Question

Homework Assignment III (Due on May3, 2018)

• Answer All Questions

• Show all your work (use of formula, etc.) in solving the problems. You still need to show your work even if you use the financial calculator to get the answers. (Please show all work and do not use excel)

1. Drill Mart Inc. is considering a new product launch. The project will cost $1,200,000 have a eight-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 24,000 units per year; price per unit will be $250, variable costs per unit will be $150 and fixed costs will be $400,000 per year. The required return on the project is 14 percent, and tax rate = 0% (i.e., ignore taxes). a. What is the accounting break-even level of output for this project? b. Find the firm’s operating cash flow (OCF) if the firm just breaks-even on an accounting basis (that is, at Q = accounting break-even level).   c. What is the cash break-even level of output for this project? d. How many units, at a minimum, must Drill Mart sell before the project’s NPV becomes negative? e. The marketing department of Drill Mart reports the annual expected sales of 7,000 units. Shall Drill Mart accept this project? Why? Calculate NPV and IRR at this level of sales (7,000 units).

2. At an output level of 2,000 units, you calculate that the degree of operating leverage is 3. Fixed costs are $35,000. (a) If output rises to 2,500 units, calculate the percentage change in OCF, new OCF and new DOL. (b) If output falls to 1,500 units, calculate the percentage change in OCF, new OCF and new DOL. (hint: start by finding the OCF at 2,000 units using DOL equation of 1+ FC/OCF)

3. Forrest Corporation has 500,000 shares of common stock, 10,000 shares of preferred stock, and 5,000 bonds with 8 percent (coupon) outstanding. The common stock currently sells for $25 per share and has a beta of 0.95. Preferred stocks pay a dividend of $8 per share and currently sell for $98 with a floatation cost of $2 per share. The bonds have par value of $1,000, 20 years to maturity, currently sell for 102.5 percent of par, and the coupons are paid semiannually. The bond’s floatation cost is 1% of the current market price. The expected return on market portfolio is 9 percent, T-bills are yielding 2 percent, and the tax rate is 35 percent. What is the firm’s market value capital structure? If Forrest is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should the firm use to discount the project’s cash flows?

4. Finance, Inc., currently has no debt outstanding and has a total market value (equity) of $200,000. EBIT is projected to be $15,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 40 percent higher. If there is a recession, then EBIT will be 50 percent lower. Finance is considering a $60,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes. a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession. b. Repeat part (a) assuming that Finance goes through with recapitalization. What do you observe? (Explain it in terms of percentage change in EPS in both cases: without debt and with debt) c. Find the break-even EBIT. Find the EPS under both cases at break-even EBIT.

Answer 1

Question 1:

a.Accounting break even = Fixed cost/(sales price - variable cost) = 400,000/(250-150) = 4,000 units

b. OCF at break even will be zero. becuase Revenue will be equal too fixed cost plus variable cost. Since there are no taxes, depreciation will have no tax savings. So OCF at breakeven level =0

c.

c. Cash break even takes place at 5,500 units as shown below:

Year	0	1	2	3	4	5	6	7	8
Initial Cost	-1200000
Sales		1375000	1375000	1375000	1375000	1375000	1375000	1375000	1375000
Variable Cost		-825000	-825000	-825000	-825000	-825000	-825000	-825000	-825000
Fixed Cost		-400000	-400000	-400000	-400000	-400000	-400000	-400000	-400000
Cash flow	-1200000	150000	150000	150000	150000	150000	150000	150000	150000
Cash break even	0

At 5,500 units cash flow will be 150,000 per year. For 8 years, this will make the cash flows equal to initial cost of 1,200,000

Cash break even= 5,500

d. By trail and error at 6088 units, the NPV beomes negative. So number of units to be produced before NPV beocmes negative is 6089

d. NPV and IRR at 7000 units of sale is shown as below

Year	0	1	2	3	4	5	6	7	8
Initial Cost	-1200000
Sales		1750000	1750000	1750000	1750000	1750000	1750000	1750000	1750000
Variable Cost		-1050000	-1050000	-1050000	-1050000	-1050000	-1050000	-1050000	-1050000
Fixed Cost		-400000	-400000	-400000	-400000	-400000	-400000	-400000	-400000
Cash flow	-1200000	300000	300000	300000	300000	300000	300000	300000	300000
NPV	$523,991.68
IRR	18.62%

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