Answer to FIN 402 Exam 1 – Section002 – Version 2

Group B (70 Points)

1. [12 Points] Angela would like to purchase a house of $150,000. She can borrow a 15-year
mortgage loan with the APR of 6%. The mortgage loan calls for equal monthly payment at
the end of each month. How much should she pay each month for her house? Also, please fill
in the following amortization table (Please show how to figure out the numbers in the table as
needed):
Beginning Balance Monthly Monthly Interest Monthly Principal Ending Balance
Payment Payment Payment
$150,000 $1,265.79 $750 $515.79 $149,484.21

Answer:
1) Using formula:
$150,000 = C {[1 – 1 / (1 + 6%/12)15×12] / (6%/12)}
C = $1,265.79

2) Using financial calculator:

180 N, 6/12=0.5 I/Y, 150,000 PV, CPT PMT = -1,265.79

Monthly interest payment = $150,000 × 0.5% = $750

Monthly Principal Payment = $1,265.79 - $750 = $515.79
Ending Balance = $150,000 - $515.79 = $149,484.21

2. [16 Points] Summer Tyme, Inc., is considering a new three-year expansion project that
requires an initial fixed asset investment of $4.2 million. The fixed asset will be fully
depreciated based on the straight-line depreciation approach over its three-year tax life. The
project is estimated to generate $2,750,000 in annual sales, with costs of $1,240,000.
Suppose the project requires an initial investment in net working capital of $650,000, and the
fixed asset will have a market value of $540,000 at the end of the project. The tax rate is

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 21%. Suppose that the WACC is 10% and the risk level of this project is the same as the risk
level of the overall firm. The firm’s debt/equity ratio is 0.4. The floatation cost for equity is
7%, and the floatation cost for debt is 3%. What is the project’s NPV after adjusting for
floatation costs? Should the firm accept this project?

Answer:

Depreciation = $4.2M/3 = $1.4M

OCF = ($2,750,000 – $1,240,000) × (1 – 21%) + $1,400,000 × 21%

= $1,192,900 + $294,000 = $1,486,900

After-tax salvage value = $540,000 × (1 – 21%) = $426,600

CF0 = -$4,200,000 - $650,000 = -$4,850,000

CF1 – CF2 = $1,486,900
CF3 = $1,486,900 + $426,600 + $650,000 = $2,563,500

Floatation cost = 0.4/1.4 × 3% + (1 – 0.4/1.4) × 7% = 0.2857 × 3% + 0.7143 × 7% = 5.86%

Initial investment = $4,850,000 / (1 – 5.86%) = $5,151,901.42

1) Using formula:

$ 1,486,900 $ 1,486,900 $ 2,563,500

NPV =−5,151,901.42+ + + =−$ 645,335.68
(1+1 0 % ) ( 1+1 0 % )2 ( 1+1 0 % )3

2) Using financial calculator:

CF, CF0 = -5,151,901.42; C01 = 1,486,900; F01 = 2; C02 = 2,563,500, F02 = 1; I = 10; CPT
NPV = -645,335.68

The firm should reject the project.

3. [14 Points] You are considering a new product launch. The project will cost $2,500,000,
have a three-year life, and have no salvage value. The depreciation is straight-line to zero.
Price per unit will be $25,000, variable cost per unit will be $10,600, and fixed costs will be
$360,000 per year. The required return on the project is 12%. If the effects of taxes are
ignored,

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 (1) what is the financial break-even level of output for this project? How do you interpret this
number?
(2) what is the degree of operating leverage at the financial break-even level of output? How
do you interpret this number?

Answer:

[ ]
1
1−
(1) 1.123
$ 2,500,000=OCF ×
.12
OCF=$ 1,040,872.45

Financial break-even = ($1,040,872.45 + $360,000) / ($25,000 - $10,600) = 97

When the sales volume is 97 units per year, the NPV of the project will be zero.

(2) DOL = 1 + $360,000 / $1,040,872.45 = 1.35

If sales change by 1%, OCF will change by 1.35%.

4. [16 Points] Dinklage Corp. has 5 million shares of common stock outstanding. The common
stock currently sells for $45 per share and has a beta of 0.8. The market risk premium is 7%,
T-bills are yielding 2.4%, The company also has 200,000 issues of bonds outstanding. The
bond has a coupon rate of 8% and makes semiannual coupon payments. The bond sells for
102% of the par and the par value is $1,000. The bond matures in 20 years. The tax rate of
the firm is 21%.
(1) What is the cost of equity of the firm?
(2) What is the cost of debt of the firm?
(3) What is the firm’s WACC?

Answer:

(1) RE = 2.4% + 0.8 × 7% = 8%

(2) N = 40, PV = -1,020, PMT = 40, FV = 1,000; CPT I/Y = 3.9004

YTM = 3.9004% × 2 = 7.8009%

(3) MV_E = 5,000,000 × $45 = $225M

MV_B = 200,000 × $1,020 = $204M

MV = $225M + $204M = $429M

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 W_E = 225 / 429 = 52.45%
W_B = 204 / 429 = 47.55%

WACC = 52.45% × 8% + 47.55% × 7.8009% × (1 – 21%) =

= 4.196% + 2.9304% = 7.13%

5. [12 Points] Leah, Inc., is proposing a rights offering. Presently there are 450,000 shares outstanding
at $75 each. There will be 30,000 new shares offered at $65 each.
(1) How many rights will it take to purchase one new share?
(2) What is the value of a right?

Answer:

(1) 450,000 / 30,000 = 15 rights

(2) MV = 450,000 × $75 + 30,000 × $65 = $35,700,000

$75 - $35,700,000 / (450,000 + 30,000) = $0.63