Tutorial 2

Chapter4
4. Continuous Compounding Compute the future value of $1,900 continuously compounded for 9 years at
an APR of 12 percent.
F = PV x
eAPRXn = $1 900
,
x 212
% x9
=
$5 , 594 89 .

5.

APR
y 2

semiannually : EAR =
(1 + ( 1 =
0 9%.
=> APR = 8 71 %
.

Monthly : EAR =
(1 +
- =
18 8 % . =s APR = 17 35 %
.

Weekly
r
: EAR =
1 +
-
1 = 10 4 %
. => APR = 9 9%.

52

Infinite : APR = In (1 + EAR) = In (1 + 13 6 % .

) = 12 75 % .

APR/r

Bank charges O
6. Calculating EAR First NationalAPRIr 10.3 percent compounded monthly on its business loans.
First United Bank chargesO 10.5 percent compounded semiannually. As a potential borrower, to which
bank would you go for a new loan?
12

S
1st National bank : EAR = 1 +
10 3 % .

-
1 = 10 80 %
.

12
=>
As a
potential borrower ,
choose 1st United Bank
2
1st united Bank : EAR =
1 +
10 5 % .

-
1 = 10 78 %
.

2
7. Interest Rates Well-known financial writer Andrew Tobias argues that he can earn 177 percent per
year buying wine by the case. Specifically, he assumes that he will consume one $10 bottle of fine
Bordeaux per week for the next 12 weeks. He can either pay $10 per week or buy a case of 12 bottles
today. If he buys the case, he receives a 10 percent discount and, by doing so, earns the 177 percent.
Assume he buys the wine and consumes the first bottle today. Do you agree with his analysis? Do you
see a problem with his numbers?
PV of 12 bottles of wine = $10 x 12x 90 % = $108 =
10 +
1 1 - piry => + = 1 .
98 % (per week)

52
102 77 %
=> APR = 1 98 %
. x 52 = 102 .
77 % = EAR = I +
.

- 1 = 177 19 .
%
52

8. Calculating Number of Periods One of your customers is delinquent on his accounts payable balance.
You’ve mutually agreed to a repayment schedule of $500 per month. You will charge 1.1 percent per
month interest on the overdue balance. If the current balance is $18,450, how long will it take for the
account to be paid off?

/month 4
C $500/month 5001 . 176 a
?
= 10.450n = mont
%U +=
= n

9. Growing Perpetuities Mark Weinstein has been working on an advanced technology in laser eye
surgery. His technology will be available in the near term. He anticipates his first annual cash flow
from the technology to be $215,000, received two years from today. Subsequent annual cash flows
will grow at 3.8 percent in perpetuity. What is the present value of the technology if the discount rate
is 10 percent? 3 8% % g= .
r= 10

CFz 215 , 000 (1 + 3 8 % )

2
3 4
g I

PV $3 599 516 13
.

I I I -
= I = , ,
.

r -

g 10 % -

3 8%
PVo 15 , 008 C C
.

M
W
PVz
PVz <
CF3 => PVo = =
2 974
, .
806 .
72
2) + 10 % /2
10. Growing Annuity Your job pays you only once a year for all the work you did over the previous 12
months. Today, December 31, you just received your salary of $72,500, and you plan to spend all of it.
However, you want to start saving for retirement beginning next year. You have decided that one year
from today you will begin depositing 5 percent of your annual salary in an account that will earn 9
percent per year. Your salary will increase at 3.7 percent per year throughout your career. How much
money will you have on the date of your retirement 40 years from today?

Salaryo
C =
:

5 % of
$72 500 ,

salary
95 =

+
3 7%.

= 9% n- 40yrs ( FV =

(1 + 3 7% 19
%

Growing annuity PV CF 72 , 500 (1 + 3 7 % x5 %

-3
.

: x
= =

% 19 %
-

37 %I 9 %
.

r
g .
7 -

= $317 .
47
Chapter 5
1. Payback Period and Net Present Value
a, If a project with conventional cash flows has a payback period less than the project’s life, can
you definitively state the algebraic sign of the NPV? Why or why not?
Conventional cash flows and payback period less than the project's life.
This simply means that only when the discount rate is zero, the project will have a positive NPV.
In case discount rate is positive and which will be the case usually, we can't make any claim
withabsolute certainty, about the sign of the NPV. If discount rate is positive, and the payback
period is less than the project's life then:
NPV will be negative if discount rate > IRR
NPV will be zero if discount rate = IRR
NPV will be positive if discount rate < IRR

b, If you know that the discounted payback period is less than the project’s life, what can you
say about the NPV? Explain.
If a project has positive NPV then:
Then it will certainly have payback period less than the life of the project. This is because if
NPVis positive at some discount rate then NPV will certainly be positive at zero discount rate.
The Project will certainly have an IRR greater than the discount rate. This is because IRR is that
discount rate at which NPV is zero. NPV is inversely related to discount rate. If NPV is positive
at a given discount rate and cash flows are conventional, then we need to increase discount rate
further to make NPV zero. This implies IRR (the discount rate at which NPV is zero) is greater
than discount rate.

2. Internal Rate of Return Projects A and B have the following cash flows:

a. If the cash flows from the projects are identical, which of the two projects would have a higher
IRR? Why?
b. If C1B=2C1A, C2B=2C2A, and C3B=2C3A, then is IRRA=IRRB
a .
CFs from the

Initial
projects are identical
investmenta (Initial investment i
3 => IRRA) IRRB
~

.
b CIB = 2CIA ,
C2B = 2CCA ,
C3B = 223A

=> IRRA = IRRB bes both of CFs & initial investments are twice that of Project B
3. Calculating Profitability Index Suppose the following two independent investment opportunities are
available to Relax, Inc. The appropriate discount rate is 8.5 percent.

a. Compute the profitability index for each of the two projects.

b. Which project(s) should the company accept based on the profitability index rule?
1 , 200 1 , 100 900
a Project Alpha :
Plapha =
+ +
2 , 100 = 1 .
3071
1 085
.
1 .
0852 1 .
0853

Project Beta 100

2 300 2 900 3, 700 1 3409
PlBeta
, ,
: =
= + + .

1 .
0852 1 .
0853

b
. The co .
should accept project Beta based on the
profitability index rule .

4. Calculating Incremental Cash Flows Darin Clay, the CFO of MakeMoney.com, has to
decide between the following two projects:

The expected rate of return for either of the two projects is 12 percent. What is the range of initial
investment (I0) for which Project Billion is more financially attractive than Project Million?
Project Billion is more financially attractive than Project Million =>
NPVB NPVM =>
NPVCFB-CFM > O
400 160 1 200 960

60020
-
-

1
10
,
1 200 ye
,
=> -
+ , +
+ t
1 12
.
1 .
122

=> 1 890 327

. .
Do

Conclusion : The initial investment should be greater than $1 ,

890 .
32 for which project Billion is more
financially
attractive than project Million
.
 Tutorial 3 investment

Chapter 6 change of CFs resulted from

1 Incremental Cash Flows Which of the following should be treated as an incremental cash flow when
computing the NPV of an investment?
a. A reduction in the sales of a company’s other products caused by the investment. Side effects:
erosion => Yes Relevant outflow
b. An expenditure on plant and equipment that has not yet been made and will be made only if the
project is accepted. Capital expenditure => Yes Relevant outflow
c. Costs of research and development undertaken in connection with the product during the past three
years. Sunk cost (cannot recoverable by our decision) => No Irrelevant outflow
d. Annual depreciation expense from the investment. Depreciation tax shield => Yes Relevant inflow
e. Dividend payments by the firm. Not the CF from the project/investment => No Irrelevant inflow
f. The resale value of plant and equipment at the end of the project’s life. Salvage value => Yes
Relevant inflow
g. Salary and medical costs for production personnel who will be employed only if the project is
accepted. => Yes Relevant outflow
2. Incremental Cash Flows Your company currently produces and sells steel shaft golf clubs. The board
of directors wants you to consider the introduction of a new line of titanium bubble woods with
graphite shafts. Which of the following costs are not relevant?
a. Land you already own that will be used for the project, but otherwise will be sold for $700,000, its
market value. Opportunity cost => Relevant outflow (ICF0)
b. A $300,000 drop in your sales of steel shaft clubs if the titanium woods with graphite shafts are
introduced. Side effects: erosion => Relevant outflow (annual CF)
c. $200,000spent on research and development last year on graphite shafts. Sunk cost (cannot
recoverable) => Irrelevant
 1 Calculating Project NPV Flatte Restaurant is considering the purchase of a $7,500 soufflé maker. The
soufflé maker has an economic life of five years and will be fully depreciated by the straight-line
method. The machine will produce 1,300 soufflés per year, with each costing $2.15 to make and priced
at $5.25. Assume that the discount rate is 14 percent and the tax rate is 34 percent. Should the
company make the purchase?
7 , 500
(Fo = $7 , 500 n =
5yrs => Deprec .
cost = 5 = $1 500 ,
r = 14 %

Sale = 1 , 300 x $5 25.

= $6 , 825 Cost = 1 , 300 x
$2 . 15 = $2 , 795 tc = 34 %

OCF = EBITDA (1-tc) + Dx + c = (6 , 825 -

2 , 795) x 66 % + 1 , 500 x 34 % =
$3 ,
169 .
8
3 169
NPV 7 , 500
81-1145 $3 382 18
, .

= +
-

= , .

14 %

2. Calculating Project NPV The Best Manufacturing Company is considering a new investment. Financial
projections for the investment are tabulated here. The corporate tax rate is 34 percent. Assume all
sales revenue is received in cash, all operating costs and income taxes are paid in cash, and all cash
flows occur at the end of the year. All net working capital is recovered at the end of the project.

a. Compute the incremental net income of the investment for each year.
b. Compute the incremental cash flows of the investment for each year.
c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?
Year O Year 1 Year 2 Year 3 Year 4

EBITDA 10 , 200 11 , 200 12 , 300 , 100

9 Isale-cost)

Depres 6 85, 6 , 850 6 , 858 6 85

,

NI 2 , 211 2 , 871 3 597

.
1. 485 (EBITDA-D)(1-te)
a .
ANI 668 726 (2 , 112)

b .
OCF 9 06/ . 9, 721 10 , 447 8 , 335 EBITDALI-tc) + DXtc

Investment -

27 400
,

NWC -
300 -

200 -

225 -
150 875

CF -

27 400, .. 861
8 . 496
9 10 , 297 9
, 210

ACF 32 261 ,
635 801 (1 087)
,

8 86/ 9
, 496 10 , 297 9 , 218
.
C NPV =
-

27 700
, +
,

+ + + = $964 .
08
1 .
12 1 .
122 1 .
123 1 .
124
 3. Project Evaluation Your firm is contemplating the purchase of a new $530,000 computer-based
order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be
worth $50,000 at the end of that time. You will save $186,000 before taxes per year in order
processing costs, and you will be able to reduce working capital by $85,000 (this is a one-time
reduction). If the tax rate is 35 percent,what is the IRR for this project?
530 000
CFo = $530 000 , n =
5yrs = Deprec . = , = $106, 000 ly
o
Salvage value = $50 ,
000 EBITDA = $186 ,
000 NWC = $85, 000

I 11 I 000 I
yearo Year 1 Year 2 Year 3 Year 4 Year 5

Investment -
530 000 ,

186 , 000 (1-35 % ) +

CFO = EBITDA(1-tc) + DX te 106 , 000 x 35% = 158 000 ,

158 000 ,
10 . 158 000
,
158 000 ,

NWC -
85 000,

Salvage value 50kx0 65.

= 32, 500

Incremental (Fs 158 , 000 158, 000

1580 1000
-

53 000 158
, 000 105, 000

05
j 530 , 000
000+32500 IRR O
12 7%
-

,
=
- + = .

4. Calculating EAC (Equivalent Annual Cost) You are evaluating two different silicon wafer milling
machines. The Techron I costs $245,000, has a three-year life, and has pretax operating costs of
$39,000 per year. The Techron II costs $315,000, has a five-year life, and has pretax operating costs
of $48,000 per year. For both milling machines, use straight-line depreciation to zero over the
project’s life and assume a salvage value of $20,000. If your tax rate is 35 percent and your discount
rate is 9 percent, compute the EAC for both machines. Which do you prefer? Why?
Techron 1 (Fo $245, 000 3 , 000 /
EBITDA -$39 year
I salvage value $20 000
-

: : n =
=
=
,

Techron #: (Fo :
-

$315, 000 n= 5 EBITDA = -$48 ,

000 /
year
tc = 35 % r = 9%

NPL
EAC =

PV (r , n)

245 , 000

Techron I : OCF = EBITDA(1-tc) + Dxtc =

-
39 000 11-35% )
,
+ 3 x 35 % = $3 233 33
, .

%
000x135
NPV 245
3 233 33 1-1 20 ,
$226 77.
, 000
, . -

= +
+ ,

9% (1 + g % 3

-
$226 777 1
EAC ,
$89 589 37
.
-

= = ,
.

gy 1- logs
315 000 ,

Techron
1 : OCF =
-

48 , 000 (1-35 %) + 5 x 35 % =
-

$9 .
158

20 , 00011 35 % )
150 1
%95
9,
$342
-

NPV 315, 000

-

=
-

+ -

+ =
-

,
141 2
.

9% 1 095
.

$342 141 2
Conclusion Prefer Techron #I bcs of lower cost
,

$87 961 92
.

EAC = = , . :

go (1-1 0g5)
=

.
5. Capital Budgeting with Inflation Consider the following cash flows on two mutually exclusive
projects:

The cash flows of Project A are expressed in real terms, imwhereas those of Project B are expressed in
nominal terms.inThe appropriate nominal discount rate is 13 percent and the inflation rate is 4 percent.
Which project should you choose? in 13 % 4% = # =

Fisher equation : (1 + in) = (1 + ir) (1 + +) => (1 + 13 % ) = (1 + ip)(1 + 4 % ) = i = 8 65 %

.

18 , 000 16 , 000 12 , 000

Project A : NPV =
-

, 000
30 + + + = $9 476 78 , .

1. 0865 1 .
08652 1 .
08653

21 000 23
, 000 25
, 000
Project B : NPV =
45 000, +
,

+ t = $8 922 , .
7
1 . 13 1 .
132 1 .
133

NPVA> NPVB => Choose Project A

6. Calculating NPV and IRR for a Replacement A firm is considering an investment in a new machine
with a price of $15.6 million to replace its existing machine. The current machine has a book value of
$5.4 million and a market value of $4.1 million. The new machine is expected to have a four-year life,
and the old machine has four years left in which it can be used. If the firm replaces the old machine
with the new machine, it expects to save $6.3 million in operating costs each year over the next four
years. Both machines will have no salvage value in four years. If the firm purchases the new machine,
it will also need an investment of $250,000 in net working capital. The required return on the
investment is 10 percent, and the tax rate is 39 percent. What are the NPV and IRR of the decision to
replace the old machine? $5 4 . m

Old machine : BV = $5 4m .
MV = $4 1 .
m n = 4 => Depres .
= 4 = $1 .

35m/year 15 6
.
m

New machine -$15 6 m 4 $6 3m/year NWC $250 Deprec

(Fo n EBITDA , 000 = 4 3
.
-

: = .
= = . = =

Both no salvage value += 10 % to = 39 %

Decision to replace the old machine : sell old , buy new =>
ACFnew-old
DEBITDA ll-tc) ADxtc 6 3m 0 61 13 9m 35 m) 0 39 4 8375m
DOCFnew-old + x + 1 x
-

= = . =
. . . . .

&
CFo : Sell old : 4 Im
.

Tax gain on loss disposal : 15 4m-4 1m)

. .
x 0 . 39 = 0 507m
. => (Fo = -$11 243 .
m

15 6 m
Buy new
-

: .

NWC :
-
0 25 m
.

(F1 -

4 = OCF = 4 .
8375m

CF4 = 0 25m
.

025m
4 8375m
Should replace the old machinese
NPVnew-old -11 243m
1-1 $4 262m0 =
.

= . + + = .

10 %
Chapter 7
1. Decision Trees Ang Electronics, Inc., has developed a new DVDR. If the DVDR is successful, the
present value of the payoff (when the product is brought to market) is $27 million. If the DVDR fails,
the present value of the payoff is $9 million. If the product goes directly to market, there is a 50
percent chance of success. Alternatively, Ang can delay the launch by one year and spend $1.3 million
to test market the DVDR. Test marketing would allow the firm to improve the product and increase
the probability of success to 80 percent. The appropriate discount rate is 11 percent. Should the firm
conduct test marketing?

%Success Payoff
S
50
Go
directly to market : = $27m => PV = 27mx0 5 .
+ 9x0 5 . = $16 . 22m
1 11
50
% Fail.Payoff = $9 m
.

Delay
CFo =
test market

-$1 3 m.
00

20
%
%,
Success

Fail
·

:
Payoff
Payoff
=

=
$27m)
$9m
= PV = -1 3m
.
+ 27mx0 8 .

1 11
+

.
9mx0 2 .
=
$19 78m
.

Conclusion should conduct test

: The firm
marketing.

2. Decision Trees The manager for a growing firm is considering the launch of a new product. If the
product goes directly to market, there is a 50 percent chance of success. For $125,000 the manager
can conduct a focus group that will increase the product’s chance of success to 65 percent.
Alternatively, the manager has the option to pay a consulting firm $285,000 to research the market
and refine the product. The consulting firm successfully launches new products 80 percent of the
time. If the firm successfully launches the product, the payoff will be $1.8 million. If the product is a
failure, the NPV is zero. Which action will result in the highest expected payoff to the firm?

directly to market % Success Payoff

S
Go 50 : = $1 8 m . => NPV = 1 8m
.
x 0 5 .
= $0 .
9m

50
%, Fail :
Payoff = O

Conduct
cost =
a focus group

$125, 000
65

35
%
%
Success

Fail :
:

0
Payoff = $1 8 m .

S => NPV =
-

125
, 000 + 1 8m
.
x 0 65.
= $1 045m
.

Consulting
Cost = $285, 000
firm 80 %

20
%
Success Payoff
Fail :
:

O
= $1 8 m
.

& => NPV = - 285 , 000 + 1 8

.
x 08 . = $1 155m .

Conclusion :
Pay a
consulting firm will result in the highest expected payoff to the firm
.
 3. Abandonment Value We are examining a new project. We expect to sell 7,000 units per year at $38
net cash flow a piece for the next 10 years. In other words, the annual operating cash flow is
projected to be $38 x 7,000 = $266,000. The relevant discount rate is 16 percent, and the initial
investment required is $1,040,000.
a. What is the base-case NPV?
b. After the first year, the project can be dismantled and sold for $820,000. If expected sales are
revised based on the first year’s performance, when would it make sense to abandon the investment?
In other words, at what level of expected sales would it make sense to abandon the project?
c. Explain how the $820,000 abandonment value can be viewed as the opportunity cost of keeping the
project in one year.
OCF = $266, 000/yr r = 16 % [Fo =
-

$1 , 040 , 000 n= 18

266
1610
Base-case , 000
a NPV =
-
1 , 040 000 + 1 = $245 638 51
-1
,
,
.

16% ,

b we would abandon the project if the CF from

selling equip (PV of future IF

Abandon project at sale quantity where CF PV of future (F(t1-g)

=> from
selling equip =

$38xQ 1
abandon
$820 ,
000 = 1 -
=> Q = 4684 .
41 = 4685 units => Q14685 >
-

16 % (1 + 16 % )9

=> At expected sales of 4685 units it would make sense to abandon the project.

2
. $820 000 is the market value of the project. If the project is continued in 1 co foregoes the
,
yr , .

that could been used for else.

$ 820 ,
000 have
something

4. Abandonment In the previous problem, suppose you think it is likely that expected sales will be
revised upward to 9,500 units if the first year is a success and revised downward to 3,800 units if the
first year is not a success.
If success and failure are equally likely, what is the value of the option to abandon?
Value of abandon option PV(DCFofabandon option)
C : = = PV
(CEwopt- (Fuoopt) = $248 087 22 -$181 356 58
, .
,
.
= $66 730 64
, .

Without option to abandon 50

%Success OCF
: : = 9 500
,
x 38 = $361 000 ,

50
% Failure : OCF = 3 800
,
x 38 =
$144 ,
400

361 , 000 x 0 5 144 400x0 5

=>
NPVw/o opt =
-
1 040 , 000
, +
.
+ , .

1-1 = $181 , 356 58 .

10
16 % 1 16.

With option to abandon :

50
%, Success : OCF = $361 ,
000

50
% Failure : Abandon value = $820 , 000
361 , 000 (144 400 820 , 0001 x0 5
/g
+

NPVw 1 ,040 , 000 1 05 ,

$248 087 22
.

=> + x +
-1
=
- .
= , .

.
opt 16 % ,
1 16
.

abandon
I I
I
C2 Value of
:
option to =
DCFabd-failure =
820 , 000 -
144 400 ,
1- X0 5
.

16 % 1 .
169
= $66 730 , .
63

1 16
.
 5. Abandonment and Expansion In the previous problem, suppose the scale of the project can be
doubled in one year in the sense that twice as many units can be produced and sold. Naturally,
expansion would be desirable only if the project were a success. This implies that if the project is a
success, projected sales after expansion will be 19,000. Again assuming that success and failure are
equally likely, what is the NPV of the project? Note that abandonment is still an option if the project
is a failure. What is the value of the option to expand?
6 : 50 %Success :
Expansion (F2 = $38 x 19 , 000 = $722 ,
000 = DV =

722,000 1 =
$3 ,
325 924
,
.
68

50 % Failure : Abandon Abandon value = $820 000 ,

=> NPV
project =
-

1 , 040 , 000 +
1361 ,
000 +
722,000 x-ig)]x0 .
5 + 1144 , 400 + 820 , 000 x -

= $964 881
, .
33

1 16
.

7 22 , 000 361 , 000 I

value of option expand 0 5
-

to =
DCFexp-success =

16 %
1-
1 169
X .

= $716 ,
794 11.

1 16 .

C2 Without
:
option to expand 50
% success : OCF = $38 x 9 , 500 =
$361 ,
000

50
% Failure : Abandon at $820 ,
000

=> NPV $248 087 22

opt
=
wout , .

With option to abandon 50

%Success : (F = 361 , 000 (F2-10 = $38 x 19 000
,
= $722 000 ,

50
% Failure (F1 :
= 144 , 000 CF = , 000
820

I 000l-ig)]x0.5
722
,
361 000 , + + 1144 , 400 + 820 , 000 x -

-1 , 040 , 000 $964 881

=>
NPVw/opt = + = , .
33

1 16.

=> value of option to expand = $964 881 33 ,

.
-

$248 087 22 , . = $716 794 ,

. 11
Chapter 16
Tutorial 4
1. True/False
a. In a world with no taxes, no transaction costs, and no costs of financial distress, if a firm issues
equity to repurchase some of its debt, the price per share of the firm’s stock will rise because the
shares are less risky. Explain.
False. ~ leverage s risk of E
in - ~Re(required rate of return by SH)
>

MM proposition
> "stock unchanged
absence of taxes

b. The riskiness of a firm’s equity will rise if the firm increases its use of debt financing. True
c. If a firm increases its use of borrowing, the likelihood of default increases, thereby increasing the
risk of the firm’s debt. True
d. Given that the firm uses only debt and equity financing, and given that the risks of both are
increased by increased borrowing, so that increasing debt increases the overall risk of the firm and
therefore decreases the value of the firm. False

2. Why is the use of debt financing referred to as financial “leverage”?

Debt financing is referred to as financial "leverage" because it allows a company to amplify its returns
and potential profits. Just like a lever helps to lift heavy objects with less effort, debt financing
enables a company to increase its financial power and achieve higher returns on investment. By using
borrowed funds, a company can leverage its existing capital to finance projects or investments that
have the potential to generate greater returns than the cost of borrowing. However, it's important to
note that while leverage can magnify gains, it can also amplify losses, as the company is obligated to
repay the borrowed funds regardless of the outcome of the investment.
1 EBIT and Leverage Music City, Inc., has no debt outstanding and a total market value of $295,000.
Earnings before interest and taxes, EBIT, are projected to be $23,000 if economic conditions are
normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a
recession, then EBIT will be 40 percent lower. The company is considering an $88,500 debt issue with
an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are
currently 5,000 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is
issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) if the company goes through with recapitalization. What do you observe?
100 % E VE = Vn =
$295 ,
000 no of shares
outstanding = 5 , 000 D = $88 500 , =
0 3
. = 30 % D ,
70 % E
$295,000
Normal : EBIT = $23 000 ,

Expansion : EBIT = $23 000 ,

x 1 25
.
= $28 750 , in = 8%

Recession : EBIT = $23 000 ,

x 0 6 . = $13 , 800
23 000 ,

Normal EPS $4 6 share

a :
=
28 .
5000 =
.

(5 75 4 6)
.
-

Expansion EPS = 000= $5 75/share DEPS 4. 6 25 %

13 8005
:
, . => = =

,
(2 76 4 .
-

. 6)
Recession : EPS =
5, 000= $2 76 share .
=> DEPS = 4 6 .
=
-

40%

b .
30 % D ,
70% E

Intpmt = 88 500 ,
x 8% = 7 , 080
shares

P =
295,000 = $59/share = Repurchased -500 1
share ,
500 share - Share outstanding =
, 00
5 -
1 , 500 = 3
, 500

23 , 000 7 , 080
Normal EPS $4 55/share
-

:
= = .

3 , 500

28 ,750 7 080 6 19-4 55

$6 19/ share
-

Expansion EPS DEPS 57 8 %

, .

=>
.

: = = =
.
= .

3 , 500 4 55
.

13 800 7 , 080 1 92 4 55
Recession 92/ share 36 04 %
-

EPS $1
-

DEPS
.
,
=>
.

: =

= = .
= -
.

3 , 500 4 45 .

2 Break-Even EBIT Franklin Corporation is comparing two different capital structures, an all-equity plan
(Plan I) and a levered plan (Plan II). Under Plan I, the company would have 315,000 shares of stock
outstanding. Under Plan II, there would be 225,000 shares of stock outstanding and $4.14 million in
debt outstanding. The interest rate on the debt is 10 percent and there are no taxes.
a. If EBIT is $750,000, which plan will result in the higher EPS?
b. If EBIT is $1,750,000, which plan will result in the higher EPS?
c. What is the break-even EBIT?
750 , 000 750 , 000 4 14mx0 !
a .
Plan I : EPS = = $2 38/ share.
Plan It : EPS =
-

.
.

=
$1 49/share
.

315 , 000 225 , 000

1 , 750, , 000 1 ,750

, 000 4 14mx0 1
b Plan I EPS $5 56/share I
Plan EPS $5 94/share
-
.
.

: = : =
=
.
.
= .

315 , 000 225 , 000

EBIT EBIT-4 14m X 0 1

C . =
.
.

=> Break-even EBIT = $1 449 000

, ,

315 , 000 225 , 000

3 Homemade Leverage Star, Inc., a prominent consumer products firm, is debating whether to convert
its all-equity capital structure to one that is 35 percent debt. Currently there are 6,000 shares
outstanding and the price per share is $58. EBIT is expected to remain at $39,600 per year forever.
The interest rate on new debt is 7 percent, and there are no taxes.
a. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the
current capital structure, assuming the firm has a dividend payout rate of 100 percent?
b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that
she keeps all 100 of her shares.
c. Suppose the company does convert, but Ms. Brown prefers the current all-equity capital structure.
Show how she could unlever her shares of stock to recreate the original capital structure.
d. Using your answer to part (c), explain why the company’s choice of capital structure is irrelevant.
100 % E P : $58/share Shares
outstanding = 6 , 000 shares EBIT = $39 , 600/year

> 35 % D ,
65 % E In = 7% => D = $58x6 , 000 x 35 % = $121 800
, => Intprnt = 121 , 800 x 7% =
$8 526
,

> Repurchased shares = 6 , 000 x 0 35

.
= 2 100
,
shares >
-

Shares outstanding = 6 000

,
-

2 , 100 = 3 900 shares

,

39 , 600
a .
Current capital structure : 100 % E CF = x 100 = $660
6
, 000

39 600 8 , 526
Proposed capital structure
-

.
b : . 65 % E
35 % D CF =
,

X 100 = $796 77.

3 908
,

unlever
C .
35 % D .
65 % E , 100 % E => Sell 35 % of shares = 35 sharesa lend the proceed at 7%

39 600 8 , 526
65 35x58x7 % $660
-

=> CF
,

= x + =

3 , 900

6 The co .
's choice of capital structure is irrelevant bes SH can create their own
leverage unlever stock , regardless
of the capital structure the firm
actually chooses.

4. Scarlett Corp. uses no debt. The weighted average cost of capital is 8.4 percent. If the current market
value of the equity is $43 million and there are no taxes, what is EBIT?
100 % E WACC =
rE =
A
= 8 4% .
E = $43m =
Va no t
EBIT EBIT
VA = I =
43m = EBIT = $3 .
612m
rA 8 4%.

5. Calculating WACC Weston Industries has a debt–equity ratio of 1.5. Its WACC is 10.5 percent, and its
cost of debt is 6 percent. The corporate tax rate is 35 percent.
a. What is the company’s cost of equity capital?
b. What is the company’s unlevered cost of equity capital?
c. What would the cost of equity be if the debt–equity ratio were 2? What if it were 1.0? What if it
were zero?
DIE = 1 . 5 => D = 1 .
5E

WACC = 10 5 % . = ra VD = 6% tc = 35 %
 pPEXDX(l-tc) = Xx6 % x (1 - 35 % )
E
a WACC = *
E + =
10 5 %
. =3 Ve = 20 4 %
.

D+ E

b
. rE =
ru +
P(1-tc)(rn -

-b) Es rn +
1 (1 -
35% )(ru -
6 %) = 20 4 % . => m = 13 29 %
.

C .
DIE = 2 = D = 2E rE =
ru + 11-tc)(ru -rp) = 13 29 %
. + 2x 0 65 .
x (13 29 %.
-
6% ) = 22 77 %
.

DIE = 10 => D = 10E re = 13 29%

.
+ 10 x 0 65
.
x (13 29 .
-
6 %) = 60 68 % .

DIE = 0 => D = 0 VE =
ru = 13 29 %
.

6. Firm Value Cavo Corporation expects an EBIT of $26,850 every year forever. The company currently
has no debt, and its cost of equity is 14 percent. The tax rate is 35 percent.
a. What is the current value of the company?
b. Suppose the company can borrow at 8 percent. What will the value of the company be if it takes on
debt equal to 50 percent of its unlevered value?
EBIT =
$26 , 850/yr 100 % E rE = 14 % tc = 35 %

EBIT (1-tc) 26 , 850 x65 %

a .
Va = VE = I = $124 660 , .
71
rE 14 %

b
. 50 % D ,
50 % E rD =
8% => D = 50 % x 124 , 660 71 .
= $62 338 36 , .

V = Un + Dtc = $124 660 71 , .

+ $62 330 36 . . x 35 % = $146 ,
476 .
34

7 MM Proposition I with Taxes The Dart Company is financed entirely with equity. The company is
considering a loan of $2.6 million. The loan will be repaid in equal installments over the next two years,
and it has an interest rate of 8 percent. The company’s tax rate is 35 percent. According to MM
Proposition I with taxes, what would be the increase in the value of the company after the loan?
100 % E Loan amt = $2 6 m .
n = 2 Ta = 8% tc = 35 %

1st 1 3 . m int = 2 6m.

x 8% = $208, 000 => Tax Shield = $200 000 ,
x 35 % = $72 ,
800

principal
2nd 1 3m.
int = 1 3mx 8 %
.
= $104 ,
000 => Tax Shield = $104 , 000 x 35 % =
$36 400
,

principal
36 , 400
↑ in value of co .
after the loan = PV of tax shield =
72,800 t

1 .
082
= $98 614 54 , .
8. MM Proposition I without Taxes Alpha Corporation and Beta Corporation are identical in every way
except their capital structures. Alpha Corporation, an all-equity firm, has 18,000 shares of stock
outstanding, currently worth $35 per share. Beta Corporation uses leverage in its capital structure. The
market value of Beta’s debt is $85,000, and its cost of debt is 9 percent. Each firm is expected to have
earnings before interest of $93,000 in perpetuity. Neither firm pays taxes. Assume that every investor
can borrow at 9 percent per year.
a. What is the value of Alpha Corporation?
b. What is the value of Beta Corporation?
c. What is the market value of Beta Corporation’s equity?
d. How much will it cost to purchase 20 percent of each firm’s equity?
e. Assuming each firm meets its earnings estimates, what will be the dollar return to each position in
part (d) over the next year?
f. Construct an investment strategy in which an investor purchases 20 percent of Alpha’s equity and
replicates both the cost and dollar return of purchasing 20 percent of Beta’s equity.
g. Is Alpha’s equity more or less risky than Beta’s equity? Explain.

Alpha
Beta
corp . :

corp :
100 % E

D= $85, 000
shares

ro =
outstanding
9%
= 18 , 000 share P = $35/share
S EBIT

no ta
= $93, 000

a .
VAlpha = 18 000
, x $35 = $630 000 ,

b .
MM Proposition I wont Taxes : V = Vn => VBeta =
Valpha = $630 ,
000

C .
VBeta = D + E = $85, 000 + E = $630 , 000
= > E = $545, 000

d Cost to purchase 20% E of Alpha corp : 20 % x $630 ,

000 = $126 000
,

Beta 20% x $545 ,

000 =
$109 ,
000

e .
EBIT = $93 ,
000 => $ return for investor ind =?

Alpha corp . : 100 % E =>

Earnings = EBIT = $93, 000
=> $return for investor
owning 20 % E = 20 % x 93 000
,
= $18 600,

Beta corp . · Earnings : EBIT -int = 93 000

,
-

85 000
,
x 9% = $85 ,
350

=> $return for investor

owning 20 % E = 20 % x 85 350 , = $17 ,
070

.
f

Alpha corp : Cost to purchase 20 % E = $126, 000

Beta corp : Cost to purchase 20 % E = $109

, 000

=> In order to purchase $126 ,

000 of Alpha's E using only $109 ,
000 of his own
money ,
the investor
must borrow $17 ,
000 /126
, 000 -

109 , 000)

=> Investor receives the same amt of $return from Alpha & int the amt borrowed.
corp .

pays on

=> Net $ return = 18 , 600 -

17 000
, x 9% = $17 ,
070

Alpha's less risky than Beta's bes Beta has to its debt holders by to
pay to paying
E is E SH.
.
g
Since SH are residual claimnants they receive nothing if Beta does not do biz well.
,
may
 Chapter 17
Tutorial 5
1 Costs of Financial Distress Steinberg Corporation and Dietrich Corporation are identical firms except
that Dietrich is more levered. Both companies will remain in business for one more year. The
companies’ economists agree that the probability of the continuation of the current expansion is 80
percent for the next year, and the probability of a recession is 20 percent. If the expansion continues,
each firm will generate earnings before interest and taxes (EBIT) of $2.7 million. If a recession occurs,
each firm will generate earnings before interest and taxes (EBIT) of $1.1 million. Steinberg’s debt
obligation requires the firm to pay $900,000 at the end of the year. Dietrich’s debt obligation
requires the firm to pay $1.2 million at the end of the year. Neither firm pays taxes. Assume a
discount rate of 13 percent.
a. What is the value today of Steinberg’s debt and equity? What about that for Dietrich’s?
b. If there is no Financial Distress cost, calculate the value of Steinberg and Dietrich, comment on the
result.
Expansion : 80 % EBIT = $2 7 m .
Int put Steinberg = $900 000 ,
rd = 13 %

Recession : 20 % EBIT = $1 1 . m Int put Dietrich

= $1 2m . ta = 0%

.
a
Steinberg Expansion N1 $2 7 m $0 9 m $1 8 m
-

: : = .
. = .

Recession : N1 = $1 1m- $0 9 m
.
.
= $0 . 2m

$1 8m

&
x 80% $0 2m x 20 %
=> VE =
. + .

=
$1 309 735
, ,

1 + 13% =>

$900 000
Vsteinberg = $2 106 195
, ,

VD =
,
=
$796 , 466
1 13
.

($2 7m -$1 (m) 80%% 0x20%

&
Dietrich x
-

VE $1 061 947
.
.

:
= = , ,

1 13
=>
VDietrich $2 106 195
.

= , ,

$1 2m x 80 % + $1 1m x 20%
VD =
.
.

=
$1 044 248
, ,

1 13.

b
. If there is no Financial Distress cost => EBIT = NI

$2 7m x80% $1 /m x 20% % 106 , 194 19

Vstenberg $2
+

VDietrich
.
.

= =
= , .

1 13
.
 2. Financial Distress Good Time Company is a regional chain department store. It will remain in business
for one more year. The probability of a boom year is 60 percent and the probability of a recession is
40 percent. It is projected that the company will generate a total cash flow of $148 million in a boom
year and $61 million in a recession. The company’s required debt payment at the end of the year is
$88 million. The market value of the company’s outstanding debt is $67 million. The company pays no
taxes.
a. What payoff do bondholders expect to receive in the event of a recession?
b. What is the promised return on the company’s debt?
c. What is the expected return on the company’s debt?

Boom : 60% EBIT = $148m FV of D = $88m

Recession : 40%% EBIT = $61m MV of D = $67m

a In event of recession ,
bondholders will receive $61m .

6
. Promised return on co 's debt $88m 1 31 34 %
.
= - = .

$67m

c .
Expected value of clebt : $88m x 60 % + $61m x 40 % = $77 2m
.

(pmts to bondholders

debt $77
Expect return on =
.
2m - 1 =
15 22 % .

$67m