Division of Business and Economics

F301 Financial Management

Fall 2000

Professor William Nelson

- a. True b. False

Rollins Corporation is constructing its MCC schedule. Its target capital
structure is 20 percent debt, 20 percent preferred stock, and 60 percent
common equity. Its bonds have a 12 percent coupon, paid semiannually, a
current maturity of 20 years, and sell for $1,000. The firm could sell,
at par, $100 preferred stock which pays a 12 percent annual dividend, but
flotation costs of 5 percent would be incurred. Rollins=
beta is 1.2, the risk-free rate is 10 percent, and the market risk premium
is 5 percent. Rollins is a constant growth firm which just paid a dividend
of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent.
The firm=s policy is to use a
risk premium of 4 percentage points when using the bond-yield-plus-risk-premium
method to find k_{s}.

3. What is Rollins' component cost of debt?

a. 10.0% b. 9.1% c. 8.6% d. 8.0% e. 7.2

4. What is Rollins' cost of preferred stock?

a. 10.0% b. 11.0% c. 12.0% d. 12.6% e. 13.2%

5. What is Rollins' cost of retained earnings using the CAPM approach?

a. 13.6% b. 14.1% c. 16.0% d. 16.6% e. 16.9%

6. What is the firm's cost of retained earnings using the DCF approach?

a. 13.6% b. 14.1% c. 16.0% d. 16.6% e. 16.9%

7. What is Rollins' WACC?

a. 13.6% b. 14.1% c. 16.0% d. 16.6% e. 16.9%

8. The internal rate of return is that discount rate which equates the present value of the cash outflows (or costs) with the present value of the cash inflows.

a. True b. False

9. The NPV and IRR methods, when used to evaluate an independent project, will lead to different accept/reject decisions unless the IRR is greater than the cost of capital.

a. True b. False

The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10 percent. Assume cash flows occur evenly during the year, 1/365th each day.

10. What is the payback period for this investment?

1 $2,000 $3,000

2 2,500 2,600

3 2,250 2,900

Model B, which will use a new type of laser disk drive, is considered a high-risk project, while Model A is of average risk. Real Time adds 2 percentage points to arrive at a risk-adjusted cost of capital when evaluating a high-risk project. The cost of capital used for average risk projects is 12 percent. Which of the following statements regarding the NPVs for Models A and B is most correct?

a. NPV_{a} = $380; NPV_{b} = $1,815

b. NPV_{a} = $197; NPV_{b} = $1,590

c. NPV_{a} = $380; NPV_{b} = $1,590

d. NPV_{a} = $5,380; NPV_{b} = $6,590

e. None of the above statements is correct.

The president of Real Time Inc. has asked you to evaluate the proposed
acquisition of a new computer. The computer=s
price is $40,000, and it fall into the MACRS 3-year class. Purchase of
the computer would require an increase in net working capital of $2,000.
The computer would increase the firm=s
before-tax revenues by $20,000 per year but would also increase operating
costs by $5,000 per year. The computer is expected to be used for 3 years
and then be sold for $25,000. The firm=s
marginal tax rate is 40 percent, and the project=s
cost of capital is 14 percent.

INDIANA UNIVERSITY NORTHWEST

Division of Business and Economics

F301 Financial Management

Fall 1997

Test 3

ANSWER KEY FOR TEST

Retained earnings

2. b

Cost of capital

3. e. 7.2%

Cost of debt

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are

equal. Thus, the before-tax cost of debt to Rollins is 12.0 percent. The after-tax

cost of debt equals.

k d,After-tax = 12.0%(1 - 0.40) = 7.2%.

Financial calculator solution:

Inputs: N = 40; PV = -1,000; PMT = 60; FV = 1,000;

Output: I = 6.0% - k d/2 .

k d = 6.0% x 2 = 12%.

k d (1 - T) = 12.0%(0.6) = 7.2%.

4. d. 12.6%

Cost of preferred stock

Cost of preferred stock: k ps = $12/$100(0.95) = 12.6%.

5. c. 16.0%

Cost of equity: CAPM

Cost of retained earnings (CAPM approach):

k s = 10% + 1.2(5%) = 16.0%.

6. c. 16.0%

Cost of equity: DCF

Cost of retained earnings (DCF approach):

^ $2.00(1.08)

k s = k s = + 8% = 16.0%.

$27

7. a. 13.6%

Wacc=.2(.12)(1-.4)+.2(12.6)+.6(.16) = .136

8. a

IRR

9. b

NPV versus IRR

10. b. 4.86 years

Payback period

Using the even cash flow distribution assumption, the project will

completely recover initial investment after 30/35 = 0.86 of Year 5:

30

Payback = 4 + = 4.86 years.

35

11. d. $ 51,138

NPV

Tabular solution:

NPV = $30,000(PVIFA % , ) + $35,000(PVIFA % , )(PVIF % , )

+ $40,000(PVIF % , ) - $150,000

= $30,000(3.1699) + $35,000(3.7908)(0.6830)

+ $40,000(0.3855) - $150,000 = $51,136.07 $51,136.

Financial calculator solution: (In thousands)

Inputs: CF = - 150; CF = 30; N j = 4; CF = 35; N j = 5; CF = 40;

I = 10.

Output: NPV = $51.13824 = $51,138.24 $51,138.

12. d. 16.0%

Modified IRR

Tabular solution:

TV = $73,306(FVIFA % , ) = $73,306(12.300) = $901,663.80

901,663.80

$275,000 =

(1 + MIRR)

1

0.30499 =

(1 + MIRR)

(1 + MIRR) = (FVIF IRR, ) = 3.27869.

Look in table: Periods = 8, i = 16%. MIRR = 16%.

Alternate method

3.27869 = 1 + MIRR

MIRR = 16%.

Financial calculator solution:

TV Inputs: N = 8; I = 12; PMT = 73,306. Output: FV = -$901,641.31.

MIRR Inputs: N = 8; PV = -275,000; FV = 901,641.31. Output: I = 16%.

Alternate method:

Inputs: CF = 0; CF = 73,306; N j = 8; I = 12. Output: NFV =

$901,641.31.

Inputs: CF = -275,000; CF = 0; N j = 7; CF = 901,641.31.

Output: IRR = 16.0% = MIRR.

13. e. 18 - 19%

IRR of uneven CF stream

Time line: ( In millions )

0 IRR = ? 1 2 3 4 5 years

-5 1 1 2 2 2

Financial calculator solution: (In millions)

Inputs: CF = -5; CF = 1.0; CF = 1.5; CF = 2.0; N j = 3.

Output: IRR% = 18.37%.

14. b

Relevant cash flows

15. b

Sunk costs

16. c. NPV A = $380; NPV B = $1,590

Risk-adjusted NPV

Time lines:

Project A

0 1 2 3 Periods

k = 12%

CFs A -5,000 2,000 2,500 2,250

NPV A = ?

Project B

0 1 2 3 Periods

k = 14%

CFs B -5,000 3,000 2,600 2,900

NPV B = ?

Project A: k Average risk = 12%.

Project B: k High risk = 12% + 2% = 14%.

Tabular solution:

NPV A = $2,000(PVIF % , ) + $2,500(PVIF % , ) + $2,250(PVIF % , ) -

$5,000

= $2,000(0.8929) + $2,500(0.7972) + $2,250(0.7118) - $5,000

= $380.35 $380.

NPV B = $3,000(PVIF % , ) + $2,600(PVIF % ) + $2,900(PVIF % , )

- $5,000

= $3,000(0.8772) + $2,600(0.7695) + $2,900(0.6750) - $5,000

= $1,589.80 $1,590.

Financial calculator solution:

A : Inputs: CF = -5,000; CF = 2,000; CF = 2,500; CF = 2,250;

I = 12%

Output: NPV = $380.20 $380.

B : Inputs: CF = -5,000; CF = 3,000; CF = 2,600; CF = 2,900;

I = 14%

Output: NPV = $1,589.61 $1,590.

17. a. -$42,000

New project investment

Initial investment:

Cost ($40,000)

Change in NWC (2,000 )

($42,000)

Operating cash flow:

18. e. $16,200

Operating cash flow

Depreciation schedule:

Depreciable basis = $40,000.

MACRS Depreciable Annual

Year Percent Basis Depreciation

1 0.33 $40,000 $13,200

2 0.45 40,000 18,000

3 0.15 40,000 6,000

4 0.07 40,000 2,800

$40,000

Operating cash flows:

Year 1 2 3

1) Increase in revenues $20,000 $20,000 $20,000

2) Increase in costs (5,000) (5,000) (5,000)

3) Before-tax change in

earnings 15,000 15,000 15,000

4) After-tax change in

earnings (line 3 x 0.60) 9,000 9,000 9,000

5) Depreciation 13,200 18,000 6,000

6) Tax savings deprec.

(line 6 x 0.40) 5,280 7,200 2,400

7) Net Operating CFs

(line 4 + 6) $14,280 $16,200 $11,400

19. a. $18,120

Non-operating cash flows

Additional Year 3 cash flows:

3

Salvage value $25,000

Tax on Salvage value (8,880) *

Recovery of NWC 2,000

$18,120

* (Market value - Book value)(Tax rate)

($25,000 - $2,800)(0.40) = $8,800.

20. d. $792,286.54

Replacement chain

Machine A (Time line in thousands):

0
1 2 3
4

-1,000 350 350 375 375

-1,200

-850

With a financial calculator input the following:

CF = -1,000,000

CF 1-4 = 350,000

CF 5 = -850,000

CF 6-10 = 375,000

I = 12%

Solve for NPV A = $347,802.

Machine B (Time line in thousands):

0
1 2 3

-1,500 400 400 400

100

500

CF = -1,500,000

CF 1-9 = 400,000

CF = 500,000

I = 12%

Solve for NPV B = $792,286.54.

Copyright Harcourt Brace 1997

http://www.iun.edu/~busnw/bill/f31f97t3.html

Comments: Dr. William Nelson

Copyright 1999, The Trustees of Indiana University