The salesman from Superfast Machines claims that if you trade-in your old machine for one of his new machines, you could save your company $60,000 a year. As his new machine costs $120,000 after the trade-in, the investment pays for itself in 2 years. Since the machine has a life of 3 years and a salvage value of $30,000, the salesman claims that this deal lets you use the machine for free in year 3 as well as receiving a $30,000 when the machine is sold. Having learnt about capital budgeting techniques, you are quite skeptical of his claims. Use the data below to do your own sums. • Cost of new machine $120,000 • Salvage value of machine at end of life $30,000 • Useful life 3 years • Operating cost savings $60,000 (excluding depreciation) from new machine • Depreciation policy Depreciate to zero
You have also obtained the following financial information regarding the company and the market.
Shares • Issued 2,000,000 shares. • Current share price = $10 • Company just paid a dividend of $1.20 per share. Dividends are expected to be maintained at this level for the foreseeable future. • Beta of shares = 1.0

Bonds • Issued 20,000, 5% coupon bonds with par value of $1,000 with remaining maturity of 10 years. • Bonds are currently selling at the par value.
Market • 10-year Treasury bond yield = 4% • 10-year AAA bond yield = 4.5% • 10-year AA bond yield = 5% • Expected return of the stock market = 12% • Corporate tax rate = 20% (a) Compute the cost of equity, cost of debt and the weighted average cost of capital.
(b) Explain which capital budgeting method the salesman is using when he claims that the machine pays for itself in 2 years. (c) Calculate the operating cash flows related to this project.
(d) Calculate the cash flows from assets for the project.
(e) Determine whether the machine should be bought.
(f) Discuss two (2) advantages of using the NPV versus the payback period.

A Business Dilemma

Subway, the fast food restaurant franchise, announced in early 2018 it planned to bring back the “$5 Footlong” promotion. Hundreds of Subway franchise owners protested the promotion saying that they cannot afford to sell the footlong sub sandwiches for $5. You'll want to review the Subway webpage featured in the Chapter 8 module.

Assume that the costs related to a Subway footlong and a Subway franchise include the following

Question #1:  Bob owns a subway franchise and he is furious at the thought of offering $5.00 footlongs. His comment was “they cost us $5.41 each so we will be upside down on each sub sold. I’ll lose my shirt!”. Do you agree or disagree with Bob that this idea should be immediately rejected without any further analysis? If you don’t agree with Bob, why do you think further analysis is required?  

Question #2: What are the relevant and irrelevant costs in this pricing decision? (hint: there are 6 relevant costs)

Question #3: Can you think of any other reasons/factors besides the costs listed above that might be relevant to the pricing decision to offer the $5.00 footlongs? Use your imagination.

Ghost, Inc., has no debt outstanding and a total market value of $273,600. Earnings before interest and taxes, EBIT, are projected to be $43,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 17 percent higher. If there is a recession, then EBIT will be 28 percent lower. The company is considering a $145,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,600 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0 and the stock price remains constant.

c-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) Assume the firm has a tax rate of 21 percent.  

c-2. Calculate the percentage changes in ROE when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

c-3. Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

c-4. Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

The Rivoli Company has no debt outstanding, and its financial position is given by the following data: Assets (Market value = Book value) $3,000,000 EBIT $500,000 Cost of equity, rS 10% Stock price, P0 $15 Shares outstanding, n0 200,000 Tax rate, T 40% Unlevered beta 1.0 The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 30% debt based on market values, its cost of equity, rS, will increase to 11% to reflect the increased risk. Bonds can be sold at a cost, rd, of 7%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time. a) What effect would this use of leverage have on the value of the firm? Calculate the value of the company with a new level of debt. Also, calculate the value of equity and debt in U.S. dollars. b) The problem provides the new cost of equity. Use the cost of equity formula of M&M Proposition II with taxes to show that the new cost of equity is approximately 11%. c) What would be the price of Rivoli’s stock after announcing the recapitalization? d) Calculate the number of shares purchased during the recapitalization, the number of remaining shares outstanding. Also, prove that market capitalization of equity is equal to the number of shares outstanding times the price per share you calculated from part (c). Your answer to this question (market capitalization of equity) should be equal to the value of equity you calculated in part (a). e) What happens to the firm’s earnings per share after the recapitalization? Calculate EPS before and after the recapitalization. f) Calculate the beta of the company after the recapitalization (with debt), using the Hamada formula. g) The $500,000 EBIT given previously is actually the expected value from the following probability distribution: Probability EBIT 0.1 ($100,000) 0.2 200,000 0.4 500,000 0.2 800,000 0.1 1,100,000 Determine the times-interest-earned ratio for each probability. What is the probability of not covering the interest payment at the 30% debt level?

MAT 117 Problem Set 1                               Name: ___________________________

Directions: Show all work and explain your thinking as you solve these problems or write the explanations. Each problem is worth five points.

1. Below are definitions of different math number concepts. Write the concept that goes with each description. (no explanation needed for this problem only).

2. Explain the difference between the expressions 6x⁰ and (6x)⁰. If there is no difference, explain why.

Grading: 2 points: Worked out Problem Mathematically; 3 points: Explanation

3. For a recent year, the United States consumed about 1.0 x 10⁴ of petroleum per second. (Source: U.S. Energy Information Administration)

How many gallons of petroleum did the United States use that year?

Show work for all intermittent steps and Explain each step used to get your answer.

Grading: 1 point: Correct Answer; 2 points: Work; 2 points: Explanation

4. State whether the following statement is true and explain why or why not: A trinomial is always a higher degree than a monomial. Give an example proving your answer is correct.

Grading: 2 points: Correct Answer; 2 points: Explanation; 1 point: Example

5. Explain why x+ 7 is a polynomial, but x+7 is not a polynomial.

Grading: 5 points: Complete explanation

Smoky Mountain Corporation makes two types of hiking boots—Xtreme and the Pathfinder. Data concerning these two product lines appear below:   

The company has a traditional costing system in which manufacturing overhead is applied to units based on direct labor-hours. Data concerning manufacturing overhead and direct labor-hours for the upcoming year appear below:    

Required:

1. Compute the product margins for the Xtreme and the Pathfinder products under the company’s traditional costing system. (Do not round your intermediate calculations.)

2. The company is considering replacing its traditional costing system with an activity-based costing system that would assign its manufacturing overhead to the following four activity cost pools (the Other cost pool includes organization-sustaining costs and idle capacity costs):   
   .

Compute the product margins for the Xtreme and the Pathfinder products under the activity-based costing system. (Negative product margins should be indicated with a minus sign. Round your intermediate calculations to 2 decimal places.)

3. Prepare a quantitative comparison of the traditional and activity-based cost assignments. (Do not round intermediate calculations. Round your "Percentage" answer to 1 decimal place. (i.e. .1234 should be entered as 12.3))

The Rivoli Company has no debt outstanding, and its financial position is given by the following data:

The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 30% debt based on market values, its cost of equity, rS, will increase to 11% to reflect the increased risk. Bonds can be sold at a cost, rd, of 7%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time.

a) What effect would this use of leverage have on the value of the firm? Calculate the value of the company with the new level of debt. Also, calculate the value of equity and debt in U.S. dollars.

b) The problem provides the new cost of equity. Use the cost of equity formula of M&M Proposition II with taxes to show that the new cost of equity is approximately 11%.

c) What would be the price of Rivoli’s stock after announcing the recapitalization?

d) Calculate the number of shares purchased during the recapitalization, the number of remaining shares outstanding. Also, prove that market capitalization of equity is equal to the number of shares outstanding times the price per share you calculated from part (c). Your answer to this question (market capitalization of equity) should be equal to the value of equity you calculated in part (a).

e) What happens to the firm’s earnings per share after the recapitalization? Calculate EPS before and after the recapitalization.

f) Calculate the beta of the company after the recapitalization (with debt), using the Hamada formula.

g) The $500,000 EBIT given previously is actually the expected value from the following probability distribution:

Determine the times-interest-earned ratio for each probability. What is the probability of not covering the interest payment at the 30% debt level?

You are a pension fund manager looking for an investment that will provide a reliable stream of income over the next 5 years. You want to find the best yield possible while still conforming to the pension fund covenant of investing in investment grade bonds or better. Decide among the following investment options for your fund.

a. Eastern Telecommunications Inc.: 5 years, 10% yield, EBIT Interest Coverage ratio = 4.4, EBITDA interest coverage ratio = 5.8, total debt of $72,625,000 (all of which is long term), total equity of $175,000,000, and a return on equity (ROE) of 7.9%.

b. Anderson Nuclear Power: 5 years, 15% yield, EBIT Interest Coverage ratio = 0.75, EBITDA interest coverage ratio = 0.9, total debt of $48,000,000, total equity of $70,000,000, and a return on capital (ROE) of 7.8%.

c. Titan Tech Company: 5 years, 6% yield, EBIT Interest Coverage ratio = 24.1, EBITDA interest coverage ratio = 30.5, total debt of $90,000,000 (all of which is long term), total equity of $1,500,000,000, and a return on equity (ROE) of 19.9%.

The following table shows the three-year median ratios for U.S. Industrials with long-term debt. Use the table to discuss the pros and cons of each investment option, described above. Determine the grade of each bond (as closely as you can). Which bond is appropriate for your pension fund?

Answer:

a. Eastern Telecommunications Inc.:

b. Anderson Nuclear Power:

c. Titan Tech Company

d. Summary recommendation:

A full-service car wash has an automated exterior conveyor car wash system that does the initial cleaning in a few minutes. However, once the car is through the system, car wash workers hand clean the inside and the outside of the car for approximately 15 to 25 additional minutes. There are enough workers to handle four cars at once during this stage. On a busy day with good weather, the car wash can handle up to 150 cars in a 12-hour time period. However, on rainy days or on certain days of the year, business is slow. Suppose 50 days of work are randomly sampled from the car wash’s records and the number of cars washed each day is recorded. A stem-and-leaf plot of this output is constructed and is given below. Study the plot and write a few sentences describing the number of cars washed per day over this period of work. Note that the stem-and-leaf display is from Minitab, the stems are in the middle column, each leaf is only one digit and is shown in the right column, and the numbers in the left column are cumulative frequencies up to the median and then decumulative thereafter.

From the stem and leaf display, the original raw data can be obtained. For example, the fewest number of cars washed on any given day are ____. The most cars washed on any given day are _____. The modal stems are 3, 4, and 10 in which there are ___ days with each of these numbers. Studying the left column of the Minitab output, it is evident that the median number of cars washed is ____. There are only ___ days in which 90 some cars are washed (90 and 95) and only _____ days in which 130 some cars are washed (133 and 137).

In 2015, the Keenan Company paid dividends totaling $3,810,000 on net income of $20 million. Note that 2015 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 4%. However, in 2016, earnings are expected to jump to $32 million and the firm expects to have profitable investment opportunities of $14.6 million. It is predicted that Keenan will not be able to maintain the 2016 level of earnings growth because the high 2016 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2016, the company will return to its previous 4% growth rate. Keenan's target capital structure is 40% debt and 60% equity.

1. 
   Calculate Keenan's total dividends for 2016 assuming that it follows each of the following policies: (Write out your answers completely. For example, 25 million should be entered as 25,000,000.)
   1. Its 2016 dividend payment is set to force dividends to grow at the long-run growth rate in earnings. Round your answer to the nearest cent.
      $
   2. 
      
   3. It continues the 2015 dividend payout ratio. Round your answer to the nearest cent. Do not round intermediate calculations.
      $
   4. 
      
   5. It uses a pure residual dividend policy (40% of the $14.6 million investment is financed with debt and 60% with common equity). Round your answer to the nearest cent.
      $
   6. 
      
   7. It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual dividend policy. Round your answer to the nearest cent.

1. Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2016 and to have the dividend grow at 4% after 2016. The stock's total market value is $180 million. What is the company's cost of equity? Round your answer to two decimal places.
   %
2. What is Keenan's long-run average return on equity? [Hint: g = Retention rate x ROE = (1.0 - Payout rate)(ROE).] Do not round intermediate calculations. Round your answer to two decimal places.
   
   %