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Corporate Finance
Operating cash flows, rather than accounting profits, are used in project analysis. What is the basis for this emphasis on cash flows as opposed to net income?
Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included.
Explain how net operating working capital is recovered at the end of a project’s life and why it is included in a capital budgeting analysis.
Define (a) Simulation analysis, (b) Scenario analysis, and (c) Sensitivity analysis.
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?
Distinguish among beta (or market) risk, within-firm (or corporate) risk, and standalone risk for a project being considered for inclusion in a firm’s 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 stand-alone risk?
Talbot Industries is considering an expansion project. The necessary equipment could be purchased for $9 million, and the project would also require an initial $3 million investment in net operating
Cairn Communications is trying to estimate the first-year operating cash flow (at t = 1) for a proposed project. The financial staff has collected the following information:Projected sales
Allen Air Lines is now in the terminal year of a project. The equipment originally cost $20 million, of which 80% has been depreciated. Carter can sell the used equipment today to another airline for
The Chen Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has both a book value and a market value of zero; it is in good
Wendy is evaluating a capital budgeting project that should last for 4 years. The project requires $800,000 of equipment. She is unsure what depreciation method to use in her analysis, straight-line
The Campbell Company is evaluating the proposed acquisition of a new milling machine. The machine’s base price is $108,000, and it would cost another $12,500 to modify it for special use. The
You have been asked by the president of your company to evaluate the proposed acquisition of a new spectrometer for the firm’s R&D department. The equipment’s basic price is $70,000, and it would
The Rodriguez Company is considering an average-risk investment in a mineral water spring project that has a cost of $150,000. The project will produce 1,000 cases of ineral water per year
The Taylor Toy Corporation currently 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
St. Johns River Shipyards is considering the replacement of 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
Shao Industries is considering a proposed project for its capital budget. The company estimates the project's NPV is $12 million. This estimate assumes that the economy and market conditions will be
Madison Manufacturing is considering a new machine that costs $250,000 and would reduce pre-tax manufacturing costs by $90,000 annually. Madison would use the 3-year MACRS method to depreciate the
The Everly 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 Balboa 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
The Bartram-Pulley Company (BPC) must decide between two mutually exclusive investment projects. Each project costs $6,750 and has an expected life of 3 years. Annual net cash flows from each project
Singleton Supplies Corporation (SSC) manufactures medical products for hospitals, clinics, and nursing homes. SSC may introduce a new type of X-ray scanner designed to identify certain types of
The Yoran Yacht Company (YYC), a prominent sailboat builder in Newport, may design a new 30-foot sailboat based on the “winged” keels first introduced on the 12-meter yachts that raced for the
Should you subtract interest expense or dividends when calculating project cash flow?
Now assume that the plant space could be leased out to another firm at $25,000 per year. Should this be included in the analysis? If so, how?
Finally, assume that the new product line is expected to decrease sales of the firm’s other lines by $50,000 per year. Should this be considered in the analysis? If so, how?
Disregard the assumptions in part a. What is Shrieves’ depreciable basis? What are the annual depreciation expenses?
Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows?
Construct annual incremental operating cash flow statements.
Estimate the required net working capital for each year, and the cash flow due to investments in net working capital.
Calculate the after-tax salvage cash flow.
Calculate the net cash flows for each year. Based on these cash flows, what are the project’s NPV, IRR, MIRR, PI, payback, and discounted payback? Do these indicators suggest the project should be
What does the term “risk” mean in the context of capital budgeting; to what extent can risk be quantified; and when risk is quantified, is the quantification based primarily on statistical
1. What are the three types of risk that are relevant in capital budgeting?2. How is each of these risk types measured, and how do they relate to one another?
How is each type of risk used in the capital budgeting process?
What is sensitivity analysis?
Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume each of these variables can vary from its base-case, or expected, value by ±10%, ±20%,
What is the primary weakness of sensitivity analysis? What is its primary usefulness?
What is the worst-case NPV? The best-case NPV?Use the worst-, base-, and best-case NPVs and probabilities of occurrence to find the project’s expected NPV, standard deviation, and coefficient of
Are there problems with scenario analysis? Define simulation analysis, and discuss its principal advantages and disadvantages.
Assume that Shrieves’ average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new line be classified as high risk, average risk, or low risk? What type of risk is being
Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust for risk. Should the new line be accepted?
Are there any subjective risk factors that should be considered before the final decision is made?
What is a real option? What are some types of real options?
Changes in sales cause changes in profits. Would the profit change associated with sales changes be larger or smaller if a firm increased its operating leverage? Explain your answer.
Would each of the following increase, decrease, or have an in determinant effect on a firm’s break-even point (unit sales)?a. The sales price increases with no change in unit costs.b. An increase
Discuss the following statement: All else equal, firms with relatively stable sales are able to carry relatively high debt ratios. Is the statement true or false? Why?
WIf Congress increased the personal tax rate on interest, dividends, and capital gains but simultaneously reduced the rate on corporate income, what effect would this have on the average company’s
Which of the following would likely encourage a firm to increase the debt in its capital structure?a. The corporate tax rate increases.b. The personal tax rate increases.c. Due to market changes, the
Why do public utilities generally use different capital structures than pharmaceutical companies?
Why is EBIT generally considered independent of financial leverage? Why might EBIT actually be affected by financial leverage at high debt levels?
Is the debt level that maximizes a firm’s expected EPS the same as the debt level that maximizes its stock price? Explain.
If a firm goes from zero debt to successively higher levels of debt, why would you expect its stock price to rise first, hit a peak, and then begin to decline?
When the Bell System was broken up, the old AT&T was split into a new AT&T in addition to seven regional telephone companies. The specific reason for forcing the breakup was to increase the degree of
A firm is about to double its assets to serve its rapidly growing market. It must choose between a highly automated production process and a less automated one. It also must choose a capital
A company’s fixed operating costs are $500,000, its variable costs are $3.00 per unit, and the product’s sales price is $4.00. What is the company’s break-even point; that is, at what unit
Jackson Trucking Company is in the process of setting its target capital structure. The CFO believes the optimal debt ratio is somewhere between 20% and 50%, and her staff has compiled the following
a. Given the following information, calculate the expected value for Firm C’s EPS. Data for Firms A and B are as follows: E(EPSA) = $5.10, and σA = $3.61; E(EPSB) = $4.20, and σB = $2.96.b. You
Harley Motors has $10 million in assets, which were financed with $2 million of debt and $8 million in equity. Harley’s beta is currently 1.2, and its tax rate is 40%. Use the Hamada equation to
Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $20 million in assets, has $4 million of EBIT, and is in the 40% federal-plus-state
The Weaver Watch Company sells watches for $25, the fixed costs are $140,000, and variable costs are $15 per watch.a. What is the firm’s gain or loss at sales of 8,000 watches? at 18,000 watches?b.
The Neal Company wants to estimate next year’s return on equity (ROE) under different leverage ratios. Neal’s total assets are $14 million, it currently uses only common equity, and its
Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists of 25% debt and 75% equity; however, the CEO believes that the firm should use more
Tapley Inc. currently has assets of $5 million, has zero debt, is in the 40% federal-plus-state tax bracket, has a net income of $1 million, and pays out 40% of its earnings as dividends. Net income
a. Given the following graphs, calculate the total fixed costs, variable costs per unit, and sales price for Firm A. Firm B’s fixed costs are $120,000, its variable costs per unit are $4, and its
Currently, Bloom Flowers Inc. has a capital structure consisting of 20% debt and 80% equity. Bloom’s debt currently has an 8% yield to maturity. The risk-free rate (rRF) is 5%, and the market risk
Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $28.80 per set, and this year’s sales are expected to be 450,000 units. Variable production costs for the
The Severn Company plans to raise a net amount of $270 million to finance new equipment and working capital in early 2009. Two alternatives are being considered: Common stock may be sold to net $60
Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure,
What is business risk? What factors influence a firm’s business risk?
What is operating leverage, and how does it affect a firm’s business risk?
What do the terms financial leverage and financial risk mean?
How does financial risk differ from business risk?
To develop an example that can be presented to CD?s management as an illustration, consider two hypothetical firms, Firm U, with zero debt financing and Firm L, with $10,000 of 12% debt. Both firms
Be prepared to discuss each entry in the table and to explain how this example illustrates the effect of financial leverage on expected rate of return and risk.
To begin, define the terms optimal capital structure and target capital structure.
Why does CD’s bond rating and cost of debt depend on the amount of money borrowed?
Assume that shares could be repurchased at the current market price of $25 per share. Calculate CD’s expected EPS and TIE at debt levels of $0, $250,000, $500,000, $750,000, and $1,000,000. How
Using the Hamada equation, what is the cost of equity if CD recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000?
Considering only the levels of debt discussed, what is the capital structure that minimizes CD’s WACC?
What would be the new stock price if CD recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000? Recall that the payout ratio is 100%, so g = 0.
Is EPS maximized at the debt level that maximizes share price? Why or why not?
What is the WACC at the optimal capital structure?
Suppose you discovered that CD had more business risk than you originally estimated. Describe how this would affect the analysis. How would the analysis be affected if the firm had less business risk
What are some factors a manager should consider when establishing his or her firm’s target capital structure?
What assumptions underlie the MM theory? Are these assumptions realistic?
Put labels on Figure IC 13-1, and then discuss the graph as you might use it to explain to your boss why CD might want to use somedebt.
How does the existence of asymmetric information and signaling affect capital structure?
You might expect the price of a mature firm’s stock to decline if it announces a stock offering. Would you expect the same reaction if the issuing firm were a young, rapidly growing company?
What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits?
Discuss the pros and cons of having the directors formally announce what a firm’s dividend policy will be in the future.
The cost of retained earnings is less than the cost of new outside equity capital. Consequently, it is totally irrational for a firm to sell a new issue of stock and to pay dividends during the same
Would it ever be rational for a firm to borrow money in order to pay dividends? Explain.
Modigliani and Miller (MM) on the one hand and Gordon and Lintner (GL) on the other hand have expressed strong views regarding the effect of dividend policy on a firm’s cost of capital and
How would each of the following changes tend to affect aggregate (that is, the average for all corporations) payout ratios, other things held constant? Explain your answers.a. An increase in the
One position expressed in the financial literature is that firms set their dividends as a residual after using income to support new investment.a. Explain what a residual dividend policy implies,
Executive salaries have been shown to be more closely correlated to the size of the firm than to its profitability. If a firm’s board of directors is controlled by management rather than outside
What is the difference between a stock dividend and a stock split? As a stockholder, would you prefer to see your company declare a 100% stock dividend or a two-for-one split? Assume that either
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