = \$10,320 ! --25000 - 1554 + 11000 (PV of annuity, 5 years, 15%)

Problem 3
Now Yrs 1-5 Yr 5 only
Kitchen upgrade -50000 10000 ! Dont forget salvage in year 5)

Revenues 60000 (You can show the lost sales separately. If you do, your after tax cash flow will be
Direct costs 24000 \$17,600 and your lost CF from cannibalization will be \$ 3,000/year)
Incremental salary 12000 ! Allocation is irrelevant. Only the incremental salary counts
Lost profits at restaurant 5000 ! 10% of operating profits
Depreciation 8000
Operating income 11000 ! Showed allocated salary instead of incrmental: -1 point
Taxes 4400 ! Errors in computing value from lost restaurant business: -1 point
After-tax operating income 6600 ! No salvage value shown: -0.5 point
+ Depreciation 8000 ! Errors in computing cash flow: -1 point
After-tax cash flows 14600

Net present value \$8,304 ! -50000 + 14600 (PV of annuity, 5 years, 12%) + 10000 (PV of CF, 5 years, 10%)

Spring 2011
Problem 1
Cost of capital in US\$ = 10% ! Did not estimate cost of capital correctly: -1 point
Inflation rate in rupiah = 9% ! Error in computing NPV: -1 point
Inflation rate in US\$ = 2%
Cost of capital in Rupiah = 17.55% ! (1+ Cost of capital in US\$) (1+ inflation rate in Rupiah)/ (1+inflation rate in US\$)
As an approximation, you can add the inflation rate difference of 7% to the \$ cost of capital to get 17%. You get full credit.
0 1 2 3
Cash flow in rupiah -Rp1,000.00 Rp350.00 Rp450.00 Rp500.00
Present value -Rp1,000.00 Rp297.75 Rp325.67 Rp307.83
NPV = -Rp68.75

Problem 2
Initial investment -50000
Annual cash flow for break \$14,916 ! PMT given PV = 50000

## Operating income \$8,192.96 This is the answer. I worked backwards to it.

- Taxes \$3,277.19 ! Solved for breakeven cash flow but did not go further: -1 point
After-tax operating income \$4,916 ! Brought in existing revenue (non-incremental) into decision: -1 point
+ Depreciation 10000
After-tax cash flow \$14,916

## Alternatively, you can compute the PV of depreciation tax benefits first

Initial investment = -\$50,000.00
+ Depreciation tax benefit \$13,408.62
Remaining cost to be recov -\$36,591.38
Annuity needed to cover \$10,915.78
Pre-tax CF needed \$18,192.96 ! This is really EBITDA. If you did get this, though, I still gave you credit.
Subtracting the depreciation will give you the same answer as above.
Problem 3
PV of St, Louis offer \$114.25 ! Use the cost of debt for St. Louis as discount rate
PV of Yankee offer \$157.96 ! Use the cost of debt for Yankees as discount rate
! Used wrong discount rate: -1 point
Equivalent annuity = \$27.12 ! Convert back into annuity ! Computed NPV incorrectly: -0.5 to -1 point
Equivalent annuity (Yankee \$27.30 ! Did not compute annuity: -1 point

## Yankee offer pips the scale (barely).

Some of you did try adding on to the shorter term offer to make the lives equivalent. If you did, you got 0.5 point.

Problem 4
NPV of project = \$5.00
- PV of tax savings from d \$25.67 ! Did not compute PV of tax benefits: -1 point
+ PV of tax savings from \$40.00 ! Did not compute PV of immediate expensing: -1 point
New NPV \$19.33 ! Brought in existing cash flows (non-incremental) into NPV: -1 point

Spring 2012
Problem 1
a. Market value of interest bearing debt
Interest expense = 10 ! Used after-tax cost of debt: -0.5 points
Book value of debt = 250 ! Math errors: -0.5 point
Pre-tax cost of debt = 7.50%
Estimated market value = \$189.94

b. Market value of lease commitments ! Used after-tax cost of debt: -0.5 points
Lease commitment 20 ! Math errors: -0.5 point
Number of years 8
PV of of lease commitments \$117.15

## c. Cost of capital computation

Debt = \$307.09
Equity = 1200
D/E = 25.59%
Debt/Capital = 20.38%

## Unlevered beta = 1.2 ! Beta of entertainment business

Levered beta = 1.3843 ! Used wrong beta: -1 point
Cost of equity = 11.31% ! Did not lever beta: - 0.5 point
After-tax cost of debt = 4.50% ! Used effective tax rate: -0.5 point
Cost of capital = 9.92% ! Did not after-tax cost of debt: -0.5 point

Problem 2
Cost of shift to social media ! Ignored initial investment in analysis: -1.5 points
Initial investment = 25 ! Did not incorporate tax savings on depreciation: -1.5 points
Depreciation/year 5 ! Did not pre-tax savings: -0.5 points
Tax savings each year 2 ! Math errors: -0.5 point each
PV of tax savings \$7.58
Net cost of shift = \$17.42
Convert into annualized values
Annualized cost = \$4.59
Pre-tax savings needed = \$7.66

## Problem 3 Year 0 Year 1- forever

Initial investment -\$80.00 ! Used company's discount rate of 10% to discount project cashflow
! Lease revenue from parking ignored/wrong: -0.5 point
Revenues \$30.00 ! Fixed G&A counted/wrong: -0.5 point
- Direct Expenses \$10.00 ! Did not offset depreciation in perpetuity: -1 point
- Incremental G&A \$2.00 ! Counted salvage value in PV (you cannot have terminal value
- Lost lease revenue (from land) \$1.00 and salvage value in the same PV
- Depreciation \$7.00 ! Other math errors: -0.5 point
Operating income \$10.00
- Taxes \$4.00
After-tax operating income \$6.00
+ Depreciation \$7.00
- Capital maintenance \$7.00
Cash flow \$6.00

NPV = -\$5.00

Acceptable variations
1. If you discounted the lost lease revenue separately using the company's cost of capital (instead of this project's cost of
capital), you should get full credit. In fact, the right discount right for lease revenues should be the pre-tax cost of debt of the
lessee.
2. If you estimated the cash flows for the first 10 years without a maintenance cap ex and introduced a cap ex after year 10, I
gave you full credit (even though I think you are starting too late). If you do this though, remember to bring your terminal
value back ten years. Your NPV will be as follows:
NPV = -80 + 13 (PVA, 10 years, 8%) + (6/.08) / 1.08^10

Spring 2013
First, estimate the levered beta
Unlevered beta = 1.1 1. Used company's beta: -1 point
D/E ratio = 25% 2. Error on levering beta: -1/2 point
Tax rate = 35% 3. Did not adjust ERP for country risk: -1/2 point
Levered beta = 1.27875 4. Error on after-tax cost of debt: -1/2 point
5. Did not convert into Indian Rs: -1 point
Next, estimate the ERP & cost of equity 6. Error on conversion formula to Rs: -0.5 point
ERP = 8.500% 7. Error on D/E or D/C ratio: -0.5 point
Cost of equity = 13.8694% 8. Mistake in computing pre-tax cost of debt: -0.5 point

## Then, compute the US\$ cost of capital

Cost of debt = 4.00%
After-tax cost of debt = 2.60%
Debt to capital = 20%
Cost of capital = 11.57550%

## Finally, convert to an Indian rupee cost of capital

Inflation rate (INR) = 6% ( I gave full credit if you just added the differential inflation rate
Inflation rate (US \$) = 2% of 4% to the US \$ cost of capital)
Cost of capital in INR = 15.95% ! (1+ US \$ Cost of capital) (1.06/1.02) -1

Problem 2
1 2 3
Revenues \$50 \$65 \$70 1. Did not add back depreciation: -1/2 point
Depreciation \$15 \$12 \$8 2. Improper adjustment for fixed G&A: -1/2 point
AllocatedG&A \$10 \$10 \$10 3. Wrong taxes: -1/2 point
OtherOperatingExpenses \$20 \$22 \$26 4. Change in WC wrong: -1/2 point
OperatingIncome \$5 \$21 \$26
Operatingincome(1t) \$3.00 \$12.60 \$15.60
+Depreciation \$15 \$12 \$8
+FixedG&A(1t) \$4.50 \$4.50 \$4.50
ChangeinWC \$5.0 \$1.50 \$0.50 1. Forgot salvage value (either investment or WC): -1/2 point
AftertaxCashflow \$17.50 \$27.60 \$27.60 2. Math error: -1/2 point
Costofcapital= 9%
Initialinvestment \$45
SalvageValue \$17 ! Book value of initial investment + BV of Working Capital
NPV= \$28.72

Annualsidebenefits 7.5 ( I know that there are cases where you may wan 1. Wrong cost of capital: -1 point
Costofcapital(movies) 12% to apply the project's cost of capital to side benefi2. Math error: -1/2 point
PVover4years \$18.01 but this does not seem to fit those parameters. If
IncreaseNPVbythisamount you can make a really good case, I will listen.)

Problem3
Governmentcontract 1. Used risk adjusted rate on government contract: - 1 point
Riskfreerate= 3% 2 Used risk free rate for corporate contract: -1 point
1 2 3 3. Error on etimating risk adjusted discount rate: -0.5 point
Cash flow \$60,000 \$70,000 \$75,000 4. NPV of share of profits contract wrong: -1/2 point
PV @ riskfree rate \$58,252 \$65,982 \$68,636 5. Did not or error on converting govt contract to annuity: -1/2 point
NPV \$192,870 6. Did not or error on converting share of profit contract to annuity: -1/2 point
Share of profits contract
Cost of equity = 9.00%
1 2 3 4 5
Total net profits \$200,000 \$250,000 \$300,000 \$350,000 \$400,000
Share (20%) \$40,000 \$50,000 \$60,000 \$70,000 \$80,000
PV @ 9% \$36,697 \$42,084 \$46,331 \$49,590 \$51,995
NPV \$226,697
! I gave full credit if you tax adjusted the latter, though I am not sure whose taxes you
To make them comparable, convert into annuities are netting out. If it the your (the consultant's) taxes, why would it not affect both contracts.
Annuity (Government contract) = \$68,185.32 X Better Since net income is usually after corporate taxes, it should already be tax adjusted but I allowed
Annuity (Share of profits contract) = \$58,281.97 for some leeway on this one.

Spring 2014
Unlevered Beta = 0.9 1. Wrong risk free rate: -1/2 point
D/E ratio = 25% 2. Wrong unlevered beta: -1 point
Tax rate = 20% 3. Error in levering: -1/2 point
Levered Beta = 1.08 4. Wrong after-tax cost of debt: -1/2 point
5. Wrong debt ratio weights: -1/2 point
Risk free rate = 2.00% You cannot mix interest rates or costs of capital in different
ERP = 6.50% currencies and then try to take a weighted average. You can
Cost of equity = 9.0200% try to compute the cost of capital entirely in a different
Cost of debt = 3.500% currency and try to convert into your currency of choice, using
Afrte-tax cost of debt = 2.80% different inflation rates. Since the problem does not give you
Debt to capital = 20% those inflation rates, you can use interest rates as a proxy.
Cot of capital = 7.78%

Problem 2
Part a
Initial Investment -1000000 1. After-tax cash flow wrong: -0.5 to -1.5 points
2. Wrong discount rate: -1/2 point
Revenues 400000 3. Math errors: -1/2 point each
- Direct Expenses 150000
- Depreciation 200000
Operating Income 50000
-Taxes 20000
Operating Income after taxes 30000
+ Depreciation 200000
FCFF 230000
NPV (at 10%) -\$128,119.04

Part b
Increase in sales = 400000 1. After-tax operating income wrong: -0.5 to -1 point
After-Tax Operating margin = 15% 2. Wrong discount rate: -1/2 point
incremental After-tax Operating In 60000 3. Math errors: -0.5 point each
To get the operating margin on equipment sales,
PV @12% \$216,286.57 Current revenues from equipment = 2000000 (40% of \$5 million)
NPV with synergy = \$88,167.53 After-tax oper income from equip. sales 300000 (60% of 500000)
Prohect bcomes a good one, with synergy considered. Current after-tax oper margin = 15%

Problem 3
Licensing option
Initial pre-tax cash flow \$200.00
PV of pre-tax CF at 4% = \$1,667.76
PV (pre-tax) = \$1,867.76 Use Amgen's cost of debt (Fixed & guaranteed by Amgen)
PV (after-tax) = \$1,307.43 My answer
If you treated the initial cash flow \$1,357.43 Full credit for this answer as well

In my infinite compassion, I also gave full credit if you Amgen's after-tax cost of debt (2.4%) in your discounting, though it mismatches taxes
PV of after-tax cash flows at 2.4% = \$1,449.66

Do it yourself
Initial investment -\$1,500.00 1. Wrong discount rate for licensing option: -1 point
2. Used EBITDA as cash flow in do-it-yourself option: -1 point
EBITDA \$550.00 3. Error on computing cash flow from do it yourself options: -0.5 to 1 point
- Depreciation \$100.00 4. Wrong discount rate for do it yourself: -1 point
EBIT \$450.00 5. Math errors: -0.5 point
After-tax EBIT \$315.00
+ Depreciation \$100.00
ATCF \$415.00

## NPV @12% \$1,326.51 Risk is in operations to Biozyte. Using cost of capital

of Biozyte
< depreciation, you
ate (-1/2 to -1 point)
ar 4 cashflow to get

## es, as these do.

annuity: -1/2 point
ntract to annuity: -1/2 point

## t sure whose taxes you

d it not affect both contracts.