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**Solution Bank Financial Management 14th Eugene F. Brigham**

** Chapter 1: An Overview of Financial Management and The Financial Environment**

Assume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firms clients is Michelle Dellatorre, a professional tennis player who has just come to the United States from Chile. Dellatorre is a highly ranked tennis player who would like to start a company to produce and market apparel that she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. Dellatorre is also very bright, and, therefore, she would like to understand, in general terms, what will happen to her money. Your boss has developed the following set of questions which you must ask and answer to explain the U.S. financial system to Dellatorre.

- Why is corporate finance important to all managers?
- Describe the organizational forms a company might have as it evolves from a to a major corporation. List the advantages and disadvantages of each form How do corporations go public and continue problems? What is corporate governance?
- What should be the primary objective of managers?
- What three aspects of cash flows affect the value of any investment?
- What are free cash flows?
- What is the weighted average cost of capital?
- How do free cash flows a determine a firms value?
- Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?
- What do we call the price that a borrower must pay for debt capital? What is the price of equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?
- What are some economic conditions that affect the cost of money?
- What are financial securities? Describe some financial instruments.
- List some financial institutions
- What are some different types of markets?
- How are secondary markets organized?
- Briefly explain mortgage securitization and how it contributed to the global economic crisis.

**Chapter 2: Financial Statements, Cash Flow, and Taxes**

Donna Jamison, a recent graduate of the University of Tennessee with four years of banking experience, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of electronic calculators.

The company doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Computrons results were not satisfactory, to put it mildly. Its board of directors, which consisted of its president and vice-president plus its major stockholders (who were all local business people), was most upset when directors learned how the expansion was going. Suppliers were being paid late and were unhappy, and the bank was complaining about the deteriorating situation and threatening to cut off credit. As a result, Al Watkins, Computrons president, was informed that changes would have to be made, and quickly, or he would be fired. Also, at the boards insistence Donna Jamison was brought in and given the job of assistant to Fred Campo, a retired banker who was Computrons chairman and largest stockholder. Campo agreed to give up a few of his golfing days and to help nurse the company back to health, with Jamisons help.

Jamison began by gathering financial statements and other data. Assume that you are Jamisons assistant, and you must help her answer the following questions for Campo

- What effect did the expansion have on sales and net income? What effect did the expansion have on the asset side of the balance sheet? What effect did it have on liabilities and equity
- What do you conclude from the statement of cash flows?
- What is free cash flow? Why is it important? What are the five uses of FCF?
- What is Computrons net operating profit after taxes (NOPAT)? What are operating current assets? What are operating current liabilities? How much net operating working capital and total net operating capital does Computron have?
- What is Computrons free cash flow (FCF)? What are Computrons net uses of its FCF?
- Calculate Computrons return on invested capital. Computron has a 10% cost of capital (WACC). Do you think Computrons growth added value?
- Jamison also has asked you to estimate Computrons EVA. She estimates that the after-tax cost of capital was 10 percent in both years.
- What happened to Computrons market value added (MVA)?
- Assume that a corporation has $100,000 of taxable income from operations plus $5,000 of interest income and $10,000 of dividend income. What is the companys tax liability
- Assume that you are in the 25 percent marginal tax bracket and that you have $5,000 to invest. You have narrowed your investment choices down to

California bonds with a yield of 7 percent or equally risky ExxonMobil bonds with a yield of 10 percent. Which one should you choose and why? At what

marginal tax rate would you be indifferent to the choice between California and ExxonMobil bonds?

**Chapter 3: Analysis of Financial Statements**

The first part of the case, presented in Chapter 2, discussed Computron Industries situation after an expansion program. A large loss occurred in 2010, rather than the expected profit. As a result, its managers, directors, and investors are concerned about the

firms survival.

Donna Jamison was brought in as assistant to Fred Campo, Computrons chairman, who had the task of getting the company back into a sound financial position. Computrons 2009 and 2010 balance sheets and income statements, together with projections for 2011, are shown in the following tables. Also, the tables show the 2009 and 2010 financial ratios, along with industry average data. The 2011 projected financial statement data represent Jamisons and Campos best guess for 2011 results, assuming that some new financing is arranged to get the company over the hump.

Jamison must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken. Your assignment is to help her answer the following questions. Provide clear explanations, not yes or no answers.

- Why are ratios useful? What three groups use ratio analysis and for what

reasons? - Calculate the 2011 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the companys liquidity position in 2009, 2010, and as projected for 2011? We often think of ratios as being useful (1) to managers to help run the business, (2) to bankers for credit analysis, and (3) to stockholders for stock valuation. Would these different types of analysts have an equal interest in the liquidity ratios?
- Calculate the 2011 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does Computrons utilization of assets stack up against other firms in its industry?
- Calculate the 2011 debt, times-interest-earned, and EBITDA coverage ratios. How does Computron compare with the industry with respect to financial leverage? What can you conclude from these ratios?
- Calculate the 2011 profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios?
- Calculate the 2011 price/earnings ratio, price/cash flow ratios, and market/book. Do these ratios indicate that investors are expected to have a high or low opinion of the company?
- Perform a common size analysis and percent change analysis. What do these analyses tell you about Computron?
- Use the extended Du Pont equation to provide a summary and overview of Computrons financial condition as projected for 2011. What are the firms major strengths and weaknesses?
- What are some potential problems and limitations of financial ratio analysis?
- What are some qualitative factors analysts should consider when evaluating a companys likely future financial performance?

**Chapter 4: Time Value of Money**

Assume that you are nearing graduation and have applied for a job with a local bank. As part of the banks evaluation process, you have been asked to take an examination that covers several financial analysis techniques. The first section of the test addresses

discounted cash flow analysis. See how you would do by answering the following questions.

- Draw time lines for (a) a $100 lump sum cash flow at the end of year 2, (b) an ordinary annuity of $100 per year for 3 years, and (c) an uneven cash flow stream of -$50, $100, $75, and $50 at the end of years 0 through 3.
- What is the future value of an initial $100 after 3 years if it is invested in an account paying 10% annual interest?
- What is the present value of $100 to be received in 3 years if the appropriate interest rate is 10%? We sometimes need to find out how long it will take a sum of money (or anything else) to grow to some specified amount. For example, if a companys sales are growing at a rate of 20% per year, how long will it take sales to double?
- If you want an investment to double in 3 years, what interest rate must it earn?
- What is the difference between an ordinary annuity and an annuity due? What type of annuity is shown below? How would you change it to the other type of annuity?
- What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest rate is 10%?
- What is the present value of the annuity?
- What would the future and present values be if the annuity were an annuity due?
- What is the present value of the following uneven cash flow stream? The appropriate interest rate is 10%, compounded annually.
- 1. Define (a) the stated, or quoted, or nominal rate, (iNom), and (b) the periodic rate (iPer).
- Will the future value be larger or smaller if we compound an initial amount more often than annually, for example, every 6 months, or semiannually, holding the stated interest rate constant? Why?
- What is the future value of $100 after 5 years under 12% annual compounding?

Semiannual compounding? Quarterly compounding? Monthly compounding? Daily compounding - What is the effective annual rate (EAR or EFF%)? What is the EFF% for a nominal rate of 12%, compounded semiannually? Compounded quarterly? Compounded monthly? Compounded daily?
- Will the effective annual rate ever be equal to the nominal (quoted) rate? 1. Construct an amortization schedule for a $1,000, 10% annual rate loan with 3 equal installments. 2. What is the annual interest expense for the borrower, and the annual interest income for the lender, during Year 2?
- Suppose on January 1 you deposit $100 in an account that pays a nominal, or quoted, interest rate of 11.33463%, with interest added (compounded) daily.

How much will you have in your account on October 1, or 9 months later? - 1. What is the value at the end of Year 3 of the following cash flow stream if the quoted interest rate is 10%, compounded semiannually?
- What is the PV of the same stream?
- Is the stream an annuity?
- An important rule is that you should
*never*show a nominal rate on a time line or use it in calculations unless what condition holds? (Hint: Think of annual compounding, when INOM = EFF% = IPER.) What would be wrong with your answer to questions l(1) and l(2) if you used the nominal rate (10%) rather than the periodic rate (INOM /2 = 10%/2 = 5%)? - Suppose someone offered to sell you a note calling for the payment of $1,000 15 months from today. They offer to sell it to you for $850. You have $850 in a bank time deposit which pays a 6.76649% nominal rate with daily compounding,

which is a 7% effective annual interest rate, and you plan to leave the money in the bank unless you buy the note. The note is not riskyyou are sure it will be paid on schedule. Should you buy the note? Check the decision in three ways:

(1) by comparing your future value if you buy the note versus leaving your money in the bank, (2) by comparing the PV of the note with your current bank account, and (3) by comparing the EFF% on the note versus that of the bank

account.

**Chapter 5: Bonds, Bond Valuation, and Interest Rates**

Sam Strother and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company and co-directors of the companys pension fund management division. A major new client, the Northwestern Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions. Because the Boeing Company operates in one of the leagues cities, you are to work Boeing into the presentation.

- What are the key features of a bond?
- What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?
- How is the value of any asset whose value is based on expected future cash flows determined?
- How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent?
- 1. What would be the value of the bond described in part d if, just after it had been issued, the expected inflation rate rose by 3 percentage points, causing investors to require a 13 percent return? Would we now have a discount or a premium bond?
- What would happen to the bonds value if inflation fell, and rd declined to 7 percent? Would we now have a premium or a discount bond?
- What would happen to the value of the 10-year bond over time if the required rate of return remained at 13 percent, or if it remained at 7 percent? (Hint: with a financial calculator, enter PMT, I/YR, FV, and N, and then change (override) n to see what happens to the PV as the bond approaches maturity.)
- 1. What is the yield to maturity on a 10-year, 9 percent annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship

between rd and the bonds coupon rate? - What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.)
- How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10 percent coupon bond if nominal rd = 13%.
- Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of $1,000 is currently selling for $1,135.90, producing a nominal yield to maturity of 8 percent. However, the bond can be called after 5 years for a price of $1,050.
- What is the bonds
*nominal yield to call (YTC)*? If you bought this bond, do you think you would be more likely to earn the YTM

or the YTC? Why? - Write a general expression for the yield on any debt security (rd) and define these terms: real risk-free rate of interest (r*), inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP)
- Define the nominal risk-free rate (rRF). What security can be used as an estimate of rRF?
- Describe a way to estimate the inflation premium (IP) for a T-Year bond.
- What is a bond spread and how is it related to the default risk premium? How are bond ratings related to default risk? What factors affect a companys bond rating?
- What is
*interest rate (or price) risk*? Which bond has more interest rate risk, an annual payment 1-year bond or a 10-year bond? Why? - What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond?
- How are interest rate risk and reinvestment rate risk related to the maturity risk premium?
- What is the term structure of interest rates? What is a yield curve? Briefly describe bankruptcy law. If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be

assured of receiving all of their promised payments?

**Chapter 6: Risk and Return**

Barney Smiths economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have developed a sophisticated computer program that was used to estimate the rate of return on each alternative under each state of the economy. Alta Industries is an electronics firm; Repo Men collects past-due debts; and American Foam manufactures mattresses and various other foam products. Barney Smith also maintains an index fund which owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund, and thus obtain average stock market results. Given the situation as described, answer the following questions. What are investment returns? What is the return on an investment that costs

- $1,000 and is sold after one year for $1,100?
- 1. Why is the t-bills return independent of the state of the economy? Do t-bills promise a completely risk-free return?
- Why are Alta Ind.s returns expected to move with the economy whereas Repo Mens are expected to move counter to the economy?
- Calculate the expected rate of return on each alternative and fill in the blanks onthe row for r in the table.
- You should recognize that basing a decision solely on expected returns is appropriate only for risk-neutral individuals. Because your client, like virtually everyone, is risk averse, the riskiness of each alternative is an important aspect of the decision. One possible measure of risk is the standard deviation of returns. 1. Calculate this value for each alternative, and fill in the blank on the row for in the table.
- What type of risk is measured by the standard deviation?
- Draw a graph that shows
*roughly*the shape of the probability distributions for Alta Industries, American Foam, and T-bills. - Suppose you suddenly remembered that the coefficient of variation (CV) is generally regarded as being a better measure of stand-alone risk than the standard deviation when the alternatives being considered have widely differing expected returns. Calculate the missing CVs, and fill in the blanks in the row for CV in the table. Does the CV produce the same risk rankings as the standard deviation?
- Suppose you created a 2-stock portfolio by investing $50,000 in Alta Industries and $50,000 in Repo Men.

1. Calculate the expected return ( p r ), the standard deviation (p), and the coefficient of variation (CVp) for this portfolio and fill in the appropriate blanks in the table. - How does the risk of this 2-stock portfolio compare with the risk of the individual stocks if they were held in isolation?
- Suppose an investor starts with a portfolio consisting of one randomly selected stock. What would happen (1) to the risk and (2) to the expected return of the portfolio as more and more randomly selected stocks were added to the portfolio? What is the implication for investors? Draw a graph of the two portfolios to illustrate your answer.
- 1. Should portfolio effects impact the way investors think about the risk of individual stocks?
- If you decided to hold a 1-stock portfolio, and consequently were exposed to more risk than diversified investors, could you expect to be compensated for all of your risk; that is, could you earn a risk premium on that part of your risk that you could have eliminated by diversifying?
- How is market risk measured for individual securities? How are beta coefficients calculated? Suppose you have the following historical returns for the stock market and for another company, P.Q. Unlimited. Explain how to calculate beta, and use the

historical stock returns to calculate the beta for PQU. Interpret your results - 1. Write out the Security Market Line (SML) equation, use it to calculate the required rate of return on each alternative, and then graph the relationship between the expected and required rates of return.
- How do the expected rates of return compare with the required rates of return?
- Does the fact that Repo Men has an expected return that is less than the T-bill rate make any sense?
- What would be the market risk and the required return of a 50-50 portfolio of Alta Industries and Repo Men? Of Alta Industries and American Foam?
- 1. Suppose investors raised their inflation expectations by 3 percentage points over current estimates as reflected in the 8 percent T-bill rate. What effect would higher inflation have on the SML and on the returns required on high- and lowrisk securities?
- Suppose instead that investors risk aversion increased enough to cause the market risk premium to increase by 3 percentage points. (Inflation remains constant.) What effect would this have on the SML and on returns of high- and low-risk securities?

**Chapter 7: Stocks, Stock Valuation, and Stock Market Equilibrium**

Sam Strother and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the companys pension fund management division, with Strother having responsibility for fixed income securities (primarily bonds) and Tibbs being responsible for equity investments. A major new client, the Northwestern Municipal League, has requested that Mutual of Seattle present an investment seminar to the mayors of the cities in the association, and Strother and Tibbs, who will make the actual presentation, have asked you to help them.

To illustrate the common stock valuation process, Strother and Tibbs have asked you to analyze the Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads.

You are to answer the following questions.

- Describe briefly the legal rights and privileges of common stockholders.
- Write out a formula that can be used to value any stock, regardless of its dividend pattern.
- What is a constant growth stock? How are constant growth stocks valued? What happens if a company has a constant g that exceeds its rs? Will many stocks have expected g > rs in the short run (i.e., for the next few years)? In the

long run (i.e., forever)? - Assume that Temp Force has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7%, and that the market risk premium is 5%. What is the required rate of return on the firms stock?
- Assume that Temp Force is a constant growth company whose last dividend (D0, which was paid yesterday) was $2.00 and whose dividend is expected to grow indefinitely at a 6% rate.

What is the firms expected dividend stream over the next 3 years? - What is the firms current stock price?
- What is the stocks expected value one year from now?
- What are the expected dividend yield, the capital gains yield, and the total return during the first year?
- Now assume that the stock is currently selling at $30.29. What is its expected rate of return?
- What would the stock price be if its dividends were expected to have zero growth?
- Now assume that Temp Forces dividend is expected to experience supernormal growth of 30% from Year 0 to Year 1, 20% from Year 1 to Year 2, and 10% from Year 2 to Year 3. After Year 3, dividends will grow at a constant rate of 6%. What is the stocks intrinsic value under these conditions? What are the expected dividend yield and capital gains yield during the first year? What are the expected dividend yield and capital gains yield during the fourth year (from Year 3 to Year 4)?
- Is the stock price based more on long-term or short-term expectations? Answer this by finding the percentage of Temp Forces current stock price based on dividends expected more than three years in the future.
- Suppose Temp Force is expected to experience zero growth during the first 3 years and then to resume its steady-state growth of 6% in the fourth year. What is the stocks value now? What is its expected dividend yield and its capital gains yield in Year 1? In Year 4?
- Finally, assume that Temp Forces earnings and dividends are expected to decline by a constant 6% per year forever, that is, g = 6%. Why would anyone be willing to buy such a stock, and at what price should it sell? What would be the dividend yield and capital gains yield in each year?
- What is market mutliple analysis?
- Temp Force recently issued preferred stock that pays an annual dividend of $5 at a price of $50 per share. What is the expected return to an investor who buys this preferred stock?
- Why do stock prices change? Suppose the expected D1 is $2, the growth rate is 5%, and rs is 10%. Using the constant growth model, what is the stocks price?

What is the impact on the stock price if g falls to 4% or rises to 6%? If rs increases to 9% or to 11%? - What does market equilibrium mean?
- If equilibrium does not exist, how will it be established?
- What is the Efficient Markets Yypothesis, what are its three forms, and what are its implications?
- Assume that all the growth rates used in the preceding answers were averages of the growth rates published by well known and respected security analysts. This being the case, would you say that your results are based on a purely rational

analysis? If not, what factors might have led to irrational results?

**Chapter 8: Financial Options and Applications in Corporate Finance**

Assume that you have just been hired as a financial analyst by Triple Play Inc., a mid-sized California company that specializes in creating high-fashion clothing. Since no one at Triple Play is familiar with the basics of financial options, you have been asked to prepare a brief report that the firms executives could use to gain at least a cursory understanding of the topic.

To begin, you gathered some outside materials the subject and used these materials to

draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.

- What is a financial option? What is the single most important characteristic of an option?
- Options have a unique set of terminology. Define the following terms: (1) call option; (2) put option; (3) strike price; (4) expiration date; (5) exercise value (6) option price; (7) time value; (8) covered option; (9) naked option; (10) in-themoney call; (11) out-of-the-money call; and (12) LEAPS
- Consider a stock with a current price of P = $27. Suppose that over the next 6 months the stock price will either go up by a factor of 1.41 or down by a factor of 0.71. Consider a call option on the stock with a strike price of $25 which expires

in 6 months. The risk-free rate is 6%.

1. Using the binomial model, what are the ending values of the stock price? What are the payoffs of the call option? - Suppose you write 1 call option and buy Ns shares of stock. How many shares must you buy to create a portfolio with a riskless payoff (which is called a hedge portfolio)? What is the payoff of the portfolio?
- What is the present value of the hedge portfolios riskless payoff? What is the value of the call option?
- What is a replicating portfolio? What is arbitrage?
- In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model (OPM).

1. What assumptions underlie the OPM? - Write out the three equations that constitute the model
- What is the value of the following call option according to the OPM?

Stock Price = $27.00.

Strike Price = $25.00

Time To Expiration = 6 Months = 0.5 years.

Risk-Free Rate = 6.0%.

Stock Return Standard Deviation = 0.49. - What impact does each of the following call option parameters have on the value of a call option?

1. Current Stock Price

2. Strike Price

3. Options Term To Maturity

4. Risk-Free Rate

5. Variability Of The Stock Price - What is put-call parity?

**Chapter 9: The Cost of Capital**

During the last few years, Harry Davis Industries has been too constrained by the high costof capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that has been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice-president. Your first task is to estimate Harry Daviss cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task:

1. The firms tax rate is 40%.

2. The current price of Harry Daviss 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately

placed with no flotation cost.

3. The current price of the firms 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Harry Davis would incur flotation costs equal to 5% of the proceeds on a new issue.

4. Harry Daviss common stock is currently selling at $50 per share. Its last dividend (D0) was $3.12, and dividends are expected to grow at a constant rate of 5.8% in the foreseeable future. Harry Daviss beta is 1.2; the yield on T-bonds is 5.6%; and the

market risk premium is estimated to be 6%. For the over-own-bond-yield-plusjudgmental-risk-premium approach, the firm uses a 3.2% judgmental risk premium.

5. Harry Daviss target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

To help you structure the task, Leigh Jones has asked you to answer the following questions.

- What sources of capital should be included when you estimate Harry Daviss weighted average cost of capital (WACC)?
- Should the component costs be figured on a before-tax or an after-tax basis?
- Should the costs be historical (embedded) costs or new (marginal) costs?
- What is the market interest rate on Harry Daviss debt, and what is the component cost of this debt for WACC purposes?
- What is the firms cost of preferred stock?
- Harry Daviss preferred stock is riskier to investors than its debt, yet the preferreds yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake?
- What are the two primary ways companies raise common equity?
- Why is there a cost associated with reinvested earnings?
- Harry Davis doesnt plan to issue new shares of common stock. Using the CAPM approach, what is Harry Daviss estimated cost of equity?
- What is the estimated cost of equity using the discounted cash flow (DCF) approach?
- Suppose the firm has historically earned 15% on equity (ROE) and retained 62% of earnings, and investors expect this situation to continue in the future. How could you use this information to estimate the future dividend growth rate, and what growth rate would you get? Is this consistent with the 5.8% growth rate given earlier?
- Could the DCF method be applied if the growth rate was not constant? How?
- What is the cost of equity based on the bond-yield-plus-judgmental-riskpremium method?
- What is your final estimate for the cost of equity, rs?
- What is Harry Daviss weighted average cost of capital (WACC)?
- What factors influence a companys WACC?
- Should the company use the overall, or composite, WACC as the hurdle rate for each of its divisions?
- What procedures can be used to estimate the risk-adjusted cost of capital for a particular division? What approaches are used to measure a divisions beta?
- Harry Davis is interested in establishing a new division that will focus primarily on developing new Internet-based projects. In trying to determine the cost of capital for this new division, you discover that specialized firms involved in similar projects have on average the following characteristics: Their capital structure is 10% debt and 90% common equity. Their cost of debt is typically 12%. The beta is 1.7. Given this information, what would your estimate be for the divisions cost of capital?
- What are three types of project risk? How can each type of risk be considered when thinking about the new divisions cost of capital?
- Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally as retained earnings.
- 1. Harry Davis estimates that if it issues new common stock, the flotation cost will be 15%. Harry Davis incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, taking into account

the flotation cost? - Suppose Harry Davis issues 30-year debt with a par value of $1,000 and a coupon rate of 10%, paid annually. If flotation costs are 2%, what is the aftertax cost of debt for the new bond?
- What four common mistakes in estimating the WACC should Harry Davis avoid?

**Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows**

You have just graduated from the MBA program of a large university, and one of your

favorite courses was Todays Entrepreneurs. In fact, you enjoyed it so much you have decided you want to be your own boss. While you were in the masters program, your grandfather died and left you $1 million to do with as you please. You are not an inventor and you do not have a trade skill that you can market; however, you have decided that you would like to purchase at least one established franchise in the fast-foods area, maybe two (if profitable). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is three years. After three years you will sell off your investment and go on to something else.

You have narrowed your selection down to two choices; (1) Franchise L, Lisas Soups, Salads, & Stuff and (2) Franchise S, Sams Fabulous Fried Chicken. The net cash flows shown below include the price you would receive for selling the franchise in Year 3 and the forecast of how each franchise will do over the three-year period. Franchise Ls cash flows will start off slowly but will increase rather quickly as people become more health conscious, while Franchise Ss cash flows will start off high but will trail off as other chicken competitors enter the marketplace and as people become more health conscious and avoid fried foods. Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for you to invest in both franchises. You see these franchises as perfect complements to one another: You could attract both the lunch and dinner crowds and the health conscious and not so health conscious crowds without the franchises directly competing against one another.

Here are the net cash flows (in thousands of dollars):

Expected Net Cash Flows

Year Franchise L Franchise S

0 ($100) ($100)

1 10 70

2 60 50

3 80 20

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.

You also have made subjective risk assessments of each franchise, and concluded that both franchises have risk characteristics that require a return of 10%. You must now determine whether one or both of the franchises should be accepted.

- What is capital budgeting?
- What is the difference between independent and mutually exclusive projects?
- Define the term
*net present value (NPV).*What is each franchises NPV? - What is the rationale behind the NPV method? According to NPV, which

franchise or franchises should be accepted if they are independent? Mutually exclusive? - Would the NPVs change if the cost of capital changed?
- Define the term
*internal rate of return (IRR)*. What is each franchises IRR? - How is the IRR on a project related to the YTM on a bond?
- What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?
- Would the franchises IRRs change if the cost of capital changed?
- Draw NPV profiles for Franchises L and S. At what discount rate do the profiles cross?
- Look at your NPV profile graph without referring to the actual NPVs and IRRs.

Which franchise or franchises should be accepted if they are independent?

Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6%? - What is the underlying cause of ranking conflicts between NPV and IRR?
- What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict?
- Which method is the best? Why?
- Define the term
*modified IRR (MIRR).*Find the MIRRs for Franchises L and S. - What are the MIRRs advantages and disadvantages vis-a-vis the regular IRR?

What are the MIRRs advantages and disadvantages vis-a-vis the NPV? - What does the profitability index (PI) measure? What are the PIs for Franchises S and L?
- What is the payback period? Find the paybacks for Franchises L and S.
- What is the rationale for the payback method? According to the payback criterion, which franchise or franchises should be accepted if the firms maximum acceptable payback is 2 years, and if Franchises L and S are independent? If they are mutually exclusive?
- What is the difference between the regular and discounted payback periods? What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions?
- As a separate project (Project P), you are considering sponsoring a pavilion at the upcoming Worlds Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation.

However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project Ps expected net cash flows look like this (in millions of dollars):

Year Net Cash Flows

0 ($0.8)

1 5.0

2 (5.0)

The project is estimated to be of average risk, so its cost of capital is 10%. - What are normal and nonnormal cash flows?
- What is Project Ps NPV? What is its IRR? Its MIRR?
- Draw Project Ps NPV profile. Does Project P have normal or nonnormal cash flows? Should this project be accepted?
- 1. What is each projects initial NPV without replication?
- What is each projects equivalent annual annuity?
- Now apply the replacement chain approach to determine the projects extended NPVs. Which project should be chosen?
- Now assume that the cost to replicate Project S in 2 years will increase to $105,000 because of inflationary pressures. How should the analysis be handled now, and which project should be chosen?
- After examining all the potential projects, you discover that there are many more projects this year with positive NPVs than in a normal year. What two problems might this extra large capital budget cause?

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