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1) Why is the capital budgeting decision such an important process?

Why are managers


focused on cash flows rather than on net income while analyzing capital budgeting
project? Explain, how would you incorpoarte risk in capital budgeting analysis
!apital budgeting is an important process since the future "iability of a firm depends on
it #or a firm to grow it needs to in"est in assets $hese in"estments are large in "alue and
ha"e a long time frame and are decided under the capital budgeting process %f the
process is not followed correctly, a firm may in"est in incorrect projects and may in"est a
large amount of money and not get returns which would be disastrous for the firm
!apital budgeting projects are analyzed based on cash flows since cash flows are tangible
and the firm needs to pay in cash for either ac&uiring assets or paying for expenses or to
the in"estors 'et income is only a book "alue and does not represent anything tangible
(isk is incorporated in capital budgeting through change in discounting rate ) higher
rate for higher risk and a lower rate for lower risk
*) What are real options? Why it is important for managers to determine the "alue of real
options in the capital budgeting decisions? +sing an example explain how you can
determine the "alue of a real option in the capital budgeting decision
(eal option are options which allow a firm to change the course of its capital budgeting
decisions after the project has started (eal options would allow a firm to terminate the
project before maturity or to delay the introduction of the product
%t is important to determine the "alue of real options so that managers can understand the
impact of incorporating the real options in the project %f the project ',- is higher with
real options then the options should be incorporated
$he "alue of real option is determined by calculating the ',- of the project with the
option and without the option $he difference in ',- is the "alue of the option #or
example, a real option could be to abandon the project after * years of operation #irst we
calculate the ',- as if the project would run for its life and then with the option of
abandonment $he difference in ',-s is the "alue of the real option
.) Why do firms issue stock di"idends? !omment on the following statement/ 0% ha"e a
stock that promises to pay a *1 percent stock di"idend e"ery year, and therefore
guarantees that % will break e"en in 2 years0
#irms issue stock di"idend either to conser"e cash and still be paying a di"idend or to
reduce the price of the stock which will be lower with the stock di"idend
$he statement is not correct ) stock di"idend while increasing the number of shares with
the in"estors also results in a proportionate reduction in price and so the total wealth of
the shareholder does not change 3o with stock di"idends, the shareholders has the same
wealth and without stock di"idends and so there is no break e"en
4) What are the three sources 5balance sheet may help you) of corporate financing?
Explain how managers make decisions on %,67s and the role of in"estment banking firm
in the %,6
$he three sources of financing are
a 8ebt
b ,referred stock
c !ommon stock
9anager make decisions on %,6 when a firm wants to go public :oing public increases
the capacity of the firm to raise more capital which it would not be able to do as a pri"ate
entity ;arge companies ha"e need for capital for their growth and so going public
pro"ides a source of e&uity capital
$he in"estment banking firm would help in arri"ing at the price at which the shares
would be sold to the public %t may also help in making the sale either by underwriting the
issue or by doing it on a best effort basis
2) <ased on the understanding of the corporate "aluation model, identify at least three
"ariables that you belie"e affect the "alue of the firm <riefly, explain how the identified
"ariables affect the "alue of the firm
$he corporate "aluation model pro"ides the framework for "aluing companies $he three
"ariables are
a :rowth rate in sales = ) higher growth rate would result in higher "alue as the cash
flows of the firm impro"e with higher sales
b 6perating profitability = $he higher growth in sales would translate into higher net
income through higher operating profitability )s sales increase, if the expenses do not
increase in proportion to the sales, the operating profitability will impro"e and so the net
income and cash flows would be higher
c Weighted a"erage cost of capital = $he cash flows are discounted at W)!! to get the
"alue of the firm ;ower the W)!!, higher is the "alue of firm
>) )n analyst is interested in using the <lack?3choles model to "alue call option on the
stock of )<! !orporation $he )nalyst has accumulated the following information/
@ $he price of the stock is A41
@ $he strike price is A.B
@ $he option matures in C1 days
@ 3tandard de"iation of the stock return is 11>
@ $he risk?free rate is 2 percent
:i"en the inforamtion, what is the "alue of the call option?
$he "alue is gi"en as
+sing the <lack?3choles 6ption ,ricing 9odel, we get
- D ,E'5d1)F ? Ge
Hr(#t
E'5d*)F
Iere
, D A41, '5d1) D 1JCBB, G D .B, r(# D 2K, t D C1L.>1D1*2 and '5d*) D 1JJ2>
- D 41 51JCBB) = .Be5?112)51*2) 51JJ2>)
- D A*B2
J) )<! corporation is e"aluating new e&uipment that will cost A.11,111 and another
A*1,111 for shipping, and A11,111 for installation $he e&uipment is in the 9)!(3 .?
year class and would be sold after . years for A.1,111 +se of the e&uipment will re&uire
an additional A*1,111 in in"entory, and accounts payable will increase by A11,111 $he
e&uipment will not affect re"enues, but will sa"e A**2,111 per year in operating costs
$he company7s tax rate is 41 percent and its cost of capital is 1*K
$he cash flows are
Year 0 1 2 3
Equipment

(300,000)
Shipping and installation

(30,000)
Increase in working capital

(10,000)
Saings in cost

22!,000

22!,000

22!,000
"epreciation

10#,$00

1%#,!00

%$,!00
Income &e'ore ta(

11),100

*),!00

1*!,!00
+a( (%0,)

%),%%0

30,)00

*0,200
-et Income

)$,))0

%!,$00

10!,300
.perating cash 'low

1*#,!)0

1$%,%00

1!%,#00
/ecoer0 o' working capital

10,000
1'ter ta( salage alue

2*,2%0
+otal cash 'low

(3%0,000)

1*#,!)0

1$%,%00

1$2,0%0
-23 (12,)

111,0$343%
I// 2$4$),
Part a. 5alculate the cash 'low in Year 04
5ash 'low in 0ear 0 6 783%0,000
Part b. 5alculate the incremental operational cash 'lows 4
Reference:
915/S "epreciation 2ercentages 'or three70ear class li'e
assets:
33, %!, 1!, *,
Incremental operational cash flows are in the table above
Part c. 5alculate the terminal 0ear cash 'low4
+erminal 0ear cash 'lows are
.perating cash 'low 1!%,#00
/ecoer0 o' working capital 10,000
1'ter ta( salage alue 2*,2%0
+otal 1$2,0%0
1'ter ta( salage alue is
;ook alue at the end o' 0ear 3 23,100
Sale 2rice 30,000
<ain on sale ),$00
+a( on gain 2,*)0
1'ter ta( salage alue 6 30,00072,*)0 6 2*,2%0
Part d. 5alculate the pro=ect>s -234
-23 6 111,0$3
Part g. 5alculate the pro=ect>s I//4
I// 6 2$4$),
Part i. Inestment "ecision: Should the pro=ect &e accepted or re=ected?
Since the -23 is positie the pro=ect should &e accepted
B) Manga (esorts is interested in de"eloping a new facility in )sia $he company
estimates that the hotel would re&uire an initial in"estment of A14 million $he company
expects that the facility will produce positi"e cash flows of A*> million a year at the end
of each of the next 11 years $he project7s cost of capitl is 1*K
a !alculate the expected net present "alue of the project
',- D ,- of cash flows = initial in"estment
',- D *,>11,111 G ,-%#) 51*K,11) = 14,111,111 D 14,>C1,2B1?14,111,111
',- D A>C1,2B1
b $he compa&ny recognizes that the cash flows could, in fact, be much higher or
lower than A*> million, depending on whether the host go"ernment imposes a
large facility tax 6ne year from now, the company will know whether the tax
will be imposed $here is a 41 percent chance that the tax will the imposed, in
which case the yearly cash flows will be only A* million )t the same time, there
is a >1 percent chance that the tax will not be imposed, in which case the yearly
cash flows will be A. million $he company is deciding whether to proceed with
the facility today or to wait 1 year to find out whether the tax will be imposed %f
it waits 1 year, the initial in"estment will remain at A14 million )ssume that all
cash flows are discounted at 1* percent !alculate the "alue of the real option to
wait a year before deciding
%f no tax is imposed
',- D .,111,111 G ,-%#) 51*K,11) = 14,111,111 D *,C21,>>C $his is at the end of
year 1 $he ',- now is >,>C4,111L11* D *,>.4,2*>
%f tax is imposed
',- D *,111,111 G ,-%#) 51*K,11) = 14,111,111 D ?*,>CC,22.
$his is negati"e and so the project would not be done and so the ',- will be 1 if tax is
imposed
$he expected ',- is 1>G*,>.4,2*> N 12 G 1 D 1,2B1,J1>
$he "alue of real option is the difference between two ',-
-alue of option D 1,2B1,J1>?>C1,2B1 D ABC1,1.2
C) !apra7s stock trades at A21 a share $he company is contemplating a 2?for?1 stock
split !urrently, the company has E,3 of A.11, 8,3 of A111, and 11 million shares of
stock outstanding )ssuming that the stock split will ha"e no effect on the total market
"alue of its e&uityO
a What will be the company7s stock price following the stock split?
) 2 for 1 stock split will reduce the price to 21L2 D A11
b Iow many shares of stock will be outstanding after the split?
3hares outstanding will be 11 G 2 D 21 million
11) )n in"estment banker enters into a best efforts arrangement to try and sell 11 million
shares of stock at A12 per share for ,ierre %mports $he in"estment banker incurs
expenses of A.11,111 in floating the issue and the company incurs expenses of A111,111
$he in"estment banker will recei"e 11 percent of the proceeds of the offering
a %f the offering is successful and sells out at the expected price of A12, how much
money will the company recei"e?
$he total issue is for 11 million shares )t a price of A12 per share, the total amount
collected us 11G12DA121 million 6f this the in"estment banker will get 11K which is
121G11KDA12 million and the company incurs an expense of A11 million 5A111,111)
$he amount company would recei"e D $otal amount ? fee for in"estment banker ? issue
expenses
$otal amount recei"ed by the company D 121?12?11 D A1.4C million
b %f the offering is successful and sells out at the expected price of A12, how much
money will the in"estment banker recei"e?
%n"estment banker 2 would get 11K of the proceeds $he amount is 121G11KDA12
million %n"estment banker also spends A1. 5A.11,111) on the issue
$he net proceeds to the in"estment banker is 12?1.DA14J million
c %f the offering is partially successfulO all shares are sold, but at a price of A11
Iow much does the company recei"e?
%n this case the amount recei"ed is 11G11DA111 million %n"estment banker will get 11K
of this D 111G11KDA11 million and issue costs would be A11 million
)mount company recei"es D 111?11?11 D ABCC million
d %f the offering is partially successfulO all shares are sold, but at a price of A11
Iow much does the in"estment banker recei"e?
%n"estment banker get 11K of the issue D A111G11KDA11 million and spends A1.
million on the issue $he net proceeds to the in"estment banker is 11?1.DACJ million