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Questions and Answers of Corporate Finance

What is the net present value of a firm’s investment in a U.S. Treasury security yielding 5 percent and maturing in one year?
A parcel of land costs $500,000. For an additional $800,000 you can build a motel on the property. The land and motel should be worth $1,500,000 next year. Suppose that common stocks with the same
Calculate the NPV and rate of return for each of the following investments. The opportunity cost of capital is 20 percent for all four investments.a. Which investment is most valuable?b. Suppose
In Section 2.1, we analyzed the possible construction of an office building on a plot of land appraised at $50,000. We concluded that this investment had a positive NPV of $7,143 at a discount rate
Explain why the discount rate equals the opportunity cost of capital.
Norman Gerrymander has just received a $2 million bequest. How should he invest it?There are four immediate alternatives.a.Investment in one-year U.S. government securities yielding 5 percent.b. A
Show that your answers to Practice Question 7 are consistent with the rate of return rule for investment decisions.a.Investment in one-year U.S. government securities yielding 5 percent.b. A loan to
Take another look at investment opportunity (d) in Practice Question 7. Suppose a bank offers Norman a $600,000 personal loan at 8 percent. (Norman is a long-time customer of the bank and has an
Respond to the following comments.a. “My company’s cost of capital is the rate we pay to the bank when we borrow money.”b. “Net present value is just theory. It has no practical relevance.
Ms. Smith is retired and depends on her investments for retirement income. Mr. Jones is a young executive who wants to save for the future. They are both stockholders in Airbus, which is investing
Answer this question by drawing graphs like Figure. Casper Milk toast has $200,000 available to support consumption in periods 0 (now) and 1 (next year). He wants to consume exactly the same amount
We said that maximizing value makes sense only if we assume well-functioning capital markets. What does “well-functioning” mean? Can you think of circumstances in which maximizing value would not
Why is a reputation for honesty and fair business practice important to the financial value of the corporation?
It is sometimes argued that the NPV criterion is appropriate for corporations but not for governments. First, governments must consider the time preferences of the community as a whole rather than
In Figure the sloping line represents the opportunities for investment in the capital market and the solid curved line represents the opportunities for investment in plant and machinery. The
Draw a figure like Figure 2.1 to represent the following situation.a. A firm starts out with $10 million in cash.b. The rate of interest r is 10 percent.c. To maximize NPV the firm invests today $6
For an outlay of $8 million you can purchase a tanker load of bucolic acid delivered in Rotterdam one year hence. Unfortunately the net cash flow from selling the tanker load will be very sensitive
In real life the future health of the economy cannot be reduced to three equally probable states like slump, normal, and boom. But we?ll keep that simplification for one more example. Your company
Use the discount factors shown in Appendix Table 1 at the end of the book to calculate the PV of $100 received in: a. Year 10 (at a discount rate of 1 percent). b. Year 10 (at a discount rate of 13
Use the annuity factors shown in Appendix Table 3 to calculate the PV of $100 in each of: a. Years 1 through 20 (at a discount rate of 23 percent). b. Years 1 through 5 (at a discount rate of 3
a. If the one-year discount factor is .88, what is the one-year interest rate?b. If the two-year interest rate is 10.5 percent, what is the two-year discount factor?c. Given these one- and two-year
A factory costs $800,000. You reckon that it will produce an inflow after operating costs of $170,000 a year for 10 years. If the opportunity cost of capital is 14 percent, what is the net present
Harold Filbert is 30 years of age and his salary next year will be $20,000. Harold forecasts that his salary will increase at a steady rate of 5 percent per annum until his retirement at age 60.a. If
A factory costs $400,000. You reckon that it will produce an inflow after operating costs of $100,000 in year 1, $200,000 in year 2, and $300,000 in year 3. The opportunity cost of capital is 12
Halcyon Lines is considering the purchase of a new bulk carrier for $8 million. The forecasted revenues are $5 million a year and operating costs are $4 million. A major refit costing $2 million will
As winner of a breakfast cereal competition, you can choose one of the following prizes:a. $100,000 now.b. $180,000 at the end of five years.c. $11,400 a year forever.d. $19,000 for each of 10
Refer back to the story of Ms. Kraft in Section 3.1.a. If the one-year interest rate were 25 percent, how many plays would Ms. Kraft require to become a millionaire?b. What does the story of Ms.
Siegfried Basset is 65 years of age and has a life expectancy of 12 more years. He wishes to invest $20,000 in an annuity that will make a level payment at the end of each year until his death. If
James and Helen Turnip are saving to buy a boat at the end of five years. If the boat costs $20,000 and they can earn 10 percent a year on their savings, how much do they need to put aside at the end
Kangaroo Autos is offering free credit on a new $10,000 car. You pay $1,000 down and then $300 a month for the next 30 months. Turtle Motors next door does not offer free credit but will give you
Recalculate the NPV of the office building venture in Section 3.1 at interest rates of 5, 10, and 15 percent. Plot the points on a graph with NPV on the vertical axis and the discount rates on the
a. How much will an investment of $100 be worth at the end of 10 years if invested at 15 percent a year simple interest?b. How much will it be worth if invested at 15 percent a year compound
You own an oil pipeline which will generate a $2 million cash return over the coming year. The pipeline’s operating costs are negligible, and it is expected to last for a very long time.
If the interest rate is 7 percent, what is the value of the following three investments?a. An investment that offers you $100 a year in perpetuity with the payment at the end of each year.b. A
Refer back to Section 3.2. If the rate of interest is 8 percent rather than 10 percent, how much would our benefactor need to set aside to provide each of the following?a. $100,000 at the end of each
For an investment of $1,000 today, the Tiburon Finance Company is offering to pay you $1,600 at the end of 8 years. What is the annually compounded rate of interest? What is the continuously
How much will you have at the end of 20 years if you invest $100 today at 15 percent annually compounded? How much will you have if you invest at 15 percent continuously compounded?
You have just read an advertisement stating, “Pay us $100 a year for 10 years and we will pay you $100 a year thereafter in perpetuity.” If this is a fair deal, what is the rate of interest?
Which would you prefer?a. An investment paying interest of 12 percent compounded annually.b. An investment paying interest of 11.7 percent compounded semiannually.c. An investment paying 11.5 percent
Fill in the blanks in the following table:
Sometimes real rates of return are calculated by subtracting the rate of inflation from the nominal rate. This rule of thumb is a good approximation if the inflation rate is low. How big is the error
In 1880 five aboriginal trackers were each promised the equivalent of 100 Australian dollars for helping to capture the notorious outlaw Ned Kelley. In 1993 the granddaughters of two of the trackers
A leasing contract calls for an immediate payment of $100,000 and nine subsequent $100,000 semiannual payments at six-month intervals. What is the PV of these payments if the annual discount rate is
A famous quarterback just signed a $15 million contract providing $3 million a year for five years. A less famous receiver signed a $14 million five-year contract providing $4 million now and $2
In August 1994 the Wall Street Journal reported that the winner of the Massachusetts State Lottery prize had the misfortune to be both bankrupt and in prison for fraud. The prize was $9,420,713, to
You estimate that by the time you retire in 35 years, you will have accumulated savings 0 of $2 million. If the interest rate is 8 percent and you live 15 years after retirement, what annual level of
You are considering the purchase of an apartment complex that will generate a net cash flow of $400,000 per year. You normally demand a 10 percent rate of return on such investments. Future cash
Vernal Pool, a self-employed herpetologist, wants to put aside a fixed fraction of her annual income as savings for retirement. Ms. Pool is now 40 years old and makes $40,000 a year. She expects her
At the end of June 2001, the yield to maturity on U.S. government bonds maturing in 2006 was about 4.8 percent. Value a bond with a 6 percent coupon maturing in June 2006. The bond’s face value is
Refer again to Practice Question 31. How would the bond’s value change if interest rates fell to 3.5 percent per year?
A two-year bond pays a coupon rate of 10 percent and a face value of $1,000. (In other words, the bond pays interest of $100 per year, and its principal of $1,000 is paid off in year 2.) If the bond
Here are two useful rules of thumb. The “Rule of 72” says that with discrete compounding the time it takes for an investment to double in value is roughly 72/interest rate (in percent). The
An oil well now produces 100,000 barrels per year. The well will produce for 18 years more, but production will decline by 4 percent per year. Oil prices, however, will increase by 2 percent per
Derive the formula for a growing (or declining) annuity.
Calculate the real cash flows on the 7 percent U.S. Treasury bond (see Section 3.5) assuming annual interest payments and an inflation rate of 2 percent. Now show that by discounting these real cash
The present value of investing in a stock should not depend on how long the investor plans to hold it. Explain why.
Define the market capitalization rate for a stock. Does it equal the opportunity cost of capital of investing in the stock?
Rework Table 4.1 under the assumption that the dividend on Fledgling Electronics is $10 next year and that it is expected to grow by 5 percent a year. The capitalization rate is 15percent.
In March 2001, Fly Paper’s stock sold for about $73. Security analysts were forecasting a long-term earnings growth rate of 8.5 percent. The company was paying dividends of $1.68 per share.a.
You believe that next year the Superannuation Company will pay a dividend of $2 on its common stock. Thereafter you expect dividends to grow at a rate of 4 percent a year in perpetuity. If you
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
Crecimiento S.A. currently plows back 40 percent of its earnings and earns a return of 20 percent on this investment. The dividend yield on the stock is 4 percent.a. Assuming that Crecimiento can
Vega Motor Corporation has pulled off a miraculous recovery. Four years ago, it was near bankruptcy. Now its charismatic leader, a corporate folk hero, may run for president. Vega has just announced
P/E ratios reported in The Wall Street Journal use the latest closing prices and the last 12 months’ reported earnings per share. Explain why the corresponding earnings–price ratios (the
Each of the following formulas for determining shareholders? required rate of return can be right or wrong depending on the circumstances: For each formula construct a simple numerical example
Alpha Corp’s earnings and dividends are growing at 15 percent per year. Beta Corp’s earnings and dividends are growing at 8 percent per year. The companies’ assets, earnings, and dividends per
Look again at the financial forecasts for Growth-Tech given in Table 4.3. This time assume you know that the opportunity cost of capital is r = .12 (discard the .099 figure calculated in the text).
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 CSI to remain in business,
List at least four different formulas for calculating PV(horizon value) in a two-stage DCF valuation of a business. For each formula, describe a situation where that formula would be the best choice.
Look again at Table 4.7. a. How do free cash flow and present value change if asset growth rate is only 15 percent in years 1 to 5? If value declines, explain why. b. Suppose the business is a
Icarus Air has one million shares outstanding and expects to earn a constant $10 million per year on its existing assets. All earnings will be paid out as dividends. Suppose that next year Icarus
Look one more time at Table 4.1, which applies the DCF stock valuation formula to Fledgling Electronics. The CEO, having just learned that stock value is the present value of future dividends,
Look again at Tables 4.3 (Growth-Tech) and 4.7 (Concatenator Manufacturing). Note the discontinuous increases in dividends and free cash flow when asset growth slows down. Now look at your answer
The constant-growth DCF formula is sometimes written as where BVPS is book equity value per share, b is the plowback ratio, and ROE is the ratio of earnings per share to BVPS. Use this equation
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 5 percent. Dividends and
Consider the following projects: a. If the opportunity cost of capital is 10 percent, which projects have a positive NPV? b. Calculate the payback period for each project. c. Which project(s)
How is the discounted payback period calculated? Does discounted payback solve the deficiencies of the payback rule? Explain.
Does the following manifesto make sense? Explain briefly. We’re a darn successful company. Our book rate of return has exceeded 20 percent for five years running. We’re determined that new
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 rule. As long as the minimum payback
Unfortunately, your chief executive officer refuses to accept any investments in plant expansion that do not return their original investment in four years or less. That is, he insists on a payback
Calculate the IRR (or IRRs) for the following project: For what range of discount rates does the project have positive-NPV?
Consider the following two mutually exclusive projects: a. Calculate the NPV of each project for discount rates of 0, 10, and 20 percent. Plot these on a graph with NPV on the vertical axis and
Mr. Cyrus Clops, the president of Giant Enterprises, has to make a choice between two possible investments: The opportunity cost of capital is 9 percent. Mr. Clops is tempted to take B, which has
The Titanic Shipbuilding Company has a non-cancelable contract to build a small cargo vessel. Construction involves a cash outlay of $250,000 at the end of each of the next two years. At the end of
A company that ranks projects on IRR will encourage managers to propose projects with quick paybacks and low up-front investment. Is that statement correct? Explain.
Look again at projects E and F in Section 5.3. Assume that the projects are mutually exclusive and that the opportunity cost of capital is 10 percent.a. Calculate the profitability index for each
In 1983 wealthy investors were offered a scheme that would allow them to postpone taxes. The scheme involved a debt-financed purchase of a fleet of beer delivery trucks, which were then leased to a
Borghia Pharmaceuticals has $1 million allocated for capital expenditures. Which of the following projects should the company accept to stay within the $1 million budget? How much does the budget
Consider the following capital rationing problem: Set up this problem as a linear program.
Some people believe firmly, even 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 NPV rule “assumes
Look again at the project cash flows in Practice Question 6. Calculate the modified IRR as defined in footnote 5 in Section 5.3. Assume the cost of capital is 12 percent. Now try the following
Construct a series of cash flows with no IRR.
Construct a series of cash flows with no IRR. Discuss.
Look again at projects A, B, C, and D in Section 5.4. How would the linear programming setup change if?a. Cash not invested at date 0 could be invested at an interest rate r and used at date 1.b.
Restate the net cash flows in Table 6.6 in real terms. Discount the restated cash flows at a real discount rate. Assume a 20 percent nominal rate and 10 percent expected inflation. NPV should be
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 not putting the cart
Discuss the following statement: “We don’t want individual plant managers to get involved in the firm’s tax position. So instead of telling them to discount after-tax cash flows at 10 percent,
Consider the following statement: “We like to do all our capital budgeting calculations in real terms. It saves making any forecasts of the inflation rate.” Discuss briefly.
Each of the following statements is true. Explain why they are consistent.a. When a company introduces a new product, or expands production of an existing product, investment in net working capital
Mrs. 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 an installation cost. Mrs. Potts

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