BA 440 Assignment 2

05/07/08

Ch. 5 End of chapter problems:

You do not need to plot the NPV profile in any of the questions, just calculate NPV.

6 (c, d), 8, 9, 10 11 (a, b, d), 14, 16, 17 (a)

Ch. 6 End of chapter problem:

11

Additional questions:

1.  You have been asked by the president of your company to evaluate the proposed acquisition of a new spectrometer for the firm’s R&D department. The equipment’s base price (including installation) is $90,000. This equipment will have a life of 3 years and the company expects to sell the equipment after 3 years for $10,000. Depreciation on the equipment will be 25,000 per year. Use of the equipment will require an increase in net working capital of $5,000. The equipment will have no effect on revenues but is expected to reduce costs for the firm. After-tax EBIT for the firm will increase by $30,000 yearly if the project is accepted. If the tax rate is 35% and the appropriate hurdle rate is 10%, would you recommend that the firm acquire the equipment?

2.  The table below provides the incremental cash flows for two mutually exclusive projects being considered by Tyson Corp. The appropriate hurdle rate for the two projects is 10%.

Yr. Incremental Cash Flows

Project A Project B

0 - 5 mill - 2 mill

1 4 mill 600,000

2 1.5 mill 800,000

3 1 mill 1 mill

4 0.5 mill 1.2 mill

a.  Which of these projects are acceptable using the NPV, IRR and MIRR methods?

b.  How would you rank these projects using these three methods?

c.  What firm-specific factors should you consider when determining which project, if any, the firm should choose?

d.  In general, describe one situation each in which each of these methods provide biased or incorrect rankings: NPV, IRR

3.  Toolage, Inc., a hand tool manufacturing firm, is seeking to purchase and install new equipment that will allow the firm to manufacture more efficiently. The firm has a choice of two pieces of equipment. The first piece of equipment costs $100,000 and has a life of 4 years. The second piece of equipment costs $1 million and has a life of 8 years. Regardless of which piece is selected, it will be discarded with no salvage value at the end of the equipment life. The after-tax savings (increase in after-tax EBIT) and the depreciation expense of the two are provided below. No working capital investment is required. The firm’s cost of capital is 16%.Which piece of equipment should the firm select?

Equipment 1 Equipment 2

Yr / Savings / Depr / Savings / Depr
1 / 28,000 / 25,000 / 125,000 / 125,000
2 / 30,800 / 25,000 / 125,000 / 125,000
3 / 33,880 / 25,000 / 125,000 / 125,000
4 / 37,268 / 25,000 / 125,000 / 125,000
5 / 125,000 / 125,000
6 / 125,000 / 125,000
7 / 125,000 / 125,000
8 / 125,000 / 125,000

4. You are trying to estimate the cost of capital for TransOhio Steel Corporation. The firm has provided you with the following information:

a.  There are 220 million shares outstanding, trading at $ 30 a share.

b.  The book value of the debt is $ 2.5 billion, the interest expenses in the most recent year were $ 150 million, and the weighted average maturity of the debt is 5 years.

c.  The firm is currently rated A.

d.  The current default spread for A-rated bonds is 1% for 30 years and 0.5% for 5 years.

e.  The 30-yr. treasury bond rate is 6% and the market risk premium is 5.5%.

f.  The firm’s cost of equity is 10.4%

If the tax rate for the firm is 40%, estimate the cost of capital for the firm using market values weights for equity and debt.

5. Acquire Corp. recently announced that it intends to acquire Target Corp. Target Corp. does not have any debt. The terms of the deal were as follows: Acquire will pay $100 million for the 5 million shares outstanding of Target. An analyst that evaluated the potential merger indicated that Target is expected to generate cash flows of $7 million per year forever. Acquire Corp.’s current stock price is $25 and it has 50 million shares outstanding. Both firms have a hurdle rate of 10%. If the analyst’s evaluation is accurate, what should Acquire’s stock price be after this announcement?

6. You are the financial manager of a start-up company with excellent growth opportunities in the next few years. At this time, you have identified two 5-year projects that may be beneficial for your company to adopt. The first of these projects requires an initial investment of $ 25 million and will generate cash flows of $9 million at the end of each year. The second project requires an initial investment of $250 million and will generate cash flows of $40 million, $60 million, $90 million, $120 million and $150 million at the end of each of the five years, respectively. There is no salvage value with either project and the appropriate required rate of return is 12%. Which of these projects are acceptable projects? How would you rank these projects?

7. You have been asked to evaluate the following two mutually exclusive projects, X and Y, whose costs and cash flows are shown below:

Yr X Y

0 -1000 -1000

1 100 1000

2 300 100

3 400 50

4 700 50

Your CEO prefers project analyses to be based on rates of return and would like for you to recommend either X or Y based on whether or not it provides a rate of return greater than the firm’s cost of capital of 12%. What would you recommend? Justify your choice of evaluation tool?

8. Elena Inc. currently has two projects, A and B, that it is considering. Project A has an initial outlay of $10 million and will generate cash inflows of $3 million in each of the next 5 years. Project B has an initial outlay of $2 million and will generate cash inflows of $0.45 million each year for 10 years.

a.  If the appropriate cost of capital for the project is 12%, which of these projects are acceptable?

b.  Use MIRR and NPV to rank the projects.

c.  What factors would Elena consider when deciding on an investment tool to rank the projects?

d.  Provide two reasons why the NPV method may be inappropriate to use to rank Elena’s projects.

9. Hibara Corp. has 100 million common shares outstanding, currently selling at $5 per share. In the most recent year, the firm had an operating income (EBIT) of $100 million, operating expenses of $50 million, depreciation expense of $20 million and interest expense of $40 million. The firm has two outstanding bond issues, one with a book value of $40 million and the other with a book value of $60 million. This debt has an average maturity of 7 years. The firm’s cost of equity is 15%. Assume a risk-free rate of 4%, a market risk premium of 5% and a tax rate of 35%. Using the bond spread and synthetic rating tables handed out in class, calculate the firm’s hurdle rate using market value weight for debt and equity.

10. If a firm has a convertible bond issue with 1000 bonds outstanding with 10 years to maturity, a 6% annual coupon rate (with annual coupon payments) and a yield to maturity (before-tax cost of debt) of 6.2%, and each bond is currently selling for $1,050, how much of the bonds’ value would be added to the equity of the company to determine total equity for the firm?

11. You have recently been hired as a financial analyst in the budget division of a large corporation, HT Systems, which currently manufactures and sells components for home theatre systems. The firm is interested in entering the cable service business. The firm has selected two potential projects that will allow it to make an initial foray into this business. Your first task is to complete the project evaluation on the following two mutually exclusive projects. Use the MIRR to determine which project should be selected and assume that the firm will use its own debt ratio in determining the appropriate hurdle rate.

Project incremental cash flows:

Yr. 0 1 2 3 4

A -2500 900 800 800 1200

B -2500 1200 1200 500 500

HT Systems / Cable Service Firm Averages
Beta / D/E / BTrd / Adj. R2 / Beta / D/E / BTrd / Adj. R2
1.5 / 35% / 8% / 0.68 / 1.7 / 25% / 7.5% / 0.35

Risk-free rate = 4.5%, market risk premium = 4.8%, tax rate = 35%