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Finance for Executives Managing for Value Creation 4th edition Gabriel Hawawini, Claude Viallet - Solutions
Cite two cases in which a bad decision (i.e., a decision that negatively affects the market value of a firm) would increase its return on equity.
Under what intuitive condition will increase in debt (either short term or long term) relative to equity always increase a firm’s return on equity? Can the structure of return on equity (ROE) relationship be used to determine a firm’s optimal debt-to equity ratio?
Below are summarized balance sheets and income statements of three U.S. companies:a. Compute the working capital requirement of the three firms and prepare their managerial balance sheets.b. Compute the three firms’ operating margin, invested capital turnover, return on capital employed,
Below are the last three years’ financial statements of Sentec Inc., a distributor of electrical fixtures.a. Compute Sentec Inc.’s working capital requirement (WCR) and prepare its managerial balance sheets at Year-end 1, Year-end 2, and Year-end 3.b. Compute Sentec’s operating
Mars Electronics is distributor for the Global Electric Company (GEC), a large manufacturer of electrical and electronics products for consumer and institutional markets. On the next page are the semiannual financial statements of the company for the last year and a half.a. Prepare Mars
Ambersome Inc. has decided against borrowing and to have all its assets financed by equity. Furthermore, it intends to keep its payout ratio at 40 percent. Its assets turnover ratio is 0.9, its profit margin (defined as earnings before interest and tax divided by sales) is 8 percent, and profits
Suppose you deposit $1,000 in one year, $2,000 in two years, and $4,000 in three years. Assume a 4 percent interest rate throughout.a. How much will you have in five years?b. Suppose you plan to withdraw $1,500 in four years and there is no penalty for early withdrawal. How much will you have in
A basketball player has just signed a $30 million contract to play for three years. She will receive $5 million as an immediate cash bonus, $5 million at the end of the first year, $8 million at the end of the second year, and the remaining $12 million at the end of the contract. Assuming a
You can invest in a machine that costs $500,000. You can expect revenues net of any expense, except maintenance costs, of $150,000 at the end of each year for five years. You will subcontract the maintenance costs at a rate of $20,000 a year, to be paid at the beginning of each year. You expect to
You are buying a car. No Better Deals will give you $500 off the list price on a $10,000 car.a. You can get the same car from Best Deals if you pay $4,000 down and the rest at the end of two years. If the interest rate were 12 percent, where would you buy the car?b. Best Deals has revised its
You expect that your daughter will go to college ten years from now. Taking account of inflation, you estimate that you will need $160,000 to support her during her years in college. Assume an interest rate of 4 percent on your saving accounts.How much will you have to pay into those accounts in
Suppose you have decided to set up a personal pension fund for your retirement.You just turned twenty-five. You expect to retire at age sixty-five and believe it is reasonable to count on living at least twenty years after retirement. Furthermore, you wish to have an annual income of $100,000
Five years ago, your favorite aunt won a $1,000,000 lottery. The prize money is paid out $50,000 per year for twenty years. Unfortunately, your aunt needs as much as $250,000 cash now to pay for medical bills that she and your uncle incurred as a result of an accident. A local finance company has
Hellenic Vultures is expected to generate $100,000 of net cash flows next year, $120,000 the year after, and $150,000 for the following three years. It is expected that the firm could be sold for $500,000 at the end of the fifth year. The owners of Hellenic Vultures, who would like to sell their
Lolastar Co. is evaluating two competing investment projects. They both require an investment of $25 million. The company cost of capital is 10 percent for projects of this type. The expected cash flows are as follows:a. Which of the two projects would you recommend? Why?b. Will your choice be the
Rollon Inc. is comparing the operating costs of two types of equipment. The standard model costs $50,000 and will have a useful life of four years. Operating costs are expected to be $4,000 per year. The superior model costs $90,000 and will have a useful life of six years. Its operating costs are
The Global Chemical Company (GCC) uses the following criteria to make capital investment decisions: 1. Effect on earnings per share (must be positive) 2. Payback period (must be less than six years) 3. Internal rate of return (must be at least 12 percent) 4. Net present value (must be
A project with a cash outlay now is followed by positive expected cash flows in the future and a positive net present value. What does this information tell you about the project’s discounted payback period, internal rate of return, profitability index, and average accounting return?
A project with a cash outlay now is followed by positive expected cash flows in the future and a payback period less than its economic life. Is its net present value positive or negative? Explain. Now suppose that the discounted payback period is less than the useful life of the project. Is its
The following chart plots the net present value (NPV) of projects A and B at different discount rates. The projects have similar risk and are mutually exclusive.a. What is the significance of the point on the graph where the two lines intersect?b. What is the significance of the points on the graph
The International Industrial Company has an investment project with the following cash flows:a. What is the net present value of these cash flows at 0, 25, 50, and 100 percent discount rates?b. What is the internal rate of return of this project?c. Under what conditions should the project be
You must choose between the two projects whose cash flows are shown below.The projects have the same risk.a. Compute the internal rate of return and the net present value for the two projects. Assume a 10 percent discount rate.b. Which of the projects is better according to each of the two
Consider the three projects A, B, and C. The cost of capital is 12 percent, and the projects have the following expected cash flows:a. What is the internal rate of return of the three projects?b. What is the net present value of the three projects?c. If the three projects are independent, which
You must choose between the two projects whose cash flows are shown below.The projects have the same risk.a. Compute the net present value (NPV) and the profitability index (PI) for the two projects. Assume a 10 percent discount rate.b. Which of the projects is better according to each of the two
The Alpha Printer Company is considering the purchase of a $2 million printing machine. Its economic life is estimated at five years, and it will have no resale value after that time. The machine would generate an additional $200,000 of earnings after tax for the company during the first year of
The Great Eastern Toys Company is evaluating a new product. The cash flows that are expected from this product over its five years’ expected life are shown be- low. Note that the final year’s cash flow includes $2,000 of working capital to be recovered at the end of the project.
Your brother-in-law offers you the opportunity to invest $15,000 in a project that he promises will return $17,000 at the end of the year. Because you have only $3,000 in cash, you will have to borrow $12,000 from your bank. The bank charges interest at 12 percent. After reflection, you decide not
The company's financial manager and accountant were arguing over how to properly take account of inflation when analyzing capital investment projects. The accountant typically included estimates of price-level changes when estimating and projecting future cash flows. For this, he took the
The Clampton Company is considering the purchase of a new machine to perform operations currently being performed on different, less efficient equipment. The purchase price is $110,000, delivered and installed. A Clampton production engineer estimates that the new equipment will produce savings of
Assume that the Clampton Company in the previous problem expects to pay income taxes of 40 percent and that a loss on the sale or disposal of equipment is treated as an ordinary deduction, resulting in a tax savings of 40 percent. The Clampton Company wants to earn 8 percent on its investment after
The Great Eastern Toy Company management is considering an investment in a new product. It would require the acquisition of a piece of equipment for $16 million with a ten-year operational life, providing regular maintenance is carried out.Salvage value of the equipment is estimated at $800,000.
Reviewing the cash-flow forecasts of a new investment project that appear in the following table, the Avon company's finance manager noted that there was no mention of any effect of the investment on the firm's accounts receivable and pay able. The average collection period on the new product was
According to the Modified Accelerated Cost Recovery System (MACRS) of depreciation imposed by U.S. tax law, autos and computers must be depreciated the following way for tax purposes:What is the present value of the interest tax shield from the purchase of an automobile for $50,000, with a cost of
Although he was initially satisfied by the apparent profitability of the new project, the Avon company's chief executive officer (CEO) was troubled by some other aspects of the project that he thought the finance manager had left out of the analysis. First, he was concerned about whether the new
Suppose Snowmobile Inc. is considering whether or not to launch a new snowmo bile. It expects to sell the vehicle for $10,000 over five years at a rate of 100 per year. The variable costs of making one unit are $5,000, and the fixed costs are expected to be $125,000 per year. The investment would
Maintainit Inc. is asked to submit a bid for watering and spraying trees in a housing development for the next five years. To provide this service, Maintainit would have to buy new equipment for $100,000 and invest $30,000 in working capital requirement. The equipment would be depreciated
Briefly explain the distinction between the two items that make up each of the following pairs:a. Rights issue versus general cash offeringb. Underwritten issue versus best efforts distribution c. Originating house versus selling groupd. Seasoned issue versus secondary distribution e. Credit risk
Micro-Electronics Corporation (MEC) has just announced that it will issue 10 million shares of common stock through a rights issue at a subscription price of $20.Before the announcement, MEC shares were trading at $26, and there were 50 million shares outstanding.• How many rights will MEC grant
Office Supplies (OS) Distributors needs a new truck. It can buy it for $24,000, depreciate it over four years at an annual rate of $6,000, and finance the purchase with a four-year loan at 10 percent. The truck could be sold for $5,000 in four years. Alternatively, it can lease the truck and make
Thorenberg Inc. is considering the purchase of a machine from Hydraulic Engineering Company (HECO) to make hard pressed-metal sheets. The machine will cost $100,000 and would replace the currently used one. Savings are expected to be $60,000 per year, and the new machine is expected to last five
Consider the following three bonds with $1,000 face value:Bond A: 10-year, 10 percent coupon bondBond B: 10-year, zero-coupon bondBond C: 20-year, 10 percent coupon bondCompute the market values of each of the three bonds when the market interest rate varies from 0 to 14 percent. What is your
Thalin Inc. has decided to extend its current product line. To finance the project, the firm is considering issuing a ten-year, $1,000 face value, 10 percent coupon bond. The firm has made public that its target debt-to-equity ratio of 30 percent is not going to change in the foreseeable future.
Consider the following four bonds:a. If the market yield is 7 percent, what are the values of the three first bonds (assume a face value of $1,000)? b. Why are the values of the bonds lower than their face values? c. Why is the coupon rate for the convertible bond lower than that for the non
Financial analysts expect Theron Co.'s earnings and dividends to grow at a rate of 16 percent during the next three years, 12 percent in the fourth and fifth years, and at a constant rate of 6 percent thereafter. Theron's dividend, which has just been paid, was $1.20. If the expected rate of return
Therol Inc. has no debt. Its invested capital generates $5 of earnings per share, and all these earnings are paid out as dividends.a. Suppose that Therol's shareholders require a return of 10 percent on their investment in the firm. What is Therol's stock price if the firm's earnings per share
East Harbor Company (EHC) has both preferred and common stocks outstanding. EHC has just paid a $4 dividend per share of preferred stock and a $3.50 dividend per share of common stock.a. Assume the dividend on the preferred is constant and that preferred stocks with similar risk to that of EHC are
The following table shows the annual realized returns on the following U.S. securities from 1994 to 2007: the stock market (S&P 500), corporate bonds, government bonds, and Treasury bills. The annual inflation rate for each period is shown in the last column.a. Theory suggests that the riskier the
Do you agree or disagree with the following statements? Explain.a. “The best forecast of future returns on the stock market is the average over the past ten years of historical returns.”b. “Because stocks offer a higher return over the long term than bonds, all rational investors should
Your chief operating officer argues the following:a. “Our stock price is currently $60, and our dividend per share is $6. It means that it costs us 10 percent to use shareholders’ cash ($6 divided by $60).”b. “From our balance sheet our liabilities are $80 million. From our income statement
Cordona Corp. has bonds outstanding that will mature twelve years from now. These bonds are currently quoted at 110 percent above par value. The issue makes annual payments of $80 on $1,000 bond face value. What is Cordona’s cost of debt?
The dividend of Onogo Inc. is currently $2 per share and is supposed to grow at 5 percent a year forever. Its share price is $50. Its beta is 1.08. The market risk premium is 5 percent and the risk-free rate is 4 percent. What is your best estimate of Onogo’s cost of equity?
According to the capital asset pricing model: Ri = RF + (RM − RF) × bi where Ri, the expected return on security i, is the sum of RF, the return on a risk-free investment, and (RM − RF) × bi is the expected extra return over the risk-free rate for taking on the risk of holding the security.
Suppose that Tale Inc. has the following target capital structure: 50 percent stock, 40 percent debt, and 10 percent preferred stock. Its cost of equity is estimated at10 percent, that of debt 6 percent, and that of preferred stock 4.5 percent. The tax rate is 35 percent.a. What is Tale’s cost of
You have been asked to estimate the cost of capital for the CAT corporation. The company has 4 million shares and 125,000 bonds of par value $1,000 outstanding. In addition, it has $20 million in short-term debt from its bank. The target capital structure ratio is 55 percent equity, 40 percent
FarWest Inc. manufactures telecommunication equipment and communication software. The equipment division is asking the finance department of FarWest for an estimate of its cost of capital. FarWest can borrow long term at 7 percent; its corporate tax rate is 40 percent. Its target debt ratio is 30
A diversified company plans to sell a division as part of a restructuring program. The division to be sold is a regional airline that was acquired by a previous management. The finance department has been asked by the chief executive officer (CEO) to estimate what they consider an acceptable price
Chloroline Inc. has 2 million shares outstanding and no debt. Earnings before interest and tax (EBIT) are projected to be $15 million under normal conditions, $5 million for a downturn in the economic environment, and $20 million for an economic expansion. Chloroline considers a debt issue of $50
Assume a zero corporate tax rate. Because both the risk of a firm's equity and debt increase with debt financing, then the value of the firm should decrease when it uses more and more debt. True or false?
Alberton Inc., an all-equity-financed equipment manufacturer, has announced that it will change its capital structure to one that will have 30 percent of debt, using the proceeds from the debt issue to buy back shares. The firm has 1 million shares outstanding and the share price is $60. Its
Because the cost of debt is lower than the cost of equity, firms must increase their use of debt as much as possible to increase the firm's value. What is your answer to this argument? From the capital asset pricing model presented in Chapter 10, how can you show that the cost of equity
Starline & Co. has no debt, and its cost of equity is 14 percent. It can borrow at 8 percent. The corporate tax rate is 40 percent.a. Calculate the cost of equity and the weighted average cost of capital (WACC) of Starline if it decides to borrow up to the equivalent of 25, 50, 75, or 100
Albarval Co. expects its return on assets to be stable at 12 percent, assuming a tar get capital structure of 80 percent equity and 20 percent debt. Suppose that the firm's borrowing rate is 8 percent, for a wide range of capital structures.a. Suppose that Albarval does not pay any tax. What is
Lannion Co. is a manufacturing firm with no debt outstanding. It is considering borrowing $25 million at 8 percent and using the proceeds to buy back shares. Its equity market value is $100 million, and its profits are taxed at 35 percent.a. What would be the present value of the interest tax
How would you rank these three firms in decreasing order of expected debt ratios: a biotechnology firm, an auto-parts firm, and an electric utility? Explain.
Why are companies with a weak board of directors likely to be underlevered (they would use less debt than the optimal amount they could issue)?
How can shareholders expropriate wealth from bondholders?
Explain why each of the following statements is generally incorrect:a. "Price-earnings ratios should increase when the yield on government securities rises."b. "A company's discounted cash-flow value is usually dominated by the magnitude of its expected cash-flow stream during the future five to
Comment on the following statements:a. "Only synergistic mergers have the potential to create value."b. "If a merger cannot generate synergistic gains through cost reductions, it will not create value."c. "Conglomerate mergers can create value through superior growth in earnings per share."d.
What are the potential sources of value creation and value destruction in a lever aged buyout when compared with an acquisition?
Maltonese Inc. has 5 million shares outstanding selling at $60 each, and its price-to earningsratio (P/E) is 10. Targeton Corp. has 1.5 million shares outstanding with a market price of $30 each, and its P/E ratio is 6. Maltonese is considering the acquisition of Targeton because it expects that
Mergecandor Corp. is considering the acquisition of Tenderon Inc. Mergecandor has 2 million shares outstanding selling at $30, or 7.5 times its earnings per share, and Tenderon has 1 million shares outstanding selling at $15, or five times its earnings per share. Mergecandor would offer to exchange
Motoran Inc. is contemplating the acquisition of a competitor, Tortoran Corp., for $25 million. Motoran's market value is $40 million, whereas that of Tortoran is $20 million. Motoran expects that after the merger the administrative costs of the two companies will be reduced by $1 million forever.
Murlow Company is a privately held firm. David Murlow, its owner-manager, has been approached by Murson Inc. for a possible acquisition. The firm has no debt. What is the minimum price David Murlow should ask, given the following information about his firm? • Sales, currently at $500 million, are
We wish to estimate the value of Portal Inc. under alternative assumptions about the firm's performance.a. Using the discounted cash-flow (DCF) approach to valuation and the follow ing assumptions, provide an estimate of Portal's value.• This year sales are expected to be $750 million. They are
Osiris Inc. is considering the acquisition of a competitor, Polos Corp. Osiris expects that the purchase would add $800,000 to its annual cash flow from assets indefinitely. Both firms are fully equity financed and do not carry any debt. The current market value of Osiris is $50 million, and that
Mirandel Inc. is considering the acquisition of Tarantel Corp. Mirandel's earnings after tax are $2 million, it has 2 million shares outstanding, and its price-to-earnings (P/E) ratio is 20. Tarantel's earnings are $1.5 million, it has 0.5 million shares, and its P/E ratio is 15. Mirandel's
Explain the difference between the risks that make up the following pairs:a. Business risk versus financial riskb. Diversifiable risk versus un diversifiable riskc. Systematic risk versus unsystematic riskd. Insurable risk versus uninsurable riske. Project risk versus corporate riskf.
A firm has no financial investments, and all its activities are in the domestic market where it faces no foreign competition. It has a debt-to-equity ratio of 1 and is the subject of a 40 percent tax rate. Its beta coefficient is 1.20.a. What are the risks the firm faces? Explain your answer.b.
What are the major issues that a firm risk policy must address? Indicate what a firm could do to resolve these issues.
The General Construction Company (GCC) is expecting next year a cash flow from assets of €50 million that is expected to grow forever at 3 percent. Its cost of capital is 11 percent. The firm is exposed to the following three risks:• There is a 10 percent chance that its cost of capital
HDM, a computer manufacturing company, holds computer parts in its inventory whose prices fall rapidly because suppliers can produce them faster, more efficiently, and in large quantities just a few months after they were first introduced on the market. HDM also uses a standard machine to assemble
Consider the case of a firm that borrows abroad.a. What are the two major risks the firm is exposed to?b. Show how the firm can hedge these two risks using swap contracts.
A swaption contract is a hedging instrument that combines the features of a swap contract and an option contract. Describe briefly how such a hedging instrument would work. What would be the advantage for a firm to use a swaption instead of a standard swap contract?
MPC imports computer equipment from Japan for sale in the U.S. market.Monthly imports have averaged ¥250 million to ¥275 million over the past year.A similar volume is expected for the coming year. Because of the volatility of the exchange rate between the Japanese yen and the U.S. dollar, MPC's
Charles has a problem. His boss thinks that options are a form of gambling. The company he works for exports to European markets, which require euro invoicing. The market is cutthroat, and sales are made on the basis of competitive bidding. The average-size bid is €2.5 million. Firm offers (which
You have been given the task of evaluating the hedging policy used by a Singa pore company that manufactures mobile telephones under contract for a major company in Europe. The management has a relatively new policy of taking long term forward hedges on the planned sales revenue. They use a
A U.S.-based multinational corporation has a wholly owned subsidiary in the Philippines that manufactures electronics products to be sold in the North American market. The equity of the Philippines subsidiary is peso 2,500 million (from the latest balance sheet data). Because of recent political
Indicate in one sentence what the following parity relation says:a. Purchasing power parity relationb. International Fisher effect c. Interest-rate parity relationd. The relation between forward rates and future spot rates
As a trader, you can trade based on the following data:1. Spot rate: S0USD/EUR = 1.252. Forward rate: F0USD/EUR = 1.2483. U.S. one-year deposit rate: rUSD = 3 percent4. Euro-zone one-year deposit rate: rEUR = 3.15 percenta. What is the return on one U.S. dollar deposit?b. What is the return in U.S.
You are a currency arbitrager for a Japanese bank. The spot rate this morning is JPY/USD 111.22, and early indications are that short-term interest rates in the United States (ninety-day rates) are about to rise from their current level of 3.125 percent. The Federal Reserve is worried about rising
Suppose one country has a fixed exchange-rate regime. Prices in that country are rising faster than U.S. prices. Is the money of this country appreciating or depreciating in real terms? Explain.
What are the pros and cons of real versus nominal cash-flow valuation?
a. The finance manager of a U.S. pharmaceutical company has $10 million to invest for six months. The annual interest rate in the United States is 3 percent.The annual interest rate in the United Kingdom is 1 percent. The spot rate of exchange is $1.60 per £1 and the six-month forward rate is
The Brankton Company, an American firm, considers investing in Spain. The investment will cost €125 million and is expected to generate, after taxes, €30 million a year during the next five years in real terms, that is, before inflation. The project would be liquidated at the end of the fifth
Chateau Cheval Noir is one of the leading premium wine producers of France, with its fifty-acre vineyard at St. Julien in the Bordeaux region. The owners have wanted to expand their production, but the scarcity and astronomical prices asked for vineyards adjacent to the existing property have led
A major U.S. clothes manufacturing and distributing company plans to expand in Asia. To reduce its transportation costs, it wants to set up its own manufacturing plant in Asia. Two countries are under consideration: China and Indonesia. The expected cash flows from the manufacturing plants in the
Explain why each of the following statements is generally incorrect:a. “The firm with the highest market value is the one that has created the most value for its shareholders.”b. “If a firm’s market value added (MVA) is positive, then its current return on invested capital (ROIC) must
Identify at least three value drivers related to the management of operations and three strategic value drivers that directly affect economic value added (EVA). Show how these drivers might increase or decrease EVA.
Following are the balance sheets at year-end 2009 and 2010 followed by the 2010 income statement of Sactor Inc. The annual report for year 2010 provides the following supplemental information:1. The restructuring charge of $43 million, amounted to $28 million after tax2. Accumulated goodwill
These assets are expected to generate a pre-tax operating profit of $10 million next year5. The acquisition of assets worth $100 million. These assets are expected to generate a pre-tax operating profit of $20 million next year Show how each of these decisions would improve SCC's expected pre-tax
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