Essay Questions

114. The Magic Pumpkin Limousine Company wants to purchase a car telephone system for one
of its automobiles. The telephone vendor has offered to finance the $1,500 purchase over one
year in 12 installments, with a total of $140 in interest to be paid on the loan. Magic Pumpkin's
bank has offered to finance the purchase with an instalment loan, where $155 in interest will be
repaid and payments on the loan must be made quarterly. What are the annual interest rates on
these loans? 

Vendor Plan:

   

Bank Plan:

   

Difficulty: Medium
Learning Objective: 08-02 Describe bank loans as self-liquidating; as short-term; and as having their interest cost tied to the prime rate. Also;
calculate interest rates under different conditions.
Topic: 08-12 Rate on Instalment Loans
Type: Concept
 

115. Business Book Publishing needs to borrow $700,000 in order to finance its new inventory.
Two banks in town offered different loan terms: Marine Bank offered a 10% loan with a 15%
compensatory balance to be paid back in quarterly payments. McLean National Bank offered
Business Book Publishing a 12% loan to be paid back semi-annually. Which loan terms should
Business Book Publishing take? 

MarineBank

   

   

where the compensating balance is subtracted from the principal.

McLean National Bank

   

Take McLean's offer.

Difficulty: Medium
Learning Objective: 08-02 Describe bank loans as self-liquidating; as short-term; and as having their interest cost tied to the prime rate. Also;
calculate interest rates under different conditions.
Topic: 08-12 Rate on Instalment Loans
Type: Concept
 

116. Slipshod Machine Tool Co. owes $40,000 to one of its suppliers. The supplier has offered a
trade discount of 2/10 net 30. Slipshod can borrow the funds from either of two banks. First City
Bank will loan the funds for 20 days at a cost of $400. Upstart Bank offers a discounted loan for
20 days at a cost of $320.

A) What is the cost of failing to take the discount?

B) What is the annual interest rate on each of the loans?
C) Which alternative should Slipshod follow? 

A)

   

B) First City:

   

Upstart:

   

C) Take Upstart's loan. The annual interest rate is much lower.

Difficulty: Medium
Learning Objective: 08-01 Characterize trade credit as an important form of short-term financing; and calculate its cost to the firm if a discount
is forgone.
Learning Objective: 08-02 Describe bank loans as self-liquidating; as short-term; and as having their interest cost tied to the prime rate. Also;
calculate interest rates under different conditions.
Topic: 08-05 Net Credit Position
Topic: 08-11 Interest Costs with Fees or Compensating Balances
Type: Concept
 

117. Brand Advertising is offered a 3/10 net 40 trade discount by its supplier. In the past Brand
has been able to get away with paying for supplies on credit in 60 days. Since it doesn't have
money on hand to take advantage of the discount, it tries to negotiate a loan with Second
Canadian Bank. The amount of $375,000 with a 15% compensating balance and a $5,500
interest charge has been negotiated for the month of May. Brand already maintains a $16,250
balance at the bank. Compute the annual rate of interest on the loan, and the cost of not taking
the discount. Which one should Brand take? 

Cost of not taking discount

   

Annual rate on loan

   

Additional compensating balance required

   

Take the loan. It's cheaper.

Difficulty: Medium
Learning Objective: 08-01 Characterize trade credit as an important form of short-term financing; and calculate its cost to the firm if a discount
is forgone.
Learning Objective: 08-02 Describe bank loans as self-liquidating; as short-term; and as having their interest cost tied to the prime rate. Also;
calculate interest rates under different conditions.
Topic: 08-05 Net Credit Position
Topic: 08-11 Interest Costs with Fees or Compensating Balances
Type: Concept
 118. Inorder to finance a shipment of badminton sets, Rujisawa Import-Export is seeking a
$500,000 one-year bank loan. The Marine Bank requires that Rujisawa maintain a 20%
compensating balance and requires four quarterly payments. The Prairie Bank requires only a
10% compensating balance, but requires 12 monthly payments. In addition, the Prairie Bank
discounts the loan. Both banks state that their interest rate is 9%.

A) Which bank has the lowest annual interest rate? (NOTE: deduct the compensating balances
from the principal in determining the annual rate.)
B) If Prairie Bank eliminated its compensating-balance requirement, would your answer
change? 
A) MARINE BANK:

   

PRAIRIE BANK:

   

B) Annual rate =

   

No, Prairie Bank is still more expensive.

93. You have an opportunity to buy a $1,000 bond, which matures in 10 years. The bond pays
$30 every six months. The current market interest rate is 8%. What is the most you would be
willing to pay for this bond? 

   

PV of face amount, Appendix B:

PV = FV  PVIF (4%, 20 periods)

PV = $1,000  .456
PV = $456.00

PVA of interest payments, Appendix D:

PVA = A  PVIFA (4%, 20 periods)

PVA = $30  13.590
PVA = $407.70

PV of bond = PV of face amount + PV of interest payments

= 456.00 + 407.70
= $863.70 Current value (maximum price)
 

Difficulty: Medium
Learning Objective: 09-02 Calculate present values; future values; and annuities based on the number of time periods involved and the going
interest rate.
Topic: 09-04 Present Value (Discounted Value)—Single Amount
Type: Concept
 

94. In January, 2005 Harold Black bought 100 shares of Country homes for $37.50 per share. He
sold them in January, 2015 for a total of $9,727.50. Calculate Harold's annual rate of return. 

   

FV = PV  FVIF (App. A)
$9,727.50 = 100($37.50)  FVIF
2.594 = FVIF

Looking across the 10 year line, the interest factor is for 10%.
Annual Rate of Return 10%

To check,

$9,727.50 = $3,750  (1 + .10)10

= $3,750  2.5937
= $9,726.375 (Difference due to rounding)

Difficulty: Medium
Learning Objective: 09-03 Calculate yield based on the time relationships between cash flows.
Topic: 09-15 Yield—Present Value of an Annuity
Type: Concept
 

95. Mr. Sullivan is borrowing $2 million to expand his business. The loan will be for 10 years at
12% on the declining balance, and will be repaid in equal quarterly installments. What will the
quarterly payments be? At the end of the first year, how much interest will Mr. Sullivan have
paid? By how much will he have reduced the principal? 

   

   

   

   

   

Difficulty: Medium
Learning Objective: 09-02 Calculate present values; future values; and annuities based on the number of time periods involved and the going
interest rate.
Topic: 09-07 Present Value (Cumulative Present Value)—Annuity
Type: Concept
 

96. Marcia Stubern is planning for her golden years. She will retire in 20 years, at which time she
plans to begin withdrawing $60,000 annually. She is expected to live for 20 years following her
retirement. Her financial advisor thinks she can earn 9% annually. How much does she need to
invest each year to prepare for her financial needs after her retirement? 

   

   

Amount needed in 20 years:

PVA = A  PVIFA (9%, 20 yrs) Appendix D

= 60,000  9.129
= $547,740

Amount deposited annually in order to attain that goal:

PVA = A  FVIFA (9%, 20 yrs) Appendix C

547,740 = A  51.60
A = $10,615.12
 

Difficulty: Medium
Learning Objective: 09-02 Calculate present values; future values; and annuities based on the number of time periods involved and the going
interest rate.
Topic: 09-07 Present Value (Cumulative Present Value)—Annuity
Type: Concept
 

97. Samuel Johnson invested in gold Maple Leaf coins 10 years ago, paying $185 for each one-
ounce gold coin. He could sell each coin for $734 today. What was his annual rate of return for
this investment? 

   

   

Difficulty: Medium
Learning Objective: 09-03 Calculate yield based on the time relationships between cash flows.
Topic: 09-14 Yield—Present Value of a Single Amount
Type: Concept
 

98. Gary Kiraly wants to buy a new Italian sports car in three years. The vehicle is expected to
cost $80,000 at that time. If Gary should be so lucky as to find an investment yielding 12% over
that three-year period, how much would he have to invest now in order to accumulate $80,000 at
the end of the three years? 

   

   

Difficulty: Medium
Learning Objective: 09-02 Calculate present values; future values; and annuities based on the number of time periods involved and the going
interest rate.
Topic: 09-04 Present Value (Discounted Value)—Single Amount
Type: Concept
 

99. Sara Shouppe has invested $100,000 in an account at her local bank. The bank will pay her a
constant amount each year for 6 years, starting one year from today, and the account's balance
will be 0 at the end of the sixth year. If the bank has promised Ms. Shouppe a 10% return, how
much will they have to pay her each year? 

   

   

Difficulty: Medium
Learning Objective: 09-02 Calculate present values; future values; and annuities based on the number of time periods involved and the going
interest rate.
Topic: 09-04 Present Value (Discounted Value)—Single Amount
Type: Concept
 

100. The Swell Computer Company has developed a new line of desktop computers. It is
estimated that the cash returns generated by the new product line will be $800,000 per year for
the next five years, and then $500,000 per year for 3 years after that (the cash returns occur at the
end of each year). At a 9% interest rate, what is the present value of these cash returns? 

   

Solve as the sum of two annuities: one of $500,000 per period for 8 periods, and one of $300,000
per period for 5 periods.

   
 

Difficulty: Medium
Learning Objective: 09-02 Calculate present values; future values; and annuities based on the number of time periods involved and the going
interest rate.
Topic: 09-04 Present Value (Discounted Value)—Single Amount
Type: Concept

Essay Questions
 
108. The Nickelodeon Manufacturing Co. has a series of $1,000 par value bonds outstanding.
Each bond pays interest semi annually and carries a coupon rate of 7%. Some bonds are due in 3
years while others are due in 10 years. If the required rate of return on bonds is 10%, what is the
current price of

A) the bonds with 3 years to maturity?

B) the bonds with 10 years to maturity?
C) Explain the relationship between the number of years until a bond matures and its price. 

   

C) Present Value of Interest Payments:

   

The nearer a bond is to maturity, the closer its price will be to its par value.

Difficulty: Medium
Learning Objective: 10-03 Assess the current value (price) of bonds; preferred shares (perpetuals); and common shares based on the future
benefits (cash flows).
Topic: 10-03 Valuation of Bonds
Type: Concept
 
109. Fullerton Company's bonds are currently selling for $1,157.75 per $1,000 par-value bond.
The bonds have a 10% coupon rate (paid annually) and will mature in 10 years. What is the yield
to maturity? 

   

   

Difficulty: Medium
Learning Objective: 10-04 Evaluate the yields on financial claims based on the relationship between current price and future expected cash
flows.
Topic: 10-06 Determining Yield to Maturity from the Bond Price
Type: Concept
 

110. Madison Corporation has outstanding, a $1,000 par value bond paying annual interest of
7%. The bond matures in 20 years. If the present yield to maturity for this bond is 9%, calculate
the current price of the bond using annual compounding. 

   

Present Value of Interest Payments

PVA = A  PVIFA (n = 20, i = 9%) Appendix D

PVA = $70  9.129 = $639.03

Present Value of Principal at Maturity

PV = FV  PVIF (n = 20, i = 9%) Appendix B

PV = $1,000  .178 = $178.00

   

Difficulty: Medium
Learning Objective: 10-04 Evaluate the yields on financial claims based on the relationship between current price and future expected cash
flows.
Topic: 10-07 Semiannual Interest and Bond Prices
Type: Concept
 

111. Washington Corporation has a $1,000 par value bond outstanding paying annual interest of
8%. The bond matures in 20 years. If the present yield to maturity for this bond is 10%, calculate
the current price of the bond. 

   

Present Value of Interest Payments

PVA = A  PVIFA (n = 20, i = 10%) Appendix D

PVA = $80  8.514 = $681.12

Present Value of Principal at Maturity

PV = FV  PVIF (n = 20, i = 10%) Appendix B

PV = $1,000  .149 = $149.00

   

Difficulty: Medium
Learning Objective: 10-04 Evaluate the yields on financial claims based on the relationship between current price and future expected cash
flows.
Topic: 10-06 Determining Yield to Maturity from the Bond Price
Type: Concept
 

112. The preferred stock of Gapers Inc. pays an annual dividend of $6.50. What is the price of
the preferred stock if the required return is:

A) 6%
B) 8%
C) 10% 

Price = dividend/required return

A) $6.50/.06 = $108.33
B) $6.50/.08 = $81.25
C) $6.50/.10 = $65.00

Difficulty: Medium
Learning Objective: 10-04 Evaluate the yields on financial claims based on the relationship between current price and future expected cash
flows.
Topic: 10-08 Valuation of Preferred Stock
Type: Concept
 

113. State Street Corp. will pay a dividend on common stock of $4.80 per share at the end of the
year. The required return on common stock (Ke) is 13.2%. The firm has a constant growth rate of
7.2%. Compute the current price of the stock (Po). 

   

Difficulty: Medium
Learning Objective: 10-04 Evaluate the yields on financial claims based on the relationship between current price and future expected cash
flows.
Topic: 10-12 Constant Growth in Dividends
Type: Concept
 

114. Perot Marketing is expected to pay $2.40 per share in dividends at the end of the next 12
months. The growth rate in dividends is expected to be constant at 9% per year. If the stock is
selling for $51.30 per share, what is the required rate of return? 

   

Difficulty: Medium
Learning Objective: 10-04 Evaluate the yields on financial claims based on the relationship between current price and future expected cash
flows.
Topic: 10-14 Determining the Required Rate of Return from the Market Price
Type: Concept

137. Zinger Corporation manufactures industrial type sewing machines. Zinger Corp. received a
very large order from a few European countries. In order to be able to supply these countries
with its products, Zinger will have to expand its facilities. Of the required expansion, Zinger
feels it can raise $75 million internally, through retained earnings. The firm's optimum capital
structure has been 45% debt, 10% preferred stock, and 45% equity. The company will try to
maintain this capital structure in financing this expansion plan. Currently Zinger's common stock
is traded at a price of $20 per share. Last year's dividend was $1.50 per share. The growth rate
has been at 6% and is expected to increase to 8%. The company's preferred stock is selling at $50
and has been yielding 6% in the current market. Flotation costs have been estimated at 8% of
common stock and 3% of preferred stock. Zinger Corp. has bonds outstanding at 10%, but its
investment dealer has informed the company that interest rates for bonds of equal risk are
currently yielding 9%. Zinger's tax rate is 46%.

A) Compute the cost of Kd, Kp, Ke, Kn.

B) Calculate the weighted average cost of capital, assuming no external equity financing.
C) How much can Zinger raise to fund the whole project, while using only internal financing? 
A) Kd = 9% (1 - .46) = 4.86

   

   

   

B)

   

C)

   

Difficulty: Medium
Learning Objective: 11-04 Examine how a firm attempts to find a minimum cost of capital by varying the mix of its sources of financing.
Topic: 11-11 Market Value Weightings
Type: Concept
 138. The Accidental Petroleum Company is trying to determine its weighted average cost of
capital for use in making a number of investment decisions. The firm's bonds were issued 6 years
ago and have 14 years left until maturity. They carried an 8% coupon rate paid annually, and are
currently selling for $962.50.

The firm's preferred stock carries a $4.60 dividend and is currently selling at $42.50 per share.
Accidental's investment dealer has stated that issue costs for new preferred will be 50 cents per
share.

The firm has significant retained earnings, but will also need to sell new common stock to
finance the projects it is now considering. Accidental Petroleum common stock is expected to
pay a $2.50 per share dividend next year, and is expected to maintain an 8% growth rate for the
foreseeable future. The stock is currently priced at $50 per share, but new common stock will
have flotation costs of 60 cents per share.

Calculate the costs of the various components of Accidental Petroleum's capital. The firm's tax
rate is 44%. 
Cost of Debt (before tax)

   

Cost of Debt (after tax)

   

Cost of Preferred Stock:

   

Cost of Retained Earnings:

   

Cost of New Common Stock:

   

Difficulty: Medium
Learning Objective: 11-03 Construct the cost of capital based on the various valuation techniques from Chapter 10 as applied to bonds;
preferred stocks; and common shares.
Topic: 11-02 Cost of Debt
Topic: 11-03 Cost of Preferred Stock
Topic: 11-04 Cost of Common Equity
Type: Concept
 

139. Given the information about Accidental Petroleum in the previous problem, calculate the
company's weighted average cost of capital assuming that its new financing will consist of 30%
debt, 60% equity, and 10% preferred stock. 

   

Weighted average cost of capital = 10.42%

 

Difficulty: Medium
Learning Objective: 11-04 Examine how a firm attempts to find a minimum cost of capital by varying the mix of its sources of financing.
Topic: 11-12 Calculating Market Value Weightings
Type: Concept
 

140. Jury Company wants to calculate the component costs in its capital structure. Common
stock currently sells for $27, and is expected to pay a dividend of $0.50. Jury's dividend growth
rate is 8%, and flotation cost is $1.25. Preferred stock sells for $46, pays a dividend of $4.00, and
carries a flotation cost of $1.10. Jury Company bonds yield 9% in the market. Jury is in the 40%
tax bracket.
Calculate cost of debt, cost of common stock, cost of new common stock, cost of preferred stock
and cost of retained earnings. 

Cost of Debt (after tax)

   

Cost of Preferred Stock:

   

Cost of Retained Earnings:

   

Cost of New Common Stock:

   

Difficulty: Medium
Learning Objective: 11-03 Construct the cost of capital based on the various valuation techniques from Chapter 10 as applied to bonds;
preferred stocks; and common shares.
Topic: 11-02 Cost of Debt
Topic: 11-03 Cost of Preferred Stock
Topic: 11-04 Cost of Common Equity
Topic: 11-07 Cost of New Common Stock
Type: Concept
 

141. Jury Company has the following capital structure: 55% debt, 35% equity, and 10%
preferred stock.
Calculate Jury's weighted average cost of capital (WACC) assuming no new common shares are
issued, using the answers obtained from question 117. 

   
 

Difficulty: Medium
Learning Objective: 11-04 Examine how a firm attempts to find a minimum cost of capital by varying the mix of its sources of financing.
Topic: 11-12 Calculating Market Value Weightings
Type: Concept
 142. Saven Travel Corporation is considering several investment opportunities in order to
diversify its operations. Mr. Saven, president, is trying to determine the firm's cost of capital
before he makes a decision. This diversification plan will require the firm to raise $400 million.
A share of common stock is currently selling for $50, and the amount of the last dividend paid
was $1.25. The company's earnings and dividends have been growing at about 12%, however,
this is expected to drop to 9% per year in the future. Flotation costs of new common will be
$4.00 per share. The firm can raise $150 million internally through retained earnings. The firm's
investment dealer has informed Mr. Saven that this amount of equity can support $100 million in
12% coupon bonds. The company's tax rate is 46%.

A) Compute the weighted average cost of capital on the first $250 million of funds.
B) Saven Travel will need to raise $150 of additional capital for expansion. How much of this
will be debt and equity?
C) Compute the marginal cost of capital on the additional $150 million assuming the cost of debt
stays the same.

Kd = 12% (1 ─ .46) = 0.0648 = 6.48%

   

   

   

WEIGHTS:

       
A)

   

B)

   

C)

   

Difficulty: Hard
Learning Objective: 11-04 Examine how a firm attempts to find a minimum cost of capital by varying the mix of its sources of financing.
Learning Objective: 11-05 Apply the marginal cost of capital concept.
Topic: 11-12 Calculating Market Value Weightings
Topic: 11-15 The Marginal Cost of Capital
Type: Concept
 143. Bibbidi Bobbidi Boo Fireplaces is considering the broadening of its horizons and is looking
at investing into the carriage trade. Before any analysis of the cash flows can begin, the CEO,
Ms. Cindy Ella, must select an appropriate discount rate. The accountant, Rick Tepsters, suggests
the calculation of the cost of capital.

The following is the existing (book value) capital structure of BBB Fireplaces.

   

The yield on 91-day Government of Canada Treasury Bills is currently 11.78%.

The debentures, which have been outstanding for three years, have a coupon rate of 14%.
Current market yields on this risk security are currently about 12.5%. Flotation costs would be
2% of the issue price.

The preferred shares with a fixed dividend rate of 7% currently trade at a market value of
$3,000,000. Flotation expenses of a new issue of preferreds would be 3% of the issue price.

The common shares, of which there are 5 million outstanding, are currently priced at $5.00 per
share. The current dividend is $0.10 per share. Bibbidi Bobbidi Boo's beta is 1.2 and its projected
growth rate is 16% annually, particularly if this new project does not turn into a pumpkin.
Flotation expenses would be 5% of the existing share price.

Bibbidi Bobbidi Boo's tax rate is 41% and the current exchange rate is 1 Canadian dollar equal to
$0.86 U.S.

Internally generated funds will have to be supplemented by princely new external sources for the
equity contribution to new capital projects.

Calculate the cost of capital of Bibbidi Bobbidi Boo. Use market value weightings. 
   

Bibbidi Bobbidi Boo's cost of capital is 13.53 percent.

 

Difficulty: Hard
Learning Objective: 11-03 Construct the cost of capital based on the various valuation techniques from Chapter 10 as applied to bonds;
preferred stocks; and common shares.
Learning Objective: 11-04 Examine how a firm attempts to find a minimum cost of capital by varying the mix of its sources of financing.
Topic: 11-02 Cost of Debt
Topic: 11-03 Cost of Preferred Stock
Topic: 11-04 Cost of Common Equity
Topic: 11-12 Calculating Market Value Weightings
Type: Concept
 

144. The Abacus Computer Company has decided to use the Capital Asset Pricing Model to
estimate its cost of equity. The firm's beta was estimated at 1.4. The S&P/TSX Composite-stock
index has returned 12.5% to investors over a fairly long period of time, and Abacus has decided
to use this value as the market return. Treasury bills are currently providing investors with a
6.5% yield.

A) Calculate Abacus's cost of equity using the CAPM.

B) If its beta was incorrectly estimated, and a new revised estimate of 1.8 was used in the
calculations, what would its new estimate of the cost of equity be? 

   

   
 

Difficulty: Hard
Learning Objective: 11-03 Construct the cost of capital based on the various valuation techniques from Chapter 10 as applied to bonds;
preferred stocks; and common shares.
Topic: 11-08 CAPM for the Required Return on Common Stock
Type: Concept
 

145. The M&M Theory Company has an unleveraged value of $3,250,000, $1,500,000 in debt,
and a corporate tax rate of 34%. In addition, the firm's bankruptcy costs have been estimated at
$800,000 and the probability of bankruptcy is 10%, calculate: 

A) expected bankruptcy cost

= cost of bankruptcy  probability of bankruptcy
= $800,000  .10 = $80,000

B) Value of the firm

   

Difficulty: Medium
Learning Objective: 11-04 Examine how a firm attempts to find a minimum cost of capital by varying the mix of its sources of financing.
Topic: 11-10 Optimal Capital Structure—Weighting Costs
Type: Concept

 
 115. The Weatherfield Way Construction Company has common and preferred stock
outstanding. The preferred stock pays an annual dividend of $7.50 per share, and the required
rate of return for similar preferred stocks is 11%. The common stock paid a dividend of $3.00
per share last year, but the company expected that earnings and dividends will grow by 25% for
the next two years before dropping to a constant 9% growth rate afterward. The required rate of
return on similar common stocks is 13%
What is the per-share value of the company's preferred and common stock? 
   

   

Dividends expected:

Year 1 = $3.00  1.25 (25% growth) = $3.75

Year 2 = $3.75  1.25 (25% growth) = $4.69
Year 3 = $4.69  1.09 (9% growth) = $5.11

Present Value of Future Stock Price:

   

Present Values of Dividends

   

Difficulty: Medium
Learning Objective: 10-04 Evaluate the yields on financial claims based on the relationship between current price and future expected cash
flows.
Topic: 10-12 Constant Growth in Dividends
Type: Concept