PROFESSOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.

COURSE: MBA-680-50-SUII12 Corporate Financial Theory

SEMESTER: Summer Session II

Exercises 4-5
(and solutions)

Konstantinos Kanellopoulos
6th August 2012
PART I EXERCISES FROM CHAPTERS 4 and 5

Exercise 1

 Each of the following formulas for determining shareholders’ required rate of return can be right
or wrong depending on the circumstances:
o R = (DIV1)/(Po) + g
o R = EPS1 / Po

 For each formula, construct a simple numerical example showing that the formula can give
wrong answers and explain why the error occurs. Then construct another simple numerical
example for which the formula gives the right answer.

Solution

a. An Incorrect Application. Hotshot Semiconductor’s earnings and dividends have

grown by 30 percent per year since the firm’s founding ten years ago. Current
stock price is $100, and next year’s dividend is projected at $1.25. Thus:
DIV1 1.25
r g  0 .30  0 .3125  31.25%
P0 100
This is wrong because the formula assumes perpetual growth; it is not possible for
Hotshot to grow at 30 percent per year forever.

A Correct Application. The formula might be correctly applied to the Old

Faithful Railroad, which has been growing at a steady 5 percent rate for decades.
Its EPS1 = $10, DIV1 = $5, and P0 = $100. Thus:
DIV1 5
r g  0 .05  0 .10  10.0%
P0 100
Even here, you should be careful not to blindly project past growth into the future.
If Old Faithful hauls coal, an energy crisis could turn it into a growth stock.

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 b. An Incorrect Application. Hotshot has current earnings of $5.00 per share. Thus:
EPS1 5
r   0.05  5.0%
P0 100
This is too low to be realistic. The reason P0 is so high relative to earnings is not
that r is low, but rather that Hotshot is endowed with valuable growth
opportunities. Suppose PVGO = $60:
EPS1
P0   PVGO
r
5
100   60
r
Therefore, r = 12.5%
A Correct Application. Unfortunately, Old Faithful has run out of valuable
growth opportunities. Since PVGO = 0:
EPS1
P0   PVGO
r
10
100  0
r
Therefore, r = 10.0%

Exercise 2

A widget manufacturer currently produces 200,000 units a year. It buys widget lids from an
outside supplier at a price of $2 a lid. The plant manager believes that it would be cheaper to
make these lids rather than buy them. Direct production costs are estimated to be only $1.50 a
lid. The necessary machinery would cost $150,000. This investment could be written off for tax
purposes using the seven-year tax depreciation schedule. The plant manager estimates that the
operation would require additional working capital of $30,000 but argues that this sum can be
ignored since it is recoverable at the end of the 10 years. If the company pays tax at a rate of 35
percent and the opportunity cost of capital is 15 percent, would you support the plant manager’s
proposal? State clearly any additional assumptions that you need to make.

Solution

Assume the following:

a. The firm will manufacture widgets for at least 10 years.
b. There will be no inflation or technological change.
c. The 15% cost of capital is appropriate for all cash flows and is a real, after-tax
rate of return.
d. All operating cash flows occur at the end of the year.

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 Note: Since purchasing the lids can be considered a one-year ‘project,’ the two projects
have a common chain life of 10 years.
Compute NPV for each project as follows:
10
($2  200,000)  (1  0 .35)
NPV(purchase) =     $1,304,880
t 1 1.15 t
10
($1.50  200,000)  (1  0 .35)
NPV(make) =  $150,000  $30,000  
t 1 1.15 t
 0.1429 0.2449 0.1749 0.1249
  0.35  $150,000    1
   
 1.15 1.15 2 1.15 3 1.15 4
0.0893 0.0893 0.0893 0.0445  $30,000
     $1,118,328
1.15 5 1.15 6 1.15 7 1.15 8  1.15 10
Thus, the widget manufacturer should make the lids.

Exercise 3

A project requires an initial investment of $100,000 and is expected to produce a cash inflow
before tax of $26,000 per year for five years. Company A has substantial accumulated tax losses
and is unlikely to pay taxes in the foreseeable future. Company B pays corporate taxes at a rate
of 35 percent and can depreciate the investment for tax purposes using the five-year MACRS tax
depreciation schedule. Suppose the opportunity cost of capital is 8 percent. Ignore inflation.
a. Calculate project NPV for each company.
b. What is the IRR of the after-tax cash flows for each company? What does comparison of the
IRRs suggest is the effective corporate tax rate?

Solution
5
$26,000
a. NPVA   $100 ,000  
t 1 1.08 t
 $3,810

NPVB = –Investment + PV(after-tax cash flow) + PV(depreciation tax shield)

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$26,000  (1  0 .35)
NPVB   $100,000   
t 1 1.08 t

 0.35  $100,000    0.20 

0.32

0.192 0.1152
 
0.1152

0.0576 
 1.08 1.08 2
1.08 3
1.08 4
1.08 5
1.08 6 
NPVB = –$4,127
Another, perhaps more intuitive, way to do the Company B analysis is to first calculate
the cash flows at each point in time, and then compute the present value of these cash
flows:

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 t=0 t=1 t=2 t=3 t=4 t=5 t=6
Investment 100,000
Cash Inflow 26,000 26,000 26,000 26,000 26,000
Depreciation 20,000 32,000 19,200 11,520 11,520 5,760
Taxable Income 6,000 -6,000 6,800 14,480 14,480 -5,760
Tax 2,100 -2,100 2,380 5,068 5,068 -2,016
Cash Flow -100,000 23,900 28,100 23,620 20,932 20,932 2,016
NPV (at 8%) = -$4,127

b. IRRA = 9.43%
IRRB = 6.39%
0.0639
Effective tax rate = 1   0.322  32.2%
0.0943