Question 1: The Best Manufacturing Company is considering a new investment. Financial projections for the investment are tabulated below. Cash flows are in $ thousands and the corporate tax rate is 34 percent. Assume all sales revenue is received in cash, all operating costs and income taxes are paid in cash, and all cash flows occur at the end of the year.
1. Compute the incremental net income of the investment for each year.
2. Compute the incremental cash flows of the investment for each year.
3. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?
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Year 0
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Year 1
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Year 2
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Year 3
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Year 4
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Investment
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$10,000
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-
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-
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-
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-
|
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Sales revenue
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-
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$7,000
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$7,000
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$7,000
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$7,000
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Operating costs
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-
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2,000
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2,000
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2,000
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2,000
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Depreciation
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-
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2,500
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2,500
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2,500
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2,500
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|
Net working capital (end of year)
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200
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250
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300
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200
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Question 2: A firm is considering an investment of $28 million (purchase price) in new equipment to replace old equipment with a book value of $12 million and a market value of $20 million. If the firm replaces the old equipment with the new equipment, it expects to save $17.5 million in operating costs the first year. The amount of these savings will grow at a rate of 12 percent per year for each of the following three years. The old equipment has a remaining life of four years. It is being depreciated by the straight-line method. 33.3 percent of the original book value of the new equipment will be depreciated in the first year, 39.9 percent will be depreciated in the second year, 14.8 percent will be depreciated in the third year, and 12.0 percent will be depreciated in the final year. The salvage value of both the old equipment and the new equipment at the end of four years is 0. In addition, replacement of the old equipment with the new equipment requires an immediate increase in net working capital of $5 million, which will not be recovered until the end of the four-year investment. Assume that the purchase and sale of equipment occurs today and all other cash flows occur at the end of their respective years. If the firm's cost of capital is 14 percent and is subject to a 40 percent tax rate, find:
1. The net investment.
2. The after-tax incremental cash flow at the end of each year.
3. The internal rate of return on the investment.
4. The net present value of the investment.
Question 3: The Cornchopper Company is considering the purchase of a new harvester. Cornchopper has hired you to determine the break-even purchase price (in terms of present value) of the harvester. This break-even purchase price is the price at which the project's NPV is zero. Base your analysis on the following facts: The new harvester is not expected to affect revenues, but pretax operating expenses will be reduced by $10,000 per year for 10 years. and has been depreciated by the straight-line method.
• The old harvester can be sold for $20,000 today.
• The new harvester will be depreciated by the straight-line method over its 10-year life.
• The firm's required rate of return is 15 percent.
• The initial investment, the proceeds from selling the old harvester, and any resulting tax effects occur immediately.
• The corporate tax rate is 34 percent when they are realized.
• All other cash flows occur at year-end.
• The market value of each harvester at the end of its economic
Question 4: The correlation between the returns on Ceramics Craftsman, Inc., and the returns on the S&P 500 is 0.675. The variance of the returns on Ceramics Craftsman, Inc., is 0.004225, and the variance of the returns on the S&P 500 is 0.001467. What is the beta of Ceramics Craftsman stock?
Question 5: The following table lists possible rates of return on Compton Technology's stock and debt and on the market portfolio. The probability of each state is also listed.
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State
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Probability
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Return on Stock (%)
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Return on Debt (%)
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Return on the Market (%)
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1
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0.1
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3%
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8%
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5%
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2
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0.3
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8
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8
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10
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3
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0.4
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20
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10
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15
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4
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0.2
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15
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10
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20
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1. What is the beta of Compton Technology debt?
2. What is the beta of Compton Technology stock?
3. If the debt-to-equity ratio of Compton Technology is 0.5, what is the asset beta of Compton Technology? Assume no taxes.
Question 6: The Lager Brewing Corporation has acquired the Philadelphia Pretzel Company in a vertical merger. Lager Brewing has issued $300,000 in new long-term debt to pay for its purchase. ($300,000 is the purchase price.) Construct the balance sheet for the new corporation if the merger is treated as a purchase for accounting purposes. The balance sheets shown here represent the assets of both firms at their true market values. Assume these market values are also the book values.
Question 7: Indicate whether you think the following claims regarding takeovers are true or false. In each case provide a brief explanation for your answer.
1. By merging competitors, takeovers have created monopolies that will raise product prices, reduce production, and harm consumers.
2. Managers act in their own interests at times and, in reality, may not be answerable to shareholders. Takeovers may reflect runaway management.
3. In an efficient market, takeovers would not occur because market price would reflect the true value of corporations. Thus, bidding firms would not be justified in paying premiums above market prices for target firms.
4. Traders and institutional investors, having extremely short time horizons, are influenced by their perceptions of what other market traders will be thinking of stock prospects and do not value takeovers based on fundamental factors. Thus, they will sell shares in target firms despite the true value of the firms.
5. Mergers are a way of avoiding taxes because they allow the acquiring firm to write up the value of the assets of the acquired firm.
6. Acquisitions analysis frequently focuses on the total value of the firms involved. An acquisition, however, will usually affect relative values of stocks and bonds, as well as their total value.