[1] (10 points) RATIO ANALYSIS
When analyzing a firm, you notice its current ratio is right on the industry norm. Why is it a good idea to also compute its acid test ratio before extending the firm credit?
 

[2] (20 points) RATIO ANALYSIS  Solution
As a summer intern working for a loan shark, you devise your own rule of thumb for measuring a potential borrower's risk. Your risk factor index (RFI) takes into account the firm's debt ratio (DR) expressed as a percentage and its times interest earned coverage ratio (TIE). The higher the RFI, the greater the firm's predicted likelihood of default.

Your equation is RFI = 100 + 3(DR) - 10(TIE).

Here are some partial balance sheet and income statement items for Bunky's Burgers, Inc.:

{a} Compute the RFI for Bunky's.

{b} Explain why the coefficient of DR is positive and the coefficient of TIE is negative.
 

[3] (20 points) EFFECTIVE RATES  Solution
You have two choices of where to borrow $30,000 for four years:

Jim Palmer of The Money Store will lend you the $30,000 and require 48 equal monthly payments. Jim says he charges "an APR of 12%, compounded monthly".

Ace Falcinelli, who conducts business out of his raincoat under the Hill-to-Hill Bridge, will lend you the $30,000 and require 8 equal semi-annual payments of $4,850. Ace has no clue as to what his APR is.

For each loan, compute the APR, the EAR and the total amount of interest you would pay over the life of the loan. Who gets your business, Jim or Ace and why?
 

[4] (20 points) EFFECTIVE RATES  Solution
You are thinking of buying a car for $35,000 and the dealer offers you two alternative financing plans:
Plan A would loan you $35,000 for 2.5 years at an APR of 12% compounded monthly. You would repay the loan with 30 equal installments.
Plan B would loan you $35,000 for 2.5 years. You would make five semi-annual payments of $8,195.

{a} Calculate the total amount you would have to repay over the life of each loan.

{b} Calculate the effective rate of each loan.

{c} Which loan should you accept and why? Fully explain how this conflict between the two sets of answers arises.
 

[5] (10 points) PV-FV TIME LINE  Solution
Your rich uncle is back. He gives you $100 today, your 20th birthday, and tells you he intends to give you $100 on your 21st, 22nd, 23rd, 24th and 25th birthdays as well. Someday you want to buy a new stereo with the money so you put this gift and subsequent gifts in your savings account which earns 5% a year. On your 23rd birthday right after receiving the 4th check in the mail, your stereo ironically dies. You need to replace it immediately. Your brother offers to give you a lump sum if you will sign over the uncle's two remaining checks to him when they come in. But the problem is that your brother demands a 12% annual rate of return for his generosity. Afraid that your huge Barry Manilow CD collection will go to waste, you reluctantly agree. What's the most expensive stereo you can buy on your 23rd birthday?
 

[6] (30 points) PV-FV TIME LINE  Solution
Your daughter is going to go to start college on October 5, 2013. The annual tuition today is $28,000. You expect to pay a constant annual tuition on October 5, 2013, 14, 15 and 16. The rate of inflation applied to tuition between now and 2013 is 4% a year. For simplicity, you should assume that tuition will remain constant for the four years at the 2013 rate.

You PLAN to make eight equal annual deposits starting today and running through October 05, 2007 that will be sufficient to pay the expected tuition.

After having made the first six deposits as planned, you learn that tuition will actually be $60,000 a year for the four years. Two more of the original planned deposits will not be enough to pay the four years of tuition. Instead of the last two planned deposits, you decide to deposit $X on October 2006 and $3X on October 2007.

Find the minimum amount of X necessary to pay the four $60,000 tuition bills. Assume a rate of return of 8% a year.
 

[7] (30 points) PV-FV TIME LINE  Solution
On February 20, 2001 Dale Falcinelli makes the first of what he expects to be 8 equal annual deposits (last one on February 20, 2008) into an investment account. The deposits must be of sufficient size to enable Mr. Falcinelli to withdraw $2,000 each year in perpetuity starting on February 20, 2013. When he started making the deposits, he assumed that the investment would earn 8% interest only up to February 20, 2005 and just 5% thereafter.

As it turns out, Mr. Falcinelli made all 8 originally planned deposits but the account actually paid 8% interest through February 20, 2008 and then dropped to 5% thereafter. On February 20, 2010 he decides to make only 10 withdrawals of $2,000 each starting on February 20, 2013 rather than the originally planned infinite number. If the investment continues to earn 5% after 2008, how much money can he withdraw on February 20, 2010 if he opts for the 10 withdrawals rather than the infinite number.
 

[8] (30 points) CAPITAL BUDGETING  Solution
Bunky's Burgers, Inc. is contemplating replacing some existing equipment with some new hardware. The existing equipment, carried on the books at $800,000, is being depreciated using the straight-line method to a salvage value of $80,000 over its remaining life of 8 years. Bunky's could scrap the equipment today for $900,000.

The new machinery would also be depreciated using the straight-line method to a salvage value of 20% of its purchase price over an expected life of 8 years. The new equipment would be expected to lower annual operating expenses by $750,000. The new machinery would require additional net-working-capital of $160,000. Bunky's has a required return of 12% and a marginal tax rate of 40%.

Find the maximum amount that the firm would be willing to pay for the new equipment if replacement is to be worthwhile.
 

[9] (30 points) CAPITAL BUDGETING  Solution
Emmo's Inc. is currently using a piece of equipment that originally cost the firm $660,000 ten years ago. This machine is being depreciated over a 15-year life using the straight-line method to a salvage value of $60,000. The firm's marginal tax rate is 40% and it has a required rate of return of 12%.

Emmo's is considering the purchase of a new model to replace the existing one. The new machine has a purchase price of $300,000 and is forecasted to lower annual operating expenses by $50,000. It would be depreciated over an expected 5-year life using the straight-line method to a zero salvage value. The replacement would require additional net working capital of $20,000. What is the minimum price the firm would need to receive from selling the old machine today in order for the replacement to be favorable?
 

[10] (40 points) CAPITAL BUDGETING UNDER RISK  Solution
Bunky's Burgers is contemplating the purchase of a nuclear french fryer and needs your advice. The fryer would cost $800,000 and be depreciated over a 10 year life to a zero salvage value using the straight-line method. If the fryer is purchased, Bunky's estimates the following probability distribution of revenues less pre-tax expenses for each year:
 

Bunky's is a non-diversified firm and uses the risk-adjusted discount rate approach when making a capital budgeting decision and selects its required return based upon the coefficient of variation of cash flows from the following table:

Bunky's has a marginal tax rate of 40% and the fryer would require an additional $80,000 in net working capital. Bunky's is unsure as to how long the fryer will actually last.

{a} Calculate the expected NPV of the purchase if there is a 70% chance the fryer will actually last 6 years (with a market value of $100,000) and a 30% chance it will actually last 15 years (with a market value of $0). Should Bunky's buy the nuclear fryer?

{b} Suppose that instead of using the risk-adjusted discount rate approach, Bunky's was a well-diversified firm that used the "Beta Model" for selecting its hurdle rate. Assume the risk-free rate is 4%, the fryer's beta is 1.8 and the market's risk premium is 5.5%. Should Bunky's buy the
nuclear fryer?

[11] (50 points) CAPITAL BUDGETING UNDER RISK  Solution
Al's Stuff, Inc. is contemplating the purchase of a new piece of equipment that would cost $500,000. The equipment would be depreciated over a life of 8 years to a zero salvage value using the straight-line method. Al's forecasts the following probability distributions for revenues over operating expenses for each year:

The firm has a marginal tax rate of 40% and the new investment would require additional net working capital of $40,000. Assume there is a 30% chance that the equipment will actually last only 6 years with a scrap value of $80,000 and a 70% chance that it will last 16 years with a scrap value of zero.

Additional information:

The risk-free rate of interest is 4%, the investment beta is 1.4 and the market's risk-premium over and above the risk-free rate is 6%. ??is the certainty equivalents coefficient is selected from the above table. Assume that the a for all non-operating cash flows is 1.0.

{a} If Al's is not diversified and the new equipment is for use in the firm's only line of business, calculate the expected value of the risk-adjusted NPV of the decision to buy the new equipment. Clearly and completely explain why you chose your approach to account for risk. Does your method consider systematic and/or unsystematic risk? If so, why; if not, why not?

{b} If Al's is a very diversified conglomerate with interests in many different industries, calculate the expected value of the risk-adjusted NPV of the decision to buy the new equipment. Clearly explain why you chose your approach to account for risk. Clearly and completely explain why you chose your approach to account for risk. Does your method consider systematic and/or unsystematic risk? If so, why; if not, why not?
 

[12] (25 points) LEVERAGE
The owners of the San Francisco Giants baseball team are going to renegotiate the contracts of all of the players during the upcoming winter. The owners are considering three alternative ways of compensating the players.

Plan [A] is a fixed sum of $70 million.

Plan [B] is a fixed sum of $35 million plus $17.50 for each fan who attends a game.

Plan [C] is $35.00 for each fan who attends a game.

Funds to pay these salaries will be raised through a loan with a fixed interest cost of $10,000,000. The owners know that they receive an average of $60 (treat this as PRICE) for each fan attending a game from the purchase of a ticket, refreshments and souvenirs and that last season's attendance was approximately 2 million people.

Assuming that the Giants' "product" is a seat at the ballpark that it sells for $60, and that there are no other costs involved, compute the following:

{a} The degree of operating leverage at an attendance of 2 million fans for each of the three plans.

{b} What does the degree of operating leverage for Plan A and 2 million fans computed in {a} mean; i. e., what is its significance of the coefficient you calculated?

{c} What are the pros and cons of the three plans?
 

[13] (20 points) LEVERAGE  Solution
The Suave Suede Company sells its only product, a sheepskin coat for $3,000 each. The production process is highly labor intensive with almost the entire coat being hand cut and stitched by a single craftsmen. Currently the company's very skilled craftsmen are paid on a finished coat basis. Current variable costs (including labor) per coat are $1200 and total fixed operating costs for the company are $4,000,000. Fixed interest charges are $500,000.

Suave Suede is contemplating a change in how it pays its craftsmen. If they are each paid a guaranteed fixed annual salary, total fixed operating costs will rise to $6,400,000 but variable costs per coat will drop to only $400 a coat.

{a} Compute the degree of operating leverage at a sales level of $9,000,000 under both the present pay system and the proposed new one.

{b} Explain why there is a difference between your two values in {a}.

{c} How does the forecasted volatility of future years' sales impact Suave Suede's decision?
 

[14] (10 points) CALLABLE BONDS
What is the "call feature" that is attached to some corporate bonds? What is the "cost" to the firm of using one? How does this "cost" change as the level of interest rates changes?
 

[15] (25 points) BOND VALUATION - CONVERTIBLE AND CALLABLE BONDS Solution
On November 2, 1995 you purchased a subordinated debenture of McDonald's. The bond, which matures on November 2, 2020, has an annual coupon rate of 8%, payable semi-annually, and a face value of $1000. The bond is priced to produce an annual yield to maturity of 12%, compounded semi-annually. On November 2, 2000 you sell the bond for its market value. The market yield to maturity is 6% a year compounded semi-annually on 20 year bonds and 6.5% on 25 year bonds. Initially assume that the bond is neither callable nor convertible.

{a} Compute the rate of return you earned between 1995 and today, November 2, 2000.

{b} Compute the rate of return you would have earned between 1995 and today if you converted the bond. The conversion price is $50 a share and the stock is currently selling for $64 a share.
 

[16] (30 points) BOND VALUATION - CONVERTIBLE AND CALLABLE BONDS Solution
Bunky's Burgers has some outstanding $1000 par value subordinated debentures that mature in 25 years. The bonds have an annual coupon rate of 13%, payable semiannually. The debentures are neither callable nor convertible.

{a} Suppose you buy a bond today for the market price of $900. What is the bond's yield to maturity?

{b} Suppose you hold the bond for 9 years and then sell it in the open market. The yield to maturity 9 years from now is 11% for 16 year bonds and 13% for 25 year bonds. Compute the annual rate of return you earned over the 9 year period.

{c} Now assume that the bond is callable at a price of $1065 and also convertible into Bunky's common stock at a price of $40 a share. Suppose that 9 years from today the stock is trading at $48.50 a share and the firm calls the bond. What rate of return did you earn over the 9 year period if you follow the better course of action?
 

[17] (30 points) SUPERGROWTH EQUITY VALUATION - CONVERTIBLE BONDS Solution
You buy a bond today, November 30, 2000, for $900. The $1,000 par value bond has an annual coupon rate of 12%, payable semiannually. It matures in 20 years and is convertible into the firm's common stock at a conversion price of $100 a share. Today you read a forecast that the growth rate of the firm's earnings and dividends will be 30% a year for another 10 years before declining to a 6% rate for the indefinite future. Suppose you hold the bond for 6 years and then convert. If the firm paid a dividend of $1.20 yesterday and the forecasts are still accurate in 2006, compute the IRR you earn over the 6 year period. Assume that stockholders require a 16% rate of return on the firm's common stock.
 

[18] (35 points)  SUPERGROWTH EQUITY VALUATION - CONVERTIBLE BONDS   Solution
Today, April 26, 2001, you buy a $1,000 par value bond for $900. The annual coupon rate is 12%, payable semiannually. The bond is convertible into the firm's stock at a conversion price of $10 a share. At the time of purchase you forecast that the firm's dividends will decline at 10% per year for 8 years. Thereafter, dividends will remain constant for the indefinite future. Yesterday the firm paid a dividend of $4.00 a share. Stockholders require a 16% rate of return on the stock.

If you hold the stock for 3 years and convert, calculate the rate of return you earned over the 3-year holding period.
 

[19] (70 points) - Test date is November 30, 2000 COST OF CAPITAL Solution
Mattman.com is planning its 2001 capital budget and needs your advice. The firm believes that the capital relations shown below are optimal and will be maintained.

Debt $700,000,000
Preferred Stock 50,000,000
Common Equity 250,000,000
--------------
TOTAL CLAIMS $1,000,000,000

The firm has a marginal tax rate of 40% and has $12,500,000 of retained earnings available for investment this year. On November 29, 1997 Mattman paid a dividend of $7.108 on its common stock. Yesterday it paid a dividend of $7.767. The stock is currently selling for $50 a share. Assume that this growth rate continues indefinitely. The firm can raise funds under these conditions:

BONDS: Up to $14,000,000 in new $1,000 par value perpetual bonds carrying a 10% coupon (paid annually) can be sold to net the firm $1,111.11. An additional $21,000,000 of perpetual bonds carrying an 11% coupon can be sold to net the firm $1,000. Any additional bonds would carry a coupon of 12% and the net proceeds would total $857.14.
PREFERRED STOCK: Any size issue of $50 par preferred stock can be sold for $60 a share. Flotation costs total $6.67 a share and the dividend rate is 16%.
COMMON STOCK: Up to $10,000,000 in new common stock can be sold with underpricing and flotation costs of $5.56 a share. Any additional shares can be sold with underpricing and flotation costs of $11.90 a share.

The firm is considering five potential projects with the following forecasted cash flows:

{a} Compute Mattman's marginal cost of capital for each segment of the marginal cost schedule.
{b} Clearly demonstrate using a CLEARLY LABELED graph which projects are acceptable and compute the average cost of capital for the capital budget you are advocating.
{c} Calculate the IRR of project Z.
{d} Why is Mattman accepting a project whose IRR is less than the rate of return that shareholders require?
{e} Calculate the NPV of project B. Clearly indicate your analysis - what numbers are you using and why?
 

[20] (65 points) COST OF CAPITAL  Solution
FogCat.com is planning its investment and financing decisions for the forthcoming fiscal year and needs some of your expert advice. FogCat.com has a marginal tax rate of 40%. Four years ago the firm paid a dividend per share of $2.00 and yesterday (April 25, 2001) it paid a dividend of $2.431. This rate of growth is expected to continue for the indefinite future. The common stock's dividend yield (based on next year's dividend) is 17%. The firm has $15,000,000 from retained earnings available for investment this year. The firm will raise funds using the following proportions which it considers to be optimal: debt 65%, preferred stock 5% and common equity 30%. If those percentages are maintained, new securities can be raised under the following conditions:

BONDS: Up to $19,500,000 in new perpetual bonds carrying a 12% coupon rate can be sold for $1,000 with flotation costs of $76.92 per bond. Any perpetual bonds beyond $19.5 million will carry a 14% coupon and be sold at par with the same $76.92 flotation costs.

PREFERRED STOCK: $50 par value preferred stock carrying a 15% dividend rate can sold for $45 a share with the firm netting $41.67.

COMMON STOCK: New common stock can be sold with flotation costs and underpricing of $2.235 a share.

FogCat.com has the following slate of potential investment projects:

{a} Calculate the marginal cost of capital for each of the segments of its cost of capital schedule. Clearly display your cost of capital on a graph.

{b} Plot FogCat.com's IRR schedule on the same graph. Which projects are accepted?

{c} Calculate the average cost of capital for the capital budget advocated in part {b}.

{d} Calculate the NPV for project C. Assume a life of 6 years and uniform annual cash flows.

{e} If the cost of equity is so much greater than the cost of debt, why does the firm still insist on getting 30% of its funds from retained earnings or new common stock?
 
 

[1] Much of its current assets could be inventory which would not bring book value if it needed to be liquidated in a hurry.

[2] DR = 135/450; TIE = 49.5/4.5; RFI = 80; as DR rises, RFI rises and as TIE rises, RFI falls

[3] Palmer: R=$790.02; total interest = $7,920.72; EAR = 12.68%; Falcinelli: rate per period = 6.0989%; APR = 12.198%; EAR = 12.57%; total interest = $8,800

[4] Plan A: R = $1356.18; total = 40,685.52; EAR = 12.68%; Plan B: total = 40,975.00; rate per period = 5.49%; EAR = 11.29%; choose B with a lower EAR

[5] Stereo = $600.02

[6] Tuition = $46,622.02; Deposit = $9,880.43; X = $12,428.31

[7] needs $40,000 at 2012; D = $3,309.40; needs 14,007.68 at 2010 but has 38,808.95 so W = 24,801.27

[8] DCF = 414,000 + .04MV; outlay = MV - 700,000; NPV = 0; MV = $3,870,707.51

[9] outlay = 216,000 - .6MV; DCF = 38,000; NPV=0; MV = $169,525.96

[11] (a) OL = 3.86 and OL = 5.57

[15](a) P₉₅ = $684.76; P₀₀ = 1231.15; r = 21.37%/yr, comp sa; (b) conversion value = 1280; r = 22.06%/yr, comp sa.

[16] P = 899.68; if P=900, yield = 14.49%.yr; P=1149.04, yield = 15.93%/yr; conv value = 1212.50; r = 16.72%/yr

[17] Conv value = 1279.01; P₁₀ = 175.36; IRR = 17.57%/yr.

[18] P₃ = 12.38; P₈=10.76; r = 22.74%/yr

[19] k_i1=.054, k_i2=.066; k_p= .15; k_e=.19, k_n1=.21; MC₁=.093; MC₄=.126; IRR_z=.16; ACC_6,000,000=10.13%; NPV_B=2,015,502

[20] k_i1=.078, k_i2=.091; k_p=.180; k_e=.22; k_n=.25; MC₁12.57%; MC₃=14.32%; ACC₄₀=12.78%; CF_c = 5,003,065; NPV_c=-475,284