PAF – Karachi Institute of Economics and Technology

Course: Financial Management

Faculty: Ali Sajid
Class ID: 105506 Total Marks: 40
Examination: Final (Fall-2020) Date: 12/13/2020
Student Name: ID:

Numerical Section (27 Marks)

Question 1 (7 Marks)
The Coca Cola Bottling Company is contemplating the replacement of one of its bottling machines with a
newer and more efficient one. The old machine has a book value of $700,000 and a remaining useful life of 5
years. The firm does not expect to realize any return from scrapping the old machine in 5 years, but it can sell
it now to another firm in the industry for $255,000. The old machine is being depreciated by $140,000 per
year, using the straight-line method.

The new machine has a purchase price of $1,475,000, an estimated useful life and MACRS class life of 5 years,
and an estimated salvage value of $160,000. The applicable depreciation rates are 20%, 32%, 19%, 12%, 11%,
and 6%. It is expected to economize on electric power usage, labor, and repair costs, as well as to reduce the
number of defective bottles. In total, an annual savings of $275,000 will be realized if the new machine is
installed. The company’s marginal tax rate is 30%, and it has a 15% WACC.
a. What is the initial net cash flow if the new machine is purchased and the old one is replaced?
b. Calculate the annual depreciation allowances for both machines, and compute the change in the
annual depreciation expense if the replacement is made.
c. What are the incremental net cash flows in Years 1 through 5?
d. Should the firm purchase the new machine? Support your answer.

Question 2 (6 Marks)
PIA is evaluating a lease agreement for an aircraft push truck that costs $200,000 and falls into the MACRS
five-year class. PIA is in a 35 percent tax bracket, and can borrow the money at 12 percent and amortize the
loan over the six-year period if it decides to buy rather than lease. The loan payments would be made at the
end of the year. The truck has a six year economic life and its estimated residual value is $90,500. If PIA were
to buy the push truck, it would purchase a maintenance contract that costs $4,500 for first three years and
4,537 for remaining three years, payable at the end of each year. The lease terms, which include
maintenance, call for a $40,000 lease payment at the beginning of each year. Should PIA buy or lease?

Question 3 (2+3 Marks)

 a. Does interest rate parity imply that interest rates are the same in all countries?
b. Why might purchasing power parity fail to hold?

Question 4 (6 Marks)
A firm is currently unlevered with 1 million shares each price at $50. The firm is debating of changing its
capital structure by taking 25 million in debt and repurchasing shares. It will pay down this debt by 5 million
every year. If the tax rate is 30 percent and cost of debt is 6 percent.
a. What is the value of the restructured firm if no information is available to market regarding this
particular transaction?
b. What is the price per share and No. of repurchased shares if market is aware of this particular
transaction?

Question 5 (3 Marks)
A company forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is
13%, and the FCFs are expected to continue growing at a 5% rate after Year 3. Assuming that the ROIC is
expected to remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions?

Year: 1 2 3

Free cash flow: -$15 $10 $40