# FIN 534 Homework Set #4

FIN 534 Homework Set #4

Use the following information for Questions 1 through 5:

Assume you are presented with the following mutually exclusive investments whose expected net cash flows are as follows:

EXPECTED NET CASH FLOWS:

Year Project A Project B

0 -$400 -$650

1 -528 210

2 -219 210

3 -150 210

4 1,100 210

5 820 210

6 990 210

7 -325 210

1. Construct NPV profiles for Projects A and B.

2. What is each project’s IRR?

3. If each project’s cost of capital were 10%, which project, if either, should be selected? If the cost of capital were 17%, what would be the proper choice?

4. What is each project’s MIRR at the cost of capital of 10%? At 17%? (Hint: Consider Period 7 as the end of Project B’s life.)

5. What is the crossover rate, and what is its significance?

Use the following information for Questions 6 through 8:

The staff of Porter Manufacturing has estimated the following net after-tax cash flows and probabilities for a new manufacturing process:

Line 0 gives the cost of the process, Lines 1 through 5 give operating cash flows, and Line 5* contains the estimated salvage values. Porter’s cost of capital for an average-risk project is 10%.

Net After-Tax Cash Flows

Year P = 0.2 P = 0.6 P = 0.2

0 -$100,000 -$100,000 -$100,000

1 20,000 30,000 40,000

2 20,000 30,000 40,000

3 20,000 30,000 40,000

4 20,000 30,000 40,000

5 20,000 30,000 40,000

5* 0 20,000 30,000

6. Assume that the project has average risk. Find the project’s expected NPV. (Hint: Use expected values for the net cash flow in each year.)

7. Find the best-case and worst-case NPVs. What is the probability of occurrence of the worst case if the cash flows are perfectly dependent (perfectly positively correlated) over time?

8. Assume that all the cash flows are perfectly positively correlated. That is, assume there are only three possible cash flow streams over time—the worst case, the most likely (or base) case, and the best case—with respective probabilities of 0.2, 0.6, and 0.2. These cases are represented by each of the columns in the table. Find the expected NPV, its standard deviation, and its coefficient of variation for each probability.

Use the following information for Question 9:

At year-end 2013, Wallace Landscaping’s total assets were $2.17 million and its accounts payable were $560,000. Sales, which in 2013 were $3.5 million, are expected to increase by 35% in 2014. Total assets and accounts payable are proportional to sales, and that relationship will be maintained. Wallace typically uses no current liabilities other than accounts payable. Common stock amounted to $625,000 in 2013, and retained earnings were $395,000. Wallace has arranged to sell $195,000 of new common stock in 2014 to meet some of its financing needs. The remainder of its financing needs will be met by issuing new long-term debt at the end of 2014. (Because the debt is added at the end of the year, there will be no additional interest expense due to the new debt.) Its net profit margin on sales is 5%, and 45% of earnings will be paid out as dividends.

9. What were Wallace’s total long-term debt and total liabilities in 2013?

Use the following information for Questions 1 through 3:

Boehm Corporation has had stable earnings growth of 8% a year for the past 10 years and in 2013 Boehm paid dividends of $2.6 million on net income of $9.8 million. However, in 2014 earnings are expected to jump to $12.6 million, and Boehm plans to invest $7.3 million in a plant expansion. This onetime unusual earnings growth won’t be maintained, though, and after 2014 Boehm will return to its previous 8% earnings growth rate. Its target debt ratio is35%.

Calculate Boehm’s total dividends for 2014 under each of the following policies:

1. Its 2014 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.

2. It continues the 2013 dividend payout ratio.

3. It uses a pure residual policy with all distributions in the form of dividends (35% of the $7.3 million investment is financed with debt).

4. It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long run growth rate and the extra dividend being set according to the residual policy.

Use the following information for Questions 5 and 6:

Schweser Satellites Inc. produces satellite earth stations that sell for $100,000 each. The firm’s fixed costs, F, are $2 million, 50 earth stations are produced and sold each year, profits total $500,000, and the

firm’s assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $4 million to investment and $500,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $10,000 and (2) increase output by 20 units, but (3) the sales price on all units will have to be lowered to $95,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 16%, and it uses no debt.

5. What is the incremental profit? To get a rough idea of the project’s profitability, what is the project’s expected rate of return for the next year (defined as the incremental profit divided by the investment)? Should the firm make the investment? Why or why not?

6. Would the firm’s break-even point increase or decrease if it made the change?

Use the following information for Questions 7 and 8:

Suppose you are provided the following balance sheet information for two firms, Firm A and Firm B (in thousands of dollars).

Firm A Firm B

Current assets $150,000 $120,000

Fixed assets (net) 150,000 180,000

Total assets $300,000 $300,000

Current liabilities $20,000 $80,000

Long-term debt 80,000 20,000

Common stock 100,000 100,000

Retained earnings 100,000 100,000

Total liabilities and equity $300,000 $300,000

Earnings before interest and taxes for both firms are $30 million, and the effective federal plus-state tax rate is 35%.

7. What is the return on equity for each firm if the interest rate on current liabilities is12% and the rate on long-term debt is 15%?

8. Assume that the short-term rate rises to 20%, that the rate on new long-term debt rises to 16%,and that the rate on existing long-term debt remains unchanged. What would be the return on equity for Firm A and Firm B under these conditions?

9. In 1983 the Japanese yen-U.S. dollar exchange rate was 250 yen per dollar, and the dollar cost of a compact Japanese-manufactured car was $10,000. Suppose that now the exchange rate is 120 yen per dollar. Assume there has been no inflation in the yen cost of an automobile so that all price changes are due to exchange rate changes. What would the dollar price of the car be now, assuming the car’s price changes only with exchange rates?

Use the following information for Questions 1 through 5:

Assume you are presented with the following mutually exclusive investments whose expected net cash flows are as follows:

EXPECTED NET CASH FLOWS:

Year Project A Project B

0 -$400 -$650

1 -528 210

2 -219 210

3 -150 210

4 1,100 210

5 820 210

6 990 210

7 -325 210

1. Construct NPV profiles for Projects A and B.

2. What is each project’s IRR?

3. If each project’s cost of capital were 10%, which project, if either, should be selected? If the cost of capital were 17%, what would be the proper choice?

4. What is each project’s MIRR at the cost of capital of 10%? At 17%? (Hint: Consider Period 7 as the end of Project B’s life.)

5. What is the crossover rate, and what is its significance?

Use the following information for Questions 6 through 8:

The staff of Porter Manufacturing has estimated the following net after-tax cash flows and probabilities for a new manufacturing process:

Line 0 gives the cost of the process, Lines 1 through 5 give operating cash flows, and Line 5* contains the estimated salvage values. Porter’s cost of capital for an average-risk project is 10%.

Net After-Tax Cash Flows

Year P = 0.2 P = 0.6 P = 0.2

0 -$100,000 -$100,000 -$100,000

1 20,000 30,000 40,000

2 20,000 30,000 40,000

3 20,000 30,000 40,000

4 20,000 30,000 40,000

5 20,000 30,000 40,000

5* 0 20,000 30,000

6. Assume that the project has average risk. Find the project’s expected NPV. (Hint: Use expected values for the net cash flow in each year.)

7. Find the best-case and worst-case NPVs. What is the probability of occurrence of the worst case if the cash flows are perfectly dependent (perfectly positively correlated) over time?

8. Assume that all the cash flows are perfectly positively correlated. That is, assume there are only three possible cash flow streams over time—the worst case, the most likely (or base) case, and the best case—with respective probabilities of 0.2, 0.6, and 0.2. These cases are represented by each of the columns in the table. Find the expected NPV, its standard deviation, and its coefficient of variation for each probability.

Use the following information for Question 9:

At year-end 2013, Wallace Landscaping’s total assets were $2.17 million and its accounts payable were $560,000. Sales, which in 2013 were $3.5 million, are expected to increase by 35% in 2014. Total assets and accounts payable are proportional to sales, and that relationship will be maintained. Wallace typically uses no current liabilities other than accounts payable. Common stock amounted to $625,000 in 2013, and retained earnings were $395,000. Wallace has arranged to sell $195,000 of new common stock in 2014 to meet some of its financing needs. The remainder of its financing needs will be met by issuing new long-term debt at the end of 2014. (Because the debt is added at the end of the year, there will be no additional interest expense due to the new debt.) Its net profit margin on sales is 5%, and 45% of earnings will be paid out as dividends.

9. What were Wallace’s total long-term debt and total liabilities in 2013?

Use the following information for Questions 1 through 3:

Boehm Corporation has had stable earnings growth of 8% a year for the past 10 years and in 2013 Boehm paid dividends of $2.6 million on net income of $9.8 million. However, in 2014 earnings are expected to jump to $12.6 million, and Boehm plans to invest $7.3 million in a plant expansion. This onetime unusual earnings growth won’t be maintained, though, and after 2014 Boehm will return to its previous 8% earnings growth rate. Its target debt ratio is35%.

Calculate Boehm’s total dividends for 2014 under each of the following policies:

1. Its 2014 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.

2. It continues the 2013 dividend payout ratio.

3. It uses a pure residual policy with all distributions in the form of dividends (35% of the $7.3 million investment is financed with debt).

4. It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long run growth rate and the extra dividend being set according to the residual policy.

Use the following information for Questions 5 and 6:

Schweser Satellites Inc. produces satellite earth stations that sell for $100,000 each. The firm’s fixed costs, F, are $2 million, 50 earth stations are produced and sold each year, profits total $500,000, and the

firm’s assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $4 million to investment and $500,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $10,000 and (2) increase output by 20 units, but (3) the sales price on all units will have to be lowered to $95,000 to permit sales of the additional output. The firm has tax loss carryforwards that render its tax rate zero, its cost of equity is 16%, and it uses no debt.

5. What is the incremental profit? To get a rough idea of the project’s profitability, what is the project’s expected rate of return for the next year (defined as the incremental profit divided by the investment)? Should the firm make the investment? Why or why not?

6. Would the firm’s break-even point increase or decrease if it made the change?

Use the following information for Questions 7 and 8:

Suppose you are provided the following balance sheet information for two firms, Firm A and Firm B (in thousands of dollars).

Firm A Firm B

Current assets $150,000 $120,000

Fixed assets (net) 150,000 180,000

Total assets $300,000 $300,000

Current liabilities $20,000 $80,000

Long-term debt 80,000 20,000

Common stock 100,000 100,000

Retained earnings 100,000 100,000

Total liabilities and equity $300,000 $300,000

Earnings before interest and taxes for both firms are $30 million, and the effective federal plus-state tax rate is 35%.

7. What is the return on equity for each firm if the interest rate on current liabilities is12% and the rate on long-term debt is 15%?

8. Assume that the short-term rate rises to 20%, that the rate on new long-term debt rises to 16%,and that the rate on existing long-term debt remains unchanged. What would be the return on equity for Firm A and Firm B under these conditions?

9. In 1983 the Japanese yen-U.S. dollar exchange rate was 250 yen per dollar, and the dollar cost of a compact Japanese-manufactured car was $10,000. Suppose that now the exchange rate is 120 yen per dollar. Assume there has been no inflation in the yen cost of an automobile so that all price changes are due to exchange rate changes. What would the dollar price of the car be now, assuming the car’s price changes only with exchange rates?

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