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1. Assume that you are in the 40% federa...
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1. Assume that you are in the 40% federal-plus-state marginal tax bracket and that capital gains taxes are deferred until maturity. Assuming equal investment risk and a horizontal yield curve, rank the following investment opportunities on the basis of the effective annual yields:

a. A $100 par value perpetual preferred stock with an annual coupon of 12%, quarterly payments, and selling at $105.

b. A $1,000 par value, 20-year, non callable, semiannual bond with a coupon of 12% currently selling at $1,050.

c. A $1,000 par value, 20-year, non callable, semiannual bond with a coupon of 6% selling at a price of $637.

d. How would the situation change if the ranker had been:

(1) a pension fund investment manager or

(2) a corporation that is in the 40% federal-plus-state bracket?

Part d - Explain in words but demonstrate that you could quantify your answer.


2. Assume an all equity firm has been growing at a 15 percent annual rate and is expected to continue to do so for 3 more years. At that time, growth is expected to slow to a constant 4 percent rate. The firm maintains a 30 percent payout ratio, and this year's retained earnings net of dividends were $1.4 million. The firm's beta is 1.25, the risk-free rate is 8 percent, and the market risk premium is 4 percent. If the market is in equilibrium, what is the market value of the firm's common equity (1 million shares outstand¬ing)?


3. Longstreet Communications, Inc. (LCI), has the following capital structure, which it considers to be optimal:

Debt 25%
Preferred stock 15
Common stock 60
100%

LCI’s net income expected this year is $17,142.86; its established dividend payout ratio is 30%; its tax rate is 40%; and investors expect earnings and dividends to grow at a constant rate of 9% in the future. LCI paid a dividend of $3.60 per share last year (D0), and it’s stock currently sells at a price of $60 per share. Treasury bonds yield 11%; an average stock has a 14% expected rate of return; and LCI’s beta is 1.51. These terms would apply to new security offerings:

Common: New common stock would have a flotation cost of 10%.

Preferred: new preferred would be sold to the public at a price of $100 per share, with a dividend of $11. Flotation costs of $5 per share would be incurred.

Debt: Debt could be sold at an interest rate of 12%

a. Find the component costs of debt, preferred stock, retained earnings, and new common stock.
b. How much new capital can be raised before LCI must sell new equity? (In other words, find the retained earnings break point.)
c. What is the WACC when LCI meets its equity requirement with retained earnings? With new common stock?
d. Construct a graph showing LCI’s MCC schedule.


4. You have been given the following data on a competitor:

Balance Sheets 1998 1999
Cash $ 57,600 $ 52,000
Accounts receivable 351,200 402,000
Inventory 715,200 836,000
Total current assets $ 1,124,000 $ 1,290,000
Gross Fixed assets $ 491,000 $ 527,000
Less: Accumulated Depreciation 146,200 166,200
Net fixed assets $ 344,800 $ 360,800
Total assets $ 1,468,800 $1,650,800

Accounts Payable $ 145,600 $ 175,200
Notes Payable 200,000 225,000
Accruals 136,000 140,000
Total current liabilities $ 481,600 $ 540,200
Long-term debt 323,432 424,612
Common stock 460,000 460,000
Retained earnings 203,768 225,988
Total equity $ 663,768 $ 685,988
Total claims $ 1,468,800 $ 1,650,800

Income Statements
Sales $ 3,432,000 $ 3,850,000
Cost of goods sold 2,864,000 3,250,000
Other expenses 340,000 430,300
Depreciation 18,900 20,000
EBIT $ 209,100 $ 149,700
Interest expense 62,500 76,000
EBIT $ 146,600 $ 73,700
Taxes (40%) 58,640 29,480
Net income $ 87,960 $ 44,220

Other data

December 31 stock price $8.50 $6.00
Number of share outstanding 100,000 100,000
Dividend per share $0.22 $0.22
Annual lease payment $40,000 $40,000
Ratio Average
Current 2.7x
Quick 1.0x
Inventory turnover 7.0x
Days sales outstanding (DSO) 32.0 days
Fixed asset turnover 10.7x
Total asset turnover 2.6x
Debt ratio 50.0%
TIE 2.5x
Fixed charge coverage 2.1x
Profit margin 3.5%
Basic earning power 19.1%
ROA 9.1%
ROE 18.2%
P/E 14.2x
M/B 1.40x

a. Define the term “liquidity” within a financial statement analysis context. What are the current and quick ratios? Assess the firm’s liquidity position.
b. What are the inventory turnover, days sales outstanding, fixed asset turnover, and total asset turnover? How do the firm’s asset utilization ratios stack up against the industry averages?
c. What are the debt, times-interest-earned, and fixed charge coverage ratios? How does it compare with the industry with respect to financial leverage?
d. Calculate the profitability ratios, that is, its profit margin, return on assets (ROA), return on equity (ROE).
e. What is common size analysis? Briefly describe how it an be applied to income statements and balance sheets. Does common size analysis replace ratio analysis, or should it be used to supplement ratio analysis?


5. You have been assigned to evaluate a venture wherein your corporation will set up a foreign subsidiary in the developing nation of Aluvia. Aluvia is currently adopting cable television technology for the first time and will require your company to manufacture cable equipment locally for the right to sell in their internal market. The manufacturing venture is expected to last 5 years after which you will have saturated the local market. As the lead analyst on this project you have developed the following data:

Aluvian Currency: The current exchange is 5 Alots to the Dollar. The local inflation rate in Aluvia is expected to exceed the US inflation rate by 6% each year so the Alot will depreciate by 6% per year relative to the dollar.

Investment: The investment in Plant and Equipment will be $40 Million provided by your corporation as equity for this wholly owned subsidiary. At the end of the five year project, the assets will be liquidated for 10 Million Alots. All proceeds plus accumulated cash deposits will be repatriated as a liquidating dividend.

Repatriation: Only dividends may be repatriated from the subsidiary to the parent. Depreciation cash flows must be reinvested locally until the end of the project. An Aluvian Bank will provide a 15% per year tax-free return for this cash.

Taxes: Aluvian Tax Authority (ATA) has specified that your venture will be subject to a 30% corporate tax rate. You must use straight-line depreciation of plant and equipment over the five-year life. Dividends are not taxable in Aluvia. Your parent corporation combined Federal and State tax rate is 50% but you may claim a $ for $ credit for taxes paid in Aluvia offsetting US taxes due per the Tax Treaty between the US and Aluvia.

Marketing/Operating:

Venture Fixed
Project Volume in Price Variable Cost Cash Cost
Year (1000) units Alots per unit, Alots Million Alots

1 70 7000 2500 100
2 80 6800 2600 110
3 90 6500 2700 120
4 100 6300 2800 130
5 120 6300 2900 140

If your firm requires a 25% investors return on projects of this type, should you make the investment?
1742290633141.docx

Engineering Management 535
Dr. Stephen V. Smith
Final Exam
(100 Points)

15 Points
1. Assume that you are in the 40% federal-plus-state marginal tax bracket and that
capital gains taxes are deferred until maturity. Assuming equal investment risk and a
horizontal yield curve, rank the following investment opportunities on the basis of the
effective annual yields:
a. A $100 par value perpetual preferred stock with an annual coupon of 12%,
quarterly payments, and selling at $105.
b. A $1,000 par value, 20-year, non callable, semiannual bond with a coupon of 12%
currently selling at $1,050.
c. A $1,000 par value, 20-year, non callable, semiannual bond with a coupon of 6%
selling at a price of $637.
d. How would the situation change if the ranker had been:
(1)

a pension fund investment manager or

(2)

a corporation that is in the 40% federal-plus-state bracket?

Part d - Explain in words but demonstrate that you could quantify your answer.
10 Points
2. Assume an all equity firm has been growing at a 15 percent annual rate and is
expected to continue to do so for 3 more years. At that time, growth is expected to
slow to a constant 4 percent rate. The firm maintains a 30 percent payout ratio, and
this year's retained earnings net of dividends were $1.4 million. The firm's beta is
1.25, the risk-free rate is 8 percent, and the market risk premium is 4 percent. If the
market is in equilibrium, what is the market value of the firm's common equity (1
million shares outstanding)?

Engineering Management 535 (contd)

Page 2.
(25 points)
3. Longstreet Communications, Inc. (LCI), has the following capital structure, which it
considers to be optimal:
Debt
Preferred stock
Common stock

25%
15
60
100%

LCIs net income expected this year is $17,142.86; its established dividend payout
ratio is 30%; its tax rate is 40%; and investors expect earnings and dividends to grow
at a constant rate of 9% in the future. LCI paid a dividend of $3.60 per share last year
(D0), and its stock currently sells at a price of $60 per share. Treasury bonds yield
11%; an average stock has a 14% expected rate of return; and LCIs beta is 1.51.
These terms would apply to new security offerings:
Common:

New common stock would have a flotation cost of 10%.

Preferred:

new preferred would be sold to the public at a price of $100 per share,
with a dividend of $11. Flotation costs of $5 per share would be
incurred.

Debt:

Debt could be sold at an interest rate of 12%

a. Find the component costs of debt, preferred stock, retained earnings, and new
common stock.
b. How much new capital can be raised before LCI must sell new equity? (In other
words, find the retained earnings break point.)
c. What is the WACC when LCI meets its equity requirement with retained
earnings? With new common stock?
d. Construct a graph showing LCIs MCC schedule.

Engineering Management 535 (contd)

Page 3.
25 Points

4. You have been given the following data on a competitor:
Balance Sheets
Cash
Accounts receivable
Inventory
Total current assets
Gross Fixed assets
Less: Accumulated Depreciation
Net fixed assets
Total assets

1998
57,600
351,200
715,200
$1,124,000
$ 491,000
146,200
$ 344,800
$1,468,800

1999
52,000
402,000
836,000
$1,290,000
$ 527,000
166,200
$ 360,800
$1,650,800

$

$

Accounts Payable
Notes Payable
Accruals
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total equity
Total claims

$ 145,600
200,000
136,000
$ 481,600
323,432
460,000
203,768
$ 663,768
$1,468,800

$ 175,200
225,000
140,000
$ 540,200
424,612
460,000
225,988
$ 685,988
$1,650,800

Income Statements
Sales
Cost of goods sold
Other expenses
Depreciation
EBIT
Interest expense
EBIT
Taxes (40%)
Net income

$3,432,000
2,864,000
340,000
18,900
$ 209,100
62,500
$ 146,600
58,640
$ 87,960

$3,850,000
3,250,000
430,300
20,000
$ 149,700
76,000
$ 73,700
29,480
$ 44,220

$8.50
100,000
$0.22
$40,000

$6.00
100,000
$0.22
$40,000

Other data
December 31 stock price
Number of share outstanding
Dividend per share
Annual lease payment

Engineering Management 535 (contd)

Page 4.

Problem 4 contd:
Industry
Ratio

Average
Current
2.7x
Quick
1.0x
Inventory turnover
7.0x
Days sales outstanding (DSO)
Fixed asset turnover 10.7x
Total asset turnover
2.6x
Debt ratio
50.0%
TIE
2.5x
Fixed charge coverage 2.1x
Profit margin 3.5%
Basic earning power 19.1%
ROA
9.1%
ROE
18.2%
P/E
14.2x
M/B
1.40x

32.0 days

a. Define the term liquidity within a financial statement analysis context. What
are the current and quick ratios? Assess the firms liquidity position.
b. What are the inventory turnover, days sales outstanding, fixed asset turnover, and
total asset turnover? How do the firms asset utilization ratios stack up against the
industry averages?
c. What are the debt, times-interest-earned, and fixed charge coverage ratios? How
does it compare with the industry with respect to financial leverage?
d. Calculate the profitability ratios, that is, its profit margin, return on assets (ROA),
return on equity (ROE).
e. What is common size analysis? Briefly describe how it an be applied to income
statements and balance sheets. Does common size analysis replace ratio analysis,
or should it be used to supplement ratio analysis?

Engineering Management 535 (contd)

Page 5.

25 Points
5. You have been assigned to evaluate a venture wherein your corporation will set up a
foreign subsidiary in the developing nation of Aluvia. Aluvia is currently adopting
cable television technology for the first time and will require your company to
manufacture cable equipment locally for the right to sell in their internal market. The
manufacturing venture is expected to last 5 years after which you will have saturated
the local market. As the lead analyst on this project you have developed the
following data:
Aluvian Currency: The current exchange is 5 Alots to the Dollar. The local inflation
rate in Aluvia is expected to exceed the US inflation rate by 6% each year so the Alot
will depreciate by 6% per year relative to the dollar.
Investment: The investment in Plant and Equipment will be $40 Million provided by
your corporation as equity for this wholly owned subsidiary. At the end of the five
year project, the assets will be liquidated for 10 Million Alots. All proceeds plus
accumulated cash deposits will be repatriated as a liquidating dividend.
Repatriation: Only dividends may be repatriated from the subsidiary to the parent.
Depreciation cash flows must be reinvested locally until the end of the project. An
Aluvian Bank will provide a 15% per year tax-free return for this cash.
Taxes: Aluvian Tax Authority (ATA) has specified that your venture will be subject to
a 30% corporate tax rate. You must use straight-line depreciation of plant and
equipment over the five-year life. Dividends are not taxable in Aluvia. Your parent
corporation combined Federal and State tax rate is 50% but you may claim a $ for $
credit for taxes paid in Aluvia offsetting US taxes due per the Tax Treaty between the
US and Aluvia.
Marketing/Operating:
Project
Year

Volume in
(1000) units

Price
Alots

Variable Cost
per unit, Alots

Venture Fixed
Cash Cost
Million Alots

1
2
3
4
5

70
80
90
100
120

7000
6800
6500
6300
6300

2500
2600
2700
2800
2900

100
110
120
130
140

If your firm requires a 25% investors return on projects of this type, should you make the
investment?

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Dear Student, Please find the solution attached herewith. [In case, if any clarifi... View the full answer

6874500.doc

Engineering Management 535
Dr. Stephen V. Smith
Final Exam
(100 Points)

15 Points
1. Assume that you are in the 40% federal-plus-state marginal tax bracket and that
capital gains taxes are...

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