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Third Quiz
SOLUTIONS
Finance 302
Winter 2002
Instructor:
Marlena L. Akhbari
Name:____
KEY
________________
Section I.
Problems.
Values are as marked
Problem 1. (25 Points)
Country Textiles estimate that their EBIT is expected to be $240,000 for the foreseeable
future.
Country Textiles is considering the use of one of the following capital structures
and would like to calculate which one might produce an optimal firm value.
They have
$1,000,000 in assets and no potential for growth and are 100% equity financed.
Its
common stock is currently valued at $25 per share and the firm is in the 40% tax bracket.
The capital structures under consideration are as follows:
Debt
Interest
Required Return on Equity
$300,000
8%
12.53%
$500,000
10%
14.63%
$700,000
15%
17.58%
Assuming the firm size will not change and all earnings will be paid out as dividends,
what will be the stock price under each capital structure?
Which capital structure would
be optimal?
DEBT
$300,000
$500,000
$700,000
INTEREST
24,000
50,000
105,000
#SHARES
28,000
20,000
12,000
EBIT
$240,000
$240,000
$240,000
INTEREST
(24,000)
(50,000)
(105,000)
EBT
216,000
190,000
135,000
TAXES
86,400
76,000
54,000
NET INCOME
129,600
114,000
81,000
EPS
4.63
5.70
6.75
STOCK PRICE
36.95
38.96
38.40
OPTIMAL
NOTES:
#SHARES ORIGINALLY = 1,000,000/$25 = 40,000; ADJUST BY THE
AMOUNT OF DEBT RAISED THAT IS USED TO BUYBACK SHARES, SO FIRST
COLUMN = 300,000 DEBT AND 700,000 EQUITY AND # SHARES = 700,000/25 =
28,000, ETC.
STOCK PRICE = EPS/K AND THE Ke CHANGES FOR EACH NEW DEBT
AMOUNT AS GIVEN.
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View Full Document Problem 2.
(10 Points)
Vanderheiden, Inc. is considering two averagerisk alternative ways of producing its
patented polo shirts.
Process S has a cost of $8,000 and will produce net cash flows of
$5,000 per year for 2 years.
Process L will cost $11,500 and will produce cash flows of
$4,000 per year for 4 years.
Inflation is expected to be 0 for the foreseeable future.
If
Vanderheiden’s cost of capital is 10%, which process should they choose?
Please solve
using both the common life method and the Equivalent Annual Annuity method.
PROJECT S
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This note was uploaded on 12/06/2011 for the course ECON 101 taught by Professor Adam during the Spring '06 term at Neumann.
 Spring '06
 Adam

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