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Unformatted text preview: Chapter 5: Measuring Return on Investments 1. The aftertax earnings is 120000(10.34) = 79200. The average book value of capital invested is $250,000, since the book value is depreciated from 500,000 to zero in 10 years. Hence, the aftertax return on capital equals 79200/250000 = 19.80% 2. a. Year Beginning Value Ending value Average Book Value Aftertax earnings Aftertax ROC 1 1200 800 1000 132 0.132 2 800 400 600 132 0.22 3 400 200 132 0.66 4 132 n/a 5 132 n/a Average 360 132 The market value is not used, since it is irrelevant for the purpose of defining the book value of the investment. For the last two years, the denominator is zero, and hence the ROC is undefined. To get around this problem, we use the average book value and after tax earnings over the 5 years. Return on Capital = 132/360 = 36.67% b. The geometric average cannot be defined, since the aftertax ROC for the last two years is undefined: the book value for the denominator being zero. c. Using the return on capital of 36.67% estimated from using the averages, we would accept the project since it is high enough to exceed a cost of capital of 25%. 3. If we compute the average return on equity over the entire period, we have an average equity investment of $300,000 [$1m.x(10.40) = $600,000 going down to zero in 5 years]. The yearly net income equals 50,000. Hence the beforetax return on equity = 50000/300000 = 16.67%. 4. If the debtequity ratio is 100%, the debttocapital ratio is 50%. Hence, we need Minimum return on capital = (0.5)(aftertax interest rate) + (0.5)(minimum return on equity). Solving, the implied minimum return on equity = 19%. 5. a. Year Cash Flow Cumulated cash flow 1 250000 250000 2 500000 750000 3 750000 1500000 4 750000 2250000 5 750000 3000000 6 750000 3750000 7 750000 4500000 In year 5, the cumulated cash flow equals the initial investment of $3m. Hence, the payback period = 5 years. b. The net present value = present value of the inflows  $3b. = 5,724,015.7  3 = $2.72b. 6. Year FCFF PV @ 10% PV @ 15% (2,000,000.00) 2,000,000.00) (2,000,000.00) 1 100,000.00 90,909.09 86,956.52 2 300,000.00 247,933.88 226,843.10 3 300,000.00 225,394.44 197,254.87 4 300,000.00 204,904.04 171,525.97 5 300,000.00 186,276.40 149,153.02 6 300,000.00 169,342.18 129,698.28 7 300,000.00 153,947.44 112,781.11 8 300,000.00 139,952.21 98,070.53 9 300,000.00 127,229.29 85,278.72 10 300,000.00 115,662.99 74,155.41 NPV (338,448.05) (668,282.46) The project should not be accepted at either discount rate. 7. The present value of the annual free cash flow to equity can be computed using the annuity formula: PV = 50000 0.14 (1 1 (1.14) 10 ) = $260,805.78 . This would be the maximum initial investment. 8. The entire benefit of the NPV should accrue to the shareholders. Hence the share price should rise by $2 m./1 m. = $2 per share. However, to the extent that such projects have already been foreseen by the market and incorporated into the stock price, there will be no current impact.no current impact....
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This note was uploaded on 03/12/2012 for the course FINANCE 5080 taught by Professor C during the Fall '10 term at University of Houston.
 Fall '10
 c
 Finance

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