Problem 1.
The Norman Automatic Mailer Machine Company is planning to expand production because of the increased volume of mailouts. The increased mailout capacity will cost $2,000,000. The expansion can be financed either by bonds at an interest rate of 12 percent or by selling 40,000 shares of common stock at $50 per share. The current income statement (before expansion) is as follows:
Norman Automatic Mailer
Income Statement
200X
Sales................................................
$3,000,000
Less: Variable costs (40%).............
$1,200,000
Fixed costs...................................
800,000
Earnings before interest and taxes...
1,000,000
Less: Interest expense....................
400,000
Earnings before taxes.......................
600,000
Less: Taxes (@ 35%).....................
210,000
Earnings after taxes.........................
390,000
Shares..............................................
100,000
Earnings per share...........................
$3.90
Assume that after expansion, sales are expected to increase by $1,500,000. Variable costs will remain at 40 percent of sales, and fixed costs will increase by $550,000. The tax rate is 35 percent.
a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. (For the degree of operating leverage, use the formula developed in footnote 2; for the degree of combined leverage, use the formula developed in footnote 3. These instructions apply throughout this problem.)
b. Construct the income statement for the two financial plans.
c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans.
d. Explain which financing plan you favor and the risks involved.
Footnote 2
Degree of Operating Leverage = DOL = S-TVC
S-TVC-FC
Where S= Sales, TVC= Total Variable Costs, and FC= Fixed Cost
Footnote 3
Degree of Financial Leverage = DFL= EBIT
EBIT-I
Where EBIT= Earnings Before Interest and Taxes
Degree of Combined Leverage = DCL= S-TVC
S-TVC-FC-I
Where S= Sales, TVC= Total Variable Costs, and FC= Fixed Cost, I= Interest Expense
Problem 2. The PC Shopping Network may upgrade its coomputer systems. It last upgraded 2 years ago, when it spent $115 million on equipment with an assumed life of 5 years and an assumed salvage value of $15 million for tax purposes. The firm uses straight-line depreciation.
The old equipment can be sold today for $80 million. A new modern computer system can be installed today for $150 million. This will have a 3-year life and will be depreciated to zero using straight-line depreciation. The new equipment will enable the firm to increase sales by $25 million per year and decrease operating costs by $10 million per year. At the end of 3 years, the new equipment will be worthless. Assume the firm's tax rate is 35 percent and the discount rate for projects of this sort is 10 percent.
a. What is the net cash flow at time 0 if the old equipment is replaced?
b. What are the incremental cash flows in Years 1, 2, and 3?
c. What are the NPV and IRR of the replacement project?
Problem 3. Barat Corporation investors require an after-tax rate of return of 10 percent on their stock investments. Assume that the tax rate on dividends is 30 percent while capital gains escape taxation. A firm will pay a $2 per share dividend 1 year from now, after which it is expected to sell at a price of $20.
a. Find the current price of the stock.
b. Find the expected before-tax rate of return for a 1-year holding period.
c. Now suppose that the dividend will be $3 per share. If the expected after-tax rate of return is still 10 percent, and investors still expect the stock to sell at $20 in 1 year, at what price must the stock now sell?
d. What is the before-tax rate of return? Why is it now higher than in part (b)?
Problem 4. The Gold Rush Mining Company is concerned about short-term volatility in its revenues. Gold currently sells for $300 an ounce, but the price is volatile and could fall as low as $280 or rise as high as $320 in the next month. The company will bring 1,000 ounces to the market next month.
a. What will be total revenues if the firm remains unhedged for gold prices of $280, $300, and $320 an ounce?
b. The futures price of gold for 1-month-ahead delivery is $301. What will be the firm's total revenues at each gold price if the firm enters a 1-month futures contract to deliver 1,000 ounces of gold?
c. What will total revenues be if the firm buys a 1-month put option to sell gold for $300 an ounce? The puts cost $2 per ounce.