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Questions and Answers of Corporate Finance

What is a replicating portfolio? What is arbitrage?MINI CASEAssume that you have just been hired as a financial analyst by Triple Play Inc., a mid-sized California company that specializes in
In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option Pricing Model (OPM).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
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. Option’s Term To Maturity 4. Risk-Free Rate 5.
What is put-call parity?
Define each of the following terms:a. Weighted average cost of capital, WACC; after-tax cost of debt, rd(1 − T)b. Cost of preferred stock, rps; cost of common equity (or cost of common stock), rsc.
How would each of the factors in the following table affect a firm?s cost of debt, rd(1 ? T); its cost of equity, rs; and its weighted average cost of capital, WACC? Indicate by a plus (+), a minus
Distinguish between beta (or market) risk, within-firm (or corporate) risk, and standalone risk for a potential project. Of the three measures, which is theoretically the most relevant, and why?
Suppose a firm estimates its overall cost of capital for the coming year to be 10%.What might be reasonable costs of capital for average-risk, high-risk, and low-risk projects?
Calculate the after-tax cost of debt under each of the following conditions:a. Interest rate of 13%, tax rate of 0%b. Interest rate of 13%, tax rate of 20%c. Interest rate of 13%, tax rate of 35%
Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $50 a share with an annual dividend of $4.50 a share. Ignoring flotation costs, what is the company’s cost of preferred
Summerdahl Resort’s common stock is currently trading at $36 a share. The stock is expected to pay a dividend of $3.00 a share at the end of the year (D1 = $3.00), and the dividend is expected to
Shi Importer’s balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common equity. Shi’s tax rate is 40%, rd = 6%, rps = 5.8%, and rs = 12%. If Shi
David Ortiz Motors has a target capital structure of 40% debt and 60% equity. The yield to maturity on the company’s outstanding bonds is 9%, and the company’s tax rate is 40%. Ortiz’s CFO has
A company’s 6% coupon rate, semiannual payment, $1,000 par value bond that matures in 30 years sells at a price of $515.16. The company’s federal-plus-state tax rate is 40%. What is the firm’s
The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per year in the future. Shelby’s common stock sells for $23 per share, its last dividend was $2.00, and the
Radon Homes’ current EPS is $6.50. It was $4.42 five years ago. The company pays out 40% of its earnings as dividends, and the stock sells for $36.a. Calculate the historical growth rate in
Spencer Supplies’ stock is currently selling for $60 a share. The firm is expected to earn $5.40 per share this year and to pay a year-end dividend of $3.60.a. If investors require a 9% return,
Messman Manufacturing will issue common stock to the public for $30. The expected dividend and the growth in dividends are $3.00 per share and 5%, respectively. If the flotation cost is 10% of the
Suppose a company will issue new 20-year debt with a par value of $1,000 and a coupon rate of 9%, paid annually. The tax rate is 40%. If the flotation cost is 2% of the issue proceeds, then what is
On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm’s present market value
Suppose the Schoof Company has this book value balance sheet: The current liabilities consist entirely of notes payable to banks, and the interest rate on this debt is 10%, the same as the rate on
The table below gives the balance sheet for Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains. The following facts also apply to TII.(1) Short-term
What sources of capital should be included when you estimate Harry Davis’s weighted average cost of capital (WACC)?
Should the component costs be figured on a before-tax or an after-tax basis?
What is the market interest rate on Harry Davis’s debt, and what is the component cost of this debt for WACC purposes?
Should flotation costs be included in the estimate?
Should you use the nominal cost of debt or the effective annual cost?
What is the firm's cost of preferred stock?
Harry Davis’s preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a
What are the two primary ways companies raise common equity?
Why is there a cost associated with reinvested earnings?
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
What is the cost of equity based on the bond-yield-plus-judgmental-risk-premium method?MINI CASEDuring the last few years, Harry Davis Industries has been too constrained by the high cost of
What is your final estimate for the cost of equity, rs?
What is Harry Davis’s weighted average cost of capital (WACC)?
What factors influence a company’s 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 division’s 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
What are three types of project risk? How can each type of risk be considered when thinking about the new division’s cost of capital?During the last few years, Harry Davis Industries has been too
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.
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
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 after-tax cost of debt for the new bond?
What four common mistakes in estimating the WACC should Harry Davis avoid?
Define each of the following terms:a. Capital budgeting; regular payback period; discounted payback periodb. Independent projects; mutually exclusive projectsc. DCF techniques; net present value
Explain why the NPV of a relatively long-term project, defined as one for which a high percentage of its cash flows are expected in the distant future, is more sensitive to changes in the cost of
In what sense is a reinvestment rate assumption embodied in the NPV, IRR, and MIRR methods? What is the assumed reinvestment rate of each method?
Suppose a firm is considering two mutually exclusive projects. One has a life of 6 years and the other a life of 10 years. Would the failure to employ some type of replacement chain analysis bias an
A project has an initial cost of $52,125, expected net cash inflows of $12,000 per year for 8 years, and a cost of capital of 12%. What is the project’s NPV?
Refer to Problem 10-1. What is the project’s MIRR?
Refer to Problem 10-1. What is the project’s PI?
Refer to Problem 10-1. What is the project’s payback period?
Refer to Problem 10-1. What is the project’s discounted payback period?
Your division is considering two investment projects, each of which requires an upfront expenditure of $15 million. You estimate that the investments will produce the following net cash flows: a.
Edelman Engineering is considering including two pieces of equipment, a truck and an overhead pulley system, in this year's capital budget. The projects are independent. The cash outlay for the truck
Davis Industries must choose between a gas-powered and an electric-powered forklift truck for moving materials in its factory. Since both forklifts perform the same function, the firm will choose
Project S has a cost of $10,000 and is expected to produce benefits (cash flows) of $3,000 per year for 5 years. Project L costs $25,000 and is expected to produce cash flows of $7,400 per year for 5
Your company is considering two mutually exclusive projects, X and Y, whose costs and cash flows are shown below: The projects are equally risky, and their cost of capital is 12%. You must make
After discovering a new gold vein in the Colorado mountains, CTC Mining Corporation must decide whether to go ahead and develop the deposit. The most costeffective method of mining gold is sulfuric
Cummings Products is considering two mutually exclusive investments whose expected net cash flows are as follows: a. Construct NPV profiles for Projects A and B.b. What is each project's IRR?c. If
The Ewert Exploration Company is considering two mutually exclusive plans for extracting oil on property for which it has mineral rights. Both plans call for the expenditure of $10 million to drill
The Pinkerton Publishing Company is considering two mutually exclusive expansion plans. Plan A calls for the expenditure of $50 million on a large-scale, integrated plant that will provide an
Shao Airlines is considering two alternative planes. Plane A has an expected life of 5 years, will cost $100 million, and will produce net cash flows of $30 million per year. Plane B has a life of 10
The Perez Company has the opportunity to invest in one of two mutually exclusive machines that will produce a product it will need for the foreseeable future. Machine A costs $10 million but realizes
Filkins Fabric Company is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: Machine 190-3, which has a cost of $190,000, a 3-year expected
The Ulmer Uranium Company is deciding whether or not it should open a strip mine whose net cost is $4.4 million. Net cash inflows are expected to be $27.7 million, all coming at the end of Year 1.
The Aubey Coffee Company is evaluating the within-plant distribution system for its new roasting, grinding, and packing plant. The two alternatives are (1) A conveyor system with a high initial cost
a. Your division is considering two investment projects, each of which requires an upfront expenditure of $25 million. You estimate that the cost of capital is 10% and that the investments will
The Scampini Supplies Company recently purchased a new delivery truck. The new truck cost $22,500, and it is expected to generate net after-tax operating cash flows, including depreciation, of $6,250
What is capital budgeting?
What is the difference between independent and mutually exclusive projects?
Define the term net present value (NPV). What is each franchise’s 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?
Define the term internal rate of return (IRR). What is each franchise’s IRR?
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
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 MIRR’s advantages and disadvantages vis-a-vis the regular IRR? What are the MIRR’s advantages and disadvantages vis-a-vis the NPV?
What does the profitability index (PI) measure? What are the PI’s 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 firm’s maximum acceptable payback is 2 years, and if
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 World's Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental
What is Project P’s NPV? What is its IRR? Its MIRR?
Draw Project P’s NPV profile. Does Project P have normal or nonnormal cash flows? Should this project be accepted?
In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects:The projects provide a necessary service, so whichever one is selected is expected
What is each project’s 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?
You are also considering another project which has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end
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
Define each of the following terms:a. Project cash flow; accounting incomeb. Incremental cash flow; sunk cost; opportunity cost; externality; cannibalization; expansion project; replacement projectc.

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