Problem 1: EPS Analysis
ABC Company has 11,000 shares of equity outstanding with a market price of $100. The company is not encumbered with any debt. Management is looking at two alternative recapitalization plans. The first alternative calls for issuing $250,000 of debt. The second alternative calls for issuing $500,000 of debt. The proceeds from the debt issuance would be used to buy back equity shares at market price (i.e., treasury stock). The cost of debt is 7% annually. Assume that the company pays no taxes for purposes of this problem.
a) Earnings before interest and tax (EBIT) are expected to be either $90,000 or $150,000. What would be ABC company’s EPS at both income levels for the two refinancing plans? If both income possibilities are equally likely so that the expected EBIT is $130,000, what would be the expected EPS?
b) If EBIT will be equal to $100,000, what would EPS be under each of the two recapitalization plans? What does this confirm?
Problem 2:
ABC Donut Company is operating an old machine that is not expected to last more than two years. In the next two years, the machine is expected to generate a cash inflow of $20,000 per year. A replacement machine is available at a cost of $150,000. The new machine would be more efficient and is expected to generate a net cash inflow of $75,000 per year for three years. Management is considering the replacement machine. The Donut Company’s cost of capital is 10 percent.
a. Assume that the current resale value of the old machine is zero and that the new machine will also have a zero resale value in the future. What is the annual-equivalent cash flow of using the new machine?
b. What should the management of the donut company do?
Problem 3:
Company X has an equity beta of 1.25 and a debt to equity ratio of 2. The expected market portfolio return is 8 percent. The interest rate on governmental bonds is 4 percent. Company X can borrow long term at a rate of 6 percent. The corporate tax rate is 32 percent.
(a) What is the cost of equity?
(b) What is the cost of capital?
Problem 4: Cash Flow Statement
|
The comparative balance sheet of Max Company, for 2008 and the preceding year ended December 31, 2007 appears below in condensed form:
|
Year
|
Year
|
|
|
2008
|
2007
|
|
|
|
|
|
Cash
|
$ 45,000
|
$ 113,500
|
|
Accounts receivable (net)
|
51,300
|
58,000
|
|
Inventories
|
247,200
|
135,000
|
|
Investments
|
0
|
0
|
|
Equipment
|
493,000
|
375,000
|
|
Accumulated depreciation-equipment
|
(113,700)
|
(128,000)
|
|
|
$722,800
|
$553,500
|
|
Accounts payable
|
$ 61,500
|
$ 42,600
|
|
Bonds payable, due 2012
|
50,000
|
100,000
|
|
Common stock, $10 par
|
250,000
|
200,000
|
|
Paid-in capital in excess of par--
|
|
|
|
common stock
|
125,000
|
50,000
|
|
Retained earnings
|
236,300
|
160,900
|
|
|
$722,800
|
$553,500
|
The income statement for the current year is as follows:
|
Sales
|
|
$623,000
|
|
Cost of merchandise sold
|
|
348,500
|
|
Gross profit
|
|
$274,500
|
|
Operating expenses:
|
|
|
|
Depreciation expense
|
$24,700
|
|
|
Other operating expenses
|
75,300
|
100,000
|
|
Income from operations
|
|
$174,500
|
|
Other income:
|
|
|
|
Gain on sale of investment
|
$ 0
|
|
|
Other expense:
|
|
|
|
Interest expense
|
2,000
|
(2,000)
|
|
Income before income tax
|
|
$172,500
|
|
Income tax
|
|
55,000
|
|
Net income
|
|
$117,500
|
Additional data for the current year are as follows:
(a) Fully depreciated equipment costing $39,000 was scrapped, no salvage, and equipment was purchased for $157,000.
(b) Bonds payable for $50,000 were retired by payment at their face amount.
(c) 5,000 shares of common stock were issued at $25 for cash.
(d) Cash dividends declared were paid $42,100.
(e) All sales are on account.
Prepare a statement of cash flows, using the direct method of reporting cash flows from operating activities.
Problem 5: Net Present Value
– Net Present Value, Internal Rate of Return and Profitability index methods
You must choose between the two projects whose cash flows are shown below. Both projects are of equivalent risk.
Year End Project A Project B
Now -$45,000 -$9,000
1 15,000 3,000
2 15,000 2,000
3 20,000 3,000
4 20,000 2,000
Compute for both projects:
a) The internal rate of return (IRR)
b) Assuming a 12% discount rate, compute net present value (NPV)
c) Assuming a 12% discount rate, compute profitability index (PI)
d) Assuming a 12% discount rate, which of the projects is better and why?