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Forecasted Statements and Ratios Upton Computers makes bulk purchases of small computers, stocks them in conveniently located warehouses, ships them to its chain of retail stores, and has a staff to advise customers and help them set up their new computers. Upton's balance sheet as of December 31, 2016, is shown here (millions of dollars):
Sales for 2016 were $450 million and net income for the year was $13.5 million, so the firm's profit margin was 3.0%. Upton paid dividends of $5.4 million to common stockholders, so its payout ratio was 40%. Its tax rate was 40%, and it operated at full capacity. Assume that all assets/sales ratios, (spontaneous liabilities)/sales ratios, the profit margin, and the payout ratio remain constant in 2017. Do not round intermediate calculations.
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In: Finance
Johnson Enterprises’s stock is currently selling for $25.67 per share, and the firm expects its per-share dividend to be $2.35 in one year. Analysts project the firm’s growth rate to be constant at 7.27%. Using the cost of equity using the discounted cash flow (or dividend growth) approach, what is Johnson’s cost of internal equity?
22.17%
20.53%
17.24%
16.42%
It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF or DG approach. In general, there are three available methods to generate such an estimate:
| • | Carry forward a historical realized growth rate, and apply it to the future. |
| • | Locate and apply an expected future growth rate prepared and published by security analysts. |
| • | Use the retention growth model. |
Suppose Johnson is currently distributing 45% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 24%. Johnson’s estimated growth rate is %.
In: Finance
The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk.
Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address.
Consider the case of Turnbull Co.
Turnbull Co. has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 8.2%, and its cost of preferred stock is 9.3%.
If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.4%. However, if it is necessary to raise new common equity, it will carry a cost of 14.2%.
If its current tax rate is 40%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings? (Note: Round your intermediate calculations to two decimal places.)
0.92%
1.10%
1.01%
1.20%
Turnbull Co. is considering a project that requires an initial investment of $270,000. The firm will raise the $270,000 in capital by issuing $100,000 of debt at a before-tax cost of 10.2%, $30,000 of preferred stock at a cost of 11.4%, and $140,000 of equity at a cost of 14.3%. The firm faces a tax rate of 40%. What will be the WACC for this project? (Note: Round your intermediate calculations to three decimal places.)
Consider the case of Kuhn Co.
Kuhn Co. is considering a new project that will require an initial investment of $4 million. It has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. Kuhn has noncallable bonds outstanding that mature in five years with a face value of $1,000, an annual coupon rate of 10%, and a market price of $1,050.76. The yield on the company’s current bonds is a good approximation of the yield on any new bonds that it issues. The company can sell shares of preferred stock that pay an annual dividend of $8 at a price of $95.70 per share.
Kuhn does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $22.35 per share, and it is expected to pay a dividend of $1.36 at the end of next year. Flotation costs will represent 3% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 8.7%, and they face a tax rate of 40%. What will be the WACC for this project? (Note: Round your intermediate calculations to two decimal places.)
In: Finance
Moerdyk Corporation's bonds have a 15-year maturity, a 5.25% coupon rate with interest paid semiannually, and a par value of $1,000. The nominal required rate of return on these bonds is 6.50%. What is the bond’s intrinsic value? Enter your answer rounded to two decimal places. Do not enter $ or comma in the answer box. For example, if your answer is $12,300.456 then enter as 12300.46 in the answer box.
In: Finance
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National Business Machine Co. (NBM) has $4.9 million of extra cash after taxes have been paid. NBM has two choices to make use of this cash. One alternative is to invest the cash in financial assets. The resulting investment income will be paid out as a special dividend at the end of three years. In this case, the firm can invest in either Treasury bills yielding 2.7 percent or a 5.1 percent preferred stock. IRS regulations allow the company to exclude from taxable income 50 percent of the dividends received from investing in another company’s stock. Another alternative is to pay out the cash now as dividends. This would allow the shareholders to invest on their own in Treasury bills with the same yield or in preferred stock. The corporate tax rate is 24 percent. Assume the investor has a 28 percent personal income tax rate, which is applied to interest income and preferred stock dividends. The personal dividend tax rate is 20 percent on common stock dividends. |
| Suppose the company reinvests the $4.9 million and pays a dividend in three years. | |
| a-1. |
What is the total aftertax cash flow to shareholders if the company invests in T-bills? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.) |
| a-2. | What is the total aftertax cash flow to shareholders if the company invests in preferred stock? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.) |
| Suppose instead that the company pays a $4.9 million dividend now and the shareholder reinvests the dividend for three years. | |
| b-1. | What is the total aftertax cash flow to shareholders if the shareholder invests in T-bills? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.) |
| b-2. | What is the total aftertax cash flow to shareholders if the shareholder invests in preferred stock? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.) |
In: Finance
Assume that you are considering the purchase of a 30 year bond with an annual coupon rate of 7.50%. The bond has a face value of $1,000 and makes semiannual interest payments. If you require a 5.75% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for this bond?
In: Finance
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After completing its capital spending for the year, Carlson Manufacturing has $2,700 of extra cash. The company’s managers must choose between investing the cash in Treasury bonds that yield 3.7 percent or paying the cash out to investors who would invest in the bonds themselves. |
| a. |
If the corporate tax rate is 22 percent, what personal tax rate would make the investors equally willing to receive the dividend or to let the company invest the money? (Do not round intermediate calculations and enter your answer as a percent rounded to the nearest whole number, e.g., 32.) |
| b. | Is the answer to (a) reasonable? |
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| c. |
Suppose the only investment choice is a preferred stock that yields 5.9 percent. The corporate dividend exclusion of 50 percent applies. What personal tax rate will make the stockholders indifferent to the outcome of the company’s dividend decision? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) |
| d. | Is this a compelling argument for a low dividend payout ratio? |
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In: Finance
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Geary Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $691,200 is estimated to result in $230,400 in annual pretax cost savings. The press falls in the MACRS five-year class (MACRS Table), and it will have a salvage value at the end of the project of $100,800. The press also requires an initial investment in spare parts inventory of $28,800, along with an additional $4,320 in inventory for each succeeding year of the project. |
| Required : |
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If the shop's tax rate is 34 percent and its discount rate is 14 percent, what is the NPV for this project? (Do not round your intermediate calculations.) |
In: Finance
Marsha Jones has bought a used Mercedes horse transporter for
her Connecticut estate. It cost $43,000. The object is to save on
horse transporter rentals.
Marsha had been renting a transporter every other week for $208 per
day plus $1.40 per mile. Most of the trips are 80 or 100 miles in
total. Marsha usually gives Joe Laminitis, the driver, a $35 tip.
With the new transporter she will only have to pay for diesel fuel
and maintenance, at about $0.53 per mile. Insurance costs for
Marsha’s transporter are $1,600 per year.
The transporter will probably be worth $23,000 (in real terms)
after eight years, when Marsha’s horse Spike will be ready to
retire. Assume a nominal discount rate of 9% and a 2% forecasted
inflation rate. Marsha’s transporter is a personal outlay, not a
business or financial investment, so taxes can be ignored.
Calculate the NPV of the investment.
In: Finance
1- Commonwealth Construction (CC) needs $3 million of assets to get started, and it expects to have a basic earning power ratio of 30%. CC will own no securities, all of its income will be operating income. If it so chooses, CC can finance up to 40% of its assets with debt, which will have a 12% interest rate. If it chooses to use debt, the firm will finance using only debt and common equity, so no preferred stock will be used.
Assuming a 25% tax rate on taxable income, what is the difference between CC's expected ROE if it finances these assets with 40% debt versus its expected ROE if it finances these assets entirely with common stock? Round your answer to two decimal places.
2- Assume the following relationships for the Caulder Corp.:
Sales/Total assets 2.2×
Return on assets (ROA) 4.0%
Return on equity (ROE) 9.0%
Calculate Caulder's profit margin and debt-to-capital ratio assuming the firm uses only debt and common equity, so total assets equal total invested capital. Do not round intermediate calculations. Round your answers to two decimal places. Profit margin: % Debt-to-capital ratio: %
In: Finance
You are considering making a movie. The movie is expected to cost $ 10.3 million upfront and take a year to make. After that, it is expected to make $ 4.4 million in the first year it is released (end of year 2) and $ 1.9 million for the following four years (end of years 3 through 6) . What is the payback period of this investment? If you require a payback period of two years, will you make the movie? What is the NPV of the movie if the cost of capital is 10.1 % ? According to the NPV rule, should you make this movie? What is the payback period of this investment?
In: Finance
Currently, Atlas Tours has $6.04 million in assets. This is a peak six-month period. During the other six months, temporary current assets drop to $480,000.
| Temporary current assets | $1,280,000 | |
| Permanent current assets | 1,960,000 | |
| Capital assets | 2,800,000 | |
| Total assets | $6,040,000 | |
Short-term rates are 5 percent. Long-term rates are 7 percent.
Annual earnings before interest and taxes are $1,160,000. The tax
rate is 38 percent.
a. If the assets are perfectly hedged throughout
the year, what will earnings after taxes be? (Enter answers
in whole dollar, not in million.)
Earnings after taxes $
b. If short-term interest rates increase to 7 percent when assets are at their lowest level, what will earnings after taxes be? For an example of perfectly hedged plans, see Figure 6–8
Earnings after taxes $
In: Finance
Glucose Scan Incorporated (GSI) currently sells its latest glucose monitor, the Glucoscan 3000, to diabetic patients for $129. GSI plans on lowering their price next year to $99 per unit. The cost of goods sold for each Glucoscan unit is $50, and GSI expects to sell 100,000 units over the next year. (1) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales over the next year by 35% to 135,000 units. What is the incremental impact of this price drop on the firms EBIT? (Hint: EBIT=Sales-COGS) (3 points) (2) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales over the next year by 35% to 135,000 units. Also suppose that for each Glucoscan monitor sold, GSI expects additional sales of $100 per year on glucose testing strips and these strips have a gross profit margin of 70%. Considering the increase in the sale of testing strips, what is the incremental impact of this price drop on the firms EBIT? (Hint: EBIT=Sales-COGS) (3 points)
In: Finance
Finally examine how each measure relates to excess returns and the relevant risk. In your analysis make a comparison between two of the four performance measures which would best be applicable in an economy slowly recovering from recession.
Jenson Alpha
Sharpe
Treynor or another other measure
In: Finance
You are considering making a movie. The movie is expected to cost $ 10.9 million upfront and take a year to make. After that, it is expected to make $ 4.8 million in the first year it is released (end of year 2) and $ 1.8 million for the following four years (end of years 3 through 6) . What is the payback period of this investment? If you require a payback period of two years, will you make the movie? What is the NPV of the movie if the cost of capital is 10.5 % ? According to the NPV rule, should you make this movie? What is the payback period of this investment?
In: Finance