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fundamentals of corporate finance

Questions and Answers of Fundamentals Of Corporate Finance

35. Prices and spot interest rates (S3.3) What spot interest rates are implied by the following Treasury bonds? Assume for simplicity that the bonds pay annual coupons. The price of a one-year strip
36. Prices and spot interest rates (S3.3) Look one more time at Table 3.6.a. Suppose you knew the bond prices but not the spot interest rates. Explain how you would calculate the spot rates. (Hint:
b. Suppose that you could buy bond C in large quantities at $1,040 rather than at its equilibrium price of $1,076.20. Show how you could make a zillion dollars without taking on any risk.
1. Use www.wsj.com to answer the following questions:a. Find a long-term Treasury bond with a low coupon and calculate its duration. Now find another bond with a similar maturity and a higher coupon.
2. Bond transactions are reported on FINRA’s TRACE service, which was the source of the data for Table 3.7. Use the Advanced Search facility in TRACE to find bond prices for Johnson& Johnson (JNJ),
1. Stock markets (S4.1) True or false?a. The sale of shares by a large investor usually takes place in the primary market.b. Electronic Communications Network refers to the automated ticker tape on
2. Stock quotes (S4.1) Go to finance.yahoo.com or another Internet source and get trading quotes for IBM.a. What is the latest IBM stock price and market cap?b. What is IBM’s dividend payment and
3. Valuation by comparables (S4.2) Look up P/E and P/B ratios for Entergy (ticker symbol ETR), using Yahoo! Finance or another Internet source. Calculate the same ratios for the following potential
4. Dividend discount model (S4.3) True or false?a. All stocks in an equivalent-risk class are priced to offer the same expected rate of return.b. The value of a share equals the PV of future
5. Dividend discount model (S4.3) Respond briefly to the following statement: “You say stock price equals the present value of future dividends? That’s crazy! All the investors I know are looking
6. Dividend discount model (S4.3) Company X is expected to pay an end-of-year dividend of$5 a share. After the dividend, its stock is expected to sell at $110. If the cost of equity is 8%, what is
7. Dividend discount model (S4.3) Company Y does not plow back any earnings and is expected to produce a level dividend stream of $5 a share. If the current stock price is $40, what is the cost of
8. Constant-growth DCF model (S4.4) Company Z’s earnings and dividends per share are expected to grow indefinitely by 5% a year. If next year’s dividend is $10 and the cost of equity is 8%, what
9. Constant-growth DCF model (S4.4) Consider three investors:a. Mr. Single invests for one year.b. Ms. Double invests for two years.c. Mrs. Triple invests for three years.Assume each invests in
10. Constant-growth DCF model (S4.4) Pharmecology just paid an annual dividend of $1.35 per share. It’s a mature company, but future EPS and dividends are expected to grow with inflation, which is
11. Constant-growth DCF model (S4.4)Here are forecasts for next year for two stocks:Stock A Stock B Return on equity 15% 10%Earnings per share $ 2.00 $ 1.50 Dividends per share $ 1.00 $ 1.00a. What
12. Constant-growth DCF model (S4.4) Look up General Mills (GIS), Kellogg (K), and Campbell Soup (CPB).a. What are the current P/E and P/B ratios for these food companies? What are the dividend and
b. What are the growth rates of EPS and dividends for each company over the last five years?What EPS growth rates are forecasted by analysts? Do these growth rates appear to be on a steady trend that
c. Would you be confident in applying the constant-growth DCF model to measure these companies’ costs of equity? Why or why not?
13. Two-stage DCF model (S4.4) Company Z-prime is like Z in Problem 8 in all respects save one: Its growth will stop after year 4. In year 5 and afterward, it will pay out all earnings as dividends.
14. Two-stage DCF model (S4.4) Consider the following three stocks:a. Stock A is expected to provide a dividend of $10 a share forever.
b. Stock B is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 4% a year forever.
c. Stock C is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 20% a year for five years (years 2 through 6, as C recovers from a severe recession) and zero
15. Two-stage DCF model (S4.4) Company Q’s current return on equity (ROE) is 14%. It pays out one half of earnings as cash dividends (payout ratio = 0.5). Current book value per share is $50. Book
b. What is Q’s stock worth per share? How does that value depend on the payout ratio and growth rate after year 4?114 Part One Value
16. Two-stage DCF model (S4.4) Compost Science Inc. (CSI) is in the business of converting Boston’s sewage sludge into fertilizer. The business is not in itself very profitable. However, to induce
b. Now the MDC announces a plan for CSI to treat Cambridge sewage. CSI’s plant will, therefore, be expanded gradually over five years. This means that CSI will have to reinvest 80% of its earnings
17. Cost of equity (S4.5) Under what conditions does r, a stock’s market capitalization rate, equal its earnings–price ratio EPS1/P0?
18. Cost of equity (S4.5) Each of the following formulas for determining shareholders’ required rate of return can be right or wrong depending on the circumstances:a. r = DIV1/ P0 + gb. r = EPS1/
19. Growth opportunities (S4.5) If company Z (see Problem 8) were to distribute all its earnings, it could maintain a level dividend stream of $15 a share. How much is the market actually paying per
20. Growth opportunities (S4.5) Look up Intel (INTC), Oracle (ORCL), and HP (HPQ) on finance.yahoo.com or another Internet source. Rank the companies’ forward P/E ratios from highest to lowest.
21. Growth opportunities (S4.5) Alpha Corp’s earnings and dividends are growing at 15% per year. Beta Corp’s earnings and dividends are growing at 8% per year. The companies’ assets, earnings,
22. Growth opportunities (S4.5) Look again at the financial forecasts for Growth-Tech given in Table 4.5. This time assume you know that the opportunity cost of capital is r = 0.12 (discard the 0.099
b. What part of that value reflects the discounted value of P3, the price forecasted for year 3?
c. What part of P3 reflects the present value of growth opportunities (PVGO) after year 3?
d. Suppose that competition will catch up with Growth-Tech by year 4 so that it can earn only its cost of capital on any investments made in year 4 or subsequently. What is Growth-Tech stock worth
23. Free cash flow (S4.6) What do financial managers mean by “free cash flow”? How is free cash flow calculated? Briefly explain.Chapter 4 Valuing Stocks 115
24. Horizon value (S4.6) What is meant by the “horizon value” of a business? How can it be estimated?
25. Horizon value (S4.6) Suppose the horizon date is set at a time when the firm will run out of positive-NPV investment opportunities. How would you calculate the horizon value? (Hint:What is the
26. Valuing a business (S4.6) Permian Partners (PP) produces from aging oil fields in west Texas. Production is currently 1.8 million barrels per year, but is declining at 7% per year for the
b. What is PP’s E/P ratio, and why is it not equal to the 9% cost of capital?
27. Valuing a business (S4.6) Construct a new version of Table 4.8, assuming that competition drives down profitability (on existing assets as well as new investment) to 11.5% in year 6, 11% in year
28. Valuing a business (S4.6) Mexican Motors’ market cap is 200 billion pesos. Next year’s free cash flow is 8.5 billion pesos. Security analysts are forecasting that free cash flow will grow by
b. Mexican Motors has generally earned about 12% on book equity (ROE = 12%) and reinvested 50% of earnings. The remaining 50% of earnings has gone to free cash flow. Suppose the company maintains the
29. Valuing a business (S4.6) Phoenix Corp. faltered during the Covid pandemic but is recovering.Free cash flow has grown rapidly. Forecasts made in 2021 are as follows:($ millions) 2022 2023 2024
b. Assume that Phoenix has 12 million shares outstanding. What is the price per share?
c. Confirm that the expected rate of return on Phoenix stock is exactly 9% in each of the years from 2022 to 2026.116 Part One Value CHALLENGE
30. Constant-growth DCF formula (S4.4) The constant-growth DCF formula:P 0  =  _ Dr_ −I_V_ g_ 1 is sometimes written as:P 0  =    R_O_E_ ( _ 1_ −__ b_ )_ B_V_P_S_
31. DCF valuation (S4.4) Portfolio managers are frequently paid a proportion of the funds under management. Suppose you manage a $100 million equity portfolio offering a dividend yield(DIV1/P0) of
32. Valuing a business (S4.6) Construct a new version of Table 4.8, assuming that Concatenator grows at 20%, 12%, and 6%, instead of 12%, 9%, and 6%. You will get negative early free cash flows.a.
1. Help Jenny to forecast dividend payments for Reeby Sports and to estimate the value of the stock. Of course, you will have to make some simplifying assumptions. For example, you could assume a ROE
2. How much of your estimate of the value of Reeby’s stock comes from the present value of growth opportunities?
a. What is the payback period on each of the following projects?Cash Flows ($)Project C0 C1 C2 C3 C4 A –5,000 +1,000 +1,000 +3,000 0 B –1,000 0 +1,000 +2,000 +3,000 C –5,000 +1,000 +1,000
b. Given that you wish to use the payback rule with a cutoff period of two years, which projects would you accept?c. If you use a cutoff period of three years, which projects would you accept?d. If
2. Payback (S5.2) Consider the following projects:Cash Flows ($)Project C0 C1 C2 C3 C4 C5 A –1,000 +1,000 0 0 0 0 B –2,000 +1,000 +1,000 +4,000 +1,000 +1,000 C –3,000 +1,000 +1,000 0 +1,000
3. Payback and Accounting Rate of Return (S5.2) In Section 5.1, we listed five key features of the NPV rule. Which of these features characterize the payback rule? What about the accounting rate of
4. Payback and IRR rules (S5.2, S5.3) Respond to the following comments:a. “I like the IRR rule. I can use it to rank projects without having to specify a discount rate.”b. “I like the payback
5. IRR (S5.3) Write down the equation defining a project’s internal rate of return (IRR). In practice, how is IRR calculated?● ● ● ● ●PROBLEM SETS ®For a survey of capital budgeting
6. IRR (S5.3)a. Calculate the net present value of the following project for discount rates of 0, 50, and 100%:Cash Flows ($)C0 C1 C2–6,750 +4,500 +18,000b. What is the IRR of the project?
7. IRR (S5.3) Calculate the IRR (or IRRs) for the following project:C0 C1 C2 C3–3,000 +3,500 +4,000 –4,000 For what range of discount rates does the project have a positive NPV?
8. IRR rule (S5.3) You have the chance to participate in a project that produces the following cash flows:Cash Flows ($)C0 C1 C2–5,000 +4,000 –11,000 The internal rate of return is 13%. If the
9. IRR rule (S5.3) Consider a project with the following cash flows:Cash Flows ($)C0 C1 C2–100 +200 –75a. How many internal rates of return does this project have?
b. Which of the following numbers is the project IRR: (i) –50%; (ii) –12%; (iii) +5%;(iv) +50%?
c. The opportunity cost of capital is 20%. Is this an attractive project?d. For what range of discount rates is the project attractive?
10. IRR rule (S5.3) Consider projects Alpha and Beta:Cash Flows ($)Project C0 C1 C2 IRR (%)Alpha –400,000 +241,000 +293,000 21 Beta –200,000 +131,000 +172,000 31 The opportunity cost of capital
11. IRR rule (S5.3) Consider the following two mutually exclusive projects:Cash flows ($)Project C0 C1 C2 C3 A –50 +60 +60 0 B –50 0 0 +140a. Calculate the NPV of each project for discount rates
b. What is the approximate IRR for each project?
c. In what circumstances should the company accept project A?
d. Calculate the NPV of the incremental investment (B – A) for discount rates of 0%, 10%, and 20%. Plot these on your graph. Show that the circumstances in which you would accept A are also those
12. IRR rule (S5.3) Cyrus Clops, the president of Giant Enterprises, has to make a choice between two possible investments:Cash Flows ($000)Project C0 C1 C2 IRR (%)A –400 +250 +300 23 B –200 +140
13. IRR rule (S5.3) The Titanic Shipbuilding Company has a noncancelable contract to build a small cargo vessel. Construction involves a cash outlay of $250,000 at the end of each of the next two
14. IRR rule (S5.3) Plot the NPVs for the following projects for discount rates from 0% to 30%:Project C0 C1 C2 A –100 20 100 B –1,000 2,260 –1,270 C 100 –50 –80 D –1,080 2,510 –1,500a.
15. IRR rule (S5.3) The following table shows the forecast cash flows for two projects:C0 C1 C2 C3 C4 C5 A –1,000 20 20 20 20 1,200 B –1,000 50 50 1,050 Now suppose that the term structure is
16. Investment criteria (S5.1–S5.3) Consider the following two projects:Cash Flows Project A Project B C0 –$200 –$200 C1 80 100 C2 80 100 C3 80 100 C4 80a. If the opportunity cost of capital is
17. Profitability index (S5.4) Look again at projects D and E in Section 5-3. Assume that the projects are mutually exclusive and that the opportunity cost of capital is 10%.a. Calculate the
18. Profitability index (S5.4) Sometimes firms use the profitability index as an investment criterion when there is no rationing of capital or other resources. Look back at the pitfalls surrounding
19. Capital rationing (S5.4) Suppose you have the following investment opportunities, but only$90,000 available for investment. Which projects should you take?Project NPV ($) Investment ($)1 5,000
20. Capital rationing (S5.4) Borgia Pharmaceuticals has $1 million allocated for capital expenditures.Which of the following projects should the company accept to stay within the $1 million budget?
21. NPV and IRR rules (S5.3) Some people believe passionately that ranking projects on IRR is OK if each project’s cash flows can be reinvested at the project’s IRR. They also say that the IRR
22. Modified IRR (S5.3) Look again at the project cash flows in Problem 7. Calculate the modified IRR (MIRR) as defined in footnote 4 in Section 5-3. Assume the cost of capital is 12%.Now try the
23. Capital rationing (S5.3) Consider the following capital rationing problem:Project C0 C1 C2 NPV W −10,000 −10,000 0 +6,700 X 0 −20,000 +5,000 +9,000 Y −10,000 +5,000 +5,000 +0 Z −15,000
1. Are the accounting rates of return reported in Tables 5.1 and 5.2 useful inputs for the capital investment decision?
2. Calculate NPV and IRR for each process. What is your recommendation? Be ready to explain to the CFO.
2. Cash flows (S6.1) True or false?a. Project cash flows should take account of interest paid on any borrowing undertaken to finance the project.b. Accelerated depreciation reduces near-term project
3. Cash flows (S6.1) In 1898, Simon North announced plans to construct a funeral home on land he owned and rented out as a storage area for railway carts. (A local newspaper commended Mr. North for
4. Cash flows (S6.1) Andronicus Corporation has the following jumbled information about an investment proposal:a. Revenues in each of years 1–3 = $20,000b. Year 0 initial investment = $40,000c.
5. Operating cash flow (S6.1) A company is considering the purchase of a universal grinding machine. The following table sets out a forecast of the annual accounting profit:Revenues $ 400,000 Costsa
6. Real and nominal flows (S6.1) Mr. Art Deco will be paid $100,000 one year hence. This is a nominal flow, which he discounts at an 8% nominal discount rate:PV = 100,000/1.08 = $92,593 The inflation
7. Real and nominal flows (S6.1) Restate the net cash flows in Table 6.3 in real terms. Discount the restated cash flows at a real discount rate. Assume a 20% nominal rate and 10% expected inflation.
8. Real and nominal flows (S6.1) Guandong Machinery is evaluating a new project to produce encapsulators. The initial investment in plant and equipment is CNY 500,000.12 Sales of encapsulators in
9. Working capital (S6.1) Each of the following statements is true. Use an example to explain why they are consistent.a. When a company introduces a new product, or expands production of an existing
b. Forecasting changes in net working capital is not necessary if the timing of all cash inflows and outflows is carefully specified.
10. Working capital (S6.1) The following table tracks the main components of working capital over the life of a four-year project.2021 2022 2023 2024 2025 Accounts receivable 0 150,000 225,000
11. Taxes and project NPV (S6.2) In the International Mulch and Compost example(Section 6-3), we assumed that early losses on the project could be used to offset taxable profits elsewhere in the
12. Taxes and project NPV (S6.2) Suppose that Sudbury Mechanical Drifters is proposing to invest $10 million in a new factory. It can depreciate this investment straight-line over 10 years. The tax
b. What would be the present value of the tax shield if the government allowed Sudbury to write-off the factory immediately?
13. Taxes and project NPV (S6.2) Ms. T. Potts, the treasurer of Ideal China, has a problem.The company has just ordered a new kiln for $400,000. Of this sum, $50,000 is described by the supplier as
14. Project NPV (S6.3) Better Mousetrap’s research laboratories have developed a new trap. The project requires an initial investment in plant and equipment of $6 million. This investment will be
15. Project NPV (S6.3) A widget manufacturer currently produces 200,000 units a year. It buys widget lids from an outside supplier at a price of $2 a lid. The plant manager believes that it would be
16. Project NPV (S6.3) Marsha Jones has bought a used Mercedes horse transporter for her Connecticut estate. It cost $35,000. The object is to save on horse transporter rentals. Marsha had been

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