Finance 3310

Test 3

1. Photon Corporation is 100% financial 60% with equity and 40% with debt.
The company expects to retain earnings of $300,000 in the coming year.
The cost of internal equity is 15%.
The cost of new equity is 16%.
The before tax cost of debt is 8%.
The marginal tax rate is 40%.
If Photon has the following investment opportunities, what is its optimal capital budget?
What capital structure supports this capital budget?
(How much new equity and how much debt is needed?)
Project Cost IRR
1 $300,000 14.0%
2 300,000 13.0
3 200,000 12.0
4 200,000 10.5
5 150,000 9.0
Answer

Chapter 11
2. Boudreaux Industries plans to invest in a new computer system.
The company has narrowed its choice to System A and System B.
System A requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $60,000 at
the end of each of the next 2 years.
System B also requires an up-front cost of $100,000 and then generates positive after-tax cash flows of $48,000
at the end of the next 3 years.
System B can be replaced every 3 years with the cash inflows and outflows remaining the same.
The company needs a computer system for the six years, after which the current owners plan on retiring and
liquidating the firm.
The company’s cost of capital is 12%.
What is the Modified Internal Rate of Return (MIRR) (on a 6-year extended basis) of each system?
Which system creates the most value for the company – has the highest NPV?
Answer
A B I = 12
Cost 100,000 100,000
Cash Flow 60,000 48,000
Life 2 3

A 0 1 2 3 4 5 6 NPV = $10,369.668
| | | | | | |
–100,000 60,000 60,000 60,000 60,000 60,000 60,000

B 0 1 2 3 4 5 6 NPV = $33,921.03
| | | | | | |
–100,000 48,000 48,000 48,000 48,000 48,000 48,000
3. You are the director of capital budgeting for Denver Corporation and you are evaluating 2 mutually exclusive
projects with the following net cash flows:
Project X Project Y
Year Cash Flow Cash Flow
0 – $100,000 – $100,000
1 60,000 20,000
2 50,000 40,000
3 30,000 60,000
4 20,000 80,000
Denver’s cost of capital is 10%.
Based on Profitability Index, which project would you choose?
Answer
Project X
PI = NPV = $32,067.48173 + 100,000 = 0.320675
NINV = $100,000

Project Y
PI = NPV = $50,959.63390 + 100,000 = 0.509596
NINV = $100,000

Chapter 14
4. Texas Products Inc. has a division that makes burlap bags for the citrus industry.
The division has fixed costs of $10,000 per month, and it expects to sell 50,000 bags per month.
If the variable cost per bag is $2.00, what price must the division charge in order to break even?
FC = $10,000
VC = $2.00
Q = 50,000
TVC = 50,000 x $2.00 = $100,000

P x Q = VC x Q + FC
P x 50,000 = $2.00 x 50,000 + $10,000
P x 50,000 = $110,000
P = $110,000 / 50,000
P = $2.20 per bag

Chapter 16
5. MVP.Com currently has $1,000,000 in accounts receivable.
Its day’s sales outstanding (DSO) is 48 days.
Assume a 360-day year.
The company wants to reduce its DSO to the industry average (32 days) by encouraging its customers to pay
on time.
According to the CFO, the company’s average sales will fall by 10%.
Assume that the company reduces its DSO and that sales fall by 10%.
What will be the new level of accounts receivable?
Answer
Chapter 14
6. US Robotics (USR) is evaluating a new investment with an expected return of 15%.
The beta for USR is 1.25.
If USR acquires the company, it will finance the investment with the same capital structure as its current
business (70% common equity and 30% debt).
USR’s marginal tax rate is 40%.
The target company has a beta of 1.5, a capital structure of 40% common equity and 60% debt, and a marginal
rate of 40%.
If USR acquires the company, use the Hamada equation to calculate the beta and required return for the new
investment.
The risk free rate is 4% and the market risk premium is 8.0%.
Should USR acquire the company?
(Hint: Compare the required return and the expected return.)
Answer
Current New
We = 0.70 We = 0.40 T = 0.40
Wd = 0.30 Wd = 0.60 Rf = 0.04
B = 1.25 B = 1.50

Bu = [ 1 + (1 – 0.4) (0.30 / 0.70)]

Bu = 1.25 / 1.257143
Bu = 0.994318

BL = 0.994318[ 1 + 0.60(0.60 / 0.40)]

BL = 1.889204

CAPM = K = Rf + B(Rm – Rf)

K = 0.04 + 1.889204(0.08)
K = 19.1136%
7. The spot rate is 1.85 Brazilian reals to one US Dollar.
If the forward rate is 1.98 reals to $1 US dollar and the 1-year risk free rate in the US is 4.8%, what is the 1-year
risk free rate in Brazil?
Answer

8. A Big Mac from McDonalds costs $3.00 in the US.

The current exchange rate is 955.72 Korean won per US dollar.
If purchasing power parity holds, what should be the price of a Big Mac in Seoul, Korea?
Answer
$1.00 = $955.72
x3
$3.00 = $2,867.16
Chapter 12
9. Tyler Inc. is considering the purchase of a new machine that will reduce manufacturing costs by $12,000
annually.
Tyler will use the MACRS method to depreciate the machine (5-year MACRS).
It expects to sell the machine at the end of its 5-year operating life for $10,000 before taxes.
The firm must increase its working capital by $5,000 to accommodate the project.
The working capital will be available for redeployment at the conclusion of the project.
Tyler’s marginal tax rate is 40%.
It uses a 10% cost of capital to evaluate project of this type.
If the machine costs $50,000, what are the project’s NPV and IRR?
Should you accept the project?

Cost = $50,000
Salvage = $10,000

Year 1 Year 2 Year 3 Year 4 Year 5

Revenues $12.000 $12,000 $12,000 $12,000 $12,000
20% 32% 19% 12% 11%
– DEPR 10,000 16,000 9,500 6,000 5,500
EBIT 2,000 – 4,000 2,500 6,000 6,500

(1 – T) 60% (1 – 0.40)
NOPAT 1,200 – 2,400 1,500 3,600 3,900

+ DEPR 10,000 16,000 9,500 6,000 5,500

OCF $11,200 $13,600 $11,000 $9,600 $9,400

BV = Cost – Accumulated Depreciation

BV = 50,000 – 47,000 = 3,000

CG = SV – BV
CG = 10,000 – 3,000 = 7,000

SVAT = SV – T(CG)
SVAT = 10,000 – (0.40) (7,000)
SVAT = 7,200

TV = SVAT + AWC
TV = 7,200 + 5,000
TV = $12,200

Cash Flow
CF0 = +/– 55,000
CF1 = 11,200
CF2 = 13,600
CF3 = 11,000
CF4 = 9,600
CF5 = 9,410 + 12,200 = $21,600
I = 10
NPV = – $345.2198

IRR = 9.7495%

No, don’t accept because IRR is less than Cost of Capital

IRR < Cost of Capital
9.7495 < 10