Question-3 (10 Points)

OF Corporation purchased a machine 5 years ago at a cost of $90. The machine had an expected life of 10 years at the time of purchase. For tax purposes, assume that OF Corporation uses straight-line method to depreciate machine.

If the machine is not replaced, it can be sold for $10 at the end of its expected life. However, if it is replaced, the old machine can be sold today for $55.

A new machine can be purchased for $150. MACRS depreciation will be used for this machine. According to MACRS, its life is 3 years. Therefore, the applicable depreciation rates are 33%, 45%, 15%, and 7%.

The useful life of this machine is, however, 5 years. During this life, it will reduce operating expenses by $50 per year. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worthless.

The firms tax rate is 35%. What are the cash flows that will occur from year 0 through year 5?

Question-4 (10 Points)

OF Corporation is considering an ambitious project. The life of the project is 10 years. The project will involve an initial investment of 170,000 AZN. For tax purposes, OF Corporation will use straight line depreciation.

In each of years 1 to 10, the project expects to generate revenues of 400,000 AZN and incur variable costs of 50% of revenues and fixed costs of 90,000 AZN. The corporate tax rate is 30%, and the cost of capital is 10%.

Suppose that managers are worried that the corporate tax rate will be increased immediately after investment is made. Calculate the break-even rate of taxes.

Question-5 (10 Points)

OF Corporation has the opportunity to buy one of two mutually exclusive machines that will produce computers. Machine-A costs $10 million and generates after-tax inflows of $2 million per year for 4 years. After 4 years, the machine must be replaced. Machine-B costs $15 million and generates after-tax inflows of $1.5 million per year for 7 years, after which it must be replaced. The cost of capital is 10%. Which machine should be preferred?

Question-6 (5 Points)

Assume that OF Corporation is planning to raise the capital by selling new stocks. The company estimates that it can sell new shares for $100 per share in the primary market. This price, however, is below the fundamental value of stocks by $5 per share. Assume that the company has to pay $3 per share to underwriters. What is the cost of equity? Assume first future dividend of $4 and perpetual growth rate of 5% for dividends.

Question-7 (5 Points)

Share prices are considered as an indicator of shareholder wealth. What is another advantage of using share price as an indicator of measuring managerial performance?

Question-8 (5 Points)

OF Corporation has issued three bonds to raise the capital required for investing in the expansion of its automobile factory. The least risky bond (short-term bond) has a beta of 1.7, while the medium risk bond has a beta of 1.8, and the riskiest bond (long-term bond) a beta of 2.1. The market value of the least risky bond is $11 billion, $6 billion for the middle risk bond, and $7 billion for the riskiest bond. Assume that OF Corporation is in 40% tax bracket. What is the cost of debt, if the risk-free rate is 3% and market risk premium is 4%?