Use the following information to answer questions 1-3:
• You hold a diversified portfolio of stocks and are considering investing in the XYZ Company. The firm’s prospects look good and you estimate the following probability distribution of possible returns:
Probability Return
70% 15%
20% 9%
10% 20%
• The return on the market is 13.5% and the risk free rate is 7%. You have calculated XYZ’s beta from past returns as 1.3 and you believe this will be the future beta.
1) What is the expected return for XYZ?
2) What is the required return for XYZ according to the CAPM?
3) Based on your calculations for the two questions above, should you buy stock in XYZ Company? Explain your answer.
Chapter: The Time Value of Money
Use the following information to answer questions 4-6:
• Joe Student has just rented an apartment with a one-year lease and a $250 damage deposit.
• Joe has a savings account in a local bank that pays 5% interest on any balance over $100.
4) If at the end of the lease, he moves and receives his $250 deposit, has he really paid a $250 deposit? Explain your answer.
5) What is his “real” damage deposit or the future value of his damage deposit after 1 year if he had deposited $250 in his savings account instead of using it for his damage deposit? In other words, what is the future value of $250 after one year with a 5% discount rate?
6) What amount should Joe have had to pay as a damage deposit in order for him to receive $250.00 in one year AND compensate him for the opportunity cost of not earning 5% interest on the money? In other words, what is the present value of $250 after one year with a 5% discount rate?
Use the following information to answer questions 7:
• Your mechanic says your car needs a new transmission, but you can wait a maximum of one year.
• Replacement today will cost $500.
• He says if you wait another year before replacement, the cost will be $520 due to the additional wear-and-tear on the driveshaft.
• Ignore income taxes, and ignore the risk of driving with a less than optimal transmission for a year.
7) If you currently have money invested in a savings account earning 8%, should you replace the transmission now or in one year? Explain your answer.
Chapter: The Cost of Capital
Use the following information to answer questions 8-12:
• The XYZ Corporation forecasts it will have Earnings Available to Common Stockholders of $1 million next year.
• It plans to follow its regular dividend policy of paying out 40% of earnings in dividends.
• The firm is in the 40% tax bracket.
• The firm’s capital base of $15 million is considered optimal and is composed of $7.5 million in debt, $3 million in preferred stock, and $4.5 million in equity.
• The firm’s stock price is currently selling at $30 per share.
• The next annual dividend is expected to be $1.50 per share.
• Dividends are expected to grow in the future at a constant rate of 7%.
• Flotation costs on any new stock issued will be $5 per share.
• The before-tax cost of debt is 6.4%. (kd = 6.4%).
• The firm’s preferred stock, which is currently selling for $45 per share, pays an annual dividend of 4% of $100 face value.
• The firm can raise additional debt and preferred stock at its current cost in the financial markets.
• The firm’s capital budgeting, production, and marketing people have estimated the IRRs and costs of the following three possible new projects for the coming year (in millions of dollars):
Project Cost Cumulative Cost IRR
A $1.0 $1.0 8.5%
B $1.5 $2.5 8%
C $2.0 $4.5 7.5%
8) What is the firm’s WACC without new equity?
9) What is the firm’s WACC with new equity?
10) Where does the retained earnings breakpoint occur?
11) Which projects, if any, should the firm undertake?
Fill in the below table.
Project Cost Cumulative Cost IRR MCC Decision (Accept or Reject)
A $1.0 $1.0 8.5%
B $1.5 $2.5 8%
C $2.0 $4.5 7.5%
12) What is the optimal level of capital spending?
Chapter: Capital Budgeting Decision Methods
Use the following information to answer questions 13-14:
• As head coach of a major national professional football team you are thinking about signing a somewhat unknown but very promising college quarterback to the team.
• The “normal” rate of return required for the average player is 5% and this particular player requires an addition 2% risk premium.
• Assume that if you sign this player there would be an immediate $1 million signing bonus.
• After the initial signing bonus, you are prepared to pay this player an annual salary of $300,000 for five years.
• You estimate this player will increase total annual team revenue $0 for year one, $400,000 for year two, $500,000 for year three, $1,000,000 for year 4 and $1,500,000 for year 5.
13) Use NPV analysis to find the dollar amount of the change in the value of the team over the next five years as a result of signing this player.
14) Based on the NPV analysis should you decide to accept or reject this player? Explain your answer.
Chapter: Estimating Incremental Cash Flows
Use the following information to answer questions 15-21:
• You have been asked to render an opinion to your boss as to whether your employer should enter into a short-term capital project.
• The project requires the purchase of a new piece of equipment for a price of $25,000.
• The firm has paid a consultant $1,000 to estimate the revenues expected from the project.
• The firm that ships the equipment and installs it in our plant will charge $500.
• The project’s change in sales will be $12,000 (before taxes) per year for three years.
• At the end of three years the equipment will be sold for $5000.
• The equipment has a three-year useful life and will be depreciated using the three-year MACRS depreciation schedule. (33.3%, 44.5%, 14.8%, 7.4%)
• The tax rate is 34%.
• The firm’s required rate of return is 17%.
15) What is the tax basis for the equipment?
Hint: The value of equipment for tax purposes = purchase price + installation cost.
16) What are the depreciation deductions for years 1, 2, and 3?
17) What will be the after tax net cash flow from the sale of the asset at the end of year three?
Hint: To compute the taxable income, you need to subtract the MACRS 4 year depreciation expense (25,500 x 7.4%) from the sale of the asset at the end of three years ($5000). Once you know the taxable income, you can compute the tax on the sale. Subtract the tax dollar amount from the sale price to get the net cash flow from the sale.
18) Calculate the net incremental operating cash flows for each of the three years.
Hint: To compute the net incremental operating cash flows, remember you subtract the depreciation expense before you calculate the tax dollar amount and you have to add the depreciation expense back after you compute after tax net income.
19) Based on the net incremental cash flows that you have calculated in the question above, using the payback decision rule should the project be accepted if the firm sets 2 years as its required payback period? What about if the firm sets 3 years as its required payback period?
20) Based on the net incremental cash flows that you have calculated in the question above, what is the net present value
Hint:The last year’s cash flow is made up of an incremental operating flow plus the incremental salvage value flow.
21) Based on the NPV you just calculated and an IRR of 18.28% should the project be accepted? Explain your answer.
Chapter: Business Valuation
Estimating the Firm’s Stock Price:
Use the following information to answer questions 22-25:
• The president of the Zeos Company estimates the growth of the firm’s dividends into the foreseeable future at 6%.
• The next expected dividend is $2.00 per share.
• The required return on the firm’s stock is 15%.
• A private financial analyst, on the other hand, agrees with the $2.00 expected dividend but believes a 3% growth rate is more appropriate.
• The book value of the firm’s assets = $40 million, while its book liabilities = $30 million.
• The firm has 2 million common shares outstanding.
• The current market price for the firm’s stock, which is actively traded on all the major stock exchanges, is $24 per share.
22) Estimate of the firm’s share price using the Zeos Company estimates and the Constant Growth Dividend Model.
23) Estimate of the firm’s share price using private financial analyst’s estimate and the Constant Growth Dividend Model.
24) Estimate of the firm’s share price using the Book Value Model.
25) Using the given information and your answers to questions 22– 24, what is the best estimate of the firm’s share price? Explain your answer.