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c
Pr oprietorship Tax in 1997= $5,850 + (0.28) ($43,750 - $39,000)
= $5,850 + 0.28($43,750)
= $5,850 + $1,330 = $7,180.

The corporate form of organization allows Thompson to pay the lowest taxes in each
year; therefore, on the basis of taxes during the 3-year period, Thompson should
incorporate his business. However, note that to get money but out of the corporation so
he can spend it, Thompson will have to have the corporation pay dividends, which will
be taxed to Thompson, and thus he will, sometimes in the future, have to pay additional
taxes.

Question No 34:
ST – 1: Realized rates of return Stocks A and B have the following historical returns:
Year Stock A‟s Return. k A Stock B‟s Returns, k g
1992 (10.00% (3.00%)
1993 18.50 21.29
1994 38.6 44.25
1995 14.33 3.67
1996 33.00 28.30

a. Calculate the average rate of return for each stock during the period 1992 through 1996.
Assume that someone held a portfolio consisting of 50 percent of stock A and 50 percent
of stock B. What would have been the realized rate of return on the portfolio in each
year from 1992 through 1996? What would have been the average return on the portfolio
during this period?
b. Now calculate the standard deviation of returns for each stock and for the portfolio.
c. Looking at the annual returns data on the two stocks, would you guess that the
correlation coefficient between returns on the two stocks is closer to 0.9 or to -0.9?
d. If you added more stocks at random to the portfolio, which of the following is the most
accurate statement of what would happen to OP ?
1) OP would remain constant.
2) OP would decline to somewhere in the vicinity of 18 percent.
3) OP would decline to zero if enough stocks were included.
Answer:-
ST – 1
a. The average rate of return for each stock is calculated simply by averaging the returns
over the 5 – year period. The average return for each stock is 18.90 percent, calculated for
stock A as follows:
kAVg = (-10.00 % + 18.50% + 38.67% + 14.33% + 33.00%)/5
= 18.90%
The realized rate of return on a portfolio made up of Stock A and Stock B would be
calculated by finding the average return in each year as k A (% of Stock A) + kB (% of
Stock B) and then averaging these yearly returns.

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Year Portfolio AB‟s Returns, k AB

1992 (6.5%)
1993 19.90
1994 41.46
1995 9.00
1996 30.65
kAvg = 18.90%

b. The standard deviation of returns is estimated, using Equation 4 – 3 a, as follows.

(k
n
k )2
t Avg
Estimated   s  t 1
n 1
For stock A, the estimated  is 19.0 percent:
(10.00 18.9)2  (18.50 18.9)2 ...  (33.00 18.9)2
 
 5 1
1, 445.92
  19.0%
4

The standard deviations of returns for Stock B and for the portfolio are similarly
determined, and they are as follows:
Stock A Stock B Portfolio AB
Standard deviation 19.0 19.0 18.6

c. Since the risk reduction from diversification is small (  AB falls only from 19.0 to 18.6
percent), the most likely value of the correlation coefficient is 0.9. if the correlation
coefficient were -0.9, the risk reduction would be much larger. In fact, the correlation
coefficient between Stock A and B is 0.92.
d. If more randomly selected stocks were added to the portfolio,  P would decline to
somewhere in the vicinity of 18 percent; see Figure 4-8.  P would remain constant only
if the correlation coefficient were +1.0, which is most unlikely.  P would decline to zero
only if the correlation coefficient, r, were equal to zero and a large number of stocks
were added to the portfolio, or if the correct proportions were held in a two – stock
portfolio with r = - 1.0.

Question No 35:-
ST – 1: Risk and Return you are planning to invest $200,000. Two securities, A and B, are
available and you can invest in either of them or in a portfolio with some of each. You estimate
that the following probability distributions or returns are applicable for A and B:

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SECURITY A SECURITY B
PA KA PB KB
0.1 -10% 0.1 -30%
0.2 5 0.2 0
0.4 15 0.4 20
0.2 25 0.2 40
0.1 40 0.1 70
 

k A
=? k B
=20.0%
 A =?  B =25.7%

 

a. The expected return for Security B is B = 20%, and  B =25.7%. Find A and  A .
k k
b. Use the equation in Footnote 3 to find the value of WA that produces the minimum risk
portfolio. Assume rAB =-0.5 for parts b and c.


c. Construct a table giving k P

and  P for portfolios with WA = 1.00, 0.75, 0.50, 0.25, 0.0, and

the minimum risk value of WA . (Hint: For WA = 0.75, =16.25% and  P =8.5%; for WA
 
k P

=0.5. P =17.5% and  P =11.1%; for WA =0.25, P =18.75% and  P =17.9%.)

k k
d. Graph the feasible set of portfolios and identify the efficient frontier of the feasible set.
e. Suppose your risk/return trade-off function, or indifference curve, is tangent to the

efficient set at the point where =18%. Use this information, plus the graph
P k
constructed in Part d. to locate (approximately) your optimal portfolio. Draw in a
reasonable indifference curve, indicate the percentage of your funds invested in each
 
security; and determine the optimal portfolio‟s  P and k . (Hint: Estimate  P and k
P P


graphically, and then use the equation for P

to determine WA .)
k
f. Now suppose a riskless asset with a return K RF =10% becomes available. How would
this change the investment opportunity set? Explain why the efficient frontier becomes
linear.
g. Given the indifference curve in part e, would you change your portfolio? If so, how?
(Hint: Assume the indifference curves are parallel.)
h. What are the beta coefficient of Stocks A and B? [Hints: (1) Recognize that K1 = K RF + b1 (
K M - K RF ) and solve for b1 and (2) assume that your preferences match those of most
other investors.]

Answer:-

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Question No 36:-
ST – 1: Future Value Assume that it is now January 1, 1997. On January 1, 1998, you will deposit
$1,000 into a savings account that pays 8 percent.
a) If the bank compounds interest annually, how much will you have in your account
on January 1, 2001?
b) What would your January 1, 2001, balance be if the bank used quarterly
compounding rather than annual compounding?
c) Suppose you deposited the $1,000 in 4 payments of $250 each on January 1 of 1998,
1999, 2000, and 2001. How much would you have in your account on January 1,
2001, based on 8 percent annual compounding?
d) Suppose you deposited 4 equal payments in your account on January 1 of 1998,
1999, 2000, and 2001. Assuming an 8 percent interest rate, how large would each of
your payments have to be for you to obtain the same ending balance as you
calculated in part a?
ST – 2: Time Value of Money Assume that it is now January 1, 1997 and you will need $1,000
on January 1, 2001. Your bank compounds interest at an 8 percent annual rate.
a) How much must you deposit on January 1, 1998, to have a balance of $1,000 on January
1, 2001?
b) If you want to make equal payments on each January 1 from 1998 through 2001 to
accumulate the $1,000 how large must each of the 4 payments be?
c) If your father were to offer either to make the payments calculated in part b ($221.92) or
t give you a lump sum of $750 on January 1, 1998, which would you choose?
d) If you have only $750 on January 1, 1998, what interest rate, compounded annually,
would you have to earn to have the necessary $1,000 on January 1, 2001?
e) Suppose you can deposit only $186.29 each January 1 from 1998 through 2001, but you
still need $1,000 on January 1, 2001. What interest rate, with annual compounding, must
you seek out to achieve your goal?

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f) To help you reach your $1,000 goal, your father offers to give you $400 on January 1,
1998. You will get a part – time job and make 6 additional payments of equal amounts
each 6 months thereafter. If all of this money is deposited in a bank which pays 8
percent, compounded semiannually, how large mush each of the 6 payments be?
g) What is the effective annual rate being paid by the bank in part f?
h) Reinvestment rate risk was defined in Chapter 3 as being the risk that maturing
securities (and coupon payments on bonds) will have to be reinvested at a lower rate of
interest than they were previously earning. Is there a reinvestment rate risk involved in
the preceding analysis? If so, how might this risk be eliminated?
ST – 3: Effective Annual Rates Bank A pays 8 percent interest, compounded quarterly, on its
money market account. The managers of Bank B want its money market account to equal Banks
A‟s effective annual rate, but interest is to be compounded on a monthly basis. What nominal,
or quoted, rate must Bank B set?

Answer:-

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Question No 37:-

ST – 1: Stock Growth Rates and Valuation You are considering buying the stocks of two
companies that operate in the same industry; they have very similar characteristics expect for
their dividend payout policies. Both companies are expected to earn $6 per share this year.
However, Company D (for “dividend”) is expected to pay out all of its earnings as dividend,
while Company G (for “growth”) is expected to pay out only one – third of its earnings, or $2
per share. D‟s stock price is $40. G and D are equally risky. Which of the following is most likely
to be true?

a. Company G will have a faster growth rate than company D. Therefore, G‟s stock price
should be greater than $40.

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b. Although G‟s growth rate should exceed D‟s, D‟s current dividend exceeds that of G,
and this should cause D‟s price to exceed G‟s.
c. An investor in stock D will get his or her money back faster because D pays out more of
its earnings as dividends. Thus, in a sense, D is like a short – term bond, and G is like a
long – term bond. Therefore, if economic shifts cause k d and ks to increase, and if the
expected streams of dividends from D and G remain constant, Stocks D and G will both
decline, but D‟s price should decline further.

d. D‟s expected and required rate of return is = ks =15%. G‟s expected return will be
k s
higher because of its higher expected growth rate.
e. On the basis of the available information, the best estimate of G‟s growth rate is 10
percent.

ST – 2: Bond Valuation The Pennington Corporation issued a new series of bonds on January 1,
1971. The bonds were sold at per ($1,000), have a 12 percent coupon, and mature in 30 years, on
December 31, 2000. Coupon payments are made semiannually (on June 30 and December 31).

a. What was the YTM of Pennington‟s bond on January 1, 1971?

b. What was the price of the bond on January 1, 1976, 5 years later, assuming that the level
of interest rates had fallen to 10 percent?
c. Find the current yield and capital gains yield on the bond on January 1, 1976, given the
price as determined in part b.
d. On July 1, 1994, Pennington‟s bonds sold for $196.42. What was the YTM as that date?
e. What were the current yield and capital gain yield on July 1, 1994?
f. Now assume that you purchased an outstanding Pennington bond on March 1, 1994,
when the going rate of interest was 15.5 percent. How large a check must you have
written to complete the transaction?

S – T 3: Constant Growth Stock Valuation Ewald Company‟s current stock price is $36, and its
last dividend was $2.40. In view of Ewald‟s strong financial position and its consequent low
risk, its required rate of return is only 12 percent. If dividends are expected to grow at a
constant rate, g, in the future, and if ks is expected to remain at 12 percent, what is Ewald‟s
expected stock price 5 year from now?

S – T 4: Supernormal Growth Stock Valuation Snyder Computer Chips Inc. is experiencing a

period of rapid growth. Earnings and dividends are expected to grow at a rate of 15 percent
during the next 2 years, at 13 percent in the third year, and at a constant rate of 6 percent
thereafter. Synder‟s last dividend was $1.15, and the required rate of return on the stock is 12
percent.

a. Calculate the value of the stock today.

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 
b. Calculate
P and 2 .
1
P
c. Calculate the dividend yield and capital gains yield for Years 1,2, and 3.

Answer:-

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Question No 38:-

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Answer:-

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Question No 39:-

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Answer:-

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Question No 40:-

ST – 1: New Project Analysis you have been asked by the president of the Farr Construction
Company to evaluate the proposed acquisition of a new earth mover. The mover‟s basic price is
$50,000, and it would cost another $10,000 to modify it for special use. Assume that the mover
fails into the MACRS 3 – year class, it would be sold after 3 years for $20,000, and it would
require an increase in net working capital (share parts inventory) of $2,000. The earth mover
would have no effect on revenues, but it is expected to save the firm $20,000 per year in before –
tax operating costs, mainly labor. The firm‟s marginal federal – plus – state tax rate is 40
percent.

a. What is the net cost of the earth mover? (That is, what are the Year 0 cash flows?)
b. What are the operating cash flows in Years 1, 2 and 3?

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c. What are the additional (non-operating) cash flows in year 3?

d. If the project‟s cost of capital is 10 percent, should the earth mover be purchased?

ST – 2: Replacement Project Analysis The Erickson Toy Corporation currently uses an injection
molding machine that was purchased 2 years ago. This machine is being depreciated on a
straights line basis toward a $550 salvage value, and it has 6 years or remaining life. Its current
book value is $2,600, and it can be sold for $3,000 at this time. Assume, for case of calculation,
that the annual depreciation expense is $350 per year.

The firm is offered a replacement machine which has a cost of $8,000, an estimated useful life of
6 years, and an estimated salvage value of $800. This machine falls into the MACRS 5 – year
class. The replacement machine would permit an output expansion, so sales would rise by
$1,000 per year; even so, the new machine‟s much greater efficiency would still cause operating
expenses to decline by $1,500 per year. The new machine would require that inventories be
increased by $2,000, but accounts payable would simultaneously increase by $500.

The firm‟s marginal federal – plus – state tax is 40 percent. And its cost of capital is 15 percent.
Should it replace the old machine?

Answer:-

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Question No 41:-

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Answer:-

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Question No 42:-

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Answer:-

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Question:
Dawlance Co has undertaken market research at a cost of Rs.200,000 in order to forecast the
future cash flows of an investment project with an expected life of four years, as follows:

Year 1 2 3 4
Sales revenue (Rs.000) 1,250 2,570 6,890 4,530
Costs (Rs.000) 500 1,000 2,500 1,750
These forecast cash flows are before taking account of general inflation of 4·7% per year.
The capital cost of the investment project, payable at the start of the first year, will be
Rs.2,000,000. The investment project will have zero scrap value at the end of the fourth year.
The level of working capital investment at the start of each year is expected to be 10% of the
sales revenue in that year.
Capital allowances would be available on the capital cost of the investment project on a 25%
reducing balance basis. Dawlance Co pays tax on profits at an annual rate of 30% per year,
with tax being paid one year in arrears. Dawlance Co has a nominal (money terms) after-
tax cost of capital of 12% per year.
Required:
a) Calculate the net present value of the investment project in nominal terms and comment
on its financial acceptability.

b) Write down limitations of internal rate of return (IRR) and net present value (NPV).

Answer:

1 (a) Calculating the net present value of the investment project using a nominal terms approach
requires the discounting of nominal (money terms) cash flows using a nominal discount rate,
which is given as 12%.
Year 1 2 3 4 5
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Sales revenue 1,308·75 2,817·26 7,907·87 5,443·58
Costs (523·50) (1,096·21) (2,869·33) (2,102·93)
–––––––– ––––––––– ––––––––– –––––––––
Net revenue 785·25 1,721·05 5,038·54 3,340·65

Tax payable (235·58) (516·32) (1,511·56) (1,002·20)

CA tax benefits 150·00 112·50 84·38 253·13

–––––––– ––––––––– ––––––––– ––––––––– –––––––––
After-tax cash flow 785·25 1,635·47 4,634·72 1,913·47 (749·07)
Working capital (150·86) (509·06) 246·43 544·36
–––––––– ––––––––– ––––––––– ––––––––– –––––––––
Project cash flow 634·39 1,126·41 4,881·15 2,457·83 (749·07)
Discount at 12% 0·893 0·797 0·712 0·636 0·567
–––––––– ––––––––– ––––––––– ––––––––– –––––––––
Present values 566·51 897·75 3,475·38 1,563·18 (424·72)
–––––––– ––––––––– ––––––––– ––––––––– –––––––––
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Rs.000
PV of future cash flows 6,078·10
Initial investment (2,000·00)
Working capital (130·88)
–––––––––
NPV 3,947·22
–––––––––
The net present value is Rs.3,947,220 and so the investment project is financially acceptable.

Workings
Year 1 2 3 4
Sales revenue (Rs.000) 1,250 2,570 6,890 4,530
Inflated sales revenue (Rs.000) 1,308·75 2,817·26 7,907·87 5,443·58
Year 1 2 3 4
Costs (Rs.000) 500 1,000 2,500 1,750
Inflated costs (Rs.000) 523·50 1,096·21 2,869·33 2,102·93
Year 1 2 3 4
Inflated sales revenue (Rs.000) 1,308·75 2,817·26 7,907·87 5,443·58
Working capital (Rs.000) 130·88 281·73 790·79 544·36
Incremental (Rs.000) (130·88) (150·86) (509·06) 246·43
Year 1 2 3 4
Capital allowance (Rs.000) 500·00 375·00 281·25 843·75
Tax benefit (Rs.000) 150·00 112·50 84·38 253·13

b):

Limitations of the Internal Rate of Return (IRR):

One problem with the IRR is that it ignores the initial investment amount. If you’re
comparing two alternative investments and your only decision criteria is the IRR, then
which is better – a 50% return on $1,000 investment, or a 10% return on a $50,000
investment? If IRR was your only decision criteria, then you’d choose the first option,
ignoring the size of your initial investment, and therefore the actual cash you’re able
receive as a result of your investment.

Another limitation of the IRR is that it doesn’t always equal the return on your initial
investment over the holding period. When periodic cash flows exist in an investment that
results in capital recovery, the IRR makes no assumptions about what you do with these
interim cash flows. For example, you might put that cash flow into a bank account with a
much lower yield than the IRR, which can be problematic when evaluating the true return
for an investment.
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Limitations of the Net Present Value (NPV):

One limitation of the NPV is that it doesn’t take into account the timing or variability of
cash flows. For example, which is better, a project that returns one lump sum in 10 years,
or instead a project with even cash flows every year for ten years? These are two different
investments and, depending on your needs, you might prefer one over the other, even if
the NPV for both projects is the same.

Another limitation of the NPV is that it’s often difficult to accurately estimate the discount
rate. Because of this, it might also be difficult to accurately account for the riskiness of
projected cash flows. For example, if you’re evaluating a building with short term leases,
then you might consider bumping up your discount rate to account for this rollover risk.
But exactly how much higher should your discount rate be? This is often a subjective
decision that an objective measure, like the NPV, can’t easily account for.

QUESTION :

Bata Co sells both Product P and Product Q, with sales of both products occurring
evenly throughout the year.
Product P
The annual demand for Product P is 300,000 units and an order for new inventory is placed
each month. Each order costs Rs.267 to place. The cost of holding Product P in inventory is
10 Paisas per unit per year. Buffer inventory equal to 40% of one month’s sales is
maintained.
Product Q
The annual demand for Product Q is 456,000 units per year and Bata Co buys in this
product at Rs.1 per unit on 60 days credit. The supplier has offered an early settlement
discount of 1% for settlement of invoices within 30 days.
Other information
Bata Co finances working capital with short-term finance costing 5% per year. Assume
that there are 365 days in each year.

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Required:
(a) Calculate the following values for Product P:
(i) The total cost of the current ordering policy;
(ii) The total cost of an ordering policy using the economic order quantity;

(iii) The net cost or saving of introducing an ordering policy using the economic order
quantity.

(b) Calculate the net value in Rs. (000) to Bata Co of accepting the early settlement
discount for Product Q.
(c) Discuss how invoice discounting and factoring can aid the management of trade
receivables.

Answers:

(a) (i) Cost of current ordering policy

Ordering cost = 12 x 267 = Rs.3,204 per year
Monthly order = monthly demand = 300,000/12 = 25,000 units
Buffer inventory = 25,000 x 0·4 = 10,000 units

Average inventory excluding buffer inventory = 25,000/2 = 12,500 units

Average inventory including buffer inventory = 12,500 + 10,000 = 22,500 units
Holding cost = 22,500 x 0·1 = Rs.2,250 per year
Total cost = 3,204 + 2,250 = Rs.5,454 per year

(ii) Cost of ordering policy using economic order quantity (EOQ)

EOQ = ((2 x 267 x 300,000)/0·10)0·5 = 40,025 or 40,000 units per order
Number of orders per year = 300,000/40,000 = 7·5 orders per year

Order cost = 7·5 x 267 = Rs.2,003

Average inventory excluding buffer inventory = 40,000/2 = 20,000 units
Average inventory including buffer inventory = 20,000 + 10,000 = 30,000 units

Holding cost = 30,000 x 0·1 = Rs.3,000 per year

Total cost = Rs.2,003 + Rs.3,000 = Rs.5,003 per year

(iii) Saving from introducing EOQ ordering policy = 5,454 – 5,003 = Rs.451 per year

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(b) Product Q trade payables at end of year = 456,000 x 1 x 60/365 = Rs.74,959

Product Q trade payables after discount = 456,000 x 1 x 0·99 x 30/365 = Rs.37,105
Decrease in Product Q trade payables = 74,959 – 37,105 = Rs.37,854
Increase in financing cost = 37,854 x 0·05 = Rs.1,893
Value of discount = 456,000 x 0·01 = Rs.4,560
Net value of offer of discount = 4,560 – 1,893 = Rs.2,667

(c) Invoice discounting refers to the purchase of selected invoices by a financial

company at a discount to their face value. Invoice discounting can provide
immediate cash to a company rather than waiting for the invoices to be settled. It
tends to be used as an occasional source of short-term finance, rather than a regular
source of cash. Invoice discounting can therefore aid in the management of trade
receivables by accelerating cash inflow from trade receivables when short-term cash
flow problems arise.
Factoring refers to a commercial arrangement whereby a financial company takes over
the management of a company’s trade receivables. This will include invoicing
customers, accounting for sales and collections of amounts owed. Factors will
advance cash to a company against the amounts outstanding. If the client requires,
insurance against bad debts may also be provided (non-recourse factoring).
Factoring can assist in the management of trade receivables through the expertise offered by
the factoring company. This may lead to a reduction in bad debts, a decrease in the level of
trade receivables, a decrease in the amount of managerial time devoted to chasing slow
payers, and taking advantage of early settlement discounts from trade suppliers due to the
availability of cash from trade receivables.

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Question No 43:-

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Answer:-

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Question No 44:-

Answer:-

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Question No 45:-

Answer:-

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Question No 46:-

Answer:-

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Question No 47:-

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Question No 48:-

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Problems
1 -1:- If you deposit $100 in the bank today and it earns interest at a rate of 8% compounded
annually, how much will be in the account 50 years from today?

Answer: - $4,690.10

1 – 2:- A loaf of bread costs $0.79 today. If its price increases by 6% per year, how much will an
equivalent loaf cost in 20 years?

Answer: - $2.53

1 – 3:- How much money must you deposit in a savings account today to have $20,000 in 20
years if the interest rate is 8% compounded annually?

Answer: - $4,290.96

1 – 4:- Your sister borrows $1,000 and promises to repay $2,000. If you want at least a 5% return
on your loan, within how many years must she pay you back?

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Answer: - 14.2 Years = 14 Years

1 – 5:- Which would you prefer: $3,000 now, $2,000 that was placed in a savings account 5 years
ago or $1,000 that was placed in a savings account 10 years ago if

a. Your time value of money is 12%

b. Your time value of money is 16%
c. Your time value of money is 8%

Answer:-

a. $2,000 from five years ago

b. $1,000 from 10 years ago
c. $3,000 now

1 – 6:- Using a discount rate of 12%, find the future value as of the end of year 4 of $100 received
at the end of each of the next four years

a. Using only the FVF table.

b. Using only the FVFA table

Answer:-

a. $477.93
b. $477.93

1 – 7:- How much must you save at the end of each of the next 10 years to have $100,000 at the
end of the 10th year if the interest rate is 10%?

Answer:-$6,274.55

1 – 8:- If the discount rate is 14%, what is FV10 of $300 received at the end of each of the next 10
years except for the fourth year?

Answer: - $5,142.69

1 – 9:- What is FV12 of a 10 – year $500 annuity for which the first $500 payment is made at the
end of the 3rd year (and the 10th payment at the end of the 15th year) if the discount rate is 16%?

Answer: - $10,660.69

1 – 10:- What FV10 of a 10 – year annuity due with payments of $1,000 if the discount rate is
10%?

Answer: - $17,530.70

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1 – 11:- You are buying a $100,000 home with a 30 – year mortgage requiring payments to be
made at the end of each year. The interest rate is 10% for the first 15 years of the mortgage but
then increases to 15% for the last 15 years. How much will your annual payments be?

Answer:-$11,103.75

1 – 12:- A device is for sale that will save you 10% of your utility bill every year. Your time value
of money is 12% and your utility bill is $500 per year. Assuming that your utility bill remains
constant and that you (and your heirs) will be around to enjoy the benefits of the device forever,
how much should you be willing to pay for it?

Answer: - $416.67

1 – 13:- You are trying to decide whether to buy a $2,500 motorcycle on credit or to save money
to buy it in 30 months. If you buy on credit, you will make 30 equal and – of – the month
payments at a finance charge of 2% per month. If you save money to buy it in 30 months, you
will earn 1% per month on your savings. However, the semiannual inflation rate is 5%, so the
motorcycle will cost more in 2.5 years. (Suppose that you don‟t care when you take possession
of the motorcycle; that is, you will make your decision solely on the basis of which plan has
lower monthly requirements.)

a. What will your monthly payments be if you buy on credit?

b. What must your monthly deposits be if you choose to save money and buy it in 30
months?
c. What should you do?

Answer:-

a. $111.62
b. $91.73
c. Buy in 30 months

1 – 14:- Consider an investment that pays $80 in interest every year plus $1,000 when it matures
in 12 years. You can buy the investment today for $753. What is the IRR of this investment? (Use
a financial calculator for this problem.)

Answer: - 11.98%

1 – 15:- A certificate of deposit (CD) offered by a new bank will pay $10,000 in three years. Your
current bank offers a 9% rate on three – year CDs. What is the most you should be willing to
pay for the new bank‟s CD?

Answer: - $7,722.00

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1 – 16:- After spending $300 on advertising, Van Harlow has found a buyer for his twin – engine
plane. Van can sell the plane for $20,000, but he must then pay $500 to transport the plane to the
buyer. Alternatively, he can keep the machine for use in a new project that came up after he
placed the ads to sell. What is the appropriate cost (in dollars) of keeping the plane for the
project?

Answer: - $19,500

1 – 17:- Five years ago, you withdrew $2,000 from a money market fund paying 10% to place it
in a mutual fund. Today your investment in the mutual fund is worth $3,000.

a. What is your accounting profit from the investment in the mutual fund?
b. What was the opportunity cost of your $2,000 investment? What was your economic
profit from the mutual fund?

Answer:-

a. $1,000
b. Leave the money in the money market mutual fund.

1 – 18:- You have done some research on a new project and found that it has a required initial
outlay of $1,000 and an NPV of $10 given the opportunity cost of 10% for new projects. A co –
worker argues that it is not worth going through the trouble of adopting the project for only
$10. How do you respond?

Answer: - The project should still be accepted.

1 – 9:- You have narrowed down your housing search to two apartments to lease for your last 12
months of school. The Cloisters will lease an apartment for $500 per month, with two month‟s
rent required as a deposit. The Woodward Street Apartments will lease an apartment for $510
per month, with a one – month deposit. In either case, payments are made at the beginning of
each month and the deposit is returned at the end of 12 months. The Cloisters will not give you
any interest on your deposit; the Woodward Street Apartments will give you 1% interest per
month. You have determined that your opportunity cost is 1% per month. What should you do?

Answer: - Choose The Cloisters

1 – 10:- Your brother has decided what model of car he wants to buy and is trying to choose
between two dealers. Dempsey Motors will sell the car for $10,000 ($1,000) down, with the rest
payable on a four – year note with a monthly interest rate of 1.2%). Your brother‟s opportunity
cost is 1% per month. What should he do? (Note: You cannot use the tables for this problem.
PVFA.01,48 = 37.97, PVFA.012,48 =36.33.)

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Answer: - Purchase from Tunney

1 – 11:- Atilla Industries is a publicly held company that has 1,500,000 shares outstanding with a
market value of $23.2 million. The records show that the company has 6,805 shareholders, 4,200
of who own 100 or more shares. Atilla‟s net tangible assets are worth $24 million. If Atilla had
pretax earnings of $1.6 million this year, what other requirements must Atilla meet before it can
consider being listed on the NYSE?

Answer: - 8.75%

1 – 12:- One year ago, you purchased 100 shares of Pacific Oil for $25 each. The annual dividend
per share was $1, and the share price today is $27. On the same day you purchased your shares,
your brother purchased 100 shares of Georiga Edison for $15 per share. The annual dividend
per share was $2.30, and the share price today is $14.50. Who earned a greater rate of return,
you or your brother?

Answer: - $17.50

1 – 13:- Sergeat Motors Common shares are trading for $30 each. You expect annual dividends
(paid at the end of the year) to be constant at $1 for the next four years. If you expect 15% return
on your investment, what must you expect the share price to be in four years?

Answer: - 15%

1 – 14:- The Midwest Grain Company pays an annual dividend of $1.80 and is expected to do so
permanently. If you require a 15% return on your investment, how much will you be willing to
pay for a share?

Answer: - $15.00

1 – 15:- Telstar, Inc., just paid a $1.60 dividend. They paid a dividend of $0.89 12 years ago.
What has been the annual growth rate in dividends during this time? If the growth rate remains
the same, how much will you be willing to pay for a share if you require a return of 12%?

Answer: - $38.00

1 – 16:- Sam Malone, vice – president of AMI, Inc., wishes to find the YTM on his company‟s 10
year, 10% bond selling for 106.38% of the par value of $1,000. Calculate the YTM, using

a. A financial calculator.
b. The trial – and – error method.
c. The approximation formula.

Answer:-

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a. 9.0%
b. 9.0%
c. 9.1%

1 – 17:- A 20 – year, 10% coupon – interest – rate bond has a $1,000 par value. The market rate of
interest is 8%. Compute the market price of this bond if it has 5 years to maturity. Assume that
interest is paid annually.

Answer: - $1,196.36

1 – 18:- A bond with six years left to maturity has a coupon rate of 9% and a par value of $1,000.
How much will you be willing to pay for the bond if you require an annual rate of return of
12%?

Answer: - $876.66

1 – 19:- A bond pays interest annually and sells for $835. It has six year left to maturity and a par
value of $1,000. What is its coupon if it‟s promised YTM is 12%?

Answer: - 7.99%

1 – 20:- Four years ago, your firm purchased a printing press for $12,000. The press is being
depreciated straight line to a salvage value of zero in six more years.

a. What is the annual depreciation of the press?

b. What is the book value of this asset today?

Answer:-

a. $1,000
b. $7,200

1 – 21:- The long – term liabilities and stockholders‟ equity portion of BT&T‟s balance sheet on
December 31, 1987, is shown. During 1988, BT&T issued $5,000,000 of long – term debt, issued
$10,000,000 or equity, earned $3,000,000, and paid $1,000,000 in dividends. Construct a new
balance sheet for December 31, 1988, that reflects these changes.

Long – term debt $60,000,000

Preferred stock 20,000,000
Common stock 60,000,000
Retained earnings 40,000,000
Total long – term liabilities
And stockholder‟s equity $180,000,000

Answer: - Dec. 31, 1987 Dec. 31, 1988

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Long – term debt $60 $65

Preferred stock 20 20
Common stock 60 70
Retained earnings 40 42
Total long $180 $197

1 – 22:- Following are parts of an income statement and two balance sheets of the O‟Conner
Broadcasting Company. Sheila O‟Conner, station manager, has asked you to produce a
statement or retained earnings. Do it.

1986 Balance Sheet 1987 Balance Sheet

Long – term debt $500,000 Long – term debt $550,000
Common stock 600,000 Common stock 700,000
Retained earnings 750,000 Retained earnings 775,000
Total long-term liabilities $1,850,000 Total long-term liabilities $2,025,000
and stock holder‟s equity and stock holder‟s equity

1987 Income Statement

Net operating income $80,000
Less: Interest expense 25,000
Plus: Non-operating income 15,000
Net profit before taxes $70,000
Less: Taxes 32,000
Net income $38,000

Answer: - Retained Earnings = $25

1 – 23:- During 1988, Magee Auto Supply Outlets has gross sales of $900,000, cost of goods sold
of $300,000, and general and selling expenses of $400,000. They also had outstanding $200,000 of
10% notes and $400,000 of 12% coupon bonds. Non-operating income was zero, depreciation
was $100,000, and dividends of $80,000 were paid.

a. What was NOI?

b. What was NPBT?
c. What was NI if the average tax rate was 40%?
d. If retained earnings were $240,000 on December 31, 1987, what are they on December 31,
1988?

Answer:-

a. $100
b. $32
c. $19.2
d. $179.2

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1 – 24:- Wilfong Brothers, Inc., reported a net cash flow from operations of $63,000 during the
fourth quarter of 1988. In addition, Wilfong has a net financial cash inflow of $12,000 and a net
investment cash outflow of $52,000.

a. What was Wilfong‟s net cash flow for the fourth quarter of 1988?
b. If Wilfong‟s level of cash was $55,000 on December 31, 1988, what was it on September
31, 1988?

Answer:-

a. $23,000
b. $78,000

1 – 25:- The Harris Corporation has a taxable income of $128,000.

a. What is its total tax liability?

b. What is Harris‟ average tax rate?
c. What is Harris‟ Marginal tax rate?

Answer:-

a. $33,170
b. 0.2591
c. 0.39

1 – 26:- Your firm must raise $150,000 in new capital. This capital may be raised by issuing new
stock, which requires dividend payments of 9%, or by issuing new debt, which requires interest
payments of 10%. The firm‟s tax rate is 25%.

a. What is the after – tax cost of acquiring the capital by issuing equity?
b. What is the after – tax cost of acquiring the capital by issuing debt in terms of dollars? In
terms of the interest rate?
c. Based on the costs, which plan would you prefer?

Answer:-

a. $13,500
b. $11,250, 0.075
c. Issue Debt

1 – 27:- Clifton Industries has just purchased a metal press for $120,000 and will depreciate the
press using straight – line depreciation over 10 years to a $5,000 salvage value.

a. How much is the annual depreciation claimed on the press?

b. What is the accumulated depreciation on the press after 4 years?

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Answer:-

a. $11,500
b. $46,000

1 – 28:- Three years ago your firm purchased a forklift for $10,000. The forklift is being
depreciated straight – line to a salvage value of zero in two more years. If your firm sells the
forklift today for $5,000, it will receive only $4,750 after taxes.

a. What is annual depreciation on the machine?

b. What is the current book value of the machine?
c. What is your firm‟s marginal tax rate?

Answer:-

a. $2,000
b. $4,000
c. 25%

1 – 29:- The December 31, 1984, balance sheet and income statement for May – berry Cafeterias,
Inc. are given.

a. Compute the specified ratios, and compare them to the industry average (better or
worse).

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Answer:-

a. Current = 3.13; B: Quick = 1.67; W: Debt/Equity = 0.76; W: Times Interest Earned =

8.25; W: Average Collection Period = 1.02; B: Inventory Turnover = 57.56; W: Fixed
Asset Turnover = 15.54; W: Operating Profit Margin = 0.031; Net Profit Margin = 0.016;
W: ROA = 0.167; W: ROE = 0.25; W

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b. The ratios that are most out of line with the industry average are the current, quick,
debt – equity, times interest earned, and inventory turnover.

1 – 30:- At the same time, Genco applies to a bank for a three – year loan. The bank had loaned
money earlier to Barzini and, based on past experience, has decided not to lend money to any
firm riskier than Barzini. However, the bank uses different ratios for making the decision – the
debt – equity ratio and the time interest ratio. If these two ratios for Barzini are 1.32 and 2.56,
respectively, would the bank loan money to Genco?

Answer: - Do not lend the money.

1 – 31:- David Willis is considering opening up a new copy center store near a large university.
If he does, he will rent six machines for $1,200 per month for each machine. Rent, utilities, and
wages will total $2,000 per month. David‟s cost of paper and ink is $0.01 per copy, and he plans
to charge $0.05 per copy.

a. What is his break – even point?

b. Suppose that David thinks he can get by with only four machines. What will his break –
even point fall to?
c. Suppose that David rents four machines and sells 200,000 copies in one month. What is
his NOI for that month?
d. David is considering placing in the student newspaper a $200 ad with a coupon for $0.04
per copy for orders of 50 copies or more. He estimates that if he places the ad, he will sell
250,000 copies and that about 50% of his customers will use the coupon. If he places the
ad, what will his break – even point and his NOI be?

Answer:-

a. 230,000 Copies per Month

b. 170,000 Copies per Month
c. $1,200 = NOI
d. 200,000 Copies per Month, $1,750 = NOI

1 – 32:- The C&D TV store currently has fixed costs of $6,000 per month and $400 per TV set.
Their sales price of the TV sets is $700 each, and their current volume is 25 sets per month.

a. Find C&D‟s break – even point and their NOI and DOL at the current level of sales.
b. Find C&D‟s break – even point and their NOI and DOL if fixed costs decrease to $4,750
and at the time the cost of the TV sets rises to $450.

Answer:-

a. 20 Units per Month, 1,500 = NOI, 5.0 = DOL

b. 19 Units per Month, $1,500 = NOI, 4.1667 = DOL

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1 – 33:- The Newcastle Utility Company has fixed costs of $20,000 per month and sells electricity
for $0.015 per kilowatt-hour. It costs them $0.005 per kilowatt-hour to produce the electricity.

a. What is Newcastle‟s break – even point?

b. What is Newcastle‟s DOL at a sales level of 2,750,000 kilowatt-hours?

Answer:-

a. 2,000,000 Units per Month

b. 3.6667 = DOL

1 – 34:- The Magee Publishing Company last year had sales of $800,000, an NOI of $20,000, and
a DOL of 6. What will its NOI be if sales increase to $900,000?

Answer:-

a. NI for all equity = $270,000, NI for the 50%-50% plan = $126,000

EPS for all equity = $0.450, EPS for the 50%-50% plan = $0.252
DLF for all equity = 1.00, DLF for the 50%-50% plan = 2.14
b. 98,286

1 – 35:- Nater, Inc., expects sales of $4,000 in March, $6,000 in April, $5,000 in May, $4,000 in
June, $5,500 in July. On average, they collect 35% of their monthly sales in cash, 45% in one
month, and 19% in two months (the remaining 1% is bad – debt expense and is never collected).
Find Nater‟s expected cash inflows during the months of May, June and July.

Answer: - Expected Cash Inflows: May = $5,210; June = $4,790; July = $4,675

1 – 36:- Koufand‟s Jewler‟s has expected cash inflows, variable cash outflows (outflows that
depend on sales), and fixed cash outflows as follows:

Jan. Feb. Mar. Apr.

Inflows $600,000 $700,000 $620,000 $500,000
Variable outflows 290,000 330,000 270,000 235,000
Fixed outflows 320,000 320,000 320,000 320,000

Koufand‟s has a cash balance of $50,000 as of January 1 and a minimum desired balance of
$40,000. Find Koufand‟s expected net cash flow for each of the four months listed, and construct
a monthly cash budget for the four months.

Answer: - Cash Surplus (Deficit): Jan = $0; Feb = $50,000; Mar = $80,000; Apr = $25,000

1 – 37:- Five years ago, the Van de Graaf Electric Company purchased a generator for $180,000.
At that time, the generator was estimated to have a salvage value of $30,000 in 15 years (i.e., 10

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years from today). Van de Graff has a marginal tax rate of 25% and uses straight – line
depreciation.

a. What is the book value of the generator today?

b. What will Van de Graaf‟s initial cash flows be if it sells the generator today for $100,000?
c. What will Van de Graaf‟s initial cash flows be if it sells the generator today for @150,000?

Answer:-

a. $130,000
b. $107,500
c. $145,000

1 – 38:- Gamma Rayco is planning to replace an old cathode ray tube (CRT) (book value:
$15,000) with a newer model, which costs $30,000. If it decides to replace the old CRT, it can be
sold for $10,000. Furthermore, the new CRT has installation costs of $1,000 and an anticipated
salvage value of $5,000 in 10 years. Gamma Rayco has a marginal tax rate of 25%. What will be
the net cash outflow associated with the purchase of the new CRT (and the sale of the old one)?

Answer: - $11,250 = CFAT, - $16,500 = Net Cash Flow from Replacement

1 – 39:- The Godfrey Vending Company plans to replace 10 of its vending machines with newer
models. The current machines were purchased three years ago for $8,000 each and are being
depreciated (straight – line) to a salvage value of $2,000 five years from now. The machines
collectively generate annual revenues of $30,000 and annual expenses of $12,000. New machines
can be purchased for $12,000 each and will be depreciated (straight – line) to a salvage value of
$7,000 five years from now. The new machine will generate annual sales of $40,000 because of
less down – time than the old machine and annual expenses of $8,000 (smaller repair bills than
the old machines).

a. If Godfrey‟s marginal tax rate is 25%, what will be the incremental change in its annual
cash flow if the old machines are replaced?
b. Use ACRS instead of straight – line depreciation to compute the annual incremental
changes in operating cash flows from replacing the old vending machines with new
ones. Assume that the vending machines are in the five – year ACRS class.

Answer:-

a. $11,125 = CFAT
b. CFAT1 = $11,125, CFAT2 = $12,625, CFAT3 = $11,025, CFAT4 = $10,065, CFAT5 =
$10,065, CFAT6 = - $1,155

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1 – 40:- Victoria Korchnoi is thinking of importing caviar to sell the restaurants and specialty
stores. She estimates that this venture will require an initial outlay of $300,000 to buy a
refrigerated storage unit, which can be depreciated (straight – line) to a salvage value of $50,000
in eight years. In addition, Ms. Korchnoi estimates that she will need $40,000 in working capital
during in eight years of the project. Annual sales are estimated to be $110,000 and annual
expenses $20,000. Ms. Korchnoi estimates that the marginal tax rate will be 25% during the
lifetime of the project.

a. What is the initial outlay associated with starting the business?

b. What is the annual cash flow from operations?
c. What will be the terminal cash flow in year 8?
d. Assuming that the refrigerated storage unit is in the five – year ACRS class, use ACRS
instead of straight – line depreciation to compute the annual cash flow from operations.
e. What is the payback period for this project?
f. What is the AROR of this project?
g. If Ms. Korchoni requires a 16% RRR to make this investment, what is the project‟s NPV?
What is its PI?
h. What is the project‟s IRR?

Answer:-

a. $340,000
b. $75,312.50
c. $90,000
d. CFAT1 = $80,000, CFAT2 = $87,500, CFAT3 = $79,500, CFAT4 = $74,700, CFAT5 =
$74,700, CFAT6 = $71,100, CFAT78 = $67,500
e. 4.51
f. 22.59%
g. -$49,470.62
h. 15.24%

1 – 41:- Joley‟s department store has recently received the results of a study that suggests that
potential sales are being lost because many customers dislike having to use the elevator in
Joley‟s and prefer to go across the street to Foske‟s department store, which has an escalator.
Consequently, Joley‟s is considering the department store, which has an escalator.
Consequently, Joley‟s is considering the replacement of the elevator with a new escalator. The
elevator was purchased 10 years ago for $140,000 and is being depreciated (straight – line) to a
salvage value of $40,000 10 years from now. It can be sold today for $80,000. The escalator can
be purchased for $300,000 and would be depreciated (straight – line) to a salvage value of
$100,000 in 10 years. In addition, Joley‟s anticipates that having an escalator rather than an

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elevator will increase sales by $20,000 annually and decrease operating expenses by $5,000
annually. Joley‟s has a marginal tax rate of 25%.

a. What is the present book value of the elevator?

b. What is the initial cash outflow associated with the replacement of the elevator?
c. What will the incremental change in annual cash flow be if Joley‟s replaces the elevator?
d. What will the terminal cash flows be if Joley‟s replaces the elevator?

Answer:-

a. $90,000
b. $217,500
c. $21,000
d. $100,000

1 – 42:- Barbarian Pizza is analyzing the prospect of purchasing an additional firebrick oven.
The oven costs $200,000 and would be depreciated (straight – line) to a salvage value of
$120,000 in 10 years. The extra oven would increase annual revenues by $120,000 and annual
operating expenses by $90,000. Barbarian‟s marginal tax rate is 25%.

a. What would be the initial, operating, and terminal cash flows generated by the new
over?
b. What is the payback period for the additional oven?
c. What is the AROR for the additional oven?
d. Barbarian Pizza‟s RRR is 12%. What is the NPV of the additional oven?
e. What is the PI for the additional oven?
f. What is the IRR of the additional oven?

Answer:-

a. $200,000 = Initial CF, CFAT = $24,500, $120,000 = Terminal CF

b. 8.16
c. 10.31%
d. -$22,930
e. 0.7921
f. 7.81%

1 – 43:- Dinesh Vaswami of the Dutch League Importing Company is considering a project that
will require an initial outlay of $1,250,000 for a freighter plus $500,000 working capital. The
freighter will be depreciated (straight – line) to a salvage value of $250,000 in 10 years. This
project is expected to produce sales of $850,000 and require expenses of $425,000 annually for
the next 10 years. Dutch League Importing has a marginal tax rate of 25%.

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a. Calculate the incremental cash flow from operations for this project.
b. Calculate the NPV of this project for the following discount rates: 6%, 8%, 10%, 12%,
14% and 16%. Drew a graph with the NPV on the vertical axis and the discount rate on
the horizontal axis. Where will the NPV curves cross the horizontal axis? Is there any
special significance to the point at which the graph crosses the horizontal axis?

Answer:-

a. $1,750,000 = Initial CF, $343,750 = Annual CF, $750,000 = Terminal CF

b. The curve crosses NPV = 0 at an interest rate of approximately 17% = IRR.

1 – 44:- Plot an NPV profile for Barbarian Pizza in Problem 1 – 42. Uses discount rates of 0%, 5%,
10%, 15%, 20% and 25% in drawing the graph. What is the approximate IRR for the additional
oven?

Answer: - The IRR is approximately 10%. (A calculator determined that the actual IRR equals
9.7%)

1 – 45:- An investment will have a return of 30% if economic conditions improve 20% if they
stay the same and -5% if they get worse. The probability that conditions will improve is 20%,
that they will stay the same is 40%, and that they will get worse 40%. What is the expected
return from this investment?

Answer: - 12% = E(R)

1 – 46:- The DJIA is a number that reflects the value of a portfolio of shares of the 30 DJIA
stocks. Suppose that the stocks in this portfolio have the same return as the market, and that his
return is expected to be 15%. The DIJA is currently 1,150, and you expect it to be 1,270 at the end
of the year. What dividend yield (dividends paid/initial value of the portfolio) do you expect
on this portfolio of 30 DIJA stocks?

Answer: - 4.57% = E(Dividend Yield)

1 – 47:- Given the following investment opportunities, only one of which you can select, which
ones (if any) can you exclude from consideration

a. If you are risk averse?

b. If you are risk averse and use the CV rule?
Standard
Expected Deviation
Opportunity Return (%) of Returns
Build new restaurant 30 20
Purchase existing restaurant 20 10
Build new convenience store 20 10

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Purchase existing convenience store 15 10

Build new adhesive – tape store 5 10
Answer:-

a. The decision is unclear.

b. Choose to buy the old restaurant.

1 – 48:- Two companies respond to the economy in the following manner:

Return on Return on
Valcan Tire Good
Recapping wealth Tire
Co. Shares Co. Shares
Event Probability (%) (%)
Economic upturn 0.3 12 24
No change in the economy 0.4 18 18
Economic 0.3 18 18

One of your friends argues that since both shares have the same expected return and the same
risk (as measured by the standard deviation of returns), investors will be indifferent to buying
shares of either company. Is this true?

Answer: - Vulcan would probably be preferred. Valcan‟s returns are negatively correlated
with the returns of the market and would serve to reduce portfolio risk relatively more than
inclusion of Good wealth.

1 – 49:- Given the following information on two stocks, A and B, answer the following
questions:

Return on Return on
Stock A Stock B Probability
10% 8% 0.3
11% 10% 0.4
12% 12% 0.3

a. What is the expected return on Stock A and B?

b. What are the variances of the rates of return on stock A and B?
c. What is the variance of the rates of return on a portfolio consisting of 20% invested in
stock A and 80% invested in stock B, given that the two stocks are perfectly positively
correlated?

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Answer:-

a. 11% = E(R A ) , 10 = E(R B )

b.  2A 0.6%2 , 2B  2.4%2
c.  P2  0.864%2

1 – 50:- Being a sharp analyst, you have narrowed the possible outcomes for two potential
investments as follows (also included is your estimate of the returns on the market):

State of the Return (%)

Economy Probability Stock A Stock B Market
1 (great) 0.30 25 20 18
2 (good) 0.50 16 14 16
3 (mediocre) 0.20 8 12 14
a. Calculate the expected returns for stocks A and B and the market.
b. Calculate the standard deviation of returns for stocks A and B and the market.
c. Find the covariance between stock A and the market, and between stock B and the
market.
d. Find the correlation coefficients between stock A and the market and between stock B
and the market.

Answer:-

a. 17.1%  E(R A ),15.4%  E(R B ),16.2%  E(R M )

b.  A 5.99%, B  3.10%, M  1.40%
2 2 2

c.  AM  8.38%2 , BM  4.12% 2
d. PAM  1.00, PBM  0.95

1 – 51:- A stock has a beta of 1.5, and the risk – free rate is 10%. What is the expected return on
the stock if

a. The expected return on the market is 14%?

b. The expected return on the market is 16%?
c. The expected return on the market is 18%?

Answer:-

a. E(R M )  16%
b. E(R M )  19%
c. E(RM )  22%

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1 – 52:- A stock has a beta of 1.2 and an expected return of 15% when the market‟s expected
return is 14%. What must the risk – free rate be?

Answer:- Rf  9%

1 – 53:- Stock X has a beta of 0.5, stock Y has a beta of 1.0, and stock Z has a beta of 1.25. the risk
– free rate is 10%, and the expected market return is 18%.

a. Find the expected return on stock X.

b. Find the expected return on stock Y.
c. Find the expected return on stock Z.
d. Suppose that you construct a portfolio consisting of 40% X, 20 Y, and 40%Z. Using your
answers to parts (a), (b), (c), find the expected return on this portfolio.
e. What is the beta of the portfolio specified in part (d)?
f. Using the information in the body of the problem and your answer to part (e), find the
expected return on your portfolio.

Answer:-

a. E(R X )  14.0%
b. E(RY )  18.0%
c. E(RZ )  20.0%
d. E(RP )  17.2%
e.  P  0.90
f. E(RP )  17.2%

1 – 54:- Suppose that the risk – free rate is 12% and the expected market return is 20%. The FM
Corporation has a beta of 0.75 and the Gord Corporation has a beta of 1.25.

a. Find the expected return on the FM Corporation.

b. Find the expected return on the Gord Corporation.
c. Suppose that because of a suddenly unanticipated increase in inflation, the risk – free
rate rises to 16% and the market risk premium remains at 8%. Find the expected return
on FM and Gord.

Answer:-

a. E(RM )  18%
b. E(RFGord )  22%
c. E(RFM )  22%

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d. E(RFGord )  26%

1 – 55:- The Baldwin – Mills Corporation has a beta of 1.25 and pays no dividends. The expected
market return in 20%, and the T – bill rate is expected to remain constant at 10%. You expect
Baldwin – Mills shares to be worth $50 in one year. Using the CAPM, find the value of a share
today.

Answer:- Po  $40.82

1 – 56:- You invested $10,000 in the Jaguar Vitamin Company (which has a beta of 1.5) and
$20,000 in the Laverty Game Corporation (which has a beta of 1.2). The risk – free rate is 10%
and the expected market return is 16%. What are the beta and the expected return of your
portfolio?

Answer:-  P  1.4, E(R P )  18.4%

1 – 57:- You are considering the purchase of 100 shares of the Mead Beverage Company. The
shares pay an annual dividend of $1 (which you expect to remain constant for the next several
years) and have a beta of 1.25. Although you expect the T – bill rate to remain at 10% for the
next three years, you believe that the market return will be 16%, 14%, and 12%, respectively. If
you think that the share price will be $25 immediately after paying the dividend three years
from today, how much are you willing to pay for a share today?

Answer:- PO  $18.69

1 – 58:- The Yorkshire Shrubbery Company uses the WACC approach for determining the RRR
for new projects. Yorkshire‟s financial manager, Steve Smith, has determined that the relevant
cost of equity is 18% and the relevant cost of debt is 12%. Further, he wishes to maintain
Yorkshire‟s current mix of 70% equity, 30% debt.

a. What is Yorkshire‟s WACC for the coming year?

b. Suppose that next year Yorkshire‟s relevant cost of equity is 19% and their WACC is
17.5%. If Steve has maintained the same capital structure (70% equity, 30% debt), what
must the relevant cost of debt have been?

Answer:-

a. WACC = 16.2%
b. WACC = 14.0%

1 – 59:- The Blow Fast Company has determined that it‟s after – tax costs of equity and debt are
16% respectively. Its total capital is $2 million and the firm has $666,667 of equity.

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a. What is Blow Fast‟s WACC?

b. What would Blow Fast‟s WACC be if its capital structure contained $1million in equity?

Answer:-

a. WACC = 12%
b. WACC = 13%

1 – 60:- Consider the situation of Big Catch Fisheries in the previous problem. Big Catch
attempted to raise the full amount of capital needed to start its canning factory with equity. It
failed; Big Catch‟s managers have come up with a revised financing plan that would entail
raising $3 million in equity and $3 million in debt to finance the venture. Given this new
financing plan and the information from the previous problem, should Big Catch invest in the
canning industry?

Answer:- E(RPr oj )  17.6%, NVPV  $39, 454,545

1 – 61:- The Fleener Corporation raised $90 million from a bond issue. The issue of $1,000 face
value, 9.5% bonds (semiannual interest payments) maturing in 25 years sold at par, with a 6%
flotation fee. Fleener is in the 25% marginal tax bracket. What is the YTM, adjusted for flotation
costs?

Answer:- kd  7.63%

1 – 62:- Fleener is retaining $10 million of earnings this year for reinvestment in the company.
This year‟s dividend is $2 per share, and it is estimated that investors expect a dividend growth
rate of 6% for the indefinite future. The stock is now selling for $25 per share. What is the cost of
capital for the retained earnings?

Answer:- ks  14.48%

1 – 63:- The Horizon Products Company raised $2 billion of new capital from the following
sources. Calculate the WACC for this increment of funding.

$800 million from bonds with an after – tax cost of capital of 6%.
$400 million from an issue of preferred stock, which costs 14%.
$500 million from retained earnings, which costs 19%.
$300 million from new common stock, which costs 20%.
Answer: - WACC = 12.95%

1 – 64:- The Dooley Company is in the 25% marginal tax bracket. The current market value of
the firm is $10 million. If there are no costs to bankruptcy:

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a. What will Dooley‟s annual tax savings from interest deductions are if it issues $2million
of five – year bonds at a 12% interest rate? What will be the value of the firm?
b. What will Dooley‟s annual tax savings from interest deductions are if it issues $2 million
of perpetual bonds at a 12% interest rate? What will be the value of the firm?

Answer: -

a. PV of Tax Shield = $216,288, V L  $10, 216, 288

b. PV of Perpetual Debt = $500,000, V L  $10, 500, 00

1 – 65:- The Geraci Corporation issued $50 million in equity and invested the entire proceeds in
rental property. The Pollard Corporation, on the other hand, invested in similar property by
issuing $25 million in equity and $25 million in debt. The market value of the property ($25
million) is the same for both companies. Because the Pollard Corporation plans to continuously
refinance (roll over) the debt at maturity, its debt is effectively perpetual. If Pollard is in the 15%
tax bracket and its debt carries a coupon interest rate of 10%, by how much will the value of
Pollard exceed the value of Geraci?

Answer: - Pollard is $3.75 m more valuable than Geraci.

1 – 66:- Linguistics International has just issued perpetual bonds with a face value of $6 million,
paying 10% per year.

a. If Linguistics is in the 25% tax bracket, what are its annual tax savings on interest
payments?
b. What is the value of the tax saving on interest? (Assume that the bonds were sold at face
value.)

Answer:

a. Annual Tax Savings = $0.15m

b. Total Tax Savings = $1.5 m

1 – 67:- The Hamilton Federal Paper Company is planning to open a new mill near Madison,
Wisconsin. This project will require an initial outlay of $20 million during the coming year, and
Hamilton is trying to decide whether to raise the money with common stock or with bonds.
Hamilton currently has 6 million shares outstanding, and the shares and treading for $10 each.
Hamilton currently has no long – term debt in its capital structure, but if bonds are issued, they
can be sold at a 12% interest rate. The company has a marginal tax rate of 25%.

a. If Hamilton raises the money by selling new shares, how many new shares must be
issued?

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b. If Hamilton issues mew shares, what will EPS be if NOI is $8 million next year? If NOI is
$12 million next year?
c. If Hamilton issues bonds, what will its annual interest payments are?
d. If Hamilton issues bonds, what will EPS be if NOI is $8 million next year? If NOI is $12
million next year?
e. Your answers to parts (b) and (d) should be that the equity plan has higher EPS than the
debt plan if NOI is $8 million but that lower EPS will result if NOI is $12 million. Will it
always be true that issuing equity is more favorable (i.e., has a higher EPS than debt) if
NOI is low and debt is more favorable if NOI is high?
f. At what level of NOI will EPS be the same for either plan?

Answer:-

a. 2,000,000
b. EPS = $0.75, EPS = $1.13
c. Interest = $ 2,400,000
d. $0.70
e. It will always be true that debt is more attractive, as measured by EPS, than equity at
relatively low levels of NOI.
f. NOI = $9,600,000

1 – 68:- The McGovern Bakery Chain manufactures French breads and pastries and is
considering expansion into the West Coast area. Such a move would necessitate a capital
expenditure of $200 million. McGovern is considering raising this money through one of two
plans: (1) sell 20 million new shares of stock at $10 each of (2) sell 10 million new shares of stock
at $10 each and sell $100 million of 13.7% coupon bonds. McGovern currently has outstanding
100 million common shares and $500 million face value of 12% coupon bonds. McGovern‟s
marginal tax rate is 25%.

a. What will EPS be if McGovern adopts plan 2 and NOI is $200 million? If NOI is $250
million?
b. What will EPS be if McGovern adopts plan 1 and NOI is $200 million? If NOI is $250
million?
c. At what level of NOI will the two plans have the same EPS?

Answer:-

a. EPS = $0.86, EPS = $1.20

b. EPS = $0.88, EPS = $1.19
c. $224.5 m

1 – 69:- The Zapata Mexican Food Company needs $25 million to produce and market its new
frozen dinner, the “Zapata Supreme.” Zapata will raise the money either by selling 500,000 new

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common shares at $50 each or by selling 625,000 shares of $5 dividend preferred stock at $40
each. Zapata currently has outstanding 4.5 million shares of common stock and no preferred
stock. Their marginal tax rate is 25%.

a. If Zapata issues preferred shares, what is the required annual dividend? What must NOI
be to cover this dividend?
b. What will EPS be under each of the two plans if NOI is $45 million? If NOI is $55
million?
c. At what level of NOI will EPS be the same under either plan?

Answer:-

a. Preferred Dividend = $3,125,000, NOI = $4,166,667

b. EPS for Plan 1 = $6.75, EPS for Plan 2 = $6.81
EPS for Plan 1 = $8.25, EPS for Plan 2 = $4.47
c. NOI = $41.67m

1 – 70:- Harris Services is analyzing a proposal to change its capital structure from 100% equity
to 80% equity/20% debt. The financial vice – president has presented you with the following
information and requests that you determine whether the proposal is viable. More specifically,
will Harris have a surplus or deficit of funds in each of the next four years if the plan is
adopted? What would your recommendation be in either case?

Year
1 2 3 4
Operating Revenues
Net funds from operations $25 $35 $60 $55
Change in Non – cash Working Capital Items
Funds from working capital ($2) ($1) ($3) ($1)
Non – Operating Expenses
Total non – operating expenses $20 $18 $15 $20
Disbursements to Providers of Capital
Total disbursement to providers of capital $20 $22 $19 $22
Beginning funds $3 $2 $2 $1

Answer: - If we have access to funds that will enable us to cover our short – term deficits,
then the financing plan is feasible.

1 – 71:- Prepare the list of the factors that mangers must take into account in making the
dividend payment decision.

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Answer:- Transaction costs, flotation costs, institutional restrictions, the firm‟s financial
resources, flexibility, access to equity capital, control of the firm, ability to borrow, past
dividend policy and inflation. This list is not exhaustive.

1 – 72:- Company A declares a dividend on May 10, 1986, to all stockholders on record on May
14. If Howard Smith buys the stock from Ralph Biggy on May 16, who is entitled to the
dividend?

Answer: - The dividend will be paid to Mr. Biggy.

1 – 73:- The Zetamax Corporation has expected earnings of $4.5 million. It plans a total
investment outlay of $3 million this year. Historically, Zetamax has had a dividend payout ratio
of 25%. Calculate the amount of dividends that the company will distribute.

Answer: - $375,000

1 – 74:- XYZ Company has issued 100,000 shares ($2 per value) at $15 per share. The company‟s
retained earnings amount to $5 million and its current stock price is $50 per share. If the
company declares a 15% stock dividend, show how the stockholders equity section of the
company‟s balance sheet will appear before and after the stock dividend.

Answer: - After the stock dividend, Com stock = $230,000; paid – in – capital = $2,020,000;
Rent Earn = $4,250,000; Total stockholders‟ equity = $6,500,000

1 – 75:- The Kaler Appliance Store is considering the acquisition of a personal computer and
associated software to improve the efficiency of its inventory and accounts receivable
management. Andrea Kaler estimates that the initial cash outflow for the computer and
software will be $15,000, and the associated net cash savings will be $3,000 annually.

a. If Kaler‟s discount rate for the cash flows associated with this project is 12% and the
$3,000 savings will occur for only 10 years (at which time the computer and software are
valueless), should she buy the computer?
b. What if the project lasts 10 years but the discount rate is 16%?
c. What if the project lasts forever and the discount rate is 12%?
d. What if the project lasts forever and the discount rate is 16%?

Answer:-

a. $1,951
b. -$500
c. $10,00
d. $3,750

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1 – 76:- Jimmy Hilliard, manager of the Hilliard Racquetball Club, is considering lowering the
usage fee for the courts. He estimates that this will result in an immediate (one – time) cash flow
of $18,000 from new membership fees. On the other hand, the annual net cash flow from usage
fees is expected to fall by $3,000 indefinitely (because of the lower fees).

a. Should Jimmy lower the usage fee if his discount rate for this project is 15%?
b. Should he lower the usage fee if his discount rate for this project is 20%?
c. At what discount rate would he be indifferent to lowering the usage fee?

Answer:-

a. -$2,000
b. $3,000
c. 16.7%

1 – 77:- The Crary Seafood Company has annual sales of $1,440,000. Its average levels of
accounts receivable, inventory, and accounts payable are as follows (these levels are expressed
in terms of sales dollars):

Accounts receivable $50,000

Inventory 14,000
Accounts payable 28,000
a. Assuming a 360 – day‟s year, what are average daily sales?
b. How many days of sales are represented by accounts receivable?
c. How many days of sales are represented by inventory?
d. How many days of sales are represented by accounts payable?
e. What is Crary‟s net cash conversion rate?
f. Suppose that sales and the current accounts shown are all to increase by 25%. What
would the new net cash conversion cycle be?

Answer:-

a. $4,000
b. 13.0
c. 3.5
d. 7.0
e. 9.5
f. 9.5

1 – 78:- The Corporeal Foods Company is considering certain changes that will result in
increased automation of food processing and canning. This change will require an additional
investment of $40,000 is fixed assets, but it will allow the level of current assets to decrease by
$40,000 because of an increase in operating efficiency. Corporeal currently has current assets of

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$160,000, fixed assets of $240,000, and current liabilities of $100,000. Further, Corporeal‟s board
of directors has estimated that investment in fixed assets yields 18% on average. Hence
Corporeal‟s return on total assets is now.

$160, 000 (0.08)  $240, 000 (0.18)  14%

$160, 000 $240, 000 $160, 000 $240, 000

a. Calculate Corporeal‟s present current ratio and level of working capital.

b. Calculate Corporeal‟s current ratio, level of working capital, and return on total assets if
the change to increased automation is made. Will the change increase or reduce the
liquidity risk? Will it increase or reduce profitability?

Answer:-

a. 1.60, $60 k
b. 1.20, $20 k, 15%

1 – 79:- Allen Motors last year has sales of $7,200,000 and current assets and liabilities as
follows:

Cash $20,000 Accounts payable $80,000

Market securities 10,000 Notes payable 120,000
Accounts receivable 60,000 $200,000
Inventory 450,000
$540,000

Assume that the levels of cash, accounts receivable, inventory, and accounts payable change in
the same proportion that sales do (e.g., if sales are 10% higher next year, you would also expect
each of these four accounts to be 10% higher).

a. What is the current ratio now?

b. If sales increase by 10%, what will the new current ratio be?
c. To what value must sales fall for the current ratio to fall to 2.0?
d. To what value must sales fall for the current ratio to fall to 1.0?

Answer:-

a. 2.7
b. 2.851
c. $4,475,520
d. $1,759,680

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1 – 80:- The Jameson Building Supplies Company has annual sales of $9 million (all credit). On
average, it takes five days for a customer‟s mailed check to be deposited. Mel Jameson believes
that he can reduce this float time by two days through the use of a lockbox. The bank will
charge a flat fee of $4,000 per year to perform this service.

a. What are average daily sales for January? (Assume a 360 – day‟s year.)
b. All of January‟s receipts from sales go into a money market mutual fund. By how much
will the average balance in this fund increase if Mel adopts the use of the lockbox?
c. Suppose that the money market fund earns 10% per year. Should Mel enter into the
lockbox agreement?
d. Should Mel enter into the lockbox agreement if the money market fund earns 10% but
the lockbox reduces float by only one day?

Answer:-

a. $25m
b. $50k
c. Accept
d. Reject

1 – 81:- The Texron Oil Company is headquartered in Houston but has customers in Dallas, Fort
Worth, EI Paso, San Antonio, and Austin as well Mark Hannah, the collections manager, is
planning to open collection offices in these cities to speed up the collection manger, is planning
to open collection offices in these cities to speed up the collection process. The dollar volume of
collections, the annual cost of running the collections center and the reduction in float time for
each city are as follows:

Annual Annual Cost of Reduction in

City Collections Center Float Time (Days)
Dallas $300,000,000 $80,000 1
Fort Worth 160,000,000 76,000 2
El Paso 120,000,000 75,000 3
San Antonio 220,000,000 78,000 2
Austin 150,000,000 80,000 2

a. Using a 360 – day year, find the daily collections from each of the five cities.
b. What marginal increase in deposits (because of reduced float) will each city‟s collection
center contribute to Texron‟s deposits?
c. Suppose that the rate earned on these accounts is 8%. In which cities (if any) should Mr.
Hannah open up collection centers?

Answer:-

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a. Dallas = $833,333; Fort Worth = $444,444; EI Paso = $333,333; San Antonio = $611,111;
Austin = $416,667
b. Dallas = $833,333; Fort Worth = $888,889; EI Paso = $1,000,000; San Antonio = $19,778;
Austin = $833,333
c. Dallas = -$13,333; No: Fort Worth = -$4,889; No: EI Paso = $5,000; Yes: San Antonio =
$19,778; Yes: Austin = -$13,333; No

1 – 82:- Andrew Senchack, financial manager of the Phoenix Renovation Service, has been
keeping the firm‟s funds in the Sparrow Fund, a money market fund that pays 8% on deposits
and has no charge for withdrawals. Andrew has found another fund, the Hawkeye Fund, which
pays 10.5% on deposits but has a $20 fee for a withdrawal of any size. Phoenix has annual cash
disbursements of $4 million. Andrew is considering establishing on account with Hawkeye,
transferring funds to Sparrow only occasionally, and using the Sparrow account to handle daily
transactions.

a. Using a 360 – day year, find the daily disbursement of funds.

b. When Andrew makes a transfer, what will the size of the transfer be?
c. How often will Andrew make transfers?
d. If Andrew does not change to the Hawkeye Fund, what is his average balance in the
Sparrow Fund (assuming the $4 million for disbursements is available at the beginning
of the year)? What annual interest does this account earn?
e. If Andrew establishes the Hawkeye account, what will be his average balance in
Sparrow? His annual interest from Sparrow?
f. What will be the average balance in Hawkeye? The annual interest from Hawkeye?
g. What is the marginal dollar value of establishing the Hawkeye account?

Answer:-

a. $11,111.11
b. $80,000
c. 7.2 days
d. $320,000
e. $40,000, $3,200
f. $1,960,000, $205,800
g. -$112,000

1 – 83:- The National Record Club (based in New York) has many mail – order customers in
California and is losing substantial revenue as a result of the average of seven days between the
time a customer, deposits his payment and the time the deposit is credited to National‟s account
in a New York bank. Accordingly, Socorro Quintero, collections manager for National, is trying

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to find a way to reduce this float time and has narrowed the solutions to (1) operating a
collection center in Los Angeles or (2) opening lockbox accounts in the major California cities.
Socorro estimates that a collection center in Los Angeles will require an annual expenditure of
$70,000. Lockbox expenditure and new float time for each city are shown in the following table.

Float Time for Float Time for

Los Angeles Lockbox Lockbox Annual
City Collection Center (Days) Expenses (Days) Receipts
Los Angeles 1 $25,500 1 $18,000,000
San Francisco – Oakland 2 15,000 1 10,000,000
San Diego 2 18,000 1 12,000,000
Santa Barbara 2 14,000 1 8,000,000
Pasadena 3 9,000 1 6,000,000

Any receipts are placed in a money market fund yielding 10%

a. Find the net marginal benefit of opening the Los Angeles collection center.
b. Find the net marginal benefit of opening each lockbox.
c. What should Socorro do?

Answer:-

a. $8,333 = Net Benefit

b. Los Angeles = $4,500, San Francisco – Oakland = $1,667, San Diego = $0, Santa Barbara
= -$667, Pasadena = $1,000
c. Choose the L.A. collection center

1 – 84:- Steve Smith is credit manager for the southeast branch of the Earnest, Pearce, and Brown
Clothing Stores. The stores currently under Steve‟s responsibility have annual credit sales of $60
million. Operating costs total 90% of sales. The average collection period is 40 days and bad –
debt losses total 2% of sales. The Mueller Credit Corporation has guaranteed that it can reduce
the average collection period to 30 days and bad – debt loss to 0.5% of sales. However, Steve
estimates that the changes necessary to implement the Mueller proposal will reduce annual
credit sales to $50 million. Any reduction in current assets will allow Steve to reduce current
liabilities by the same amount. The estimated cost of short – term credit is 10%. Mueller Credit
will charge an annual fee of $75,000 for their service. Steve is determining the marginal benefits
and costs of hiring Muller before making a final decision. If Mueller is hired:

a. What is the marginal savings from the reduced bad – debt loss?
b. What is the marginal savings from the reduced investment in accounts receivable?
c. What is the marginal expense of lost sales?
d. What should Steve do?

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Answer:-

a. -$950,000
b. $250,000
c. -$1,000,000
d. $125,000

1 – 85:- Bobby Wolff, manager of Ace Groceries, has some extra space in one store and is trying
to decide between opening a pharmacy and a record and tape department. The relevant data
are as follows:

Record and Tape

Pharmacy Department
Average age of inventory 30 days 90 days
Average collection period 30 days 60 days
Bad – debt loss 1% 2%
Annual sales $540,000 $450,000
Operating cost as percentage 0.60 0.50

Bobby estimates that any investment in current assets has an opportunity cost of 12%.

a. What is average level of inventory for each plan measured in sales dollars? Measured in
terms of the cost of goods sold dollars?
b. What is the average level of accounts receivable for each plan?
c. What is the cost of the required increase in current assets for each plan?
d. What is the bad – debt expense for each plan?
e. What is the gross profit (sales – cost of goods sold) for each plan?
f. What plan should Bobby choose?
g. What plan should Bobby choose if the opportunity cost of investing in current assets is
only 6%?

Answer:-

a. Pharmacy: Sales = $45,000, CGS = $27,000

Record and Tape: Sales = $112,500, CGS = $56,250
b. Pharmacy: Average A/R = $45,000
Record and Tape: Average A/R = $75,000
c. Pharmacy: Change in Fixed Assets = $8,640
Record and Tape: Change in Fixed Assets = $15,750
d. Pharmacy: Bad Debt Expense = $9,000
Record and Tape: Bad Debt Expense = $9,000
e. Pharmacy: Gross Profit = $216,000

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Record and Tape: Gross Profit = $225,000

f. Accept the Pharmacy
g. Accept the Record and Tape Department

1 – 86:- Tom Buggington, the new inventory manager for Nordic Designs, a paint company, has
decided that the EOQ for the company is 200 ten gallon cans per order. He arrived at this
number taking into account the company‟s ordering cost of $200 per order and its annual
holding cost of $4 per can. How many cans does Nordic Designs sell? How many orders will
the company have to place to meet its requirements?

Answer:- Demand = 400, Order = 2

1 – 87:- Your credit card has an interest rate of 1.5% per month.

a. What is the approximate annual rate (or simple annual rate)?

b. What is the effective annual rate (compounded annual rate)?

Answer:-

a. 18%
b. 19.56%

1 – 88:- On August 1, you purchase some materials on terms of 1/10, n40.

a. What is the last day on which you can pay and still take a discount?
b. What is the amount of the discount?
c. When is payment due if you do not take the discount?
d. What is the approximate annual rate of interest that you are paying by failing to take the
discount?

Answer:-

a. August 11
b. 1%
c. September 10
d. 12.12%

1 – 89:- The Traynm Distributing Company offers a 2% discount on cash purchases and a 1%
discount for payment within 20 days. If you take neither discount, payment must be made in 60
days.

a. What is the cost of forgoing the cash discount and paying in 60 days instead?
b. What is the cost of forgoing the 20 – days discount and paying in 60 days instead?

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c. What is the cost of forgoing the cash discount and paying in 20 days instead?
d. If the interest rate on short – term notes is 18%, what should you do?

Answer:-

a. 12.24%
b. 9.09%
c. 18.18%
d. 9.09%

1 – 90:- What is the cost of foregoing a cash discount if the terms are

a. 1/10, n20?
b. 2/10, n30?

Answer:-

a. 36.36%
b. 36.37%

1 – 91:- Hoffman‟s Bait Shop needs to finance an increase in working capital in preparation for
the fishing season. Owner Rodney Hoffman is seeking a revolving credit agreement with the
Groos National Bank. He can establish a $200,000 line of credit with a commitment fee of 1½%
per year on the unused balance, or he can establish a $400,000 line of credit with a commitment
fee of only 1%. In either case, the cost of borrowed funds is 15% per year. Rodney will need to
borrow funds for only 90 days. The commitment fee is paid when the loan is taken out. Assume
a 360-day year. What is Rodney‟s effective annual interest rate if he secures the $200,000 lien of
credit and actually borrows $100,000?

Answer: - 15.06%

1 – 92:- The Milner – Barry Vending Company needs to raise $60 million for a period of 120
days. Irv Davidson, financial manager of Milner – Barry, is choosing between two plans for
issuing commercial paper. The first calls for 16% annual interest with a dealer‟s commission of
$150,000. The second calls for 15.2% discounted interest with a dealer‟s commission of $300,000.
Which plan should Irv choose? What is the commission on the 15.2% commercial paper were
only $200,000?

Answer: - Choose plan A under either commission schedule.

1 – 93:-The Campbell Sporting Goods Store currently pays its employees on the 1 st and the 15th
of every month and is considering paying wages monthly instead. (Assume that there are 30
days in every month.) Campbell has 340 employees, who are paid an average of $2,000 monthly.

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If Campbell‟s other sources of short – term credit have a cost of 15%, how much will Campbell
save annually by making the switch to monthly wages?

Answer: - Savings = $20,400

1 – 94:- Anita Ewing‟s electricity bill is for $120 and is due May 5. There is a 5% discount if the
bill is paid by April 5. What is the implicit simple annual interest rate being paid by not taking
the discount? The implicit compound annual interest rate?

Answer: - Simple Interest = 63.16%, Compound Interest = 85.06%, Accept the Discount

1 – 95:- Warrants of the Escher Cheese Importing Company are trading for $4. The warrants
entitle the bearer to buy one share of stock for $50. Can you draw an inference concerning share
price?

Answer: - Less than $54

1 – 96:- Warrants of the Bournias Manufacturing Corporation have a subscription price of $60.
The share price is currently $67 and the warrant currently trades for $9.50.

a. What is the formula value (or minimum value) of the warrant?

b. What is the warrant‟s premium?

Answer: - WP =$2.50

1 – 97:- The Miller Insurance Company currently has a capital structure of $60 million in equity
and $40 million in debt, both expressed in book – value terms. Miller is about to issue $20
million of $1,000 face – value bonds, each with a warrant attached that entitles the bearer to buy
10 shares at $50 each.

a. What will the capital structure be immediately after Miller issues the bonds?
b. If all the warrants are exercised if five years and no new shares or bonds are sold
between now and then, what will the capital structure be in five years?
c. If Miller wishes to keep the subscription price at $50, how many shares must they allow
the bearer of one warrant to buy if they wish to have their current capital structure if all
the warrants are exercised?

Answer:-

a. Prop of Equity = 50% and the Prop of Debt = 50%

b. Prop of Equity = 53.8% and the Prop of Debt = 46.2%
c. 30

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1 – 98:- A 10% coupon bond that is convertible to 40 shares of common stock was issued six year
ago. The bond has 14 years left to maturity. Today the share price is $29 and the yield to
maturity of nonconvertible but otherwise similar bonds is 9%.

a. What is the conversion ratio of the bond?

b. What is the conversion price of the bond?
c. What can you say about the price of the bond today?
d. What can you say about the price of the bond if the yield to maturity on nonconvertible
bonds with the same risk falls to 7% while stock price remains at 29?
e. What can you say about the price of the bond if the yield to maturity of nonconvertible
bonds with the same risk says at 9% but the price falls to %26?

Answer:-

a. 40
b. $25
c. The price must be greater than $1,160
d. Price = $1,262.36
e. The price will be greater than $1,077.86 but less than $1,160.

1 – 99:- The Kinetico Corporation is issuing 20 – year, 8% coupon convertible bonds at par. The
bonds have a conversion ratio of 25. The common shares just paid a dividend of $0.50.
Dividends are expected to grow at a 10% annual rate, and investors required return on the stock
is 15%.

a. Using the Gordon growth formula, find the value of a share today.
b. What do you expect the value of a share to be 10 years from now?
(Hint: Find D11 and use the Gordon growth formula to find P10.)
c. Will you convert the bond? Using the yield – to – maturity formula,
I  (Bn  Bo ) / n
YTM 
(Bn  Bo ) / 2

Where I is the coupon payment, n the number of years to maturity, and Bj the value of the
bond at time j, find the anticipated yield to maturity of this bond.

Answer:

a. $11.00
b. $28.60
c. The return will be 10%>8.6%

1 – 100:- John Polonchek is considering purchase of ETT‟s new issue of 20 – year, 7% coupon
bonds with a warrant. The warrant entitles the bearer to purchase 10 shares of ETT stock for $25

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per share. John expects ETT shares to pay a $1 dividend at the end of the year of expects the
dividends to grow by 8% annually. Furthermore, John feels that investors will require a 16%
return on the shares.

a. Using the Gordon growth formula, find the value of a share today.
b. Find the value of a share in year 20. (Hint: Calculate D21 and use the Gordon growth
formula.)
c. Assume that John does not wish to sell or exercise warrants until the maturity date. Will
he exercise them at the end of the 20th year? Using the yield – to – maturity formula [see
Problem 1 – 99 (c)], find John‟s yield to maturity on the bond.

Answer:-

a. $12.50
b. $58.26
c. Exercise

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The End

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