Identify the choice that best completes the statement or answers the question.
(The following data apply to the problem(s) below.)
You are employed by CGT, a Fortune 500 firm that is a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the CFO. This is a position with high visibility and the opportunity for rapid advancement, providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company. The balance sheet and some other information about CGT follows below.
Current assets $ 38,000,000
Net plant, property, and equipment 101,000,000
Total assets $139,000,000
Liabilities and equity
Accounts payable $ 10,000,000
Current liabilities $ 19,000,000
Long term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities 59,000,000
Common stock (10,000,000 shares) 30,000,000
Retained earnings 50,000,000
Total shareholders equity 80,000,000
Total liabilities and shareholders equity $139,000,000
You check The Wall Street Journal and see that CGT stock is currently selling for $7.50 per share and that CGT bonds are selling for $875.00 per bond. The bonds have a S1,000 par value, a 7.25% annual coupon rate, semiannual payments, are not callable, and a 20-year maturity. CGT's beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The expected return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. CGT is in the 40% tax bracket.
____ 1. Refer to Exhibit 10-1. What is the best estimate of the after-tax cost of debt for CGT?
____ 2. Refer to Exhibit 10-1. Using the CAPM approach, what is the best estimate of the cost of equity for CGT?
____ 3. Refer to Exhibit 10-1. Which of the following is the best estimate for the weights to be used when calculating the WACC?
a. wc = 68.2%; wd = 31.8%
b. wc = 69.9%; wd = 30.1%
c. wc = 71.6%; wd = 28.4%
d. wc = 73.4%; wd = 26.6%
e. wc = 75.3%; wd = 24.7%
____ 4. Refer to Exhibit 10-1. What is the best estimate of the WACC for CGT?
____ 5. Van Auken Inc. is considering a project that has the following cash flows:
Year Cash Flow
The company's WACC is 10%. What are the project's payback, internal rate of return, and net present value?
a. Payback = 2.4; IRR = 10.00%; NPV = $600.
b. Payback = 2.4; IRR = 21.22%; NPV = $260.
c. Payback = 2.6; IRR = 21.22%; NPV = $300.
d. Payback = 2.6; IRR = 21.22%; NPV = $260.
e. Payback = 2.6; IRR = 24.12%; NPV = $300.
____ 6. Edelman Electric Systems is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.
Year: 0 1 2 3
Cash flows: $800 $350 $350 $350
____ 7. Stewart Associates is considering a project that has the following cash flow data. What is the project's payback?
Year: 0 1 2 3 4 5
Cash flows: $1,000 $300 $310 $320 $330 $340
a. 2.11 years
b. 2.34 years
c. 2.60 years
d. 2.89 years
e. 3.21 years
____ 8. Walker & Campsey wants to invest in a new computer system, and management has narrowed the choice to Systems A and B.
System A requires an up-front cost of $100,000, after which it generates positive after-tax cash flows of $60,000 at the end of each of the next 2 years. The system could be replaced every 2 years, and the cash inflows and outflows would remain the same.
System B also requires an up-front cost of $100,000, after which it would generate positive after-tax cash flows of $48,000 at the end of each of the next 3 years. System B can be replaced every 3 years, but each time the system is replaced, both the cash outflows and cash inflows would increase by 10%.
The company needs a computer system for 6 years, after which the current owners plan to retire and liquidate the firm. The company's cost of capital is 11%. What is the NPV (on a 6-year extended basis) of the system that adds the most value?
____ 9. Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, and the MACRS rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year life. What is the operating cash flow for Year 1?
Equipment cost (depreciable basis) $65,000
Sales revenues, each year $60,000
Operating costs excl. depr'n $25,000
Tax rate 35.0%
____ 10. California Hideaways is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)
Net investment cost (depreciable basis) $65,000
Straight-line depr'n rate 33.3333%
Sales revenues, each year $60,000
Operating costs excl. depr'n, each year $25,000
Tax rate 35.0%
____ 11. Bing Services is now in the final year of a project. The equipment originally cost $20,000, of which 75% has been depreciated. Bing can sell the used equipment today for $6,000, and its tax rate is 40%. What is the equipment's net after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, Bing will receive a tax credit as a result of the sale.
____ 12. Moore & Moore (MM) is considering the purchase of a new machine for $50,000, installed. MM will use the MACRS accelerated method to depreciate the machine, which is classified as 5-year property (see the following MACRS table for depreciation rates). MM expects to sell the machine at the end of its 4-year operating life for $10,000. If MM's marginal tax rate is 40%, what will the after-tax cash flow be when it disposes of the machine at the end of Year 4?
Ownership Year Depreciation Rate
____ 13. TexMex Products is considering a new salsa whose data are shown below. The equipment that would be used would be depreciated by the straight-line method over its 3-year life, would have zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)
Pre-tax cash flow reduction in other products (cannibalization) $5,000
Investment cost (depr'ble basis) $65,000
Straight-line depr'n rate 33.333%
Sales revenues, each year $75,000
Annual operating costs, ex. depr'n $25,000
Tax rate 35.0%
____ 14. Easy Payment Loan Company is thinking of opening a new office, and the key data are shown below. Easy Payment owns the building, free and clear, and it would sell it for $100,000 after taxes if it decides not to open the new office. The equipment that would be used would be depreciated by the straight-line method over the project's 3-year life, and would have a zero salvage value. No new working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)
Opportunity cost $100,000
Net equipment cost (depreciable basis) $65,000
Straight-line depr'n rate for equipment 33.33%
Sales revenues, each year $150,000
Operating costs excl. depr'n, each year $25,000
Tax rate 35.0%
____ 15. Dumpe Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price will increase with inflation. Fixed costs will also be constant, but variable costs will rise with inflation. The project should last for 3 years, and there will be no salvage value. This is just one project for the firm, so any losses can be used to offset gains on other firm projects. What is the project's expected NPV?
Net investment cost (depreciable basis) $100,000
Units sold 40,000
Average price per unit, Year 1 $25.00
Fixed op. cost excl. depr'n (constant) $150,000
Variable op. cost/unit, Year 1 $20.20
Annual depreciation rate 33.33%
Expected inflation 5.00%
Tax rate 40.0%
____ 16. Last year Handorf-Zhu Inc. had $850 million of sales, and it had $425 million of fixed assets that were used at only 60% of capacity. What is the maximum sales growth rate the company could achieve before it had to increase its fixed assets?
____ 17. Clayton Industries is planning its operations for next year, and Ronnie Clayton, the CEO, wants you to forecast the firm's additional funds needed (AFN). Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? Dollars are in millions.
Last year's sales = S0 $350 Last year's accounts payable $40
Sales growth rate = g 30% Last year's notes payable (to bank) $50
Last year's total assets = A0 $500 Last year's accruals $30
Last year's profit margin = M 5% Target payout ratio 60%
____ 18. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm's additional funds needed (AFN). Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions.
Last year's sales = S0 $300.0 Last year's accounts payable $50.0
Sales growth rate = g 40% Last year's notes payable (to bank) $15.0
Last year's total assets = A0 $500.0 Last year's accruals $20.0
Last year's profit margin = M 20.0% Initial payout ratio 10.0%
New payout ratio 50.0%
____ 19. Last year Emery Industries had $450 million of sales and $225 million of fixed assets, so its FA/Sales ratio was 50%. However, its fixed assets were used at only 65% of capacity. If the company had been able to sell off enough of its fixed assets at book value so that it was operating at full capacity, with sales held constant at $450 million, how much cash (in millions) would it have generated?
____ 20. Suppose Leonard, Nixon, & Shull Corporation's projected free cash flow for next year is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company's weighted average cost of capital is 11%, what is the value of its operations?
____ 21. Zhdanov Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be –$10 million, but its FCF at t = 2 will be $20 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14%, what is the firm's value of operations, in millions?
____ 22. A company forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 13%, and the FCFs are expected to continue growing at a 5% rate after Year 3. Assuming that the ROIC is expected to remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions?
Year: 1 2 3
Free cash flow: –$15 $10 $40
____ 23. Rocky Top Car Wash is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over the project's 3-year life, and would have zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. This is just one project for the firm, so any losses can be used to offset gains on other firm projects. If the number of cars washed declined by 50% from the expected level, by how much would the project's NPV change? (Hint: Cash flows are constant in Years 1-3.)
Net investment cost (depreciable basis) $60,000
Number of cars washed 2,800
Average price per car $25.00
Fixed op. cost excl. depr'n $10,000
Variable op. cost/unit (i.e. per car washed) $5.357
Annual depreciation $20,000
Tax rate 35.0%
Identify the letter of the choice that best completes the statement or answers the question.
____ 1. To save money for a new house, you want to begin contributing money to a brokerage account. Your plan is to make ten contributions to the brokerage account. Each contribution will be for $1,500. The contributions will come at the beginning of each of the next 10 years, i.e., the first contribution will be made at t = 0 and the final contribution will be made at t = 9. Assume that the brokerage account pays a 9 percent return with quarterly compounding. How much money do you expect to have in the brokerage account nine years from now (t = 9)?
____ 2. You have some money on deposit in a bank account which pays a nominal (or quoted) rate of 8.0944 percent, but with interest compounded daily (using a 365-day year). Your friend owns a security which calls for the payment of $10,000 after 27 months. The security is just as safe as your bank deposit, and your friend offers to sell it to you for $8,000. If you buy the security, by how much will the effective annual rate of return on your investment change?
____ 3. You have the choice of placing your savings in an account paying 12.5 percent compounded annually, an account paying 12.0 percent compounded semiannually, or an account paying 11.5 percent compounded continuously. To maximize your return you would choose:
a. 12.5% compounded annually.
b. 12.0% compounded semiannually.
c. 11.5% compounded continuously.
d. You would be indifferent since the effective rate for all three is the same.
e. You would be indifferent between choices a and c since their effective rates are the same.
____ 4. Corporations face the following corporate tax schedule:
Taxable Income Tax on Base Rate
$ 0 - $ 50,000 $ 0 15%
$ 50,000 - $ 75,000 7,500 25%
$ 75,000 - $100,000 13,750 34%
$100,000 - $335,000 22,250 39%
Company Z has $80,000 of taxable income from its operations, $5,000 of interest income, and $30,000 of dividend income from preferred stock it holds in other corporations. What is Company Z's tax liability?
____ 5. The table below contains Bradshaw Beverages' taxable income during each year since it began operations. Notice that the company lost money in each of its first three years. The corporate tax rate has been 40 percent each year.
Year Taxable Income (EBT)
2000 ($ 700,000)
2001 ( 500,000)
2002 ( 200,000)
Assume that current carry back and carry forward provisions were available in prior years. Assuming that the company effectively used the allowed carry back, carry forward provisions of the tax code, how much did the company pay in taxes during the most recent year?
____ 6. HR Corporation has a beta of 2.0, while LR Corporation's beta is 0.5. The risk-free rate is 10 percent, and the required rate of return on an average stock is 15 percent. Now the expected rate of inflation built into rRF falls by 3 percentage points, the real risk-free rate remains constant, the required return on the market falls to 11 percent, and the betas remain constant. When all of these changes are made, what will be the difference in the required returns on HR's and LR's stocks?
____ 7. Coolidge Cola is forecasting the following income statement:
Operating costs excluding depreciation 20,000,000
Operating income (EBIT) $ 5,000,000
Interest expense 2,000,000
Taxable income (EBT) $ 3,000,000
Taxes (40%) 1,200,000
Net income $ 1,800,000
Assume that, with the exception of depreciation, all other non-cash revenues and expenses sum to zero.
Congress is considering a proposal which will allow companies to depreciate their equipment at a faster rate. If this provision were put in place, Coolidge's depreciation expense would be $8,000,000 (instead of $5,000,000). This proposal would have no effect on the economic value of the company's equipment, nor would it affect the company's tax rate, which would remain at 40 percent. If this proposal were to be implemented, what would be the company's net cash flow?
____ 8. Hebner Housing Corporation has forecast the following numbers for this upcoming year:
Cost of Goods Sold 600,000
Interest Expense 100,000
Net Income 180,000
The company is in the 40 percent tax bracket. Its cost of goods sold always represents 60 percent of its sales. That is, if the company's sales were to increase to $1.5 million, its cost of goods sold would increase to $900,000.
The company's CEO is unhappy with the forecast and wants the firm to achieve a net income equal to $240,000. Assume that Hebner's interest expense remains constant. In order to achieve this level of net income, what level of sales will the company have to achieve?
____ 9. Sanguillen Corp. showed retained earnings of $400,000 on its balance sheet last year. This year, the company's earnings per share (EPS) were $3.00 and its dividends paid per share (DPS) were $1.00. The company has 200,000 shares of stock outstanding. What is the level of retained earnings on the company's balance sheet this year?
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