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.
   
   %

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.)

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.)

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))

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. (Round your intermediate calculations to 2 decimal places.)

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" answers to 1 decimal place. (i.e. .1234 should be entered as 12.3))

Question 3
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.

Debt: 4,000, 7% semiannual coupon bonds outstanding, $1,000 par value, 18 years to maturity, selling for 102 percent of par; the bonds make semiannual payments.

Preferred Stock:  10,000 outstanding with par value of $100 and a market value of 105 and $10 annual dividend.

Common Stock: 84,000 shares outstanding, selling for $56 per share, the beta is 2.08

The market risk premium is 5.5%, the risk free rate is 3.5% and Huntington’s tax rate is 32%.

Huntington Power Co. is evaluating two mutually exclusive project that is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and decided to apply an adjustment factor of +2.1% to the cost of capital for both projects.

Project A is a five-year project that requires an initial fixed asset investment of $2.4 million. The fixed asset falls into the five-year MACRS class. The project is estimated to generate $2,050,000 in annual sales, with costs of $950,000. The project requires an initial investment in net working capital of $285,000 and the fixed asset will have a market value of $225,000 at the end of five years when the project is terminated.

Project B requires an initial fixed asset investment of $1.0 million. The marketing department predicts that sales related to the project will be $920,000 per year for the next five years, after which the market will cease to exist. The machine will be depreciateddown to zero over four-year using the straight-line method (depreciable life 4 years while economic life 5 years). Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales.  The project will also require an addition to net working capital of $150,000 immediately. The asset is expected to have a market value of $120,000 at the end of five years when the project is terminated.

Use the following rates for 5-year MACRS: 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%

1. What is project B’s cash flows for year 0-5, NPV, IRR and PI for project B

Consider the following information on Huntington Power Co.

Debt: 4,000, 7% semiannual coupon bonds outstanding, $1,000 par value, 18 years to maturity, selling for 102 percent of par; the bonds make semiannual payments.

Preferred Stock: 10,000 outstanding with par value of $100 and a market value of 105 and $10 annual dividend.

Common Stock: 84,000 shares outstanding, selling for $56 per share, the beta is 2.08

The market risk premium is 5.5%, the risk free rate is 3.5% and Huntington’s tax rate is 32%.

Huntington Power Co. is evaluating two mutually exclusive project that is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and decided to apply an adjustment factor of +2.1% to the cost of capital for both projects.

Project A is a five-year project that requires an initial fixed asset investment of $2.4 million. The fixed asset falls into the five-year MACRS class. The project is estimated to generate $2,050,000 in annual sales, with costs of $950,000. The project requires an initial investment in net working capital of $285,000 and the fixed asset will have a market value of $225,000 at the end of five years when the project is terminated.

Project B requires an initial fixed asset investment of $1.0 million. The marketing department predicts that sales related to the project will be $920,000 per year for the next five years, after which the market will cease to exist. The machine will be depreciated down to zero over four-year using the straight-line method (depreciable life 4 years while economic life 5 years). Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. The project will also require an addition to net working capital of $150,000 immediately. The asset is expected to have a market value of $120,000 at the end of five years when the project is terminated.

Use the following rates for 5-year MACRS: 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%

Please show your work.

1. Calculate project B’s cash flows for year 0-5

Consider the following information on Huntington Power Co.

Debt: 4,000, 7% semiannual coupon bonds outstanding, $1,000 par value, 18 years to maturity, selling for 102 percent of par; the bonds make semiannual payments.

Preferred Stock: 10,000 outstanding with par value of $100 and a market value of 105 and $10 annual dividend.

Common Stock: 84,000 shares outstanding, selling for $56 per share, the beta is 2.08

The market risk premium is 5.5%, the risk free rate is 3.5% and Huntington’s tax rate is 32%.

Huntington Power Co. is evaluating two mutually exclusive project that is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and decided to apply an adjustment factor of +2.1% to the cost of capital for both projects.

Project A is a five-year project that requires an initial fixed asset investment of $2.4 million. The fixed asset falls into the five-year MACRS class. The project is estimated to generate $2,050,000 in annual sales, with costs of $950,000. The project requires an initial investment in net working capital of $285,000 and the fixed asset will have a market value of $225,000 at the end of five years when the project is terminated.

Project B requires an initial fixed asset investment of $1.0 million. The marketing department predicts that sales related to the project will be $920,000 per year for the next five years, after which the market will cease to exist. The machine will be depreciated down to zero over four-year using the straight-line method (depreciable life 4 years while economic life 5 years). Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. The project will also require an addition to net working capital of $150,000 immediately. The asset is expected to have a market value of $120,000 at the end of five years when the project is terminated.

Use the following rates for 5-year MACRS: 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%

Please show your work.

1. Calculate NPV, IRR and PI for project A