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Questions and Answers of Corporate Finance

What is the logic behind the IRR method? According to IRR, which projects should be accepted if they are independent? Mutually exclusive?
Would the projects’ IRRs change if the WACC changed?
Draw NPV profiles for Projects 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 project(s) should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any
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?
Define the term modified IRR (MIRR). Find the MIRRs for Projects L and S.
What are the MIRR’s advantages and disadvantages vis-à-vis the NPV?
What is the payback period? Find the paybacks for Projects L and S.
What is the rationale for the payback method? According to the payback criterion, which project(s) should be accepted if the firm’s maximum acceptable payback is 2 years, if Projects L and S are
How would the correlation coefficient and the previously calculated combine to affect the project's contribution to corporate, or within-firm, risk? Explain.
What is Project L’s discounted payback, assuming a 10% cost of capital?
What are the two main disadvantages of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? Explain.
As a separate project (Project P), the firm is 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
Use the worst-case, most likely case (or base-case), and best-case NPVs with their probabilities of occurrence to find the project's expected NPV, standard deviation, and coefficient of variation.
Draw Project P’s NPV profile. Does Project P have normal or non-normal cash flows? Should this project be accepted? Explain.
Operating cash flows rather than accounting income are listed in Table 12-1. Why do we focus on cash flows as opposed to net income in capitalbudgeting?
Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included. Give an example of each.
Explain why working capital is included in a capital budgeting analysis and how it is recovered at the end of a project’s life.
Assume that Allied's average project has a coefficient of variation (CV) in the range of 1.25 to 1.75. Would the lemon juice project be classified as high risk, average risk, or low risk? What type
Most firms generate cash inflows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows and then using them in the
What are some differences in the analysis for a replacement project versus that for a new expansion project? Discuss.
Distinguish among beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a project being considered for inclusion in the capital budget.
In theory, market risk should be the only “relevant” risk. However, companies focus as much on stand-alone risk as on market risk. What are the reasons for the focus on standalone risk?
Define (a) Sensitivity analysis, (b) Scenario analysis, and (c) Simulation analysis. If GE was considering two projects (one for $500 million to develop a satellite communications system and the
If you were the CFO of a company that had to decide on hundreds of potential projects every year, would you want to use sensitivity analysis and scenario analysis as described in the chapter or would
Truman Industries is considering an expansion. The necessary equipment would be purchased for $9 million, and the expansion would require an additional $3 million investment in working capital. The
Eisenhower Communications is trying to estimate the first-year net cash flow (at Year 1) for a proposed project. The financial staff has collected the following information on the project:Sales
Kennedy Air Services is now in the final year of a project. The equipment originally cost $20 million, of which 80% has been depreciated. Kennedy can sell the used equipment today for $5 million, and
The Chang Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has a book value and a market value of zero. However, the machine
Kristin is evaluating a capital budgeting project that should last 4 years. The project requires $800,000 of equipment. She is unsure what depreciation method to use in her analysis, straight-line
Huang Industries is considering a proposed project whose estimated NPV is $12 million. This estimate assumes that economic conditions will be “average.” However, the CFO realizes that conditions
You must evaluate a proposed spectrometer for the R&D Department. The base price is $140,000, and it would cost another $30,000 to modify the equipment for special use by the firm. The equipment
You must evaluate a proposal to buy a new milling machine. The base price is $108,000, and shipping and installation costs would add another $12,500. The machine falls into the MACRS 3-year class,
The Dauten Toy Corporation uses an injection molding machine that was purchased 2 years ago. This machine is being depreciated on a straight-line basis, and it has 6 years of remaining life. Its
Mississippi River Shipyards is considering replacing an 8-year-old riveting machine with a new one that will increase earnings before depreciation from $27,000 to $54,000 per year. The new machine
The Butler-Perkins Company (BPC) must decide between two mutually exclusive projects. Each costs $6,750 and has an expected life of 3 years. Annual project cash flows begin 1 year after the initial
Your firm, Agrico Products, is considering a tractor that would have a net cost of $36,000, would increase pretax operating cash flows before taking account of depreciation by $12,000 per year, and
Holmes Manufacturing is considering a new machine that costs $250,000 and would reduce pretax manufacturing costs by $90,000 annually. Holmes would use the 3-year MACRS method to depreciate the
The Erley Equipment Company purchased a machine 5 years ago at a cost of $90,000. The machine had an expected life of 10 years at the time of purchase, and it is being depreciated by the
The Bigbee Bottling Company is contemplating the replacement of one of its bottling machines with a newer and more efficient one. The old machine has a book value of $600,000 and a remaining useful
You must analyze a potential new product—a caulking compound that Cory Materials’ R&D people developed for use in the residential construction industry. Cory’s marketing manager thinks the
Allied has a standard form that is used in the capital budgeting process. Part of the table has been completed, but you must replace the blanks with the missing numbers. Complete the table using
Complete the table for unit sales, sales price, total revenues, and operating costs excluding depreciation.
Complete the depreciation data.
Fill in the blanks under Year 4 for the terminal cash flows, and complete the project cash flow line. Discuss working capital. What would have happened if the machinery were sold for less than its
Allied uses debt in its capital structure, so some of the money used to finance the project will be debt. Given this fact, should the projected cash flows be revised to show projected interest
Assume that the lemon juice project would take profitable sales away from Allied’s fresh orange juice business. Should that fact be reflected in your analysis? If so, how?
Disregard all the assumptions from Part B, and assume there is no alternative use for the building over the next 4 years. Now calculate the project’s NPV, IRR, MIRR, and payback. Do these
If this project had been a replacement rather than an expansion project, how would the analysis have changed? Think about the changes that would have to occur in the cash flow table.
What three levels, or types, of project risk are normally considered?
Which type is most relevant?
Which type is easiest to measure?
Are the three types of risk generally highly correlated?
What is sensitivity analysis?
How would you perform a sensitivity analysis on the unit sales, salvage value, and WACC for the project? Assume that each of these variables deviates from its base-case, or expected, value by plus or
What is the primary weakness of sensitivity analysis? What are its primary advantages?
Assume that inflation is expected to average 5% over the next 4 years and that this expectation is reflected in the WACC. Moreover, inflation is expected to increase revenues and variable costs by
The expected cash flows, considering inflation (in thousands of dollars), are given in Table IC 12-2. Allied’s WACC is 10%. Assume that you are confident about the estimates of all the variables
Nichols Corporation’s value of operations is equal to $500 million after a recapitalization (the firm had no debt before the recap). It raised $200 million in new debt and used this to buy back
Dye Trucking raised $150 million in new debt and used this to buy back stock. After the recap, Dye’s stock price is $7.50. If Dye had 60 million shares of stock before the recap, how many shares
Explain the difference between NOPAT and net Income. Which is a better measure of the performance of a company’s operations? Discuss.
Little Books Inc. recently reported $3 million of net income. Its EBIT was $6 million, and its tax rate was 40%. What was its interest expense? (Hint: Write out the headings for an income statement
Washington-pacific invested $4 million to buy a tract of land and plant some young pine trees. The trees can be harvested in 10 years, at which time W-P plans to sell the forest at an expected price
Seven year ago, Goodwynn & Wolf incorporated sold a 20-year bond issue with a 14% annual coupon rate and a 9% call premium. Today, G&W called the bonds. The bonds originally were sold at were their
Assume that the real risk-free rate, r*, is 3% and that inflation is expected to be 8% in Year 1, 5% in year 2, and 4% thereafter. Assume also that all treasury securities are highly liquid and free
Suppose you hold a diversified portfolio consisting of a $ 7,500 investment in each of 20 different common stocks. The portfolio’s beta is 1.12. Now, suppose you sell one whose beta is 1.75.
Inventors require a 15% rate of return on brooks sisters’s stock (rs = 15%).(a) What would the value of Brook’s stock be if the previous dividend was D0 = $2 and if investors expect dividends to
Taussig Technologies Corporation (TTC) has been growing at a rate of 20% per year in recent years. This same supernormal growth rate is expected to last for an other 2 years (g1 = g2 20%)(a) If D0 =
Assuming the same information as for Problem 21-2, suppose Hastings will increase Vandell’s level of debt at the end of Year 3 to $30.6 million so that the target capital structure is now 45%
Marston Marble Corporation is considering a merger with the Conroy Concrete Company. Conroy is a publicly traded company, and its beta is 1.30. Conroy has been barely profitable, so it has paid an
VolWorld Communications Inc., a large telecommunications company, is evaluating the possible acquisition of Bulldog Cable Company (BCC), a regional cable company. VolWor1d?s analysts project the
How can the WACC be both an average cost and a marginal cost?
How would each of the factors in the following table 3 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 projects?
Burnwood Tech plans to issue some $60 par preferred stock with a 6% dividend. A similar stock is selling on the market for $70. Burnwood must pay flotation costs of 5% of the issue price. What is the
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 floating cost is 2% of the
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 cost effective 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 project A and B.(b) What is each project's IRR?(c)
What are some differences in the analysis for a replacement project versus that for a new expansion project? Discuss in detail.
List six reasons why risk management might increase the value of a firm.
Zhao Automotive issues fixed-rate debt at a rate of 7.00%. Zhao agrees to an interest rate swap in which in pays LIBOR to LEE Financial and Lee pays 6.8% to Zhao. What is Zhao’s resulting net
A Treasury bond futures contract has a settlement price of 89’08. What is the implied annual yield?
What is the implied interest rate on a Treasury bond (%100,000) futures contract that settled at 100’16? If interest rates increased by 1% what would be the contract’s new value?
Fethe’s Funny Hats is considering selling trademarked, orange-haired curly wigs for University of Tennessee football games. The purchase cost for a 2-year franchise to sell the wigs is $20,000. If
Rework Problem 25-1 using the Black-Scholes model to estimate the value of the option. Assume that the variance of the project’s rate of return is 6.87% and that the risk-free rate is 8%.
Rework Problem 25-2 using the Black-Scholes model to estimate the value of the option. Assume that the variance of the project’s rate of return is 1.11% and that the risk-free rate is 6%.
Rework Problem 25-5 using the Black-Scholes model to estimate the value of the option. Assume that the variance of the project’s rate of return is 20.2 5% and that the risk-free rate is 6%.
A utility company is allowed to charge prices high enough to cover all costs, including its cost of capital. Public service commission are supposed to take actions that stimulate companies to
Modigliani and Miller assumed that firms do not grow. How does positive growth change their conclusions about the value of the levered firm and its cost of capital?
Your firm’s CEO has just learned about options and how your firm’s equity can be viewed as an option. Why might he want to increase the riskiness of the firm, and why might the bondholders be
An unlevered firm has a value of $600 million. An otherwise identical but levered firm has $240 million in debt. Under the Miller model, what is the value of the levered firm if the corporate tax
Air Tampa has just been incorporated, and its hoard of directors is currently grappling with the question of optimal capital structure. The company plans to offer commuter air services between Tampa
Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 5% bonds outstanding. Assume that (1) there arc no corporate or personal taxes, (2) all of the
Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 5% bonds outstanding. Assume that (1) all of the MM assumption are met, (2) both firms arc
Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 5% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) both firms are
Schwarzentraub Industries’ expected free cash flow for the year is $500,000; in the future, free cash flow is expected to grow at a rate of 9%. The company currently has no debt, and its cost
International Associates (IA) is about to commence operations as an international trading company. The firm will have book assets of $10 million, and it expects to earn a 16% return on these assets
A. Fethe Inc. is a custom manufacturer of guitars, mandolins, and oilier stringed instruments that is located near Knoxville, Tennessee. Fethe’s current value of operations, which is also its value

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