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Practical Financial Management 5th Edition William R. Lasher - Solutions
13. BWP intends to purchase a machine which will result in a major improvement in product quality along with a small increase in manufacturing efficiency. The machine will cost $1 million which will be borrowed at 9%. The quality improvement is expected to have a significant impact on BWP’s
12. BWP projects sales of 100,000 units next year at an average price of $50 per unit.Variable costs are estimated at 40% of revenue, and fixed costs will be $2.4 million.BWP has $1 million in bonds outstanding on which it pays 8%, and its marginal tax rate is 40%. There are 100,000 shares of stock
11. Refer to the Cranberry company of the previous problem:a. Suppose automated equipment is added that increases fixed costs by $20,000 per month. How much will total variable cost have to decrease to keep the breakeven point the same?b. Calculate the DOL at the same output levels used in part (e)
10. Cranberry Wood Products Inc. spends an average of $9.50 in labor and $12.40 in materials on every unit it sells. Sales commissions and shipping amount to another $3.10. All other costs are fixed and add up to $140,000 per month. The average unit sells for $32.00.a. What are Cranberry’s
9. You’re a financial analyst at Pinkerton Interactive Graphic Systems (PIGS), a successful entrant in a new and rapidly growing field. As in most new fields, however, rapid growth is anything but ensured, and PIGS’s future performance is uncertain.The firm expects to earn operating profits of
8. Algebraically derive:EPS ROE (book value per share)(Hint: Write the definitions of ROE, EPS, and book value, and then start substituting.)
7. Balfour Corp. has the following operating results and capital structure ($000).The firm is contemplating a capital restructuring to 60% debt. Its stock is currently selling for book value at $25 per share. The interest rate is 9% and combined state and federal taxes are 42%.a. Calculate EPS
6. The Tanenbaum Tea Company wants to show the stock market an EPS of $3 per share, but doesn’t expect to be able to improve profitability over what is reflected in the financial plan for next year. The plan is partially reproduced below.Tanenbaum’s stock sells at book value. Will trading
5. The Canterbury Coach Corporation has EBIT of $3.62 million and total capital of $20 million, which is 15% debt. The 425,000 shares of stock outstanding sell at book value. The firm pays 12% interest on its debt and is subject to a combined state and federal tax rate of 40%. Canterbury is
4. Watson Waterbed Works Inc. has an EBIT of $2.75 million, can borrow at 15%interest, and pays combined state and federal income taxes of 40%. It currently has no debt and is capitalized by equity of $12 million. The firm has 1.5 million shares of common stock outstanding that trade at book
3. Assume Connecticut Computer Company of the last two problems is earning an EBIT of $15,000. Once again, calculate the chart showing the implication of adding more leverage. Verbally rationalize the result.
2. Reconsider the Connecticut Computer Company of the previous problem assuming the firm has experienced some difficulties and its EBIT has fallen to $8,000.a. Reconstruct the three-column chart assuming Connecticut’s EBIT remains at$8,000.b. Interpret the result in terms of stock price and the
1. The Connecticut Computer Company has the following selected financial results.The company is considering a capital restructuring to increase leverage from its present level of 10% of capital.a. Calculate Connecticut’s ROE and EPS under its current capital structure.b. Restate the financial
6. The Wycombe Company is doing well and is interested in diversifying, so it has been looking around for an acquisition target. The Albe Company has been found with the help of an investment banker. Albe is quite profitable and is about half the size of Wycombe. This size relationship is reflected
5. The Appleridge Company is a large manufacturer of capital goods. (The demand for capital goods typically swings up and down a great deal between good and bad economic times.) Business has been good lately and is expected to remain so in the foreseeable future. The firm is currently relatively
4. The Revere Company currently has good earnings and a capital structure that’s 20% debt. Its EPS is in the upper quarter of firms in its industry. Top management’s compensation is in large part based on the year-end price of the company’s stock. It’s now October and the president, Harry
3. You’re the CFO of Axelrod Trucking, a privately held firm whose owner, Joe Axelrod, is interested in selling the company and retiring. He therefore wants to pump up its value by any means possible. Joe read an article about leverage in a business magazine the other day, and has sent you a memo
2. You’re interested in investing in the Peters Company, which has shown a remarkable increase in EPS during the last three years. Investigating, you find that the company’s debt to equity ratio has increased dramatically over the same period and is now four to one. How does this information
1. The Armageddon Corp. is in big trouble. Sales are down and profits are off. On top of that, the firm’s credit rating has been reduced, so it’s facing very high interest rates on anything it borrows in the future. Current long-term borrowing represents 60% of capital but at fixed interest
23. Compare the implications of the MM model with taxes and bankruptcy costs to the things we discovered by studying the Arizona Balloon Corporation.
22. In another short paragraph, describe the effect of adding bankruptcy costs to the MM model with taxes.
21. In a short paragraph, describe the result of adding taxes to the MM model.
20. Explain in words how the tax system favors debt financing.
19. Outline the arbitrage process proposed by MM that supports the operating income argument. What is the arbitrage between?
18. Briefly summarize the operating income argument that was supported by the original MM result.
17. Briefly describe the result of MM’s original restrictive model. Why was it important in spite of its serious restrictions?
16. Explain the idea of bankruptcy costs. Why are they important to investors? When do investors start to worry about them?
15. The Braithwaite Tool Co. is considering a major modernization and automation of its plant using borrowed funds. Fully discuss a serious financial negative that could result from the project.
14. Summarize the effect of operating leverage on EBIT.
13. Describe the concept of the breakeven point in words by using the concept of contribution and fixed costs. (Short answer.)
12. Explain the idea of breakeven analysis in a brief paragraph.
11. Why do labor-intensive processes involve less operating leverage than automated processes? What fixed costs are associated with automation? Why can’t those costs be eliminated by just selling the machinery?
10. Explain the difference between a fixed and a variable cost. How do these concepts change as the time horizon lengthens? In other words, are the same things fixed over a five-year planning period that are fixed in a typical one-year period? What about a 10-year period? What’s the relevant
9. Describe generally how leverage affects stock prices. What forces are at work, driven by what effects?
8. The risk added by financing is small and insignificant in relation to the inherent risk in most businesses. Is that statement true or false? Discuss.
7. Explain in words the ROCE test for the advisability of adding leverage. That is, what is the test really telling us? When will it indicate a company is doing the wrong thing?
6. Briefly explain the pros and cons of financial leverage. In other words, what are its benefits, and what are the costs that come along with those benefits?
5. Both business risk and financial risk would exist with or without either type of leverage. Leverage just makes them more significant. Are those statements true or false? Explain.
4. Why are ROE and EPS such important measures of performance to investors?
3. Relate business and financial risk as defined in this chapter to the risks described in Chapter 9.
2. The central issue underlying the study of leverage is whether or not it influences stock price and whether there’s an optimal structure. But the whole idea seems kind of fuzzy and uncertain. Why are people so interested? (Hint: Think of management’s goals and of the world of mergers.)
1. The user of leverage might be thought of as taking advantage of the provider.Between stockholders and bondholders, who is the user, and who is the provider?Give a word explanation or illustration that might support this view. What does the used party get in return?
A finished product requires 2 pounds of material costing \($6\) per pound. What is the standard cost of direct material per unit of product?
26. Visit Ibbotson’s Cost of Capital Center Web site at http://www.ibbotson.com(click on “Knowledge Center,” then “Published Research,” and select “Cost of Capital” to review a recent research paper). Select one of the articles listed and prepare a one-page summary highlighting the
25. Newrock Manufacturing Inc. has the following target capital structure Debt 25%Preferred 20 Equity 55 Investment bankers have advised the CFO that the company could raise up to $5 million in new debt financing by issuing bonds at a 6.0% coupon rate; beyond that amount, new debt would require a
24. (Integrative Problem) Taunton Construction Inc.’s capital situation is described as follows.Debt: The firm issued 10,000 25-year bonds 10 years ago at their par value of$1,000. The bonds carry a coupon rate of 14% and are now selling to yield 10%.Preferred stock: Thirty thousand shares of
23. The Longenes Company uses a target capital structure when calculating the cost of capital. The target structure and current component costs based on market conditions follow.The firm expects to earn $20 million next year and plans to invest $18 million in new capital projects. It generally pays
22. Whitley Motors Inc. has the following capital.Debt: The firm issued 900 25-year bonds five years ago which were sold at a par value of $1,000. The bonds carry a coupon rate of 7%, but are currently selling to yield new buyers 10%.Preferred stock: 3,500 shares of 8% preferred were sold 12 years
21. Suppose Hammell of the previous problem needs to issue new stock to raise additional equity capital. What is its cost of new equity if flotation costs are 12%?
20. Hammell Industries has been using 10% as its cost of retained earnings for a number of years. Management has decided to revisit this decision based on recent changes in financial markets. An average stock is currently earning 8%, treasury bills yield 3.5%, and shares of Hammell’s stock are
19. The Longlife Insurance Company of the preceding problem has several bonds outstanding that are currently selling to yield 9%. What does this imply about the cost of the firm’s equity?
18. The Longlife Insurance Company has a beta of .8. The average stock currently returns 15% and short-term treasury bills are offering 6%. Estimate Longlife’s cost of retained earnings.
17. The Pepperpot Company’s stock is selling for $52. Its last dividend was $4.50, and the firm is expected to grow at 7% indefinitely. Flotation costs associated with the sale of common stock are 10% of the proceeds raised. Estimate Pepperpot’s cost of equity from retained earnings and from
16. A few years ago, Hendersen Corp. issued preferred stock paying 8% of its par value of $50. The issue is currently selling for $38. Preferred stock flotation costs are 15% of the proceeds of the sale. What is Hendersen’s cost of preferred stock?
15. Kleig Inc.’s bonds are selling to yield 9%. The firm plans to sell new bonds to the general public and will therefore incur flotation costs of 6%. The company’s marginal tax rate is 42%.a. What is Kleig’s cost of debt with respect to the new bonds? (Hint: Adjust the cost of debt formula
14. New buyers of Simmonds Inc. stock expect a return of about 22%. The firm pays flotation costs of 9% when it issues new securities. What is Simmonds’ cost of equitya. from retained earnings?b. from new stock?
13. Fuller, Inc., issued $100, 8% preferred stock five years ago. It is currently selling for $84.50. Assuming Fuller has to pay flotation costs of 10%, what is Fuller’s cost of preferred stock?
12. Harris Inc.’s preferred stock was issued five years ago to yield 9%. Investors buying those shares on the secondary market today are getting a 14% return. Harris generally pays flotation costs of 12% on new securities issues. What is Harris’s cost of preferred financing?
11. The Dentite Corporation’s bonds are currently selling to yield new buyers a 12%return on their investment. Dentite’s marginal tax rate including both federal and state taxes is 38%. What is the firm’s after-tax cost of debt?
10. Asbury Corp. issued 30-year bonds 11 years ago with a coupon rate of 9.5%.Those bonds are now selling to yield 7%. The firm also issued some 20-year bonds 2 years ago with an 8% coupon rate. The two bond issues are rated equally by Standard and Poors and Moody’s. Asbury’s marginal tax rate
9. The market price of Albertson Ltd.’s common stock is $5.50 and 100,000 shares are outstanding. The firm’s books show common equity accounts totaling$400,000. There are 5,000 preferred shares outstanding that originally sold for their par value of $50, pay an annual dividend of $3, and are
8. The Wall Company has 142,500 shares of common stock outstanding that are currently selling at $28.63. It has 4,530 bonds outstanding that won’t mature for 20 years. They were issued at a par value of $1,000 paying a coupon rate of 6%.Comparable bonds now yield 9%. Wall’s $100 par value
7. Five years ago Hemingway Inc. issued 6,000 30-year bonds with par values of$1,000 at a coupon rate of 8%. The bonds are now selling to yield 5%. The company also has 15,000 shares of preferred stock outstanding that pay a dividend of $6.50 per share. These are currently selling to yield 10%. Its
6. A relatively young firm has capital components valued at book and market and market component costs as follows. No new securities have been issued since the firm was originally capitalized.a. Calculate the firm’s capital structures and WACCs based on both book and market values, and compare
5. Again referring to Willerton of the two previous problems, assume the firm’s cost of retained earnings is 11% and its marginal tax rate is 40%. Calculate its WACC using its book-value–based capital structure ignoring flotation costs. Make the same calculation using the market-value–based
4. Referring to Willerton Industries of the previous problem, the company’s long-term debt is comprised of 20-year $1,000 face value bonds issued 7 years ago at an 8%coupon rate. The bonds are now selling to yield 6%. Willerton’s preferred is from a single issue of $100 par value, 9% preferred
3. Willerton Industries Inc. has the following balances in its capital accounts as of 12/31/X3:Long-term debt $65,000,000 Preferred stock 15,000,000 Common stock 40,000,000 Paid in excess 15,000,000 Retained earnings 37,500,000 Calculate Willerton’s capital structure based on book values.
2. The Aztec Corporation has the following capital components and costs. Calculate Aztec’s WACC. Component Value Cost Debt $23,625 12.0% Preferred stock 4,350 13.5 Common equity 52,275 19.2
1. Blazingame Inc.’s capital components have the following market values.Debt $35,180,000 Preferred stock 17,500,000 Common equity 48,350,000 Calculate the firm’s capital structure and show the weights that would be used for a weighted average cost of capital (WACC) computation.
4. Whitefish Inc. operates a fleet of 15 fishing boats in the North Atlantic Ocean.Fishing has been good in the last few years as has the market for product, so the firm can sell all the fish it can catch. Charlie Bass, the vice president for operations, has worked up a capital budgeting proposal
3. The engineering department at Digitech Inc. wants to buy a new state-of-the-art computer. The proposed machine is faster than the one now being used, but whether the extra speed is worth the expense is questionable given the nature of the firm’s applications. The chief engineer (who has an MBA
2. You’re the CFO of a small company that is considering a new venture. The president and several other members of management are very excited about the idea for reasons related to engineering and marketing rather than profitability. You’ve analyzed the proposal using capital budgeting
1. You’re the newly hired CFO of a small construction company. The privately held firm is capitalized with $2 million in owner’s equity and $3 million in variable rate bank loans. The construction business is quite risky, so returns of 20% to 25%are normally demanded on equity investments. The
11. Why is it appropriate to define the WACC as the highest step on the MCC under the IOS? Is anything lost by using this definition?
10. After the break in the MCC caused by using up retained earnings, the schedule can be expected to remain flat indefinitely. Is that statement right or wrong? If wrong, explain what can be expected to happen to the MCC and why.
9. Define the marginal cost of capital (MCC) and explain in words why it predictably undergoes a step-function increase (breaks) as more capital is raised during a budget period.
8. Retained earnings are generated by the firm’s internal operations and are immediately reinvested to earn more money for the company and its shareholders. Therefore, such funds have zero cost to the company. Is this statement true or false? Explain.
7. Establishing the cost of equity is the most arbitrary and difficult part of developing a firm’s cost of capital. Outline the reasons behind this problem and the approaches available to make the best of it.
6. A number of investment projects are under consideration at your company.You’ve calculated the cost of capital based on market values and rates, and analyzed the projects using IRR and NPV. Several projects are marginally acceptable.While watching the news last night, you learned that most
5. There’s an issue of historical versus market value with respect to both the cost of capital components and the amounts of those components used in developing weights. We’re willing to accept an approximation for the weights, but not for the cost/returns. Why?
4. The investor’s return and the company’s cost are opposite sides of the same coin—almost, but not quite. Explain.
3. You are a new financial analyst working for a company that’s more than 100 years old. The CFO has asked you and a young member of the accounting staff to work together in reviewing the firm’s capital structure for the purpose of recalculating its cost of capital. As you both leave the
2. Define the idea of capital structure and capital components. Why is capital structure important to the cost of capital concept? In many capital structure discussions, preferred stock is lumped in with either debt or common equity. With respect to the cost of capital, however, it’s treated
1. Compare the cost of capital concept with the idea of the required return on a stock investment made by an individual. Relate both ideas to the risk of the investment. How would a very risky investment/project be handled in the capital budgeting/cost of capital context?
17. Illinois Fabrics Inc. makes upholstery that’s used in high-quality furnture, largely chairs and sofas. Illinois has traditionally sold their fabric to manufacturers who use it to cover furniture frames they produce. These manufacturers then wholesale the finished product to furniture stores.
16. Crest Concrete Inc. has been building basements and slab foundations for new homes in La Crosse, Wisconsin for more than 20 years. However, new home sales have slowed recently and residential contruction work is hard to get. As a result, management is considering a venture into commercial
15. Hudson Furniture specializes in office furniture for self-employed individuals who work at home. Hudson’s furniture emphasizes style rather than utility and has been quite successful. The firm is now considering entering the more competitive industrial furniture market where volumes are
14. The New England Brewing Company produces a super premium beer using a recipe that’s been in the owner’s family since colonial times. Surprisingly, the firm doesn’t own its brewing facilities, but rents time on the equipment of large brewers who have excess capacity. Other small brewers
13. If Spitfire elects to do the project, what is an abandonment option at the end of year 1 worth if Spitfire can recover $8 million of the initial investment into other uses at that time? If the recovery is $13 million?
12. Spitfire Aviation Inc. manufactures small, private aircraft. Management is evaluating a proposal to introduce a new high-performance plane. High-performance aviation is an expensive sport undertaken largely by people who are both young and wealthy. Spitfire sees its target market as affluent
11. Vaughn Video of the previous problem has a real option possibility. Carlson Flooring has expressed an interest in trading buildings with Vaughn after Vaughn is refurbished. Carlson has offered to reimburse Vaughn for 70% of its refurbishment costs at the end of the first year if they make the
10. Vaughn Video is considering refurbishing its store at a cost of $1.4 million.Management is concerned about the economy and whether a competitor, Viola Video, will open a store in the neighborhood. Vaughn estimates that there is a 60% chance that Viola will open a store nearby next year. The
9. Resolve the last problem assuming Work Station Inc. has an abandonment option at the end of the first year under which it will recover $5 million of the initial investment in year 2. What is the value of the ability to abandon the project?How does your overall recommendation change?
8. Work Station Inc. manufactures office furniture. The firm is interested in“ergonomic” products that are designed to be easier on the bodies of office workers who suffer from ailments such as back and neck pain due to sitting for long periods. Unfortunately customer acceptance of ergonomic
7. Using the information from the previous problem, randomly select four NPV outcomes from the data. (Select one cash flow from each year and compute the project NPV and the probability of that NPV implied by those selections.) Plot the results on your distribution. Do your selections give a sense
6. Sanville Quarries is considering acquiring a new drilling machine that is expected to be more efficient than the current machine. The project is to be evaluated over four years. The initial outlay required to get the new machine operating is$675,000. Incremental cash flows associated with the
5. The Blazingame Corporation is considering a three-year project that has an initial cash outflow (C0) of $175,000 and three cash inflows that are defined by the following independent probability distributions. All dollar figures are in thousands.Blazingame’s cost of capital is 10%.a. Estimate
4. Assume that Keener Clothiers of the previous problem assigns the following probabilities to production cost as a percent of revenue.Sketch a probability distribution (histogram) for the project’s NPV, and compute its expected NPV. % of Revenue Probability 65% 70 .30 .50 75 .20 382
3. Keener Clothiers Inc. is considering investing $2 million in an automatic sewing machine to produce a newly designed line of dresses. The dresses will be priced at$200, and management expects to sell 12,000 per year for six years. There is, however, some uncertainty about production costs
2. If Glendale’s management in the previous problem attaches a probability of .7 to the better outcome, what is the project’s most likely (expected) NPV?
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