Problem 1) Wyoming Processing has expected annual sales of $1,200,000. Fixed cash costs are $100,000 and variable cash costs are 70% of sales. A new capital investment with a 10-year life will require an after tax cash outlay of $100,000. The result will be a change in production methods that increase fixed costs to $200,000 a year and reduce variable costs to 60% of sales. The required return is 10% and all cash flows are after tax (assuming year-end cash flow for simplicity). (a) Does the capital investment have a positive net present value? (b) Find the cash flow breakeven point for the company with and without the capital investment.
Problem 2) Klemkosky is considering the acquisition of a privately held company. The company's equity can be purchased for $1.2 million in cash and is expected to generate after tax cash flows of $250,000 a year for 10 years, with no terminal value. The acquisition candidate is financed with 60% debt and 40% equity. The interest rate on the debt is 8% and the risk-free rate is 6%. The tax rate is 34%. Companies in the same industry as the acquisition candidate have un-leveraged betas of 0.9. Should KlemKosky make the acquisition? Return on a market portfolio is 12.5%.
Problem 3) Michigan Corporation is expected to have earnings per share of $10 over the next year. Dividends are expected to be kept at 60% of earnings, and retained earnings are expected to be invested at a 14% rate of return. The price of the stock is presently $40. What is the anticipated growth rate of dividends, and what is the cost of existing equity (Hint: remember that g = return on reinvested equity * retention ratio)?
Problem 4) Athens Development Corporation is considering a new product that will be sensitive to both economic conditions and competitor response. The product manager has decided to focus on three equally likely economic conditions: weak economy, normal economy, and strong economy. Competitors either will or will not respond with a competitive product, and competitor response is unlikely unless economic conditions turn out to be strong. Annual cash flows for each of these conditions appear below. The product has a 5-year life and will require an initial cash outlay of $100,000. The cost of capital is 10%. Should Athens invest in this product? Explain.
Competitor response Weak economy Normal economy Strong economy
Yes $10,000 $20,000 $30,000
No 20,000 30,000 40,000