ANSWER KEY
4-2
Case
A FVIF 12%,2 periods = (1 +.12)2 = 1.254
B FVIF 6%,3 periods = (1 +.06)3 = 1.191
C FVIF 9%,2 periods = (1 +.09)2 = 1.188
D FVIF 3%,4 periods = (1 + .03)4 = 1.126
4-3
Case A
a. 2 = 1 x (1 + .07)n b. 4 = 1 x (1 + .07)n
2/1 = (1.07)n 4/1 = (1.07)n
2 = FVIF7%,n 4 = FVIF7%,n
10 years< n < 11 years 20 years < n < 21 years
Nearest to 10 years Nearest to 20 years
Case B
a. 2 = 1 x (1 + .40)n b. 4 = (1 + .40)n
2 = FVIF40%,n 4 = FVIF40%,n
2 years < n < 3 years 4 years < n < 5 years
Nearest to 2 years Nearest to 4 years
Case C
a. 2 = 1 x (1 + .20)n b. 4 = (1 + .20)n
2 = FVIF20%,n 4 = FVIF20%,n
3 years < n < 4 years 7 years < n < 8 years
Nearest to 4 years Nearest to 8 years
Case D
a. 2 = 1 x (1 +.10)n b. 4 = (1 +.10)n
2 = FVIF10%,n 4 = FVIF40%,n
7 years < n < 8 years 14 years < n <15 years
Nearest to 7 years Nearest to 15 years
12-4
a.
b. Total operating costs = FC + (Q x VC)
Total operating costs = $73,500 + (21,000 x $10.48)
Total operating costs = $293,580
c. 2,000 x 12 = 24,000 CDs per year. 2,000 records per month exceeds the operating breakeven by 3,000 records per year. Barry should go into the CD business.
d. EBIT = (P x Q) - FC - (VC x Q)
EBIT = ($13.98 x 24,000) - $73,500 - ($10.48 x 24,000)
EBIT = $335,520 - $73,500 - $251,520
EBIT = $10,500
12-19
a. Using $50,000 and $60,000 EBIT:
Structure A / Structure BEBIT / $50,000 / $60,000 / $50,000 / $60,000
Less: Interest / 16,000 / 16,000 / 34,000 / 34,000
Net profits before taxes / $34,000 / $44,000 / $16,000 / $26,000
Less: Taxes / 13,600 / 17,600 / 6,400 / 10,400
Net profit after taxes / $20,400 / $26,400 / $9,600 / $15,600
EPS (4,000 shares) / $5.10 / $6.60
EPS (2,000 shares) / $4.80 / $7.80
Financial breakeven points:
Structure A Structure B
$16,000 $34,000
Comparison of Financial Structures
b.
EPS ($)
EBIT ($)
c. If EBIT is expected to be below $52,000, Structure A is preferred. If EBIT is expected to be above $52,000, Structure B is preferred.
d. Structure A has less risk and promises lower returns as EBIT increases. B is more risky since it has a higher financial breakeven point. The steeper slope of the line for Structure B also indicates greater financial leverage.
e. If EBIT is greater than $75,000, Structure B is recommended since changes in EPS are much greater for given values of EBIT.
12-21
a.
Debt ratio / 0% / 15% / 30% / 45% / 60%EBIT / $2,000,000 / $2,000,000 / $2,000,000 / $2,000,000 / $2,000,000
Less interest / 0 / 120,000 / 270,000 / 540,000 / 900,000
EBT / $2,000,000 / $1,880,000 / 1,730,000 / $1,460,000 / $1,100,000
Taxes @40% / 800,000 / 752,000 / 692,000 / 584,000 / 440,000
Net profit / $1,200,000 / $1,128,000 / $1,038,000 / $ 876,000 / $660,000
Less preferred dividends / 200,000 / 200,000 / 200,000 / 200,000 / 200,000
Profits available to common stock / $1,000,000 / $ 928,000 / $ 838,000 / $ 676,000 / $ 460,000
# shares outstanding / 200,000 / 170,000 / 140,000 / 110,000 / 80,000
EPS / $5.00 / $5.46 / $5.99 / $6.15 / $5.75
b.
Debt: 0% Debt: 15%
Debt: 30% Debt: 45%
Debt: 60%
c. The optimal capital structure would be 30% debt and 70% equity because this is the debt/equity mix that maximizes the price of the common stock.
TEST QUESTIONS
1.Finance is concerned with the process institutions, markets, and instruments involved in the transfer of money among and between individuals, businesses and government.
True ______False ______
2.The president or chief executive officer is elected by the firm’s stockholders and has ultimate authority to guide corporate affairs and make general policy.
True ______False ______
3.Finance can be defined as
(a)the system of debits and credits.
(b)the science of the production, distribution, and consumption of wealth.
(c)the art and science of managing money.
(d)the art of merchandising products and services.
4. Under which of the following legal forms of organization, is ownership readily transferable?
(a)Sole proprietorships.
(b)Partnerships.
(c)Limited partnership.
(d)Corporation.
5.______is the chance of loss or the variability of returns associated with a given asset.
(a)Return
(b)Value
(c)Risk
(d)Probability
6. Prime grade commercial paper will most likely have a higher annual return than
(a)a Treasury bill.
(b)a preferred stock.
(c)a common stock.
(d)an investment grade bond.
7. Time value of money is based on the belief that a dollar that will be received at some future date is worth more than a dollar today. True ______False ______
8. In general, with an amortized loan, the payment amount grows over the life of the loan, the principal portion of each payment grows over the life of the loan, and the interest portion declines over the life of the loan.
True ______False ______
9. An annuity with an infinite life is called a(n)
(a)perpetuity.
(b)primia.
(c)indefinite.
(d)deep discount.
10. The ______is/are a graphic depiction of the term structure of interest rates.
(a)yield curve
(b)supply and demand functions
(c)risk return profile
(d)aggregate demand curve
11. Generally, long-term loans have higher interest rates than short-term loans because of
(a)the general expectation of higher future rates of inflation.
(b)lender preferences for shorter-term, more liquid loans.
(c)greater demand for long-term rather than short-term loans relative to the supply of such loans.
(d)all of the above.
12. Preferred stock is often considered a quasi debt since it yields a fixed periodic payment.
True ______False ______
13. Unlike creditors (lenders), equity holders (both preferred and common stockholders) are owners of the firm.
True ______False ______
14. The claims of the equity holders on income have priority over
(a)the claims of the preferred stockholders.
(b)the claims of the creditors.
(c)the claims of the unsecured creditors.
(d)no one.
15. The opportunity for management to purchase a certain number of shares of their firm’s common stock at a specified price over a certain period of time is a
(a)stock option.
(b)warrant.
(c)pre emptive right.
(d)stock right.