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quiz3solw02

# quiz3solw02 - Third Quiz SOLUTIONS Finance 302 Winter 2002...

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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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Problem 2. (10 Points) Vanderheiden, Inc. is considering two average-risk 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 PROJECT L Cfo = -8,000 Cfo = -11,500 CF1 = 5000 CF1 = 4000 CF2 = 5,000 CF2 = 4000 NPV OF THE ORIGINAL PROJECT = 677.69 CF3 = 4000 CF4 = 4000 PROJECT S REPEATED NPV = 1179.46 Cfo = -8,000 CF1 = 5000 CF2 = -3000 CF3 = 5000 CF4 = 5000 NPV OF THE COMMON LIFE PROJECT = 1237.76 EQUIVALENT ANNUAL ANNUITIES ARE BASED ON ORIGINAL PROJECT SIZE.
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