Prob Coz Fulll

CORPORATE FINANCE
PROBLEMS
&
SOLUTIONS
Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

PROBLEM 2.6
The Klaven Corporation has operating income (EBIT) of

$750,000. The company’s depreciation expense is
$200,000. Klaven is 100 % equity financed, and it faces a
40% tax rate. Assume that the firm has no amortization
expense. What are its net income, its net cash flow, and its
operating cash flow ?

P 2.6 - SOLUTION
EBIT = $750,000 DEP = $200,000 AMORT = 0 100% Equity T = 40%
NI = ? NCF = ? OCF = ?
First, determine net income by setting up an income statement:

EBIT $750,000
Interest 0
EBT $750,000
Taxes (40%) 300,000
NI $450,000
NCF = NI + (DEP & AMORT) = $450,000 + $200,000 = $650,000
OCF = EBIT(1 - T) + (DEP & AMORT)

= $750,000 (0.6) + $200,000 = $650,000
Note that NCF = OCF because the firm is 100 % equity financed.

PROBLEM 2.11
Computer World Inc. Reported paying out $22.5 million in
total dividends to shareholders during the most recent year,
and in its year-end balance sheet Computer World reported
$278.9 million of retained earnings. Its balance sheet the
previous year showed $ 212.3 million of retained earnings.
What was the fırm’s reported net income for the current
year ? In its recent income statement.

P 2.11 - SOLUTION
Ending R/E = Beg. R/E  Net income  Dividends
$278,900,000 = $212,300,000  Net income  $22,500,000
$278,900,000 = $189,800,000  Net income
Net income = $89,100,000

PROBLEM 2.13
Hermann Industries is forecasting the following income statement for the
upcoming year:
Sales $8,000,000
Operating costs (excluding D&A) 4,400,000
EBITDA $ 3,600,000
Depr. & amort. 800,000
EBIT $ 2,800,000
Interest 600,000
EBT $ 2,200,000
Taxes (40%) 880,000
Net income $ 1,320,000
The company’s CEO is disappointed with the forecast and would like to see
Hermann generate higher sales and a forecasted net income of$2,500,000.
Assume that operating costs (excluding depreciation and amortization) are
always 55 % of sales. Assume that the company’s depreciation and
amortization and interest expenses will increase by 10 % from what they are
now. The compan’s tax rate, which is 40 %, will remain the same. What level
of sales would the firm have to obtain to generate $2,500,000 in net income ?

P 2.13 - SOLUTION
Working up the income statement we can calculate the new sales level.
It would be $12,681,482.
Sales $12,681,482 $5,706,667 / (1  0.55)

Operating costs (excluding D&A) 6,974,815 $12,681,482  0.55
EBITDA $ 5,706,667 $4,826,667 + $880,000
Depr. & amort. 880,000 $800,000  1.10
EBIT $ 4,826,667 $4,166,667 + $660,000
Interest 660,000 $600,000  1.10
EBT $ 4,166,667 $2,500,000 / (1  0.4)
Taxes (40%) 1,666,667 $4,166,667  0.40
Net income $ 2,500,000

PROBLEM 3.3
Doublewide Dealers has an ROA of 10 %, a 2 % profıt

margin, and a return on equity equal to 15 %.
What is the company’s total assets turnover ?
What is the firm’s equity multiplier ?

P 3.3 - SOLUTION
ROA = 10% PM = 2% ROE = 15%, THEN S / TA = ? TA / E = ?
ROA = NI / A PM = NI / S ROE = NI / E
ROA = PM  S / TA
NI / A = NI / S  S / TA
10% = 2%  S / TA
S / TA = 5
ROE = PM  S / TA  TA / E
NI / E = NI / S  S / TA  TA / E
15% = 2%  5  TA / E
15% = 10%  TA / E
TA / E = 1.5

PROBLEM 3.21
Complete the balance sheet and sales information in the table that
follows for Hoffmeister Industries using the following financial data:
Debt ratio : 50 %
Current ratio : 1.8 x
Total assets turnover : 1.5 x
Days sales outstanding : 36.5 daysa
Gross profıt margin on sales : (Sales-Cost of goods sold)Sales =25%
Inventory turnover ratio : 5x
a
Calculation is based on a 365 day year.

PROBLEM 3.21
BALANCE SHEET
_________________________________________________________
Cash _____ Accounts Payable _____
Accounts Receivable _____ Long-Term Debt60,000
Inventories _____ Common Stocks _____
Fixed Assets _____ Retained Earnings 97,500
Total Assets 300,000 Total Liab.&Equity _____
Sales _____ COGS _____

P 3.21 - SOLUTION
1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000
2. Accounts payable = Debt – Long-term debt = $150,000 - $60,000 = $90,000
3. Common stock = T. Liabilities - Debt - Retained earnings

= $300,000 - $150,000 - $97,500 = $52,500
4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000
5. Inventories = Sales / 5 = $450,000 / 5 = $90,000
6. Accounts receivable = (Sales / 365)(DSO) = ($450,000 / 365)(36.5) = $45,000

P 3.21 - SOLUTION
7. Cash + Accounts receivable + Inventories = (1.8)(Accounts payable)

Cash + $45,000 + $90,000 = (1.8)($90,000)
Cash + $135,000 = $162,000
Cash = $27,000
8. Fixed assets = Total assets - (Cash + Accounts receivable + Inventories)

Fixed assets = $300,000 - ($27,000 + $45,000 + $90,000)
Fixed assets = $138,000
9. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) = $337,500

PROBLEM 3.21 - SOLUTION
BALANCE SHEET
_________________________________________________________
Cash 27,000 Accounts Payable 90,000
Accounts Receivable 45,000 Long-Term Debt 60,000
Inventories 90,000 Common Stocks 52,500
Fixed Assets 138,000 Retained Earnings 97,500
Total Assets 300,000 Total Liab.&Equity 300,000
Sales 450,000
COGS 337,500

PROBLEM 4.10
The real risk-free rate, k*, is 2.5 %. Inflation is expected to
average 2.8 % a year for the next 4 years, after which
time inflation is expected to average 3.75 % a year.
Assume that there is no maturity risk premium. An 8 year
corporate bond has a yield of 8.3 %. Assume that the
liquidity premium on the corporate bond is 0.75 %. What
is the default risk premium on the corporate bond ?

P 4.10 - SOLUTION
kC8 = k* + IP8 + MRP8 + DRP8 + LP8
8.3% = 2.5% + [(2.8%  4 + 3.75%  4)/8] + 0.0% + DRP8 + 0.75%
8.3% = 2.5% + 3.275% + 0.0% + DRP8 + 0.75%
8.3% = 6.52% + DRP8
DRP8 = 1.77%

PROBLEM 5.6
Stocks X and Y have the following probability distributions of
expected future returns:
PROBABILITY X Y______
0.1 (10%) (35%)
0.2 2 0
0.4 12 20
0.2 20 25
0.1 38 45
a. Calculate the expected rate of return, k, for Stock Y. (kx = 12 %.)

b. Calculate the standard deviation of expected returns for Stock X.
(That for stock Y is 20.35 %.) Now calculate the coeffıcient of
variation for Stock Y. Is it poosible that most investors might
regard stock Y as being less risky than Stock X ? Explain.
P 5.6 - SOLUTION
a. k =  Pi ki
kY = 0.1(-35%) + 0.2(0%) + 0.4(20%) + 0.2(25%) + 0.1(45%)

kY = 14% versus 12% for Stock X.
b. 2 =  (ki – k)2 Pi
2X = (-10% - 12%)2(0.1) + (2% - 12%)2(0.2) + (12% - 12%)2(0.4)
+ (20% - 12%)2(0.2) + (38% - 12%)2(0.1) = 148.8%
X = 12.20% versus 20.35% for Stock Y.
CVX = X / kX = 12.20% / 12% = 1.02, while
CVY = 20.35% / 14% = 1.45
If Stock Y is less highly correlated with the market than X, then it might have a
lower
Doç. Dr.beta thanTaş
Oktay Stock X, and hence be less riskyİstanbul
in a portfolio
Teknik sense.
Üniversitesi
PROBLEM 5.7
Suppose kRF = 9%, kM =14 %, and bi = 1.3

a. What is ki, the required rate of return on Stock i ?
b. Now suppose kRF (1) increases to 10 % or
(2) decreases to 8 %. The slope of the SML remains
constant. How would this affect kM and ki ?
c. Now assume kRF remains at 9 % but kM (1) increases
to 16 % or (2) falls to 13 %. The slope of the SML does
not remain constant. How would these changes affect
ki ?
P 5.7 - SOLUTION
a. ki = kRF + (kM - kRF) bi = 9% + (14% - 9%)1.3 = 15.5%
b. If kRF increases to 10%, kM increases by 1%, from 14% to 15%

ki = kRF + (kM - kRF) bi = 10% + (15% - 10%)1.3 = 16.5%
If kRF decreases to 8%, kM decreases by 1%, from 14% to 13%

ki = kRF + (kM - kRF) bi = 8% + (13% - 8%)1.3 = 14.5%
c. If kM increases to 16%:
ki = kRF + (kM - kRF)bi = 9% + (16% - 9%)1.3 = 18.1%
If kM decreases to 13%:
k =k + (kM - kRF) bi = 9% + (13% - 9%)1.3 = 14.2%
Doç. Dr. Oktay
i
Taş
RF
İstanbul Teknik Üniversitesi
PROBLEM 5.11
Stock X has an expected return of 10 %, a beta coefficient of 0.9,
and a standard deviation of expected returns of 35 %. Stock Y has
an expected return of 12.5 %, a beta coefficient of 1.2, and a
standard deviation of expected returns of 25 %. The risk-free rate
is 6 %, and the market risk premium is 5 %.
a. Calculate each stock’s coefficient of variation.

b. Which stock is riskier for diversifıed investors ?
c. Calculate each stock’s required rate of return.
d. On the basis of the stocks’ expected and required returns, which
stock would be most attractive to a diversifıed invertor ?
e. Calculate the required return of portfolio that has $7,500 invested
in Stock X and $2,500 invested in Stock Y.
f. If the market risk premium increased to 6 %, which of the two
stocks would have the largest increase in their required return ?

P 5.11 - SOLUTION
kX = 10% bX = 0.9 X = 35%
kY = 12.5% bY = 1.2 Y = 25%
kRF= 6% RPM = 5%
a. CVX = 35% / 10% = 3.5 CVY = 25% / 12.5% = 2.0
b. For diversified investors the relevant risk is measured by beta.

Therefore, the stock with the higher beta is more risky.
Stock Y has the higher beta so it is more risky than Stock X.
c. kX = 6% + 5% (0.9)
kX = 10.5%
kY = 6% + 5% (1.2)
kY = 12%
P 5.11 - SOLUTION
d. kX = 10.5% kX = 10%
kY = 12% kY = 12.5%
Stock Y would be most attractive to a diversified investor since

its expected return of 12.5% is greater than its required return of 12%.
e. bp = ($7,500 / $10,000)(0.9) + ($2,500 / $10,000)(1.2)

= 0.6750 + 0.30
= 0.9750
kp = 6% + 5% (0.975)
kp = 10.87%
f. If RPM increases from 5% to 6%, the stock with the highest beta will have
the largest increase in its required return. Therefore, Stock Y will have the
greatest increase.
Check:
kX = 6% + 6%(0.9) kY = 6% + 6%(1.2)
Doç.=Dr.
11.4% (Increase
Oktay Taş 10.5% to 11.4%) = 13.2% (Increase
İstanbul 12% to 13.2%)
Teknik Üniversitesi
PROBLEM 6.38
Find the present value of the following ordinary annuities.
Assume that discounting occurs once a year.
a. $400 per year for 10 years at 10 %.
b. $200 per year for 5 years at 5 %.
c. $400 per year for 5 years at 0 %.
d. Now rework parts a, b, and assuming that payments are made at the beginning
of each year; that is, they are annuities due.

P 6.38 - SOLUTION
PVAn = PMT(PVIFAi,n)
a. 0 1 2 3 4 5 6 7 8 9 10
| 10% | | | | | | | | | |
PV = ? 400 400 400 400 400 400 400 400 400 400
N = 10, I = 10, PMT = -400, and FV = 0; PV = $2,457.83.
b. 0 1 2 3 4 5
| 5% | | | | |
PV = ? 200 200 200 200 200
N = 5, I = 5, PMT = -200, and FV = 0; PV = $865.90.

P 6.38 - SOLUTION
c. 0 1 2 3 4 5
| 0% | | | | | PV=?
400 400 400 400 400
N =5
I =0
PMT = -400
FV =0
PV = $2,000

P 6.38 - SOLUTION
d.
1) 0 1 2 3 4 5 6 7 8 9 10
| 10% | | | | | | | | | |
400 400 400 400 400 400 400 400 400 400
PV = ?
N = 10
I = 10
PMT = -400
FV =0
PV = $2,703.61

P 6.38 - SOLUTION
2) 0 1 2 3 4 5
| 5% | | | | |
200 200 200 200 200
PV = ?
N =5
I =5
PMT=200
FV = 0
PV = $909.19

P 6.38 - SOLUTION
3) 0 1 2 3 4 5
| %0 | | | | |
400 400 400 400 400
PV = ?
N =5
I =0
PMT = -400
FV =0
PV = $2,000

PROBLEM 6.44
The First City Bank pays 7% interest, compounded annually, on time
deposits. The Second City Bank pays 6% interest, compounded quarterly.
a. Based on effective, or equivalent, interest rates, in which bank would you

prefer to deposit your money ?
b. Could your choice of banks be influenced by the fact that you might want
to withdraw your funds during the year as opposed to et the end of the
year ? In answering this question, assume that funds must be left on
deposit during the entire compounding period in order for you to receive
any interest.

P 6.44 - SOLUTION
a)
First City Bank: Effective rate = 7%.
Second City Bank: Effective rate = (1.015)4 – 1.0 = 1.0614 – 1.0

= 0.0614
= 6.14%.
You would choose the First City Bank.

P 6.44 - SOLUTION
b)
If funds must be left on deposit until the end of the compounding period (1 year for
First City and 1 quarter for Second City), and you think there is a high probability
that you will make a withdrawal during the year, the Second City account might be
preferable.
For example, if the withdrawal is made after 10 months, you would earn nothing on
the First City account but (1.015)3 – 1.0 = 4.57% on the Second City account.
Ten or more years ago, most banks and S&Ls were set up as described above,
but now virtually all are computerized and pay interest from the day of deposit to
the day of withdrawal, provided at least $1 is in the account at the end of the
period.

PROBLEM 7.14
You have just purchased a 10-year, $1,000 par value

bond. The coupon rate on this bond is 9% and interest is
paid semiannually.
If you require an “effective” annual interest rate of 8.16%,

then how much should you have paid for this bond ?

P 7.14 - SOLUTION
EAR = ( 1 + NOM / 2 )2 - 1
0.0816 = ( 1 + NOM / 2 )2 - 1
NOM = 0.08 = 8%
Semiannual interest rate = 0.08 / 2 = 0.04 = 4%.

Solving for price:
N = 20, I = 4, PMT = 45, FV = 1000
PV = -$1,067.95
VB = $1,067.95

PROBLEM 7.16
Heekin Industries currently has $140 million in long-term bonds outstanding at
an average cost of 7.5%. Therefore, the firm has an interest expense of
$10.5 million on its income statement.

The firm currently has a times-interest-earned (TIE) ratio of 3.2X. Heekin’s
bond covenants prohibit it from issuing new bonds when the TIE ratio falls
below 2.5X. Heekin’s board of directors have elected to raise funds for
expansion through a new bond issue. The firm may raise up to $25 million at a
cost of 8%, another $25 million at 10%, and an additional $25 million at a cost
of 13%.
How much money, in new bonds, can Heekin raise before it violates
its bond covenant ?

P 7.16 - SOLUTION
Using the TIE ratio, we can solve for the firm's current operating income.
TIE = EBIT / Interest Expense
3.2 = EBIT / $10,500,000
EBIT = $33,600,000
Using the same methodology, you can solve for the maximum interest expense
the firm can bear without violating its covenant.
2.5 = $33,600,000 / Interest Expense

Maximum Interest Expense = $13,440,000

P 7.16 - SOLUTION
Therefore, the firm can raise debt to the point that its interest expense increases
by $2.94 million ($13.44  $10.50).
The firm can raise $25 million at 8%, which would increase the cost of debt by
$25  0.08 = $2 million.
Additional debt will be issued at 10%, and the amount of debt to be raised can
be found, since we know that only an additional $0.94 million in interest expense
can be incurred.
Additional Interest Expense = Additional Debt  Cost of Debt
$0.94 million = Additional Debt  0.10
Additional Debt = $9.40 million
Hence, the firm may raise up to $34.4 million in additional debt without violating
its bond covenants.

PROBLEM 7.17
Last year, Baili purchased a $ 1,000 face value corporate bond with
an 11% annual coupon rate and a 10-year maturity.
At the time of the purchase, the bonds had an expected yield to
maturity of 9.79% and today she sold the bond for $1,060.49.
What is the one-period return that Baili earned on this investment ?

P 7.17 - SOLUTION
First, we must find the price Baili paid for this bond.
N = 10, I = 9.79, PMT = 110, FV = 1000
PV = -$1,075.02 VB = $1,075.02
One-period return = Ending price – Beginning price + Coupon received

Beginning price
One-period return = ($1,060.49 - $1,075.02 + $110) / $1,075.02

One-period return = 8.88%

PROBLEM 8.8
Today is December 31,2002. The following information applies to Vermeil
Airlines:
• After-tax, operating income EBIT (1 – T) for 2003 is expected to be $500 million.
• The company’s depreciation expense for 2003 is expected to be $100 million.
• The company’s capital expenditures for 2003 are expected to be $200 million.
• No change is expected in the company’s net operating working capital.
• The company’s free cash flow is expected to grow at a constant rate of 6% per year.
• The company’s cost of equity is 14 %.
• The company’s WACC is 10 %.
• The market value of the company’s debt is $3 billion.
• The company has 200 million shares of stock outstanding.
Using the free cash flow approach, what should the company’s stock price
be today ?

P 8.8 - SOLUTION
FCF = EBIT(1 – T) + Depreciation - Capital Expenditures -  NOWC
= $500,000,000 + $100,000,000 - $200,000,000 - $0
= $400,000,000
Firm value = FCF (WACC – g)

= $400,000,000 (0.10 – 0.06)
= $10,000,000,000
This is the total firm value. Now find the market value of its equity.
MVTotal = MVEquity + MVDebt

$10,000,000,000 = MVEquity + $3,000,000,000
MVEquity = $7,000,000,000
This is the market value of all equity. Divide by the number of shares to find the
price per share;
$7,000,000,000 / 200,000,000 = $35
PROBLEM 8.16
Mitts Cosmetics Co.’s stock recently paid a $2 dividend is

expected to grow by 25 % for the next 3 years, and then
grow forever at a constant rate, g. The current stock price
is $58.88. At what constant rate is the stock expected to
grow following Year if ks = 12% ?

P 8.16 - SOLUTION
D1 = $2.00  (1.25)1 = $2.50 PV(D1) = $2.50/(1.12)1 = $2.2321
D2 = $2.00  (1.25)2 = $3.125 PV(D2) = $3.125/(1.12)2 = $2.4913
D3 = $2.00  (1.25)3 = $3.90625 PV(D3) = $3.90625/(1.12)3 = $2.7804
 PV(D1 to D3) = $7.5038
Therefore, the PV of the remaining dividends is: $58.8800 – $7.5038 = $51.3762.

Compounding this value forward to Year 3, we find that the value of all dividends
received during constant growth;
$51.3762 (1.12)3 = $72.18
Applying the constant growth formula, we can solve for the constant growth rate;
P3 = D3(1 + g) / (ks – g)
$72.1807 = $3.90625(1 + g) / (0.12 – g)
$8.6616 - $72.18 g = $3.90625 + $3.90625 g
$4.7554 = $76.08625 g
g = 0.0625
g = 6.25%
PROBLEM 8.24
The risk-free rate of return, kRF, is 11%; the required rate of return on the market,
kM, is 14 %; and Upton Company’s stock has a beta coeffıcient of 1.5.
a. If the dividend expected during the coming year, D1, is $2.25 and if g = a constant
5%, at what price should Upton’s stock sell ?
b. Now, suppose the Federal Reserve Board increases the money supply, causing the
risk-free rate to drop to 9 % and kM to fall to 12 %. What would this do to the price
of the stock ?
c. In addition to the change in part b, suppose investors’ risk aversion declines;
this fact, combined with the decline in kRF, causes kM to fall to 11%. At what price
would Upton’s stock sell ?
d. Now, suppose Upton has a change in management. The new group institutes
policies that increase the expected constant growth rate to 6 %. Also, the new
management stabilizes sales and profits, and thus causes the beta coeffıcient to
decline from 1.5 to 1.3. Assume that kRF and kM are equal to the values in part c.
After all these changes, what is Upton’s new equilibrium price ?
(Note: D1 is now $2.27.)
P 8.24 - SOLUTION
a. ks = kRF + (kM - kRF) b = 11% + (14% - 11%)1.5 = 15.5%
PO = D1 / (ks - g) = $2.25 / (0.155 - 0.05) = $21.43
b. ks = 9% + (12% - 9%)1.5 = 13.5%

PO = $2.25 / (0.135 - 0.05) = $26.47
c. ks = 9% + (11% - 9%)1.5 = 12.0%

PO = $2.25 / (0.12 - 0.05) = $32.14
d. New data given: kRF = 9%, kM = 11%, g = 6%, b = 1.3

ks = kRF + (kM - kRF)b = 9% + (11% - 9%)1.3 = 11.6%
PO = D1/(ks - g) = $2.27/(0.116 - 0.06) = $40.54

PROBLEM 9.15
Ziege Systems is considering the following independent projects for
the next year.
REQUIRED RATE OF
PROJECT INVESTMENT RETURN RISK
A $4 million 14.0% High
B $5 million 11.5 High
C $3 million 9.5 Low
D $2 million 9.0 Average
E $6 million 12.5 High
F $5 million 12.5 Average
G $6 million 7.0 Low
H $3 million 11.5 Low

PROBLEM 9.15
The company estimates that its WACC is currently 10 %. The company
adjusts for risk by adding 2 % for WACC for high-risk projects and
subtracting 2 % from the WACC for low-risk projects.
a. Which projects should Ziege accept if it faces no capital constraints ?
b. If Ziege only has the ability to invest a total of $13 million, which
projects should it accept, and what will the firm’s capital budget be for
next year ?
c. Suppose that Ziege can raise additional funds in order to increase its
capital budget from the level determined in part b. However, for every
$5 million of new capital raised by Ziege, the firm’s weighted avarage
cost of capital is expected to increase by 1 %. If Ziege proceeds to use
the same method of risk adjustment, which projects will it accept, and
how much in additional funds must be raised to complete its capital
budget ?

P 9.15 - SOLUTION
a. Accept all projects if Return Cost of Capital
Required Rate of Cost of

Project Investment Return Capital
A $4 million 14.0% 12%
B $5 million 11.5 12
C $3 million 9.5 8
D $2 million 9.0 10
E $6 million 12.5 12
F $5 million 12.5 10
G $6 million 7.0 8
H $3 million 11.5 8
Therefore, Ziege should accept projects A, C, E, F, and H.

P 9.15 - SOLUTION
b. With only $13 million to invest in its capital budget, Ziege must choose
the best combination of Projects A, C, E, F, and H.
Collectively, the projects would account for an investment of $21 million,

so naturally not all these projects may be accepted.
Looking at the excess return created by the projects; A, C, E, F, and H

are 2%, 1.5%, 0.5%, 2.5%, and 3.5%.
The firm should accept the projects which provide the greatest excess returns.
By that rationale, the first project to be eliminated from consideration is
Project E. This brings the total investment required down to $15 million,
therefore one more project must be eliminated.
The next lowest excess return is Project C. Therefore, Ziege's optimal capital
budget consists of Projects A, F, and H, and it amounts to $12.

P 9.15 - SOLUTION
c. Since Projects A, F, and H are already accepted projects, we must adjust
the costs of capital for the other two value producing projects (C and E).
Required Rate of Cost of

Project Investment Return Capital
C $3 million 9.5% 8% + 1% = 9%
E $6 million 12.5 12% + 1% = 13%
If new capital must be issued, Project E becomes an acceptable project.
On the other hand, Project C's expected rate of return still exceeds
the risk-adjusted cost of capital even after raising additional capital.
Hence, Ziege's new capital budget should consist of Projects A, C, F, and

H and requires $15 million of capital.

PROBLEM 9.20
Adams Corporation has four investment projects with the

following costs and rates of return:
COST RATE OF RETURN

Project 1 $2,000 16.00 %
Project 2 $3,000 15.00
Project 3 $5,000 13.75
Project 4 $2,000 12.50

PROBLEM 9.20
The company estimates that it can issue debt at a before-tax cost of
10%, and its tax rate is 30 %. The company also can issue preferred
stock at $49 per share, which pays a constant dividend of $5 per year.
The company’s stock currently sells at $36 per share. The year-end
dividend, D1, is expected to be $3.50, and the dividend, is expected to
grow at a constant rate of 6 % per year. The company’s capital structure
consists of 75 % common stock, 15 % debt, and 10 % preferred stock.
a. What is the cost of each of the capital components ?
b. What is the WACC ?
c. Which projects should the fırm select if the projects are all of average
risk ?

P 9.20 - SOLUTION
a. kd(1 - T) = 0.10 (1 - 0.3) = 7%
kp = $5 / $49 = 10.2%
ks = ($3.50 / $36) + 6% = 15.72%
b. After-tax Weighted
Component Weight  Cost = Cost
Debt [0.10 (1 - T)] 0.15 7.00% 1.05%
Preferred stock 0.10 10.20% 1.02%
Common stock 0.75 15.72% 11.79%
WACC = 13.86%
c. Projects 1 and 2 will be accepted since their rates of return exceed the WACC.

PROBLEM 10.21
The Parrish Publishing Company is considering two mutually exclusive
expansion plans. Plan A calls for the expenditure of $40 millionon
a large-scale, integrated plant that will provide an expected CF stream of
$6.4 million per year for 20 years. Plan B calls for the expenditureof
$12 million to build a somewhat less efficient, more labor-intensive plant
that has an expected CF stream of $2.72 million per year for 20 years.
Parrish’s cost of capital is 10%.
a. Calculate each project’s NPV and IRR.

b. Graph the NPV profiles for Plan A and Plan B. From the NPV profiles
constructed, find the crossover rate.
c. Give a logical explanation, based on reinvestment rates and
opportunity costs, as to why the NPV method is better than the IRR
method when the the firm’s cost of capital is constant at some value
such as 10%.

a.
NPVA= $ 14,486,808 NPVB= $ 11,156,893
IRRA= 15.03% IRRB= 22.26%

NPV
80
60
40
Crossover = 11.7%
20
IRRB = 22.26%
0 k(%)
IRRA = 15.03%
-10

Year CFA CFB CF
0 -$40 -$12 -$28
1 6.4 2.72 3.68
2 6.4 2.72 3.68
3 6.4 2.72 3.68
. . . .
. . . .
. . . .
20 6.4 2.72 3.68
3.68 3.68 3.68

0= -28 + + +.....+
(1+k)1 (1+k)2 (1+k)20
k = 11.7%

c. NPV assumes;
- CFS are reinvested at cost of capital
IRR assumes;
- CFS are reinvested at IRR
As CFS come in from projects, the firm will either

pay out to investors, or use as substitute for
outside capital which costs 10%. Since these CFS
are expected to save the firm 10%, this is true
opportunity cost reinvestment rate.

PROBLEM 10.23
Your division is considering two investment projects, each of which requires an
up-front expenditure of $25 million. You estimate that the cost of capital is 10%
and that the investments will produce the following after-tax cash flows
(in millions of dollars):
YEAR PROJECT A PROJECT B
1 $5 $20
2 $10 $10
3 $15 $8
4 $20 $6
a. What is the regular payback period for each of the projects ?
b. What is the discounted payback period for each of the projects ?
c. If the two projects are independent and the cost of capital is 10%, which project
or projects should the firm undertake?
d. If the two projects are mutually exclusive and the cost of capital is 5%, which
project should the firm undertake ?
e. If the two projects are mutually exclusive and the cost of capital is 15%, which
project should the firm undertake ?
f. What is the crossover rate ?
g. If the cost of capital is 10%, what is the modified IRR (MIRR) of each project ?

P 10.23 - SOLUTION
a. Payback A
Period Cash Flows Cumulative
0 ($25,000) ($25,000)
1 5,000 (20,000)
2 10,000 (10,000)
3 15,000 5,000
4 20,000 25,000
PaybackA = 2 + $10,000 / $15,000 = 2.67 years
Payback B
Period Cash Flows Cumulative
0 ($25,000) ($25,000)
1 20,000 (5,000)
2 10,000 5,000
3 8,000 13,000
4 6,000 19,000
PaybackB = 1 + $5,000 / $10,000 = 1.50 years

P 10.23 - SOLUTION
b. Discounted payback A (at 10% discount)
Period Cash Flows Cash Flows Cumulative
0 ($25,000) ($25,000.00) ($25,000.00)
1 5,000 4,545.45 (20,454.55)
2 10,000 8,264.46 (12,190.09)
3 15,000 11,269.72 (920.37)
4 20,000 13,660.27 12,739.90
Discounted PaybackA = 3 + $920.37 / $13,660.27 = 3.07 years
Discounted payback B (at 10% discount)

Period Cash Flows Cash Flows Cumulative
0 ($25,000) ($25,000.00) ($25,000.00)

1 20,000 18,181.82 (6,818.18)
2 10,000 8,264.46 1,446.28
3 8,000 6,010.52 7,456.80
4 6,000 4,098.08 11,554.88
Discounted PaybackB = 1 + $6,818.18 / $8,264.46 = 1.825 years.

P 10.23 - SOLUTION
c. NPVA = $12,739,908 IRRA = 27.27%
NPVB = $11,554,880 IRRB = 36.15%
Both projects have positive NPVs, so both projects should be undertaken.
d. At a discount rate of 5%, NPVA = $18,243,813

At a discount rate of 5%, NPVB = $14,964,829
Project A has the higher NPV. Therefore, it should be accepted.
e. At a discount rate of 15%, NPVA = $8,207,071

At a discount rate of 15%, NPVB = $8,643,390
Project B has the higher NPV. Therefore, it should be accepted.

P 10.23 - SOLUTION
f.
Year Project CF =CFA-CFB
0 $0
1 (15)
2 0
3 7
4 14
IRR = Crossover Rate = 13.5254%  13.53%

P 10.23 - SOLUTION
g. Use 3 steps to calculate MIRRA @ k = 10%
Step 1: Calculate the NPV of the uneven cash flow stream.

NPV = $37,739,908
Step 2: Calculate the FV of the cash flow stream.
FV = $55,255,000
Step 3: Calculate MIRRA = 21.93%
MIRRB @ k = 10%
MIRRB = 20.96%
If two projects were mutually exclusive, Project A would be chosen because it has a
higher MIRR. This is consistent with the NPV approach.
Note: Because these two projects are equal in size, we don’t need to worry about
a conflict between the MIRR and NPV decisions.

PROBLEM 11.3
Kennedy Air Lines is now in the terminal year of a project.
The equipment originally cost $20 million, of which 80 %
has been depreciated. Kennedy can sell the used
equipment today to another airline for $5 million, and its tax
rate is 40 %.
What is the equipment’s after tax net salvage value ?

P 11.3 - SOLUTION
Equipment’s original cost $20,000,000

Depreciation (80%) 16,000,000
Book value $ 4,000,000
Gain on sale = $5,000,000 - $4,000,000 = $1,000,000

Tax on gain = $1,000,000 (0.4) = $400,000
AT net salvage value = $5,000,000 - $400,000 = $4,600,000

PROBLEM 11.8
The Harris Company is evaluating the proposed acquisition of a new
milling machine. The machine’s base price is $108,000, and it would cost
another $12,500 to modify for special use by your fırm. The machine falls
into the MACRS 3-year class, and it would be sold after
3 years for $65,000. The applicable depreciation rates are 33%, 45%,
15%, and 7%. The machine would require an increase in net operating
working capital (inventory) of $5,500. The milling machine would have no
effect on revenues, but it is expected to save the fırm $44,000 per year in
before-tax operating costs, mainly labor. Harris’s marginal tax rate is 35%
a. What is the net cost of the machine for capital budgeting purposes ?
(That is, what is the Year O net cash flow ?)
b. What are the net operating cash flows in Years 1, 2 and 3 ?
c. What is the terminal cash flow ?
d. If the project’s cost of capital is 12%, should the machine be purchased ?

P 11.8 - SOLUTION
a. Price ($108,000)
Modification (12,500)
Increase in NOWC (5,500)
Cash outlay for new machine ($126,000)
b. The operating cash flows;

Year 1 Year 2 Year 3
1. After-tax savings $28,600 $28,600 $28,600
2. Depreciation tax savings 13,918 18,979 6,326
Net cash flow $42,518 $47,579 $34,926
1. The after-tax cost savings = $44,000(1-T) = $44,000(0.65) = $28,600

2. Depreciable basis = $120,500
MACRS allowance percentages of 0.33, 0.45, and 0.15
Year 1, $120,500 (0.33)(0.35) = $13,918
Year 2, $120,500 (0.45)(0.35) = $18,979
Year 3, $120,500 (0.15)(0.35) = $ 6,326

P 11.8 - SOLUTION
c. Salvage value $65,000
Tax on SV* (19,798)
Return of NOWC 5,500
The terminal cash flow $50,702
BV in Year 4 = $120,500 (0.07) = $8,435
*Tax on SV = ($65,000 - $8,435)(0.35) = $19,798
d. Year Net Cash Flow PV @ 12%

0 ($126,000) ($126,000)
1 42,518 37,963
2 47,579 37,930
3 85,628 60,948
NPV = $ 10,841
The project has an NPV of $10,841. Thus, it should be accepted.

PROBLEM 11.9
The Butler-Perkins Company (BPC) must decide between two mutually exclusive
investment projects. Each project costs $6,750 and has an expected life of 3 years.
Annual cash flows from each project begin 1 year after the inital investment is
made and have the following probability distributions:
PROJECT A PROJECT B
Probability Net CFs Probability Net CFs
0.2 $6,000 0.2 $ 0
0.6 6,750 0.6 6,750
0.2 7,500 0.2 18,000
BPC has decided to evaluate the riskier project at a 12% rate and the less risky
project at a 10% rate.
a. What is the expected value of the annual net cash flows from each project ? What is
the coefficient of variation (CV) ? (Hint: B = $5,798 and CVB = 0.76)
b. What is the risk-adjusted NPV of each project ?
c. If it were known that Project B’s cash flows were negatively correlated with other
cash flows of the firm whereas Profect A’s cash flows were negatively correlated,
how would this knowledge affect the decision ? If Pproject B’s cash flow were
negatively correlated with gross domestic product (GDP), would that influence your
assessment of its risk ?

a. Expected annual cash flows:
Project A Probable
Probability × Cash Flow = Cash Flow
0.2 $6,000 $1,200
0.6 6,750 4,050
0.2 7,500 1,500
Expected annual cash flow = $6,750
Project B Probable
Probability × Cash Flow = Cash Flow
0.2 $ 0 $ 0
0.6 6,750 4,050
0.2 18,000 3,600
Expected annual cash flow = $7,650

Coefficient of Variation (CV) = NPV / E[NPV]
Project A
A 2 = (-750)2 (0.20) + (0)2 (0.60) + (750)2 (0.20)

A = $474.34
Project B
B 2 = (7,650)2 (0.20) + (-900)2 (0.60) + (10,350)2 (0.20)

B = $5,797.84
CVA = $474.34 / $6,750 = 0.0703

CVB = $5,797.84 / $7,650 = 0.7579

b. Project B is the riskier project because it has the greater variability in its
probable cash flows, whether measured by the standard deviation or the
coefficient of variation.
Hence, Project B is evaluated at the 12% cost of capital, while Project A

requires only a 10 % cost of capital.
NPVA = $10,036.25
NPVB = $11,624.01
Project B has the higher NPV; therefore, the firm should accept Project B.

c. The portfolio effects from Project B would tend to make it less risky
than otherwise.
This would tend to reinforce the decision to accept Project B.
If Project B were negatively correlated with the GDP (Project B is

profitable when the economy is down), then it is less risky and
Project B's acceptance is reinforced.

PROBLEM 12.6
Zappe Airlines is considering two alternative planes.
Plane A has an expected life of 5 years, will cost $100
million, and will produce net cash flows of $30 million per
year.
Plane B has a life of 10 years, will cost $132 million, and
will produce net cash flows of $25 million per tear.
Zappe plans to serve the route for 10 years. Inflation in

operating costs, airplane costs, and fares is expected to
be zero, and the company’s cost of capital is 12 %. By
how much would the value of the company increase if it
accepted the better project (plane) ?
P 12.6 - SOLUTION
Plane A
Expected life = 5 years, Cost = $100 million, NCF = $30 million, k = 12%.
Plane B
Expected life =10 years, Cost = $132 million, NCF = $25 million, k = 12%.
Plane A
0 12% 1 2 3 4 5 6 7 8 9 10
| | | | | | | | | | |
-100 30 30 30 30 30 30 30 30 30 30
-100
-70
NPVA = $12.764  $12.76 million

P 12.6 - SOLUTION
Plane B
0 1 2 3 4 5 6 7 8 9 10
| | | | | | | | | | |
-132 25 25 25 25 25 25 25 25 25 25
NPVB = $9.256  $9.26 million

PROBLEM 12.9
The Scampini Supplies Company recently purchased a new truck costs
$22,500, and it is expected to generate net after-tax operating cash flows,
including depreciation, of $6,250 per year. The truck has a 5-year expected
life. The expected year-end abondonment values (salvage values after tax
adjustment) for the truck are given below. The company’s cost of capital is
10%.
Year Annual Operating CF Abandonment Value
0 ($22,500) -
1 6,250 $17,500
2 6,250 14,000
3 6,250 11,000
4 6,250 5,000
5 6,250 0
a. Should the firm operate the truck until the end of its 5-year physical life;
if not, what is its optimal economic life ?
b. Whould the introduction of abandonment values, in addition to operating
cash flows, ever reduce the expected NPV and/or IRR of a project ?

Year Annual Operating CF Abandonment Value NPV

0 -$22,500 - -$22,500
1 6,250 $17,500 -909.09
2 6,250 14,000 - 82.64
3 6,250 11,000 1,307.29
4 6,250 5,000 726.73
5 6,250 0 1,192.42
The firm should operate the truck for 3 years.
Introduction of abandonment values does not reduce NPV or IRR

but increases.

PROBLEM 12.10
The Bush Oil Company is deciding whether to drill for oil on a tract of
land that the company owns. The company estimates that the project
would cost $8 million today. Bush estimates that once drilled, the oil will
generate positive net cash flows of $4 million a year at the end of each
of the next 4 years. While the company is fairly confident about its cash
flow forecast, it recognizes that if it waits 2 years, it would have more
information about the local geology as well as the price of oil. Bush
estimates that it if waits 2 years, the project would cost $9 million.
Moreover, if it waits 2 years, there is a 90 % chance that the net cash
flows would be $4.2 million a year a year for 4 years, and there is a 10
% chance that the cash flows will be $2.2 million a year for 4 years.
Assume that all cash flows are discounted at 10 %.
a. If the company chooses to drill today, what is the project’s net present
value ?
b. Would it make sense to wait 2 years before deciding whether to drill ?

P 12.10 - SOLUTION
a. 0 1 2 3 4
| | | | | NPV = $4.6795 million
-8 4 4 4 4
b. Wait 2 years:
(NPV@Yr=0)
k = 10% 0 1 2 3 4 5 6
10% Prob. | | | | | | |
0 0 -9 2.2 2.2 2.2 2.2 -$1.6746
| | | | | | |
0 0 -9 4.2 4.2 4.2 4.2 $3.5648
If the cash flows are only $2.2 million, the NPV of the project is negative and, thus,
would not be undertaken.
The value of the option of waiting two years =0.10($0) + 0.90($3.5648) = $3.2083
Since the NPV of waiting two years is less than going ahead and proceeding with
the project today, it makes sense to drill today.

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CORPORATE FINANCE

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

The Klaven Corporation has operating income (EBIT) of

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

First, determine net income by setting up an income statement:

NCF = NI + (DEP & AMORT) = $450,000 + $200,000 = $650,000

OCF = EBIT(1 - T) + (DEP & AMORT)

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Ending R/E = Beg. R/E  Net income  Dividends

$278,900,000 = $212,300,000  Net income  $22,500,000

$278,900,000 = $189,800,000  Net income

Net income = $89,100,000

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Sales $12,681,482 $5,706,667 / (1  0.55)

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Doublewide Dealers has an ROA of 10 %, a 2 % profıt

What is the company’s total assets turnover ?

What is the firm’s equity multiplier ?

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Sales _____ COGS _____

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

2. Accounts payable = Debt – Long-term debt = $150,000 - $60,000 = $90,000

3. Common stock = T. Liabilities - Debt - Retained earnings

4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000

5. Inventories = Sales / 5 = $450,000 / 5 = $90,000

6. Accounts receivable = (Sales / 365)(DSO) = ($450,000 / 365)(36.5) = $45,000

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

7. Cash + Accounts receivable + Inventories = (1.8)(Accounts payable)

8. Fixed assets = Total assets - (Cash + Accounts receivable + Inventories)

9. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) = $337,500

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

8.3% = 2.5% + [(2.8%  4 + 3.75%  4)/8] + 0.0% + DRP8 + 0.75%

8.3% = 2.5% + 3.275% + 0.0% + DRP8 + 0.75%

8.3% = 6.52% + DRP8

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

a. Calculate the expected rate of return, k, for Stock Y. (kx = 12 %.)

kY = 0.1(-35%) + 0.2(0%) + 0.4(20%) + 0.2(25%) + 0.1(45%)

X = 12.20% versus 20.35% for Stock Y.

CVX = X / kX = 12.20% / 12% = 1.02, while

CVY = 20.35% / 14% = 1.45

Suppose kRF = 9%, kM =14 %, and bi = 1.3

b. If kRF increases to 10%, kM increases by 1%, from 14% to 15%

If kRF decreases to 8%, kM decreases by 1%, from 14% to 13%

a. Calculate each stock’s coefficient of variation.

Doç. Dr. Oktay Taş İstanbul Teknik Üniversitesi

a. CVX = 35% / 10% = 3.5 CVY = 25% / 12.5% = 2.0

b. For diversified investors the relevant risk is measured by beta.

Stock Y would be most attractive to a diversified investor since

e. bp = ($7,500 / $10,000)(0.9) + ($2,500 / $10,000)(1.2)

a. $400 per year for 10 years at 10 %.

b. $200 per year for 5 years at 5 %.

c. $400 per year for 5 years at 0 %.

Sales _ COGS _