Part A

You are thinking of purchasing a house. The house costs $350,000. You have $50,000 in cash that you can use as a down payment on the house, but you need to borrow rest of the purchase price. The bank is offering a 20-year mortgage that requires monthly payments and has an annual interest rate of 5% per year. Determine your monthly payments if you sign up for this mortgage. Draw the amortization schedule, monthly, using Excel. Calculate the total amount of interest paid throughout the life of the loan. Create a graph depicting the changes in the portions of interest and principal for each monthly payment throughout the life of the loan. Identify the period of the break-even point, where the principal and interest payment amounts are equal.

Part B

Suppose you can only afford a monthly mortgage payment of $3,000 per month, would you purchase this house, if the interest rate increases to 7% per year and the length of repayment decreases to 15 years? Explain. Draw the new amortization schedule in a separate Excel sheet. Calculate the total amount of interest paid throughout the life of the loan. Even though the interest rate is higher, can the total amount of interest paid for the life of the loan be less than the total interest paid in the first amortization schedule? If so, by how much less? Explain.

For the most recent fiscal year, book value of long-term debt at Schlumberger was $14969 million. The market value of this long-term debt is approximately equal to its book value. Schlumberger’s share price currently is $54.64. The company has 1,000 million shares outstanding.

Managers at Schlumberger estimate that the yield to maturity on any new bonds issued by the company will be 8.66%. Schlumberger’s marginal tax rate would be 35%.

Schlumberger’s beta is 0.83. Suppose that the expected return on the market portfolio is 8% and the risk-free rate is 2%.

Assume that the company will not change its capital structure. Also assume that the business risk of the projects under consideration is about the same as the business risk of Schlumberger as a whole.

What would Schlumberger’s after-tax WACC be, given this information?

Do not round at intermediate steps in your calculation. Express your answer in percent. Round to two decimal places. Do not type the % symbol.

MGM CO. has been approached to bid on a contract to sell 500 voice recognition(VR) computer keyboards per year for four years. Due to technological improvements, beyond that time they will be outdated, and no sales will be possible. The equipment necessary for the production will cost $3 million and will be depreciated on a straight-line basis to a zero-salvage value. Production will require an investment in net working capital of $395,000 to be returned at the end of the project, and the equipment can be sold for $305,000 at the end of production. Fixed costs are $570,000 at the end of the production. Fixed costs are 570,000 per year, and variable cost are $75 per unit. In addition to the contract, you feel your company can sell 11,400, 13500, 17900, and 10400 additional units to companies in other countries over the next four years, respectively, at the price of $180. This price is fixed. The tax rate is 21 percent, and the required return is 12 percent. Additionally, the president of the company will undertake the project only

if it has an NPV of $ 120,000. What bid price should you set for the contract?

Solve with Pro Forma Income Statement

Singal Inc. is preparing its cash budget. It expects to have sales of $30,000 in January, $35,000 in February, and $20,000 in March. If 20% of sales are for cash, 40% are credit sales paid in the month after the sale, and another 40% are credit sales paid 2 months after the sale, what are the expected cash receipts for March?

Consider fixed-for-fixed currency swap. Firm A is a U.S.-based multinational. Firm B is a U.K.-based multinational. Firm A wants to finance a £2 million expansion in Great Britain. Firm B wants to finance a $4 million expansion in the U.S. The spot exchange rate is £1.00 = $2.00. Firm A can borrow dollars at 10 percent and pounds sterling at 12 percent. Firm B can borrow dollars at 9 percent and pounds sterling at 11 percent. Which of the following swaps is mutually beneficial to each party and meets their financing needs? Neither party should face exchange rate risk.

1. There is no mutually beneficial swap that has neither party facing exchange rate risk.

2. Firm A should borrow $4 million in dollars, pay 11 percent in pounds to Firm B, who in turn borrows 2 million pounds and pays 8 percent in dollars to A.

3. Firm A should borrow $2 million in dollars, pay 11 percent in pounds to Firm B, who in turn borrows 4 million pounds and pays 8 percent in dollars to A.

4. Firm A should borrow $4 million in dollars, pay 11 percent in pounds to Firm B, who in turn borrows 2 million pounds and pays 10 percent in dollars to A.

Consider a project to supply Detroit with 25,000 tons of machine screws annually for automobile production. You will need an initial $4,500,000 investment in threading equipment to get the project started; the project will last for 5 years. The accounting department estimates that annual fixed costs will be $1,075,000 and that variable costs should be $200 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the 5-year project life. It also estimates a salvage value of $450,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $302 per ton. The engineering department estimates you will need an initial net working capital investment of $430,000. You require a return of 11 percent and face a tax rate of 22 percent on this project. Calculate the accounting, cash, and financial break-even quantities.

Consider a project to supply Detroit with 27,000 tons of machine screws annually for automobile production. You will need an initial $6,000,000 investment in threading equipment to get the project started; the project will last for 6 years. The accounting department estimates that annual fixed costs will be $1,450,000 and that variable costs should be $275 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the 6-year project life. It also estimates a salvage value of $825,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $392 per ton. The engineering department estimates you will need an initial net working capital investment of $580,000. You require a return of 11 percent and face a tax rate of 22 percent on this project. a-1. What is the estimated OCF for this project? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) a-2. What is the estimated NPV for this project? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b. Suppose you believe that the accounting department’s initial cost and salvage value projections are accurate only to within ±15 percent; the marketing department’s price estimate is accurate only to within ±10 percent; and the engineering department’s net working capital estimate is accurate only to within ±5 percent. What are your worst-case and best-case NPVs for this project?

Determine Grounds Keeper’s capital structure and working capital.

Grounds Keeper Consolidated Balance Sheets (Dollars in thousands) 2012 2011 Assets Current assets: Cash and cash equivalents 78,240 44,395 Receivables 399,891 340,062 Inventories 844,737 736,677 Total current assets 1,322,868 1,121,133 Fixed assets, net 1,244,384 889,613 Other long-term assets 1,048,537 1,187,141 Total assets 3,615,789 3,197,887 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable 309,222 319,465 Accruals 201,017 145,240 Notes payable 9,748 6,669 Total current liabilities 519987 471374 Long-term debt 834574 814298 Total liabilities 1,354,561 1,285,672 Stockholders’ equity: Common stock, $0.10 par value: 15,268 15,447 Additional paid-in capital 1,464,560 1,499,616 Retained earnings 781400 397152 Total stockholders’ equity 2,261,228 1,912,215 Total liabilities and stockholders’ equity 3,615,789 3,197,887 Grounds Keeper Consolidated Statements of Operations (Dollars in thousands except per share data) 2012 2011 Net sales 3,889,426 2,642,390 Cost of sales 2,589,799 1,746,274 Gross profit 1,299,627 896,116 Selling and operating expenses 481,493 348,696 General and administrative expenses 219,010 187,016 Operating income 599,124 360,404 Interest expense 22,983 57,657 Income before income taxes 576,141 302,747 Income tax expense 212,641 101,699 Net Income 363,500 201,048 Basic income per share: Average shares outstanding 154,933,948 146,214,860 Earnings per common share

If Grounds Keeper has a required rate of return on its long-term debt of 9% (before taxes) and a required rate of return on its common stock (of 16%?, {not positive this is correct}), a tax rate of 40%, what is its weighted average cost of capital (WACC) for 2012? How could Grounds Keeper lower its WACC? (HINT: you will need to look at the balance sheet to determine the weight of debt to equity.

Grounds Keeper Consolidated Balance Sheets (Dollars in thousands) 2012 2011 Assets Current assets: Cash and cash equivalents 78,240 44,395 Receivables 399,891 340,062 Inventories 844,737 736,677 Total current assets 1,322,868 1,121,133 Fixed assets, net 1,244,384 889,613 Other long-term assets 1,048,537 1,187,141 Total assets 3,615,789 3,197,887 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable 309,222 319,465 Accruals 201,017 145,240 Notes payable 9,748 6,669 Total current liabilities 519987 471374 Long-term debt 834574 814298 Total liabilities 1,354,561 1,285,672 Stockholders’ equity: Common stock, $0.10 par value: 15,268 15,447 Additional paid-in capital 1,464,560 1,499,616 Retained earnings 781400 397152 Total stockholders’ equity 2,261,228 1,912,215 Total liabilities and stockholders’ equity 3,615,789 3,197,887   Grounds Keeper Consolidated Statements of Operations (Dollars in thousands except per share data) 2012 2011 Net sales 3,889,426 2,642,390 Cost of sales 2,589,799 1,746,274 Gross profit 1,299,627 896,116 Selling and operating expenses 481,493 348,696 General and administrative expenses 219,010 187,016 Operating income 599,124 360,404 Interest expense 22,983 57,657 Income before income taxes 576,141 302,747 Income tax expense 212,641 101,699 Net Income 363,500 201,048 Basic income per share: Average shares outstanding 154,933,948 146,214,860 Earnings per common share 2.35 1.38

MGM Co. had decided to sell a new line of golf clubs. The clubs will sell for $850 per set and have a variable cost of $400 per set. The company has spent $300,000 for a marketing study that determined the company will sell 68,500 sets per year for seven years. The marketing study also determined that the company will lose sales of 12,400 sets of its high-priced clubs. The high-priced clubs sell at $1,200 and have variable costs of $660. The company will also increase sales of its cheap clubs by 14,400 sets. The cheap clubs sell for $420 and have variable costs of $210 per set. The fixed costs each year will be $10,400,000. The company has also spent $2,500,000 on research and development for the new clubs. The plant and equipment required will cost $38,500,000 and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of $2,900,000 that will be returned at the end of the project. The tax rate is 21 percent, and the cost of the capital is 12 percent.

Suppose you feel that the values are accurate to within ±10 percent. What are the best-case and worst-case NPVs? (Hint: The price and variable costs for the two existing sets of clubs are known with certainty; only the sales gained or lost are uncertain.)

Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm plans to maintain a 40% debt-to-assets ratio. Rentz's interest rate is currently 9% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level are under consideration: (1) a restricted policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 12% of total sales, and the federal-plus-state tax rate is 40%.

What is the expected return on equity under each current assets level? Round your answers to two decimal places.

A. Restricted policy

B. Moderate policy

C. Relaxed policy

Aasir can invest his money in risk-free asset and/or in a fund F. The risk-free asset provides a guaranteed return of 4%. The fund F provides expected return of 12% with

volatility of 25%. If Aasir wants to limit his risk to no more than 20%, what is the highest expected return he can earn? If Aasir wants an expected return of at least 16%, what is the

minimum possible volatility of his portfolio?

MGM Co. has been approached to bid on a contract to sell 5,000 voice recognition (VR) computer keyboards per year for four years. Due to technological improvements, beyond that time they will be outdated and no sales will be possible. The equipment necessary for the production will cost $3million and will be depreciated on a straight-line basis to a zero-salvage value. Production will require an investment in net working capital of $395,000 to be returned at the end of the project, and the equipment can be sold for $305,000 at the end of production. Fixed costs are $570,000 per year, and variable costs are $75 per unit. In addition to the contract, you feel your company can sell 11,400, 13,500, 17,900, and 10,400 additional units to companies in other countries over the next four years, respectively, at a price of $180. This price is fixed. The tax rate is 21 percent, and the required return is 12 percent. Additionally, the president of the company will undertake the project only if it has an NPV of $120,000. What bid price should you set for the contract?

principles of corporate finance chapter 9

1. Suppose a firm uses its company cost of capital to evaluate all projects. Will it underestimate or overestimate the value of high-risk projects?

2. A company is 40% financed by risk-free debt. The interest rate is 10%, the expected market risk premium is 8%, and the beta of the company’s common stock is .5. What is the company cost of capital? What is the after-tax WACC, assuming that the company pays tax at a 35% rate?

4. Define the following terms: a. Cost of debt b. Cost of equity c. After-tax WACC d. Equity beta e. Asset beta f. Pure-play comparable g. Certainty equivalent

5. Asset betas EZCUBE Corp. is 50% financed with long-term bonds and 50% with common equity. The debt securities have a beta of .15. The company’s equity beta is 1.25. What is EZCUBE’s asset beta?

9. True or false?

a. The company cost of capital is the correct discount rate for all projects because the high risks of some projects are offset by the low risk of other projects.

b. Distant cash flows are riskier than near-term cash flows. Therefore long-term projects require higher risk-adjusted discount rates.

c. Adding fudge factors to discount rates undervalues long-lived projects compared with quick-payoff projects.

10. A project has a forecasted cash flow of $110 in year 1 and $121 in year 2. The interest rate is 5%, the estimated risk premium on the market is 10%, and the project has a beta of .5. If you use a constant risk-adjusted discount rate, what is a. The PV of the project? b. The certainty-equivalent cash flow in year 1 and year 2? c. The ratio of the certainty-equivalent cash flows to the expected cash flows in years 1 and 2?

12. Nero Violins has the following capital structure:

a. What is the firm’s asset beta? (Hint: What is the beta of a portfolio of all the firm’s securities?) b. Assume that the CAPM is correct. What discount rate should Nero set for investments that expand the scale of its operations without changing its asset beta? Assume a risk-free interest rate of 5% and a market risk premium of 6%.

16. What types of firms need to estimate industry asset betas? How would such a firm make the estimate? Describe the process step by step.

17. Binomial Tree Farm’s financing includes $5 million of bank loans. Its common equity is shown in Binomial’s Annual Report at $6.67 million. It has 500,000 shares of common stock outstanding, which trade on the Wichita Stock Exchange at $18 per share. What debt ratio should Binomial use to calculate its WACC or asset beta? Explain.

Prepare a pro forma income statement, balance sheet, and cash flow statement for Kiwi Fruit assuming a 10 percent increase in sales. (Leave no cells blank - be certain to enter "0" wherever required. Negative amounts should be indicated by a minus sign. Input all amounts as thousands of dollars. Round earnings per share to 2 decimal places. Omit the "$" sign in your response.)