AEF CORPORATE FINANCE, Winter 2015.

The following exercises are suggested for lectures 1 and 2 (weeks 6-7; exercise session is in
week 8):
2.4, 2.8
3.8, 3.13, 3.19
7.1, 7.3, 7.6, 7.8, 7.9, 7.10, 7.15, 7.19, 7.22
8.3, 8.5, 8.7, 8.9, 8.10, 8.13
Data Case from Chapter 8 (Novo Nordisk, page 267 of Berk and DeMarzo)
The exercise session will focus on questions from Chapter 7 and Chapter 8. Questions from
Chapters 2 and 3 will not be covered in the exercise session, but answer keys will be
provided.
All questions are labeled with (E), (M), or (D). These letters stand for the level of difficulty
of these questions (Easy, Medium, and Difficult). With few exceptions, the exercise session
will focus on questions of (M) and (D) difficulties.
Due to time constraints, your exercise sessions will only cover some of the posted questions,
but answer keys will be provided for all posted questions.
Exercise Teacher: Jacob Berget (jbe.fi@cbs.dk).

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Chapter 2/Introduction to Financial Statement Analysis5

Chapter 2

Introduction to Financial Statement

Analysis
2-4.(M) Consider the following potential events that might have taken place at Vodafone Group Plc on
31 March, 2012. For each one, indicate which line items in Vodafones balance sheet would be
affected and by how much. Also indicate the change to Vodafones book value of equity. (In all
cases, ignore any tax consequences for simplicity.)
a.

Vodafone used 200 million of its available cash to repay 200 million of its long-term debt.

b.

A warehouse fire destroyed 50 million worth of uninsured inventory.

c.

Vodafone used 50million in cash and 50million in new long-term debt to purchase a
100million of buildings worldwide.

d.

A large customer owing 20million for products it already received declared bankruptcy,
leaving no possibility that Vodafonewould ever receive payment.

e.

Vodafones engineers discover a new manufacturing process that will cut the cost of its
flagship product by over 50%.

f.

A key competitor announces a radical new pricing policy that will drastically undercut
Vodafones prices.

2-8.(E) In early 2009, General Electric (GE) had a book value of equity of $105 billion, 10.5 billion
shares outstanding, and a market price of $10.80 per share. GE also had cash of $48 billion, and
total debt of $524 billion. Three years later, in early 2012, GE had a book value of equity of $116
billion, 10.6 billion shares outstanding with a market price of $17 per share, cash of $84 billion,
and total debt of $410 billion. Over this period, what was the change in GEs:
a.

market capitalization?

b.

market-to-book ratio?

c.

enterprise value?

2014 Pearson Education, Inc.

Berk/DeMarzo, Corporate Finance, Global Edition, Third Edition

Chapter 3

Financial Decision Making and the Law of

One Price
3-8.(E) Your firm has a risk-free investment opportunity where it can invest $160,000 today and receive
$170,000 in one year. For what level of interest rates is this project attractive?
3-13.(E) Throughout the 1990s, interest rates in Japan were lower than interest rates in the United States.
As a result, many Japanese investors were tempted to borrow in Japan and invest the proceeds
in the United States. Explain why this strategy does not represent an arbitrage opportunity.
3-19.(E) Xia Corporation is a company whose sole assets are $100,000 in cash and three projects that it
will undertake. The projects are risk free and have the following cash flows:

Xia plans to invest any unused cash today at the risk-free interest rate of 10%. In one year, all
cash will be paid to investors and the company will be shut down.
a.

What is the NPV of each project? Which projects should Xia undertake and how much cash
should it retain?

b.

What is the total value of Xias assets (projects and cash) today?

c.

What cash flows will the investors in Xia receive? Based on these cash flows, what is the
value of Xia today?

d.

Suppose Xia pays any unused cash to investors today, rather than investing it. What are the
cash flows to the investors in this case? What is the value of Xia now?

e.

Explain the relationship in your answers to parts (b), (c), and (d).

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Chapter 2/Introduction to Financial Statement Analysis7

Chapter 7

Investment Decision Rules

7-1.(E) Your brother wants to borrow $10,000 from you. He has offered to pay you back $12,000 in a
year. If the cost of capital of this investment opportunity is 10%, what is its NPV? Should you
undertake the investment opportunity? Calculate the IRR and use it to determine the maximum
deviation allowable in the cost of capital estimate to leave the decision unchanged.
7-3.(E) You are considering opening a new plant. The plant will cost $100 million upfront. After that, it
is expected to produce profits of $30 million at the end of every year. The cash flows are expected
to last forever. Calculate the NPV of this investment opportunity if your cost of capital is 8%.
Should you make the investment? Calculate the IRR and use it to determine the maximum
deviation allowable in the cost of capital estimate to leave the decision unchanged.

7-6.(M) FastTrack Bikes, Inc. is thinking of developing a new composite road bike. Development will
take six years and the cost is $200,000 per year. Once in production, the bike is expected to make
$300,000 per year for 10 years. Assume the cost of capital is 10%.
a.

Calculate the NPV of this investment opportunity, assuming all cash flows occur at the end
of each year. Should the company make the investment?

b.

By how much must the cost of capital estimate deviate to change the decision? (Hint: Use
Excel to calculate the IRR.)

c.

What is the NPV of the investment if the cost of capital is 14%?

7-8.(E) You are considering an investment in a clothes distributor. The company needs $100,000 today
and expects to repay you $120,000 in a year from now. What is the IRR of this investment
opportunity? Given the riskiness of the investment opportunity, your cost of capital is 20%.
What does the IRR rule say about whether you should invest?
7-9.(E) You have been offered a very long term investment opportunity to increase your money one
hundredfold. You can invest $1000 today and expect to receive $100,000 in 40 years. Your cost of
capital for this (very risky) opportunity is 25%. What does the IRR rule say about whether the
investment should be undertaken? What about the NPV rule? Do they agree?
7-10.(E) Does the IRR rule agree with the NPV rule in Problem 3? Explain.

7-15.(M)Your firm spends $500,000 per year in regular maintenance of its equipment. Due to the
economic downturn, the firm considers forgoing these maintenance expenses for the next three
years. If it does so, it expects it will need to spend $2 million in year 4 replacing failed equipment.
a.

What is the IRR of the decision to forgo maintenance of the equipment?

b.

Does the IRR rule work for this decision?

c.

For what costs of capital is forgoing maintenance a good decision?

2014 Pearson Education, Inc.

Berk/DeMarzo, Corporate Finance, Global Edition, Third Edition

7-19.(E) You are a real estate agent thinking of placing a sign advertising your services at a local bus stop.
The sign will cost $5000 and will be posted for one year. You expect that it will generate
additional revenue of $500 per month. What is the payback period?
7-22.(M)You have just started your summer internship, and your boss asks you to review a recent
analysis that was done to compare three alternative proposals to enhance the firms
manufacturing facility. You find that the prior analysis ranked the proposals according to their
IRR, and recommended the highest IRR option, Proposal A. You are concerned and decide to
redo the analysis using NPV to determine whether this recommendation was appropriate. But
while you are confident the IRRs were computed correctly, it seems that some of the underlying
data regarding the cash flows that were estimated for each proposal was not included in the
report. For Proposal B, you cannot find information regarding the total initial investment that
was required in year 0. And for Proposal C, you cannot find the data regarding additional
salvage value that will be recovered in year 3. Here is the information you have:

Suppose the appropriate cost of capital for each alternative is 10%. Using this information,
determine the NPV of each project. Which project should the firm choose?
Why is ranking the projects by their IRR not valid in this situation?

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Chapter 2/Introduction to Financial Statement Analysis9

Chapter 8

Fundamentals of Capital Budgeting

8-3.(M) Home Builder Supply, a retailer in the home improvement industry, currently operates seven
retail outlets in Georgia and South Carolina. Management is contemplating building an eighth
retail store across town from its most successful retail outlet. The company already owns the
land for this store, which currently has an abandoned warehouse located on it. Last month, the
marketing department spent $10,000 on market research to determine the extent of customer
demand for the new store. Now Home Builder Supply must decide whether to build and open the
new store.
Which of the following should be included as part of the incremental earnings for the proposed
new retail store?
a.

The cost of the land where the store will be located.

b.

The cost of demolishing the abandoned warehouse and clearing the lot.

c.

The loss of sales in the existing retail outlet, if customers who previously drove across town
to shop at the existing outlet become customers of the new store instead.

d.

The $10,000 in market research spent to evaluate customer demand.

e.

Construction costs for the new store.

f.

The value of the land if sold.

g.

Interest expense on the debt borrowed to pay the construction costs.

8-5.(M) After looking at the projections of the HomeNet project, you decide that they are not realistic. It
is unlikely that sales will be constant over the four-year life of the project. Furthermore, other
companies are likely to offer competing products, so the assumption that the sales price will
remain constant is also likely to be optimistic. Finally, as production ramps up, you anticipate
lower per unit production costs resulting from economies of scale. Therefore, you decide to redo
the projections under the following assumptions: Sales of 50,000 units in year 1 increasing by
50,000 units per year over the life of the project, a year 1 sales price of $260/unit, decreasing by
10% annually and a year 1 cost of $120/unit decreasing by 20% annually. In addition, new tax
laws allow you to depreciate the equipment over three rather than five years using straight-line
depreciation.
a.

Keeping the other assumptions that underlie Table 8.1 the same, recalculate unlevered net
income (that is, reproduce Table 8.1 under the new assumptions, and note that we are
ignoring cannibalization and lost rent).

b.

Recalculate unlevered net income assuming, in addition, that each year 20% of sales comes
from customers who would have purchased an existing Linksys router for $100/unit and that
this router costs $60/unit to manufacture.

8-7.(E) Castle View Games would like to invest in a division to develop software for video games. To
evaluate this decision, the firm first attempts to project the working capital needs for this
operation. Its chief financial officer has developed the following estimates (in millions of dollars):

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10

Berk/DeMarzo, Corporate Finance, Global Edition, Third Edition

Assuming that Castle View currently does not have any working capital invested in this division,
calculate the cash flows associated with changes in working capital for the first five years of this
investment.

8-9.(M) Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term
cash flows are difficult to estimate, management has projected the following cash flows for the
first two years (in millions of dollars):

a.

What are the incremental earnings for this project for years 1 and 2?

b.

What are the free cash flows for this project for the first two years?

8-10.(M)You are a manager at Percolated Fiber, which is considering expanding its operations in
synthetic fiber manufacturing. Your boss comes into your office, drops a consultants report on
your desk, and complains, We owe these consultants $1 million for this report, and I am not
sure their analysis makes sense. Before we spend the $25 million on new equipment needed for
this project, look it over and give me your opinion. You open the report and find the following
estimates (in thousands of dollars):

All of the estimates in the report seem correct. You note that the consultants used straight-line
depreciation for the new equipment that will be purchased today (year 0), which is what the
accounting department recommended. The report concludes that because the project will

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Chapter 2/Introduction to Financial Statement Analysis11

increase earnings by $4.875 million per year for 10 years, the project is worth $48.75 million.
You think back to your halcyon days in finance class and realize there is more work to be done!
First, you note that the consultants have not factored in the fact that the project will require $10
million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you
see they have attributed $2 million of selling, general and administrative expenses to the project,
but you know that $1 million of this amount is overhead that will be incurred even if the project
is not accepted. Finally, you know that accounting earnings are not the right thing to focus on!
a.

Given the available information, what are the free cash flows in years 0 through 10 that
should be used to evaluate the proposed project?

b.

If the cost of capital for this project is 14%, what is your estimate of the value of the new
project?

8-13.(M) One year ago, your company purchased a machine used in manufacturing for $110,000. You
have learned that a new machine is available that offers many advantages; you can purchase it
for $150,000 today. It will be depreciated on a straight-line basis over 10 years, after which it has
no salvage value. You expect that the new machine will produce EBITDA (earning before
interest, taxes, depreciation, and amortization) of $40,000 per year for the next 10 years. The
current machine is expected to produce EBITDA of $20,000 per year. The current machine is
being depreciated on a straight-line basis over a useful life of 11 years, after which it will have no
salvage value, so depreciation expense for the current machine is $10,000 per year. All other
expenses of the two machines are identical. The market value today of the current machine is
$50,000. Your companys tax rate is 45%, and the opportunity cost of capital for this type of
equipment is 10%. Is it profitable to replace the year-old machine?
DC.

DATA CASE: Novo Nordisk (see page 267 of your textbook).

2014 Pearson Education, Inc.