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Questions and Answers of Corporate Finance

A project requires an initial investment of $100,000 and is expected to produce a cash inflow before tax of $26,000 per year for five years. Company A has substantial accumulated tax losses and is
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 cheaper to make these
Reliable Electric is considering a proposal to manufacture a new type of industrial electric motor which would replace most of its existing product line. A research breakthrough has given Reliable a
Marsha Jones, whom you met in the Chapter Mini-case, has bought a used Mercedes horse transporter for her Connecticut estate. It cost $35,000. The object is to save on horse transporter rentals.
United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would make use of an existing warehouse, which is currently rented out to a neighboring firm. The next
In the International Mulch and Compost example (Section 6.2), we assumed that losses on the project could be used to offset taxable profits elsewhere in the corporation. Suppose that the losses had
Table 6.8 shows investment and projected income in euros for Flanel's new perfume factory. Forecast cash flows and calculate NPV. The nominal cost of capital in euros is 11 percent.
As a result of improvements in product engineering, United Automation is able to sell one of its two milling machines. Both machines perform the same function but differ in age. The newer machine
Hayden Inc. has a number of copiers that were bought four years ago for $20,000. Currently maintenance costs $2,000 a year, but the maintenance agreement expires at the end of two years and
Return to the start of Section 6.3, where we calculated the equivalent annual cost, in cents per gallon, of producing reformulated gasoline in California. Capital investment was $400 million. Suppose
You own 500 acres of timberland, with young timber worth $40,000 if logged now. This represents 1,000 cords of wood worth $40 per cord net of costs of cutting and hauling. A paper company has offered
The Borstal Company has to choose between two machines that do the same job but have different lives. The two machines have the following costs:These costs are expressed in real terms.a. Suppose you
Look again at your calculations for question 18 above. Suppose that technological change is expected to reduce costs by 10 percent per year. There will be new machines in year 1 that cost 10 percent
The president’s executive jet is not fully utilized. You judge that its use by other officers would increase direct operating costs by only $20,000 a year and would save $100,000 a year in airline
One measure of the effective tax rate is the difference between the IRRs of pretax and after tax cash flows, divided by the pretax IRR. Consider, for example, an investment I generating a perpetual
We warned that equivalent annual costs should be calculated in real terms. We did not fully explain why. This problem will show you. Look back to the cash flows for machines A and B (in “Choosing
Suppose that after-tax investment is defined as the investment outlay minus the present value of future depreciation tax shields. In the guano project, for example, after-tax investment would be
Here are inflation rates and stock market and Treasury bill returns between 1996 and 2000:a. What was the real return on the S&P 500 in each year?b. What was the average real return?c. What was
An oil company executive is considering investing $10 million in one or both of two wells: Well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 is expected to produce $2
Each of the following statements is dangerous or misleading. Explain why.a. A long-term United States government bond is always absolutely safe.b. All investors should prefer stocks to bonds because
“There’s upside risk and downside risk. Standard deviation doesn’t distinguish between them.” Do you think the speaker has a fair point?
Hippique s.a., which owns a stable of racehorses, has just invested in a mysterious black stallion with great form but disputed bloodlines. Some experts in horseflesh predict the horse will win the
Lonesome Gulch Mines has a standard deviation of 42 percent per year and a beta of + .10. Amalgamated Copper has a standard deviation of 31 percent a year and a beta of + .66. Explain why Lonesome
Respond to the following comments:a. “Risk is not variability. If I know a stock is going to fluctuate between $10 and $20, I can make myself a bundle.”b. “There are all sorts of risk in
Lambeth Walk invests 60 percent of his funds in stock I and the balance in stock J. The standard deviation of returns on I is 10 percent, and on J it is 20 percent. Calculate the variance of
a. How many variance terms and how many covariance terms do you need to calculate the risk of a 100-share portfolio?b. Suppose all stocks had a standard deviation of 30 percent and a correlation with
Suppose that the standard deviation of returns from a typical share is about .40 (or 40 percent) a year. The correlation between the returns of each pair of shares is about .3. a. Calculate the
Table 7.8 shows standard deviations and correlation coefficients for seven stocks from different countries. Calculate the variance of a portfolio 40 percent invested in BP, 40 percent invested in
Your eccentric Aunt Claudia has left you $50,000 in Alcan shares plus $50,000 cash. Unfortunately her will requires that the Alcan stock not be sold for one year and the $50,000 cash must be entirely
There are few, if any, real companies with negative betas. But suppose you found one with β = − .25.a. How would you expect this stock’s rate of return to change if the overall market rose by an
Download “Monthly Adjusted Prices” for General Motors (GM) and Harley Davidson (HDI) from the Standard & Poor’s Market Insight website ( HYPERLINK "www.mhhe.com/"
Diversification has enormous value to investors, yet opportunities for diversification should not sway capital investment decisions by corporations. How would you explain this apparent paradox?
Here are some historical data on the risk characteristics of Dell and Microsoft: Assume the standard deviation of the return on the market was 15 percent. a. The correlation coefficient of Dell?s
Suppose that Treasury bills offer a return of about 6 percent and the expected market risk premium is 8.5 percent. The standard deviation of Treasury-bill returns is zero and the standard deviation
It is often useful to know how well your portfolio is diversified. Two measures have been suggested:a. The variance of the returns on a fully diversified portfolio as a proportion of the variance of
True or false? Explain or qualify as necessary.a. Investors demand higher expected rates of return on stocks with more variable rates of return.b. The CAPM predicts that a security with a beta of 0
Look back at the calculation for Coca-Cola and Reebok in Section 8.1. Recalculate the expected portfolio return and standard deviation for different values of x1 and x2, assuming the correlation
Mark Harrywitz proposes to invest in two shares, X and Y. He expects a return of 12 percent from X and 8 percent from Y. The standard deviation of returns is 8 percent for X and 5 percent for Y. The
M. Grandet has invested 60 percent of his money in share A and the remainder in share B. He assesses their prospects as follows: a. What are the expected return and standard deviation of returns on
M. Grandet has invested 60 percent of his money in share A and the remainder in share B. He assesses their prospects as follows: a. What are the expected return and standard deviation of returns
Percival Hygiene has $10 million invested in long-term corporate bonds. This bond portfolio’s expected annual rate of return is 9 percent, and the annual standard deviation is 10 percent. Amanda
“There may be some truth in these CAPM and APT theories, but last year some stocks did much better than these theories predicted, and other stocks did much worse.” Is this a valid criticism?
True or false?a. Stocks of small companies have done better than predicted by the CAPM.b. Stocks with high ratios of book value to market price have done better than predicted by the CAPM.c. On
Some true or false questions about the APT:a. The APT factors cannot reflect diversifiable risks.b.The market rate of return cannot be an APT factor.c. Each APT factor must have a positive risk
Consider the following simplified APT model (compare Tables 8.3 and 8.4): Calculate the expected return for the following stocks. Assume rf = 5 percent.
Look again at Practice Question 14. Consider a portfolio with equal investments in stocks P, P2, and P3.a. What are the factor risk exposures for the portfolio?b. What is the portfolio’s expected
The following table shows the sensitivity of four stocks to the three Fama?French factors in the five years to 2001. Estimate the expected return on each stock assuming that the interest rate is 3.5
In footnote 4 we noted that the minimum-risk portfolio contained an investment of 21.4 percent in Reebok and 78.6 in Coca-Cola. Prove it.
Look again at the set of efficient portfolios that we calculated in Section 8.1.a. If the interest rate is 10 percent, which of the four efficient portfolios should you hold?b. What is the beta of
“Suppose you could forecast the behavior of APT factors, such as industrial production, interest rates, etc. You could then identify stocks’ sensitivities to these factors, pick the right stocks,
The following question illustrates the APT. Imagine that there are only two pervasive macroeconomic factors. Investments X, Y, and Z have the following sensitivities to these two factors: We assume
“The cost of capital always depends on the risk of the project being evaluated. Therefore the company cost of capital is useless.” Do you agree?
The following table shows estimates of the risk of two well-known British stocks during the five years ending July 2001: a. What proportion of each stock's risk was market risk, and what proportion
you are given the following information for Lorelei Motorwerke. Note: 300,000 means 300,000 euros. a. Calculate Lorelei?s company cost of capital. Ignore taxes. b. How would requity and the cost
Look again at Table 9.1. This time we will concentrate on Burlington Northern. a. Calculate Burlingtons cost of equity from the CAPM using its own beta estimate and the industry beta estimate. How
Amalgamated Products has three operating divisions: To estimate the cost of capital for each division, Amalgamated has identified the following three principal competitors: Assume these betas
Look at Table 9.2. What would the four countries? betas be if the correlation coefficient for each was 0.5? Do the calculation and explain.
“Investors’ home country bias is diminishing rapidly. Sooner or later most investors will hold the world market portfolio, or a close approximation to it.” Suppose that statement is correct.
Consider the beta estimates for the country indexes shown in Table 9.2. Could this information be helpful to a U.S. company considering capital investment projects in these countries? Would a German
Mom and Pop Groceries has just dispatched a year’s supply of groceries to the government of the Central Antarctic Republic. Payment of $250,000 will be made one year hence after the shipment
An oil company is drilling a series of new wells on the perimeter of a producing oil field.About 20 percent of the new wells will be dry holes. Even if a new well strikes oil, there is still
Look back at project A in Section 9.6. Now assume thata. Expected cash flow is $150 per year for five years.b. The risk-free rate of interest is 5 percent.c. The market risk premium is 6 percent.d.
A project has the following forecasted cash flows: The estimated project beta is 1.5. The market return rm?is 16 percent, and the risk-free rate rf?is 7 percent. a. Estimate the opportunity cost of
The McGregor Whisky Company is proposing to market diet scotch. The product will first be test-marketed for two years in southern California at an initial cost of $500,000. This test launch is not
Suppose you are valuing a future stream of high-risk (high-beta) cash outflows. High risk means a high discount rate. But the higher the discount rate, the less the present value. This seems to say
U.S. pharmaceutical companies have an average beta of about 8. These companies have very little debt financing, so the asset beta is also about .8. Yet a European investor would calculate a beta of
What is the NPV of the electric scooter project under the following scenario?
Otobai?s staff has come up with the following revised estimates for the electric scooter project: Conduct a sensitivity analysis. What are the principal uncertainties in the project?
Otobai is considering still another production method for its electric scooter. It would require an additional investment of ¥15 billion but would reduce variable costs by ¥40,000 per unit. Other
The Rustic Welt Company is proposing to replace its old welt-making machinery with more modern equipment. The new equipment costs $10 million and the company expects to sell its old equipment for $1
Rustic Welt could commission engineering tests to determine the actual improvement in manufacturing costs generated by the proposed new welt machines. (See problem 4 above.) The study would cost
Summarize the problems that a manager would encounter in interpreting a standard sensitivity analysis, such as the one shown in Table 10.2. Which of these problems are alleviated by examining the
Operating leverage is often measured as the percentage increase in profits after depreciation for a 1 percent increase in sales.a. Calculate the operating leverage for the electric scooter project
For what kinds of capital investment projects do you think Monte Carlo simulation would be most useful? For example, can you think of some industries in which this technique would be particularly
Look back at the Vegetron electric mop project in Section 9.6. Assume that if tests fail and Vegetron continues to go ahead with the project, the $1 million investment would generate only $75,000 a
Describe the real option in each of the following cases:a. Deutsche Metall postpones a major plant expansion. The expansion has positive NPV on a discounted-cash-flow basis but top management wants
An auto plant that costs $100 million to build can produce a new line of cars that will generate cash flows with a present value of $140 million if the line is successful, but only$50 million if it
Agnes Magna has found some errors in her data (see Section 10.3). The corrected figures are as follows: Redraw the decision tree with the changed data. Calculate the value of the option to expand.
Ms. Magna has thought of another possibility. She could abandon the venture entirely by selling the plane at the end of the first year. Suppose that the piston-engine plane can be sold for $150,000
How can decision trees help the financial manager to “open up the black box” and understand a capital investment project better? Why are decision trees not complete solutions to the valuation of
You own an unused gold mine that will cost $100,000 to reopen. If you open the mine, you expect to be able to extract 1,000 ounces of gold a year for each of three years. After that, the deposit will
You are considering starting a company to provide a new Internet access service. There is a 60 percent chance the demand will be high in the first year. If it is high, there is an 80 percent chance
Explain why real options are most valuable when forecasts of future cash flows are most uncertain.
Suppose that you are considering investing in an asset for which there is a reasonably good secondary market. Specifically, you’re Delta Airlines, and the asset is a Boeing 757—a widely used
There is an active, competitive leasing (i.e., rental) market for most standard types of commercial jets. Many of the planes flown by the major domestic and international airlines are not owned by
Why is an M.B.A. student who has just learned about DCF like a baby with a hammer?What was the point of our answer?
Suppose the current price of gold is $280 per ounce. Hotshot Consultants advises you that gold prices will increase at an average rate of 12 percent for the next two years. After that the growth rate
Thanks to acquisition of a key patent, your company now has exclusive production rights for barkelgassers (BGs) in North America. Production facilities for 200,000 BGs per year will require a $25
How would your answer to question 5 change if:• Technological improvements reduce the cost of new BG production facilities by 3 percent per year? Thus a new plant built in year 1 would cost only 25
Reevaluate the NPV of the proposed polyzone project under each of the following assumptions. Follow the format of Table 11.3. What?s the right management decision in each case? a. Competitive entry
Photographic laboratories recover and recycle the silver used in photographic film. Stikine River Photo is considering purchase of improved equipment for their laboratory at Telegraph Creek. Here is
The Cambridge Opera Association has come up with a unique door prize for its December (2004) fund-raising ball: Twenty door prizes will be distributed, each one a ticket entitling the bearer to
You are asked to value a large building in northern New Jersey. The valuation is needed for a bankruptcy settlement. Here are the facts: ? The settlement requires?that the building?s value equal the
The manufacture of polysyllabic acid is a competitive industry. Most plants have an annual output of 100,000 tons. Operating costs are $.90 a ton, and the sales price is $1 a ton. A 100,000-ton plant
The world airline system is composed of the routes X and Y, each of which requires 10 aircraft. These routes can be serviced by three types of aircraft'A, B, and C. There are 5 type A aircraft
Taxes are a cost, and, therefore, changes in tax rates can affect consumer prices, project lives, and the value of existing firms. The following problem illustrates this. It also illustrates that tax
Discuss the value of postaudits. Who should conduct them? When? Should they consider solely financial performance? Should they be confined to the larger projects?
Draw up an outline or flowchart tracing the capital budgeting process from the initial idea for a new investment project to the completion of the project and the start of operations. Assume the idea
Compare typical compensation and incentive arrangements for(a) Top management, for example, the CEO or CFO, and(b) Plant or division managers. What are the chief differences? Can you explain them?
Suppose all plant and division managers were paid only a fixed salary—no other incentives or bonuses.a. Describe the agency problems that would appear in capital investment decisions.b. How would

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