[1] (10 points) RATIO ANALYSIS

Describe a scenario when it is necessary to calculat e both the times interest earned coverage ratio and the debt to asset ratio in o rder to get an accurate picture of a firm’s debt situation. In other words, des cribe a scenario in which the firm might look "safe" using one ratio b ut "risky" using the other.

[2] (15 points) RATIO ANALYSIS

{a} Illustrate with a scenario why it could be decei ving if, when analyzing a company's debt position, you looked only at either the debt ratio or the times interest coverage ratio but not both. In other words, why is it necessary to examine both ratios in order to accurately assess a firm' s debt position?

{b} Illustrate with a scenario why it could be deceiving if, when analyzing a company's liquidity position, you looked only at either the cu rrent ratio or the acid test (quick ratio) but not both. In other words, why is it necessary to examine both ratios in order to accurately assess a firm's liqu idity position?

[3] (30 points) TIME VALUE OF MONEY

You would like to be able to withdraw $100 a year in perpetuity starting on February 27, 2008. To accomplish this, you plan to make 6 equal deposits starting today and continuing through 2002 into an account that you expect to pay 8% interest forever.

You make the 6 deposits as planned. On February 27, 2004 the interest rate switches to 12% and stays at that rate forever. You make the pla nned $100 withdrawals on February 27, 2008 and 2009. After making the 2009 with drawal it dawns on you that because of the unexpected increase in the interest r ate, you have more in the account than you actually need to make the rest of the $100 withdrawals. You decide to splurge by taking the excess amount out of the account and going on a trip that same day.

How much do you have to spend on the trip?
 

[4] (30 points) TIME VALUE OF MONEY

Former Fin 225 TA Dale Falcinelli, now a successful b usiness consultant, decides to establish an endowed chair at Lehigh. He PLANS t o make five equal annual deposits for the next five years starting today, Octobe r 1996, into an account in Lehigh's name paying 10% interest. The deposits must be of sufficient size to enable Lehigh to withdraw $80,000 a year starting on O ctober 2006 and continuing in perpetuity.

After making the first four deposits (96, 97, 98 and 99) Mr. Falcinelli decides he was a bit hasty in his generosity and decides to not make the final deposit in 2000. A year later, October 2001, he tells Lehigh that he wants to change the purpose of the gift to one of student aid. He wants Lehigh to be able to provide Falcinelli Scholarships of $80,000 a year for ten years s tarting in October 2006.
 

Mr. Falcinelli knows that by October 2001 the account probabl y already has more than enough in it to support the ten years of scholarships. Therefore, he wants to take some of his money out of the endowment so he can buy more suits. He needs your help in determining the maximum amount he can remove from the account in October 2001 and still be able to endow the ten years worth of $80,000 Falcinelli Scholarships.

[5] (20 points) EFFECTIVE RATES

You decide to purchase a Macarena GT for $150,000 by putting $50,000 down and financing the remainder. You can borrow the money from the dealer and make five years of quarterly payments of $8,718.46 or from Jim P almer and make five years of monthly payments. Palmer charges an APR of 24.227% .

{a} What is the effective annual rate of both loans?

{b} What is the total annual payment of both loans?

{c} Which is the better deal for you to take? Explain!

[6] (20 points) EFFECTIVE RATES

This summer you get a job as a salesperson at "F ast Louie’s" used car lot. On your first day at work a customer comes into to buy a car and needs to borrow $10,000. You tell him you can lend him the $10 ,000 but that Louie requires monthly payments of $400 for 4 years. He tells you that 12 times $400 is $4,800 a year and that is an interest rate of 48% on the $10,000 loan.

{a} You explain to him that there is plenty wrong with his c alculation. Carefully explain what mistake(s) the customer is making?

{b} You tell him that the APR is actually X%. What is X?

{c} You tell him that the effective annual rate is actually Y%. What is Y?

[7] (40 points) CAPITAL BUDGETING -- CERTAINTY

{a} Bunky’s Burgers, Inc. is considering replacing a piece o f its equipment with a new improved model. The existing equipment was purchased 2 years ago for $80,000 and is being depreciated to a salvage value to $10,000 using the straight-line method over an expected life of 7 years. The proposed n ew equipment has a purchase price of $160,000 and would be depreciated to a zero salvage value over a life of 5 years also using the straight-line method. The new equipment would be expected to increase annual sales by $30,000; it would re quire additional net-working-capital of $5,000. Bunky’s has a marginal tax rate of 40% and a required rate of return of 12%. There is not a well-defined secon dary market for used equipment of this type so Bunky’s is unsure as to how much it would receive today if it sells the existing equipment.

Calculate the minimum amount that Bunky’s would have to recei ve from the sale of the old equipment for the replacement to provide a 12% retur n.

{b} How is the MIRR an improvement over the traditional IRR?

[8] (35 points) CAPITAL BUDGETING -- CERTAINTY

Bunky's Burgers is considering replacing a piece of old equipment with a new more efficient model. The existing equipment has a boo k value of $40,000 and is being depreciated straight line to a zero salvage valu e over a remaining life of 5 years. The new piece of equipment would cost $110, 000 and be depreciated straight line to a salvage value of $10,000 over an expec ted life of 5 years. The new machinery would require additional net working cap ital (primarily spare parts inventory) of $20,000 but would reduce annual operat ing costs by $30,000. Bunky's could scrap the existing machinery today for $30, 000. The firm uses a hurdle rate of 10% to evaluate projects.

At this point Bunky's is unsure about pending changes in the corporate tax rate. What is the highest tax rate that Bunky's could pay and sti ll find the replacement a wise decision?

[9] (35 points) CAPITAL BUDGETING -- UNCERTAINTY

Bunky's Burgers is contemplating purchasing a new piece of equipment and needs your financial expertise. The machine would cost $1,000,000 and would be depreciated using the straight-line method to a salvage value of $100,000 ov er its depreciable life of 10 years. The firm has made the following for ecast of revenues less operating expenses for each year:
 
 

The purchase would also require additional net-working-capital of $50,000 which would be returned to firm at the end of the machine's useful life. Bunky's m arginal tax rate is 40%.

The firm uses the risk-adjusted discount rate method for making its capital budgeting decisions and selects its hurdle rate from the table below:

It may be more efficient calculatorwise if you read both {a} and {b} first and calculate the required discount rates of both {a} and {b} before beginning the final NPV calculation.

{a} Compute the expected risk-adjusted NPV if there is a 30% chance that the machine will actually last only 6 years and be scrapped for $150,000 and a 70% chance that it could actually last 15 years and scrapped for nothi ng.

{b} Recompute your answer assuming that Bunky's is a well-diversified firm a nd uses the "Beta Model" to select its risk-adjusted discount rate. Assume that the risk-free interest rate is 4%, the market's risk premium is 5.5% and the fi rm estimates a beta of 1.8.

[10] (40 points) CAPITAL BUDGETING -- UNCERTAINTY

Bunky’s Burgers, Inc. is considering the purchase of a new piece of equipment. It would cost $660,000 and be depreciated over a life of 10 years to a salvage value of $60,000 using the straight-line method. If t he purchase is made, Bunky’s estimates the following probability distribution of revenues over expenses for each year:
 
 

Bunky’s uses the risk-adjusted discount rate when making a ca pital budgeting decision and selects its required return based upon the coeffici ent of variation of cash flows from this table:
 
 

Bunky’s has a marginal tax rate of 30% and the new investment would require additional net working capital of $20,000.

{a} Calculate the NPV of the investment if there is a 50% ch ance the equipment will actually last only 6 years and a 50% chance it will actu ally last 15 years.

{b} Suppose that instead of using the risk-adjusted discount rate approach, Bunky’s uses the "Beta Model" for selecting its hurdle rate. Assume the risk-free rate is 5%, the investment’s beta is 2 and the mark et’s risk-premium over and above the risk-free rate is 7%. Calculate the NPV if the information in {a} still holds.

{c} Explain the circumstances under which Bunky’s should use the Beta Model; i.e., must Bunky’s be diversified or just in one or two lines o f business? What is systematic risk and what is unsystematic risk? Which does beta account for and what happens to the other one?

[11] (20 points) CAPM & OPERATING LEVERAGE

{a} k' = R_f + B (k_m - R_f)

What does this mean? Define each term and explain what the equation is sayin g and how it should be used by a firm.

{b} Explain the concept of operating leverage. Why is it important for a fi rm to know its operating leverage?

[12] (15 points) TERM STRUCTURE

{a} Draw and explain an downward sloping yield curve. Explain what its shap e suggests about investors' expectations of future interest rates. Assuming a d ownward sloping yield curve, why might some issuers decide to issue short -term securities? Why might other issuers decide to issue long-term secu rities?

{b} Explain what would happen to the downward sloping curve if an overwhelmi ng majority of investors decide to buy short-term securities and hardly a nyone wants to buy long-term bonds.

[13] (30 points) TERM STRUCTURE

{a} Draw a downward sloping term structure of intere st rates. Carefully label the axes.

{b} Fully explain what the shape of the curve suggests about investors’ expectations of future interest rate movements; i. e., do they expec t rates to rise or fall in the future? Explain how you arrived at your answer.< /P>

{c} The firm that you’re interning at this summer is contemp lating issuing new bonds and they seek your advice on the maturity it should sel ect. Fully explain the pros and cons of issuing long-term bonds versus short-te rm bonds given the downward shape and investors’ expectations. Include what mig ht be the best strategy if interest rates do fall but also what might be the bes t strategy if rates should rise.

[14] (30 points) CONVERTIBLE BOND VALUATION

On October 31, 1986 you purchase a subordinated debenture of Oshkosh B'Gosh that has an annual yield to maturity of 15%, compounded semiannually. The bond has an annual coupon rate of 14% payable semiannually and is scheduled to mature on October 30, 2011.

{a} Suppose that today (October 31, 1996) the yield to maturity on 25 year b onds has declined to 10% and on 15 year bonds to 9.5%, compounded semiannually. You decide to sell the bond at the going market price. Compute your annual r ate of return over the 10 years that you held the bond.

{b} Suppose that bond has a convertible feature that enables the holder to convert into Oshkosh B'Gosh's common stock at a conversion price of $25 a share. Today the stock is selling for $35 a share. Recompute your annual rate of retu rn over the 10 years that you held the bond if you exercise the option.

{c1} Suppose that the bond is callable at 1070 but that it does NOT have the convertible feature of part {b}. Compute your annual return if Oshkosh B'Gosh calls the bonds.

{c2} Suppose that in order to raise the funds necessary for the call, the firm plans to issue new 15 year bonds at par (see part {a} for prevailing market r ates). Compute the IRR of the firm's decision to refinance its debt; ignore any tax effect. [Hint: for this "project", what is the outlay to buy up each old bond, and what will the firm save per old bond per year?]

[15] (30 points) BOND VALUATION (a&b), NORMAL GROWTH STOCK VALUATION (c)

In March 1991 you buy a bond issued by Oshkosh B’Gosh that has an annual coupon rate of 15%, payable semiannually. The bond has a face value of $1,000 and matures in March 2021. At the time of purchase, the yiel d to maturity on comparable securities is 17%, compounded semiannually.

{a} If you sell the bond in March 1997 when the market yield on 30 year bonds is 12% and on 24 year bonds is 10%. Assume the bond is not callable. Calculate the rate of return you earned over the 6 years.

{b} Now assume that the bond is callable at 1075 and that th e same market rates of {a} apply. Calculate the rate of return you earned over t he 6 year period if the firm exercises its call option.

{b1} Explain why investors did or did not welcome the call.

{c} Now assume that the bond is convertible into Oshkosh sto ck at a conversion price of $40 a share. You exercise your option and convert a t the end of six years. The stock is expected to pay a dividend (D1) of $12.00 per share. Earnings and dividends are expected to grow at a constant rate of 2% for the indefinite future and the market’s required return for this type of com mon stock is 22%. Calculate the rate of return you earned over the 6 year period .

[16] (35 points) SUPER GROWTH – EQUITY VALUATION

Today you purchase 100 shares of the convertible preferred stock of Mattman I ndustries. The preferred stock has a par value of $50, a dividend rate of 12% a nd is convertible into Mattman's common stock at a conversion ratio of 1 share o f preferred for 2.5 shares of common. At the time of purchase the market's rate of return on this type of convertible preferred is 9%. Also at the time of pur chase you forecast the following for the common stock: earnings and dividends w ill grow at 30% for the next 8 years and then at 7% for the indefinite future. Yesterday, Mattman paid a dividend on its common of $.50 and the market's rate of return on this type of common is 17%.

If you hold on to your preferred stock for 6 years and then convert, compute the rate of return you earned on your preferred stock over the 6 year period if your forecasts come true.

[17] (30 points) SUPER GROWTH – EQUITY VALUATION

Four years ago you purchased a share of Bunky's B urgers newly issued convertible preferred stock at par ($100). The preferred st ock pays an annual dividend of $5.00 and is convertible into 4.5 shares of Bunky 's common stock. At the time of your purchase, Bunky's common stock earnings an d dividends were expected to increase for four years at a 15% annual rate and th en decline at a 15% rate for another four years before stabilizing at a positive rate of 3%. The day before your preferred stock purchase the firm paid a commo n stock dividend of $6.00 per share.

{a} Calculate the price of Bunky's common stock as of today assuming that the market requires a rate of return of 15% on the common stock an d the forecasts of four years ago are accurate.

{b} Calculate the rate of return you earned over the four ye ar period if today you convert the preferred stock to common stock.

[18] (65 points) COST OF CAPITAL

The Solution to this problem is detailed in the Cost of Capital review notes.

On January 1, 1997 Bunky's Burgers, Inc. is planning its yearly capit al budget and is faced with a list of 5 potential independent proposals:
 
 

The firm's capital structure relations shown below are considered optimal and will be maintained:

Debt                     $120,000,000
Preferred Stock     20,000,000
    Common Stock                         24,000,000
    Retained Earnings                    36,000,000
Common Equity     60,000,000

==========

TOTAL CLAIMS $200,000,000

The firm has a marginal tax rate of 35% and has $4,500,000 from internal sour ces of equity available for investment. Four years ago Bunky's paid a common sto ck dividend of $5.545 a share. Yesterday they paid a dividend of $7.00. Assume that this dividend growth rate continues for the indefinite future. The common stock is currently priced to produce a dividend yield (based on the next d ividend) of 18%.

Bunky's can raise new funds under the following conditions:

BONDS: (Up to $24,000,000) New 20 year $1000 par value bonds carryin g a coupon of 12 per cent (payable annually) are priced to yield the investor 10 % a year. Flotation costs total $70.27 per bond.

(Beyond $24,000,000) A second issue of 20 year 12 per cent coupon bonds can be sold to yield the investor 14% a year. Flotation costs total $67.54.

PREFERRED STOCK: Any size issue of new preferred stock can be sold t o yield the investor 16%. Underwriters charge a fee of 20% of the selling pri ce.

COMMON STOCK: Issuing up to $7,500,000 of new common stock requires u nderpricing and flotation costs equal to 20% of the stock's price. Beyond $7,50 0,000 requires flotation costs equal to 30% of the selling price.
 

{a} Which projects should Bunky's accept? Your analysis must include the ca lculation of the marginal cost of capital along all of the various segments. CLEARLY display your MCC and IRR results on a CAREFULLY labeled L ARGE graph. (Carry all calculations to four decimal places; e.g., .1234 or 12.34%).

{b} What is the weighted average cost of capital for the capital budget you are advocating in part {a}?

{c} Compute the NPV of project B. Assume uniform cash flows and a life of 6 years.

{d} If Bunky's cost of equity is so much more than its cost of debt, how can it think raising nearly half of its funds from equity is "optimal"?

[19] (50 points)COST OF CAPITAL

Mattman Industries is planning i ts forthcoming capital budget and needs your advice. The firm's capital structu re relations shown below are believed to be optimal and will be maintained.

Debt                     $120,000,000
Preferred Stock      20,000,000
                    Common Stock             $20,000,000
                     Retained Earnings         40,000,000
Common Equity      60,000,000
----------------

TOTAL CLAIMS $200,000,000

The firm's common stock is currently trading for $100 per share. Three years ago yesterday the firm paid a dividend of $6.103 and yesterday it paid a di vidend of $7.477. Assume the growth rate in dividends is constant and continues for the indefinite future. Mattman’s marginal tax rate is 45%. The firm has $ 3,000,000 available from retained earnings for investment this year. New securities can be sold under the following conditions:

DEBT: Up to $12,000,000 of 20 year debentures carrying a 9% coupon (paid annually) can be sold for $1000. Flotation costs total $85.14.

Beyond $12,000,000 20 year debentures carrying an 11% coupon (paid annually) are sold for $1010.45 with flotation costs totalling $85.14.

PREFERRED STOCK: Up to $2,000,000 of $50 par value preferred stock carrying a 15% dividend rate can be sold for $60.00 with the firm netting $57.69.

Beyond $2,000,000 the stock is still sold for $60.00 but the firm only nets $50.00.

COMMON STOCK: Up to $9,000,000 new stock can be sold with underpricin g and flotation costs of $20.00. Beyond $9,000,000 the underpricing and costs rise to $27.27.

The following is a list of potential investments that the firm is considering:

PROJECT OUTLAY IRR%

A $20,000,000 11.4
B 10,000,000 10.1
C 8,000,000 12.8
D 12,000,000 14.7

{a} Calculate the 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 yo u are advocating.

{c} Compute the NPV of project B assuming a life of 6 years and uniform annu al cash flows.

[20] (20 points) OPTIMAL CAPITAL STRUCTURE

{a} Explain why the cost of retained earnings is not zero; i.e., why are they not considered free?

{b} Explain what will happen to the k₀ of Mattman Industries (problem 2) and why it will happen if their present capital structur e really is optimal as stated and they decide to instead use 80% debt.

3.  After 2 withdrawals, $1536.75 available  Need only 833.33   Trip = 703.42
4.  Planned deposits  = 81,364.28   Max withdrawals = 121,164.30
5.  EAR(dealer) = 26.2% payments = 34,873.84   EAR(Palmer) = 27.1%  payments =34,679.85
6.  APR = 36.69%  EAR = 43.54%
7.  DCF = 26,800   Outlay = 141,000 - .6MV   MktValue = 78,715
8.  DCF = 30000-18000t   Outlay = 100,000-10,000t   t = 55.55%
9.
10.  DCF = 298,000 s=81333  cv=.27  k'=12%  Term CF = 110,000 NPV(6)=600,928.81
       DCF (12-15) = 280,000  s=81333 k'=12%  NPV(15) = 1,337,574.57
       NPV'(6) = 374,849  NPV'(15) = 767,470  k' = .05+2(.07) = 19%
14.
15.
16. P(8) =  43.64, Pcs(6) = $37.54  Conversion value = 37.54x2.5 = $93.86  P(pf'd) = $66.67,  irr = 13.80%
17.
18.  Breaks:  D=40, P=none, Eq=15 and 40; ki1=7.00%, ki2=9.90%, kp=20%, ke=24%, kn1=28.50%
        kn2=31.72%; MCC(0-15)=13.40%, MCC(15-40)=14.75%, MCC(40+)=17.46%; ACC(30)=14.08%;
        NPV(B)=$1,747,636  (CF of B) = $2,465,624
19.  Breaks:  D=20, P=20, Eq=10 and 40  k(e)=15%  MCC(10-20)=9.7%  ACC(40)=9.98%
       DCF = 2,302,807  NPV(B) = -218,470