[1] (15 points)

Why might the rate of return that you require to invest in a given company increase as the firm's interest coverage ratio decreases and why might your required return decrease as the firm's debt to asset ratio decreases?

[2] (15 points)

Describe a scenario in which a firm’s debt position would be considered conservative if you look only at its times interest earned coverage ratio, and at the same time, quite risky if you look only at its debt ratio. Provide the definitions of both ratios and explain circumstances under which such a contradiction might occur.

[3] (25 points) EFFECTIVE RATES  Solution

Suppose your brother wants to borrow $10,000 from you for 3 years. He offers to repay the loan with quarterly payments of $1,004.62.

Suppose your sister wants to borrow $10,000 from you for 3 years. She offers to repay the loan with monthly payments of $332.14.

Compute the total amount you will receive, the APR and the EAR for both loans.
{a} Who gets your money and why?
{b} Is it possible for one borrower to repay you with a larger amount but actually be giving you a lower EAR? If so, how? If not, why not?

[4] (25 points)EFFECTIVE RATES  Solution

You read an advertisement for two possible investment plans: Investment A promises a payout of $10,000 at the end of 3 years if you deposit $200 per month (first deposit in one month) for 36 months.

Investment B promises a payout of $10,000 at the end of 3 years if you deposit a constant amount per quarter (first deposit in one quarter) for 12 quarters. It advertises that it pays an APR of 22%. Compare both plans with regard to:
{a} the total amount you are depositing each quarter
{b} APR
{c} EAR
Fully explain which plan you should select and why.

[5] (30 points) TIME VALUE OF MONEY  Solution

In order to save for his retirement, Dale Falcinelli makes the first of 6 equal annual deposits into an investment on October 8, 1999. He believes the investment will earn 10% a year. The last deposit will be made on October 8, 2004. The deposits must be of sufficient size to enable Mr. Falcinelli to make 30 equal annual withdrawals of $40,000 starting on October 8, 2009.

Assume that he makes the 6 deposits as planned and makes the first two $40,000 withdrawals on October 8, 2009 and 10. On the morning of October 8, 2011 Mr. Falcinelli makes a horrifying discovery: the investment has been yielding only 5% since 1999. Fully expecting to still live another 28 years, he knows he must drastically cut back on his lavish life style.

What's the maximum constant amount he can withdraw for each of the remaining 28 years, starting October 8, 2011 if the interest rate remains at its true rate of only 5%?

[6] (30 points)TIME VALUE OF MONEY  Solution

Today, February 29, 2000, Mr. Dale Falcinelli makes the first of what he expects to be 10 equal annual deposits into an investment fund that he believes will always pay 6% interest. The deposits will continue through February 29, 2009. The deposits must be of sufficient size to enable Falcinelli to withdraw $10,000 a year for 10 years starting on February 29, 2016 and continuing through February 29, 2025.

He makes the 10 deposits as planned. But he later discovers on February 29, 2012 that the interest rate had changed to 12% on February 29, 2006 and he didn’t know it. If he wants to change his withdrawal scheme to $10,000 a year for ever still starting on February 29, 2016, he figures that either he might be able to take some money out of the investment on February 29, 2012 or else he might have to make a single extra deposit on February 29, 2012. Help the guy out.

Calculate the amount he can withdraw or have to deposit on February 29, 2012 if he follows through on the planned infinite $10,000 withdrawals.

[7] (30 points)CAPITAL BUDGETING  Solution

Pooh Industries is contemplating replacing a piece of existing equipment with a more efficient model. The old equipment was purchased 2 years ago for $330,000. It is being depreciated using the straight-line method to salvage value of $30,000 over an original life of 10 years. Pooh could sell the existing equipment today for $255,000.

The new equipment would cost $800,000 and would be depreciated over an expected life of 8 years to a zero salvage value using the straight-line method. Pooh forecasts that the new machine would reduce operating expenses by $170,000 per year. The firm's marginal tax rate is 40% and its hurdle rate is 15%.

The new machine would require additional net working capital (aka motor oil) of $60,000 when it is purchased and another $60,000 at the beginning of year 5. All the working additional net working capital would be returned at the end of the 8^th year.

Should Pooh make the replacement?

[8] (30 points)CAPITAL BUDGETING  Solution

Bunky’s Burgers is contemplating replacing a meat grinder with a new, improved model. The original equipment was purchased 3 years ago for $530,000. It is being depreciated over an original life of 8 years to a salvage value of $50,000. It can be sold today for $400,000. The new equipment costs $900,000 and would be depreciated over a life of 5 years to a salvage value of $100,000. Bunky’s uses the straight-line method of depreciation and has a marginal tax rate of 40%. The new equipment would lower annual operating expenses by $150,000 but have no effect on sales revenues. The new equipment would require additional net-working-capital of $20,000. Find the maximum hurdle rate for which the replacement proposal is acceptable.

[9] (42 points)CAPITAL BUDGETING WITH RISK  Solution

Bunky's Burgers, Inc. is considering the purchase of a new piece of equipment that would cost $1,000,000. The equipment would be depreciated over an 8 year life to a zero salvage value using the straight-line method. Bunky's forecasts the following probability distribution for revenues over operaing expenses for each year:

The risk-free rate of interest is 5%, the beta coefficient of the fast food industry is 1.5 and the market's risk premium is 4%. Think about this information!

{a} Calculate the risk-adjusted NPV if the equipment actually lasts only 5 years with a scrap value of $275,000.

{b} Calculate the risk-adjusted NPV if the equipment actually lasts 12 years with a zero scrap value. You may continue to use the same a of part {a} for all operating cash flows.

[10] (30 points)CAPITAL BUDGETING WITH RISK  Solution

Emmo Enterprises is contemplating the purchase of a new piece of equipment. It has a purchase price of $500,000, will be depreciated over a 5 year expected life to a zero salvage value using the straight-line method. Additional net working capital of $100,000 would be required. The firm forecasts the following for each year: Probability DS - DC .20 500,000 .60 900,000 .20 1,100,000 The firm has a marginal tax rate of 50%. The risk-free rate of interest is 5%. If the firm utilizes the certainty equivalents method as part of its capital budgeting process, you may assume they use a certainty equivalents coefficient of .8 for all operating cash flows and 1.0 for all non-operating cash flows. YOU DO NOT NEED TO CALCULATE THE STANDARD DEVIATION OR TO FIND a FROM A CHART - THE s IS GIVEN AS .8. If the firm utilizes the “Beta Model” as part of its capital budgeting process, you may assume they use a market risk premium of 5% and a project beta of 1.6. Compute the expected NPV of the purchase if there is a 50% chance it will actually last only 3 years with a scrap value of $80,000 and a 50% chance that it will actually last 12 years with a zero scrap value. You should assume {a} that the firm is well-diversified and then repeat assuming {b} that the firm is NOT well-diversified. Obviously, a part of the problem is to decide which part uses the certainty equivalents method and which part uses the “Beta Model”.

[11] (20 points)LEVERAGE  Solution

The CFO of problem X-15 is so impressed with your knowledge of finance, she again seeks your counsel on another dilemma. Because the firm is now starting to sell its products on-line, they know they will be having to ship a lot more of their products by truck. The company faces two difficult decisions: {a} Should they buy a large fleet of trucks for which they will have to pay a fixed monthly payment to their local Mack Truck dealer or should they buy only a small number of trucks and rent others on an as needed basis? {b} Should they raise the funds to pay for (or to rent) the trucks by borrowing it from banks at a fixed interest cost (debt) or should they reduce the dividends they had expected to pay and essentially take the necessary funds from retained-earnings (equity)? Fully explain to the CFO using the concepts of operating and financial leverage, the advantages and disadvantages of {a} buying versus renting and {b} using debt versus equity. Clearly state any assumptions you are making about the company’s sales and their volatility.

[12] (30 points)BON VALUATION  Solution

MattMan industries has some outstanding $1,000 par value callable debentures that carry an annual coupon of 13%. Interest is paid semi-annually. The bonds mature on November 5, 2014. The current interest rate (yield to maturity) on the bond is 12% a year, compounded semi-annually. Calculate the effective annual rate of return earned by an investor who buys the bond today (NOVEMBER 5, 1999) and receives the call price of $1070 on November 5, 2004.

[13] (25 points)PREFERRED STOCK VALUATION (CONVERTIBLES)  Solution

Ten years ago you purchased 100 shares of Bunky’s Burgers $100 par value preferred stock when the market yield on such investments was 15% a year. The preferred stock pays an annual dividend of 12%. Parts {a} and {b} are independent of each other. {a} If you sell the stock today at the current market price, calculate the IRR you earned over the period if the market yield on preferred stock has fallen to 10% a year. {b} Now assume that the preferred stock is convertible into 4.5 shares of Bunky’s common stock. If you hold the preferred stock for the 10 year period and convert, what must be the price of the common stock today if you earn an IRR of 20%?

[14] (28 points)BONDS - YIELD DIFFERENTIALS  Solution

{a} Explain what happens to the yield differential between a firm's mortgage bonds and its debentures as the outlook for the economy begins to worsen. How would you expect investors in both types of the firm's bonds to react as they gradually have less confidence in the economy?

{b} A firm is about to sell a new issue of 20 year callable debentures and another issue of 20 year noncallable debentures. The level of interest rates has been steadily falling so now rates are thought to be near their historical lows. Comment on the relative size of the difference between the yields on the two issues.

{c} Interest rates are near their historical lows. Forecasters are predicting they are going to fall soon. Describe the probable shape of the yield curve. What are the pros and cons of issuing short-term securities? Of issuing long-term securities?

{d} Explain what happens to the yield differential between a firm's outstanding straight (nonconvertible) bonds and its outstanding convertible bonds if negative publicity regarding the company begins to surface. For example, consider a pharmaceutical company whose applications for FDA approval of several of their new drugs appear likely to be rejected.

[15] (25 points)YIELD CURVE  Solution

This summer finds you working in a finance position for a large industrial corporation. The company is contemplating raising new funds from a bond issue but is unsure of whether to issue long-term or short-term bonds. Assume that the term structure of interest rates is currently downward sloping. The CFO knows you’re a hot-shot intern from Lehigh so she asks your opinion. What do you tell her? Your answer must include all of the following: A carefully labeled downward sloping yield curve; the market’s expectations regarding the future course of interest rates, i.e., are they expected to rise or fall in the future and how you know this; the advantages and disadvantages of the firm issuing 5 year bonds versus 25 year bonds; the possibility of the firm making the bonds callable and why they may want to do this and why they may not want to do this.

[16] (30 points)EQUITY VALUATION - "SUPERGROWTH"  Solution

Bunky's Burgers pays its dividend on December 2 of each year. Yesterday it was 2.00 a share and for the next several years it is forecasted to be:

2000 2.00 2001 2.20 2002 2.40 2003 2.80 2004 3.00 2005 4.50

Thereafter, the dividend will remain at 4.50 for the indefinite future.

{a} If the market requires a rate of return of 15%, find the predicted value of Bunky's stock on December 3, 2000 and December 3, 2007 if the dividend forecasts hold.

{b} Find the rate of return earned by the person who buys it on December 3, 2007 and who sells it on December 3, 2011 for $50. Again assume that the dividend forecasts hold.

{c} Evidently what is the market's required rate of return on December 3, 2011 in order to produce a price of $50 assuming the dividend forecasts still hold?

[17] (35 points)CONVERTIBLE BONDS AND EQUITY VALUATION ("SUPERGROWTH")  Solution

Today you purchase a $1000 par value 20 year bond with an annual coupon of 10%, payable semi-annually. The bond is priced to yield 12% a year, compounded semi-annually. The bond is convertible into the firm’s common stock at a conversion price of $125 a share. At the time of purchase, the firm’s earnings and dividends are forecasted to grow at 25% for 8 years before declining to a 7% rate for the indefinite future. Stockholders require a 17% rate of return on the stock. The firm paid a dividend of $3.00 yesterday. If you hold the bond for 5 years and then convert it at the prevailing market value, calculate the IRR you earn over the 5 year period.

[18] (70 points)COST OF CAPITAL  Solution

M&M Enterprises is formulating its 2000 investment and financing plans and needs your advice. The firm has the following capital structure which it believes to optimal and will be maintained:

Long-term Debt 40,000,000
Preferred Stock 10,000,000
Common Stock 20,000,000
Retained Earnings 30,000,000
Common Equity 50,000,000
===========
TOTAL CLAIMS 100,000,000

The following slate of potential projects has been put forth:

PROJECT  OUTLAY        IRR
A       15,000,000     18%
B       10,000,000     16%
C       15,000,000     14.5%

Assume that all projects have an expected life of 4 years and uniform cash flows.

On December 2, 1992 the firm paid a dividend per share of $3.00 and yesterday (December 2, 1999) it paid a dividend of $5.484. The dividend yield, based on today's price and next year's forecasted dividend, is 11%. Assume that this growth rate continues for the indefinite future. M&M has $15,000,000 available from retained earnings for investment this coming year. The firm's marginal tax rate is 40%.

New securities can be sold under the following conditions:

BONDS: Up to $8,000,000 in new 20 year, $1,000 par value debentures can be sold to yield the investor 10% a year. The coupon rate is 9% and is paid annually. Flotation costs total $38.32. Beyond $8,000,000 the coupon rate is 14% and the firm nets $1,000 per bond.

PREFERRED STOCK: Any size issue of $50 par value preferred stock can be sold for $40 a share. Flotation costs are $6.67 per share and the dividend rate is 12%.

COMMON STOCK: Any size issue of new common stock can be sold with flotation costs and underpricing of $11.64 a share.

{a} Calculate the marginal cost of capital above and below each break point in the cost of capital schedule. Display your results accurately with a graph.

{b} Which projects should the firm accept? Clearly indicate your analysis and display on the graph.

{c} Calculate the average cost of capital for the capital budget you are recommending in {b}.

{d} Compute the NPV of project C.

[19] (40 points)COST OF CAPITAL  Solution

Bunky’s Burgers, Inc. is planning its financing needs. The firm believes that a capital structure of 30% debt, 10% preferred stock and 60% common equity is optimal. Bunky’s has $24 million available from retained earnings for investment. The firm’s common stock is currently selling for $50 a share. Earnings and dividends are expected to grow at 10% for the indefinite future. The dividend yield is also 10%. The firm’s marginal tax rate is 50%. Bunky’s can secure new financing under the following conditions:

DEBT: Up to $30 million of new 30 year $1000 par value debentures can be sold for $1035.50. The 10% coupon would be paid annually. Any additional bonds could be sold for $1175.55 and the coupon rate would need to be 16%. Both issues of bonds would have flotation costs of $35.50 per bond.

PREFERRED STOCK: New $100 par value preferred stock with a dividend of 12% can be sold to yield 13.5%. Flotation costs total $3.18 a share.

COMMON STOCK: Up to $36 million in new common stock can be sold with flotation costs and underpricing of $8.33. Additional shares can be sold with flotation costs and underpricing of $14.29.

{a} Compute the marginal cost of capital for each segment of the marginal cost schedule. Clearly display your results on a CLEARLY LABELED graph.

{b} Calculate the weighted average cost of capital for a capital budget of $120 million.

[20] (25 points)COST OF CAPITAL  Solution

Rich Snyder, a promising young finance student, draws his IRR schedule of three proposals as shown. Rich concludes the firm should accept all three projects since each project’s IRR exceeds the cost of capital.

Now it’s your turn to be the TA. Show Rich why his conclusion is wrong by:

{a} calculating the sum of the individual NPVs using Rich’s analysis

{b} correctly redrawing the IRR schedule on the same set of axes and recalculating the sum of the individual NPVs. How many proposals are you accepting?

{c} explaining why he’s wrong and you’re right.

Use the following information. Assume uniform cash flows each year.

Proposal Outlay     Years  IRR
A     10 million     5     12%
M     10 million     5     17%
Z     10 million     5     15%

[3] i_b = 3.00%; EAR Brother = 12.55%/yr; i_s = .9999%; EAR Sister = 12.68%/yr

[4] Invest A: 1.796%/month; APR = 21.55%; EAR = 23.81%; Invest B: D = $610.29/ quarter; APR = 22%; EAR = 23.88%

[5] D = $33,380.17; W = $14,919.15

[6] D = $3,936.46; W = $24,566.03

[7] DCF = 130,000; proceeds from sale = 261,000; outlay = 599,000; NPV = -20,532.24

[8] outlay = $540,000; DCF = 130,000; IRR = 9.75%

[9] Outlay = 1,050,000; DCF = 341,000; s = 66,810 a = .8; NPV₅ = 417,008; DCF₉₊ = 291; NPV₁₂ = 1,299,735

[10] {a} outlay = 600; DCF = 480; net proceeds = 140; NPV₃=$670; NPV₁₂ = 2143.52; {b} NPV₃ = 653.05; NPV₁₂2,677.82

[12] PV = 1,068.82; r = 12.18%/yr comp sa or EAR = 12.55%

[13] P₀ = 120; r = 17.21%; conversion value = 183.83; P_common = 40.85/share

[16] {a} P₀₅ = 30.00; P₀₀ = 24.437; P₀₇ = 30.00; {b} r = 26.344%; {c} c = .090

[17] P₀ = 849.54; P₅ = 150.86/share; conversioln value = 1206.86; r = 8.69%/period or 17.39%/year compounded sa

[18] Break points: debt: 20,000,000 and equity: 30,000,000; component costs k_i1=.063; k_i2 = .084; k_p = .180; k_e = .20 and k_n = .23; MC₁ = .143; MC₂ = .152; MC₃ = .167; {b} Accept A & B and raise 25,000,000; {c} ACC_25,000,000 = .1448; {d} NPV_c = -504,760

[19] Break points at 100,000,000 debt and 40,000,000 and 100,000,000 equity;k_i1 = 5%; k_i2 = 7%; k_p = 14.00%; k_e = 20%; k_n1 = 22%; k_n2 = 24%; MC₁ = 14.90%; MC₂ = 16.10%; MC₃ = 17.90%;AC/C₁₂₀ = 16.00%;

[20]Wrong way: NPV_M = 730,570; NPV_Z = 753,608; NPV_A = 516,011; Correct way: NPV_M = 1,848,629; NPV_Z = 753,608