Fundamentals of Corporate Finance

Income = Revenue – expenses

Money the firms owes to its suppliers – account payable
money owed to the firm by its customers – Account recivable
The stated interest payment made on a bond – Coupon
The principal amount of a bond that is repaid at the end of a term. – Face value of par
value
The annual coupon divided by the face value of a bond. – Coupon rate
The specified date on which the principal amount of the bond is paid Maturity
the rate required in the market on a bond – Yield to maturity
Equals Present value of the coupons + Present value of the face amount = Bond value
Effective annual rate - (1+.08)^2-1-16.65% = Effective yield on the bond
The risk that arises for bond owners from fluctuating interest rates = Interest rate risk
Cx [1-1/(1+r)]/r + F/(1+r)^t
c-coupons paid each period
r-rate per period Finding the value of a bond
t-number of periods
F-Bond's face value
easily observe its prices and trading volume Transparent
The price of a bond net of accrued interest; this is the price that is typically quoted. Clean
price
The price of a bond including accrued interest known as the full or invoice price. this is
the price that the buyer actually pays. – Dirty Price
Interest rates or rates of return that have been adjusted for inflaiton – Real rate
Interest rates or rates of return that have not been adjusted for inflation – Nominal Rate
The relationship between nominal returns, real returns and inflation – Fisher Effect
Rate of Return Formula – (D/P)+G
The relationship between nominal interest rates on default-free, pure discount securities
and time to maturity – Term Structure of interest rate
The portion of a nominal interest rate that represents compensation for expected future
inflation – Inflation Premium
The compensation investors demand for bearing interest rate risk – Interest rate risk
premium
A plot of the yields on Treasury notes and bonds relative to maturity – Treasury yield
curve
The portion of a nominal interest rate or bond yield that represents compensation for the
possibility of default – Default Risk premium
The portion of the nominal interest rate or bond yield that represents compensation for
unfavorable tax status – Taxibility premium or risk
The portion of a nominal interest rate or bond yield that represents compensation for lack
of liquidity – Liquidity premium of risk
Bond Value has what components? - 1. A face value or F paid at maturity
2. Coupon of C paid per period
3. t periods to maturity
4. A yield of r per period
What is capital debt?
Capital debt is borrowed money invested, always with interest.
What are characteristics of debt?
1.Debt is not an ownership interest in the firm. Creditors generally do not have voting
power.
2. The corporation's payment of interest on debt is considered a cost of doing business
and is fully tax deductible. Dividends paid to stockholders are not tax deductible
3. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the
assets of the firm
Syndicated Loan
Loan provided by groups of bank lenders
3-5 years in tenor
More covenants than bonds, both quality and quantity
Resolving credit
is a type of credit that does not have a fixed number of payments, in contrast to
installment credit. Credit cards are an example of revolving credit used by consumers.
Swingline
A loan that grants institutions access to large amounts of cash in order to cover possible
shortfalls from other debt commitments.
Term loans
A loan from a bank for a specific amount that has a specified repayment schedule and a
floating interest rate. Term loans almost always mature between one and 10 years
Sensitivity of interest rate risk
1. All other things being equal, the longer the time to maturity, the greater the interest
rate risk
2. All other things being equal, the lower the coupon rate, the greater the interest rate risk
Indenture
written agreement between the corporation and its creditors.
Indentures include:
1. Basic terms of the bond
2. The total amount of bonds issued
3. A description of property used as security
4. The repayment arrangements
5. The call provisions
6. Details of the protective covenants
Security
A security is a financial instrument hat represents an ownership position in a publicly
traded corporation (stock), a creditor relationship with a governmental body or a
corporation (bond), or rights to ownership as represented by an option. A security is a
fungible, negotiable financial instrument that represents some type of financial value.
Protective Convenants
A part of the indenture limiting certain actions that might be taken during the term of the
loan, usually to protect the lender's interests.
Seniority
Indicates preference in position over other lenders and debts are sometimes labeled as
senior or junior to indicate seniority
Sinking Fund
is an account managed by the bond trustee for the purpose of repaying the bonds.
Sinking Fund key Components
1. Some sinking funds start about 10 years after the initial issuance
2. Some sinking funds establish equal payments over the life of the bond.
3. Some high-quality bond issues establish payments to the sinking fund that are not
sufficient to redeem the entire issue. As a consequences, there is the possibility of a large
"balloon payment" at maturity.
Call provision
an agreement giving the corporation the option to repurchase a bond at a specified price
prior to maturity
Put provision
Holders can redeem for par at their discretion
Debenture
is an unsecured bond, for which no specific pledge of property is made
Note
Is generally used for such instruments if the maturity of the unsecured bond is less than
10 or so years when the bond is originally issued
Corporate coupons are paid how often?
Interest is payable semiannually on July 1 and January 1 of each year to the person in
whose name the bond is registered at the close of business on June 15 or December 15,
respectively.
Public bonds vs private placements
Public: auction house, strict rules which must be adhered to
Private: negotiated directly, not registered on the SEC
How are ratings used in respect to bonds?
To measure whether the bond is good or bad (i.e. whether the bond will default)--done by
Moody's and S&P
What is unique about US Treasury securities?
1. No default risk.
2. Taxed only federally
Note: Lower interest than corporate
What is unique about municipal bonds?
1. Rated like corporate bonds w/ degrees of default risk
2. Always callable
3. Exempt from federal taxes (not state)
Note: Lower interest than corporate
Sovereign Bonds
Are bonds issued by government
Zero coupon bond
A bond that makes no coupon payments and is thus initially priced at a deep discount
Convertible bond
can be swapped for a fixed number of shares of stock anytime before maturity at the
holder's option.
Bond market
Quotes made in 1/8ths or 32nds,
Equity market
Auction, stock
Accrued interest formula
fraction of coupon period passed x coupon price
Bond price quoted
Corporate: 1/8ths
Government: 1/32nd
Current yield
Annual coupon divided by price
Bond Value (Clean price)
The price of a bond net of accrued interest; this is the price that is typically quoted
Bond value (Dirty price)
The price of a bond including accrued interest, also known as the full or invoice price.
Accrued interest
Coupon*(Days between settlement and last coupon payment/total days in period)
Yield to first call
When a bond is called back and paid back before the bond yields to maturity
Discount bond
Sells for less than face value
Premium bond
Sells for more than par value
Market interest rate
aka effective interest rate, yield to maturity, discount rate, desired rate
Coupon rate=
Annual coupon/face value
Two sources of return from investing in a bond?
Face value and the coupons
Interest rate risk components
1. All other things being equal, the longer the time to maturity, the greater the interest
rate risk
2. All other things being equal, the lower the coupon rate, the greater the interest rate risk
Finding the yield on a bond
N=years to maturity
PMT= annual coupon rate
PV=- current value
FV=1,000
I/Y=Yield
Nominal rate
Rate of interest before adjustment for inflation
Real rate
Rate an investor expects to receive after inflation
Fisher Effect Formula
1+R=(1+r)(1+h)
R=nominal rate
r=real rate
h=inflation rate
Treasury Yield Curve
A plot of the yields of treasure notes and bonds relative to maturity
Three components of Term Structure
1. Nominal interest rates on default free
2. Pure discount securities
3. Time to maturity
Treasury Yield Curve Downward sloping
When short term rates are higher
Treasury Yield Curve Upward sloping
When short term rates are higher
Default risk
The portion of a nominal interest rate or bond yield that represents compensation for the
possibility of default
Bond yields represent the combined effect of what six things?
1. Expected future inflation
2. interest rate risk
3. default risk
4. taxability
5. lack of liquidity
6. real rate
Equity capital
Stocks
Characteristics of equity capital
1. Cash flows are not known in advance
2. The life of the investment is essentially forever.
3. There is no way to easily observe the rate of return that the market requires
General Dividend Growth Formula
P0=D1/(1+R)^1+(repeat with D2)
Constant Growth Formula
P0=D1/(R-g)
Nonconstant Growth
P0=D1/(1+R)^1+ (repeat with D2)
Two stage growth
P0=D1/(R-g) x {1-[(1+g)/(1+R)]t}+P1/(1+R)t
where
Pt=Dt+1/(R-g2)=[D0(1+g)tx(1+g)]/(R-g2)
Valuation Using Multiples
For stocks that don't pay dividends, we can use the PE ratio and or the price-sales ratio
Pt=Benchmark PE Ratio x EPS
Pt=Benchmark price=sales ratio x Sale per share
Pt=Benchmark price-sales ratio or sales per share
The Required Return
R=(D1/P)+g
Cumulative Voting
A procedure in which a shareholder may cast all votes for one member of the board of
directors
To permit minority participation
Straight Voting
A procedure in which a shareholder may cast all votes for each member of the board of
directors
Staggering Boards/Classified Boards
Boards are in different classes with terms that expire at different times.
1. Staggering makes it more difficult for a minority to elect a director because there are
fewer directors to be elected at one time
2. Staggering makes takeover attempts less likely to be successful because it makes it
more difficult to vote in a majority of new directors
Structure of a Corporation
Shareholders elect the board, board choses the management
This ensures that the will of the shareholders if channeled through the board.
Proxy
A grant of authority by a shareholder allowing another individual to vote his or her shares
Proxy fight
The battle that results form the attempt to replace/elect a new director through
management
Shareholders Preference of Cumulative Voting
Minority particiatpion
Characteristics of Dividends
1. Unless a dividend is declared by the board of directors, it is not a liability of the
corporation
2. The payment of dividends by the corporation is not a business expense and not
deductible from corporate tax
3. Dividends received by individual shareholders are taxable
Return from capital gains
The dividend growth rate, or the rate at which the stock's value grows
Shareholders Rights
1. The right to share proportionally in dividends paid
2. The right to share proportionally in assets remaining after liabilities have been paid in a
liquidation
3. The right to vote on stockholder matters of great importance, such as a merger.
Preemptive right
Stockholders sometimes have the right to share proportionally in any new stock
What is the theory behind why expected dividends can be used to value a share of
stock? In the long run why is this a valid assumption?
The theory behind why expected dividends can be used to value a stock is that the
dividends are part of the cash flow and part of the value.
It is a valid assumption because companies have no death date.
What are the issues with this method for valuing equity?
Companies don't have to pay dividends and will only pay dividends if they are doing
well. They could choose not to offer dividends or change the dividend yield at any point.
How are earnings multiples used to value stock as an alternative to future dividend
models?
Rather than valuing stock based on the dividends or the assumption of growth. They
calculate the worth on companies that don't pay dividends.
Purpose of capital budgeting analysis
To see if the investment creates values for the owners
Net Present Value
The different between an investment's market value and its cost
CF Calculator
Profitability Index
The present value of an investment's future cash flows divided by it's initial cost.
aka benefit-cost ratio
Advantages: closely related to NPV, generally leading to identical decisions, easy to
understand and communicate, useful when available investment funds are limited.
Disadvantages: may lead to incorrect decisions in comparisons of mutually exclusive
investments
Payback Period rule
Based on the payback rule, an investment is acceptable if it is calculated payback period
is less than some pre specified number of years.
Payback Period
the amount of time required for an investment to generate cash flows sufficient to recover
its initial cost
Advantages: easy to understand, adjusts for uncertainty of later cash flows, based towards
liquidity
Disadvantages: ignores the time value of money, requires an arbitrary cut off point,
ignores cash flows beyond the cutoff date, biased against long-term projects , such as
r&d, and new projects
Discounted Payback Period Rule
An investment is acceptable if its discounted payback is less than some pre specified
number of years.
Discounted Payback Period
Length of time required for an investment's discounted cash flows to equal its initial cost
Advantages: includes time value of money, easy to understand, does not accept NPV
investments, biased toward liquidity
Disadvantages: May reject positive NPV investments, requires an arbitrary cutoff point,
ignores cashflows beyond the cutoff date, biased against long term projects, (i.e. R&D or
new projects)
Average Accounting Return
Advantages: easy to calculate, needed information will usually be available
Disadvantages: not a true rate of return, time value of money is ignored, useds an
arbitrary benchmark cutoff rate, based on accounting (book values) not cashflows or
market values
Average Accounting Return formula
Average net income/average book value
Average Accounting Return rule
Based on the average accounting return rule, a project is acceptable if its average
accounting return exceeds a target average accounting return
Internal Rate of Return
the discount rate that makes the NPV of an investment 0
Advantages: Closely related to NPV, often leading to identical decisions
Disadvantages: may result in multiple answers and not deal with nonconventional cash
flows, may lead to incorrect decisions in comparisons of mutually exclusive investments
Internal Rate of Return Rule
An investment is acceptable if the IRR exceeds the required return. It should be rejected
otherwise
IRR with Mutually exclusive investments
Doesn't always show the investment with the higher return rate
IRR with non-conventional cash flows
Multiple rates of return problem
NPV Profile
A graphical relationship of the relationship between an investment's NPV and various
discount rates
Crossover point of an NPV Profile
IRR
Yield to first call formula
N=# of years x2
PV=-1000
PMT=Annual Coupon/2
FV=1000*premium
Holding Period Yield Formula
N= Years time 2
PV=Purchase price
PMT=Annual coupon/2
FV=Current market price
CPT I/Y
Current Yield Formula
Annual coupon/PV
Profitability Index Calculation
CF column, PV (CF)
PI=(CF)/Initial Investment
Accept Project because PI>=1
Discounted Payback Period Calculation
CF column, PV (CF)
DPP= Initial-each CF until positive
last payment before positive/last CF
DPP= Years+ last section
Payback Period Calculation
Column CF until positive
last payment before positive/last CF
PP= years+ last calculation
Crossover Rate
Subtract cashflows of one project from the other
Discount them
Then find IRR of the two
Bài tập

A group of individuals got together and purchased all of the outstanding shares of
common stock of DL Smith, Inc. What is the return that these individuals require on this
investment called?
Cost of equity
The average of a firm's cost of equity and aftertax cost of debt that is weighted based on
the firm's capital structure is called the:
Weighted average cost of capital
A firm's overall cost of equity is:
Highly dependent upon the growth rate and risk level of the firm.
Which one of the following statements related to the SML approach to equity valuation is
correct? Assume the firm uses debt in its capital structure..
The model is dependent upon a reliable estimate of the market risk premium.
The cost of preferred stock is computed the same as the:
Return on a perpetuity
If a firm uses its WACC as the discount rate for all of the projects it undertakes then the
firm will tend to:
I. reject some positive net present value projects.
II. accept some negative net present value projects.
III. favor high risk projects over low risk projects.
IV. increase its overall level of risk over time.
I, II, III, and IV
The pre-tax cost of debt:
Is based on the current yield to maturity of the firm's outstanding bonds.
Which one of the following statements is correct?
Overall, a firm makes better decisions when it uses the subjective approach than
when it uses its WACC as the discount rate for all projects
The flotation cost for a firm is computed as:
The weighted average of the flotation costs associated with each form of financing
The capital structure weights used in computing the weighted average cost of capital:
Are based on the market value of the firm's debt and equity securities.
Sweet Treats common stock is currently priced at $18.53 a share. The company just paid
$1.25 per share as its annual dividend. The dividends have been increasing by 2.5 percent
annually and are expected to continue doing the same. What is this firm's cost of equity?

9.41 percent
The weighted average cost of capital for a firm may be dependent upon the firm's:
I. rate of growth.
II. debt-equity ratio.
III. preferred dividend payment.
IV. retention ratio.
I, II, III, and IV
Southern Home Cookin' just paid its annual dividend of $0.65 a share. The stock has a
market price of $13 and a beta of 1.12. The return on the U.S. Treasury bill is 2.5 percent
and the market risk premium is 6.8 percent. What is the cost of equity?
10.12 percent
Boulder Furniture has bonds outstanding that mature in 15 years, have a 6 percent
coupon, and pay interest annually. These bonds have a face value of $1,000 and a current
market price of $1,075. What is the company's aftertax cost of debt if its tax rate is 32
percent?
3.58 percent
Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with
similar characteristics are yielding 7.5 percent. The company also has 750,000 shares of 7
percent preferred stock and 2.5 million shares of common stock outstanding. The
preferred stock sells for $65 a share. The common stock has a beta of 1.34 and sells for
$42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return on the market is
11.2 percent. The corporate tax rate is 38 percent. What is the firm's weighted average
cost of capital?

10.15 percent
Central Systems, Inc. desires a weighted average cost of capital of 8 percent. The firm
has an aftertax cost of debt of 5.4 percent and a cost of equity of 15.2 percent. What debt-
equity ratio is needed for the firm to achieve its targeted weighted average cost of capital?
2.77
Travis & Sons has a capital structure which is based on 40 percent debt, 5 percent
preferred stock, and 55 percent common stock. The pre-tax cost of debt is 7.5 percent, the
cost of preferred is 9 percent, and the cost of common stock is 13 percent. The company's
tax rate is 39 percent. The company is considering a project that is equally as risky as the
overall firm. This project has initial costs of $325,000 and annual cash inflows of
$87,000, $279,000, and $116,000 over the next three years, respectively. What is the
projected net present value of this project?
$76,011.23
Yesteryear Productions is considering a project with an initial start up cost of $960,000.
The firm maintains a debt-equity ratio of 0.50 and has a flotation cost of debt of 6.8
percent and a flotation cost of equity of 11.4 percent. The firm has sufficient internally
generated equity to cover the equity cost of this project. What is the initial cost of the
project including the flotation costs?
B. $982,265
Jungle, Inc. has a target debt-equity ratio of 0.72. Its WACC is 11.5 percent and the tax
rate is 34 percent. What is the cost of equity if the aftertax cost of debt is 5.5 percent?
D. 15.82 percent
Stock in Country Road Industries has a beta of 0.97. The market risk premium is 10
percent while T-bills are currently yielding 5.5 percent. Country Road's most recent
dividend was $1.55 per share, and dividends are expected to grow at a 7 percent annual
rate indefinitely. The stock sells for $32 a share. What is the estimated cost of equity
using the average of the CAPM approach and the dividend discount approach?
A. 13.69 percent
A project has an initial cost of $27,400 and a market value of $32,600. What is the
difference between these two values called?
A. net present value
Which one of the following methods of project analysis is defined as computing the value
of a project based upon the present value of the project's anticipated cash flows?
B. discounted cash flow valuation
The length of time a firm must wait to recoup the money it has invested in a project is
called the:
B. payback period.
The length of time a firm must wait to recoup, in present value terms, the money it has in
invested in a project is referred to as the:
E. discounted payback period
A project's average net income divided by its average book value is referred to as the
project's average:
C. accounting return.
The internal rate of return is defined as the:
D. discount rate which causes the net present value of a project to equal zero
You are viewing a graph that plots the NPVs of a project to various discount rates that
could be applied to the project's cash flows. What is the name given to this graph?
C. NPV profile
There are two distinct discount rates at which a particular project will have a zero net
present value. In this situation, the project is said to:
E. have multiple rates of return.
If a firm accepts Project A it will not be feasible to also accept Project B because both
projects would require the simultaneous and exclusive use of the same piece of
machinery. These projects are considered to be:
C. mutually exclusive.
The present value of an investment's future cash flows divided by the initial cost of the
investment is called the:
D. profitability index.
A project has a net present value of zero. Which one of the following best describes this
project?
E. The project's cash inflows equal its cash outflows in current dollar terms.
Which one of the following will decrease the net present value of a project?
D. increasing the project's initial cost at time zero
Which one of the following methods determines the amount of the change a proposed
project will have on the value of a firm?
A. net present value
If a project has a net present value equal to zero, then:
B. the project earns a return exactly equal to the discount rate.
Rossiter Restaurants is analyzing a project that requires $180,000 of fixed assets. When
the project ends, those assets are expected to have an aftertax salvage value of $45,000.
How is the $45,000 salvage value handled when computing the net present value of the
project?
B. cash inflow in the final year of the project
Which one of the following increases the net present value of a project?
D. an increase in the aftertax salvage value of the fixed assets
Net present value:
A. is the best method of analyzing mutually exclusive projects.
Which one of the following is a project acceptance indicator given an independent project
with investing type cash flows?
E. modified internal rate of return that exceeds the required return
Why is payback often used as the sole method of analyzing a proposed small project?
C. It is the only method where the benefits of the analysis outweigh the costs of that
analysis.
Which of the following are advantages of the payback method of project analysis?
C. II and III only
Samuelson Electronics has a required payback period of three years for all of its projects.
Currently, the firm is analyzing two independent projects. Project A has an expected
payback period of 2.8 years and a net present value of $6,800. Project B has an expected
payback period of 3.1 years with a net present value of $28,400. Which projects should
be accepted based on the payback decision rule?
A. Project A only
A project has a required payback period of three years. Which one of the following
statements is correct concerning the payback analysis of this project?
D. The cash flow in year two is valued just as highly as the cash flow in year one.
A project has a discounted payback period that is equal to the required payback period.
Given this, which of the following statements must be true?
B. I and II only
Which one of the following statements related to payback and discounted payback is
correct?
E. Payback is used more frequently even though discounted payback is a better
method.
Applying the discounted payback decision rule to all projects may cause:
A. some positive net present value projects to be rejected
Which one of the following correctly applies to the average accounting rate of return?
E. It can be compared to the return on assets ratio.
Which one of the following is an advantage of the average accounting return method of
analysis?
A. easy availability of information needed for the computation
Which of the following are considered weaknesses in the average accounting return
method of project analysis?
D. I, II, and IV only
Which one of the following statements related to the internal rate of return (IRR) is
correct?
C. The IRR is equal to the required return when the net present value is equal to
zero.
The internal rate of return:
E. is easy to understand
Tedder Mining has analyzed a proposed expansion project and determined that the
internal rate of return is lower than the firm desires. Which one of the following changes
to the project would be most expected to increase the project's internal rate of return?
C. condensing the firm's cash inflows into fewer years without lowering the total
amount of those inflows
The internal rate of return is:
C. tedious to compute without the use of either a financial calculator or a computer.
Which of the following statements related to the internal rate of return (IRR) are correct?
E. I, II, III, and IV
Douglass Interiors is considering two mutually exclusive projects and have determined
that the crossover rate for these projects is 11.7 percent. Project A has an internal rate of
return (IRR) of 15.3 percent and Project B has an IRR of 16.5 percent. Given this
information, which one of the following statements is correct?
E. You cannot determine which project should be accepted given the information
provided
You are comparing two mutually exclusive projects. The crossover point is 12.3 percent.
You have determined that you should accept project A if the required return is 13.1
percent. This implies you should:
C. always accept project A if the required return exceeds the crossover rate.
Graphing the crossover point helps explain:
B. how decisions concerning mutually exclusive projects are derived.
A project with financing type cash flows is typified by a project that has which one of the
following characteristics?
D. a cash inflow at time zero
Which of the following statements generally apply to the cash flows of a financing type
project?
D. I, II, and III only
Which one of the following statements is correct in relation to independent projects?
B. A project with investing type cash flows is acceptable if its internal rate of return
exceeds the required return
The profitability index is most closely related to which one of the following?
D. net present value
Roger's Meat Market is considering two independent projects. The profitability index
decision rule indicates that both projects should be accepted. This result most likely does
which one of the following?
B. assumes the firm has sufficient funds to undertake both projects
Which one of the following methods of analysis provides the best information on the
cost-benefit aspects of a project?
E. profitability index
When the present value of the cash inflows exceeds the initial cost of a project, then the
project should be:
B. accepted because the profitability index is greater than 1.
Which one of the following is the best example of two mutually exclusive projects?
E. waiting until a machine finishes molding Product A before being able to mold
Product B
Southern Chicken is considering two projects. Project A consists of creating an outdoor
eating area on the unused portion of the restaurant's property. Project B would use that
outdoor space for creating a drive-thru service window. When trying to decide which
project to accept, the firm should rely most heavily on which one of the following
analytical methods?
D. net present value
Mutually exclusive projects are best defined as competing projects which:
C. both require the total use of the same limited resource.
The final decision on which one of two mutually exclusive projects to accept ultimately
depends upon which one of the following?
D. required rate of return
Isaac has analyzed two mutually exclusive projects of similar size and has compiled the
following information based on his analysis. Both projects have 3- year lives. Isaac has
been asked for his best recommendation given this information. His recommendation
should be to accept:
C. project B and reject project A based on their net present values.
Which one of the following statements would generally be considered as accurate given
independent projects with conventional cash flows?
C. The payback decision rule could override the net present value decision rule
should cash availability be limited
In actual practice, managers frequently use the:
C. I, II, and IV only
Kristi wants to start training her most junior assistant, Amy, in the art of project analysis.
Amy has just started college and has no experience or background in business finance. To
get her started, Kristi is going to assign the responsibility for all projects that have initial
costs less than $1,000 to Amy to analyze. Which method is Kristi most apt to ask Amy to
use in making her initial decisions?
D. payback
Which two methods of project analysis were the most widely used by CEO's as of 1999?
D. internal rate of return and net present value
Which two methods of project analysis are the most biased towards short-term projects?
C. payback and discounted payback
Western Beef Exporters is considering a project that has an NPV of $32,600, an IRR of
15.1 percent, and a payback period of 3.2 years. The required return is 14.5 percent and
the required payback period is 3.0 years. Which one of the following statements correctly
applies to this project?
C. The payback decision rule could override the accept decision indicated by the net
present value
You are considering a project with conventional cash flows and the following
characteristics:Which of the following statements is correct given this information?
C. I, II, and IV only
Which of the following are definite indicators of an accept decision for an independent
project with conventional cash flows?
A. I and III only
Holdup Bank has an issue of preferred stock with a $6 stated dividend that just sold
for $85 per share. What is the bank's cost of preferred stock?
7.06%
The cost of preferred stock is the dividend payment divided by the price, so:

RP = $6/$85 = 0.0706 or 7.06%

Jungle, Inc., has a target debt—equity ratio of 0.8. Its WACC is 11.5 percent, and the tax
rate is 35 percent.

Required:

(a) If Jungle's cost of equity is 14 percent, what is the pretax cost of debt?

(b) If instead you know that the aftertax cost of debt is 7.3 percent, what is the cost of
equity?
a.) 12.88%

b.) 14.86%

(a)
Using the equation to calculate WACC, we find:

WACC = 0.115 = (1/1.8)(0.14) + (0.8/1.8)(1- 0.35)RD

RD = 0.1288 or 12.88%

(b)
Using the equation to calculate WACC, we find:

WACC = 0.115 = (1/1.8)RE + (0.8/1.8)(0.073)

RE = 0.1486 or 14.86%
The cost of preferred stock is computed the same as the:
Rate of return on a perpetuity.
The weighted average cost of capital for a firm can depend on all of the following
except the:
Standard deviation of the firm's common stock.
The Pet Market has $1,000 face value bonds outstanding with 18 years to maturity,
a coupon rate of 9 percent, annual interest payments, and a current price of $835.
What is the aftertax cost of debt if the tax rate is 34 percent?
7.37 percent
$835 = (.09 × $1,000) × ({1 - [1 / (1 + r)^18]} / r) + $1,000 / (1 + r)^18
Using trial-and-error, a financial calculator, or a computer, r = 11.16 percent

Aftertax cost of debt = 11.16 percent × (1 - .34) = 7.37 percent

The dividend growth model cannot be used to compute the cost of equity for a firm
that:
Has a retention ratio of 100 percent.
Chelsea Fashions is expected to pay an annual dividend of $1.10 a share next year.
The market price of the stock is $21.80 and the growth rate is 4.5 percent. What is
the firm's cost of equity?
9.55percent

RE = ($1.10 / $21.80) + .045 = .0955, or 9.55 percent

Southern Home Cooking just paid its annual dividend of $.75 a share. The stock has
a market price of $16.80 and a beta of 1.14. The return on the U.S. Treasury bill is
2.7 percent and the market risk premium is 7.1 percent. What is the cost of equity?

10.79 percent

RE = .027 + 1.14(.071) = .1079, or 10.79 percent

Dee's Fashions has a growth rate of 5.2 percent and is equally as risky as the market
while its stock is currently selling for $28 a share. The overall stock market has a
return of 12.6 percent and a risk premium of 8.7 percent. What is the expected rate
of return on this stock?
12.6 percent
RE = (.126 - .087) + 1(.087) = .126, or 12.6 percent
Fashion Wear has bonds outstanding that mature in 12 years, pay interest annually,
and have a coupon rate of 7.5 percent. These bonds have a face value of $1,000 and a
current market price of $1,060. What is the company's aftertax cost of debt if its tax
rate is 35 percent?
4.39 percent

$1,060 = (.075 × $1,000) × ({1 - [1 / (1 + r)^12]} / r) + $1,000 / (1 + r)^12

Using trial-and-error, a financial calculator, or a computer, r = 6.75 percent

Aftertax cost of debt = 6.75 percent × (1 - .35) = 4.39 percent

The Downtowner has 950,000 shares of common stock outstanding valued at $38 a
share along with 40,000 bonds selling for $1,020 each. What weight should be given
to the debt when the firm computes its weighted average cost of capital?

53.06 percent

D = 40,000 × $1,020 = $40,800,000

E = 950,000 × $38= $36,100,000

V = $40,800,000 + 36,100,000 = $76,900,000

WE = $40,800,000 / $76,900,000 = .5306, or 53.06 percent

Phillips Equipment has 75,000 bonds outstanding that are selling at par. Bonds with
similar characteristics are yielding 7.5 percent. The company also has 750,000
shares of 6 percent preferred stock and 2.5 million shares of common stock
outstanding. The preferred stock sells for $64 a share. The common stock has a beta
of 1.21 and sells for $44 a share. The U.S. Treasury bill is yielding 2.3 percent and
the return on the market is 11.2 percent. The corporate tax rate is 34 percent. What
is the firm's weighted average cost of capital?
9.69 percent

RE = .023 + 1.21(.112 - .023) = .13069

RP = (.06 × $100) / $64 = .09375

D = 75,000 × $1,000 = $75,000,000

P = 750,000 × $64 = $48,000,000
E = 2,500,000 × $44= $110,000,000

V = $75,000,000 + 48,000,000 + 110,000,000 = $233,000,000

WACC = ($110m / $233m)(.13069) + ($48m / $233m)(.09375) + ($75m / $233m)(.075)

(1 - .34) = .0969, or 9.69 percent
Jiminy's Cricket Farm issued a 30-year, 8 percent, semiannual bond six years ago.
The bond currently sells for 114 percent of its face value. What is the aftertax cost of
debt if the company's tax rate is 31 percent?

4.70 percent

(1.14 × $1,000) = [(.08 × $1,000) / 2] × [(1 - {1 / [1 + (r / 2)]^24 × 2}) / (r / 2)] + $1,000 /

[1 + (r / 2)]^24 × 2

Using trial-and-error, a financial calculator, or a computer, r = 6.81 percent

RDAftertax = 6.81 percent × (1 - .31) = 4.70 percent

Sixx AM Manufacturing has a target debt—equity ratio of 0.51. Its cost of equity is
17 percent, and its cost of debt is 10 percent. If the tax rate is 33 percent, what is the
company's WACC?
13.52%
Here we need to use the debt-equity ratio to calculate the WACC. Doing so, we find:

WACC = 0.17(1/1.51) + 0.1(0.51/1.51)(1 - 0.33) = 0.1352 or 13.52%

Consider the following information for Evenflow Power Co.,
Debt: 4,500 6.5 percent coupon bonds outstanding, $1,000 par value, 20 years to
maturity, selling for 103 percent of par; the bonds make semiannual payments.

Common stock: 94,500 shares outstanding, selling for $61 per share; the beta is 1.13.

Preferred stock: 14,500 shares of 5 percent preferred stock outstanding, currently selling
for $106 per share.

Market: 8 percent market risk premium and 4 percent risk-free rate.

Assume the company's tax rate is 34 percent.

Required:
Find the WACC. (Do not round your intermediate calculations.)
8.5%
We will begin by finding the market value of each type of financing. We find:

MVD = 4,500($1,000)(1.03) = $4,635,000

MVE = 94,500($61) = $5,764,500

MVP = 14,500($106) = $1,537,000

And the total market value of the firm is:

V = $4,635,000 + 5,764,500 + 1,537,000 = $11,936,500

Now, we can find the cost of equity using the CAPM. The cost of equity is:

RE = 0.04 + 1.13(0.08) = 0.1304 or 13.04%

The cost of debt is the YTM of the bonds, so:

P0 = $1,030 = $32.5(PVIFAR%,40) + $1,000(PVIFR%,40)

R = 3.1177%

YTM = 3.118% × 2 = 6.24%

And the aftertax cost of debt is:

RD = (1 - 0.34)(0.062) = 0.0412 or 4.12%

The cost of preferred stock is:

RP = $5/$106 = 0.0472 or 4.72%

Now we have all of the components to calculate the WACC. The WACC is:

WACC = 0.0412(4.635/11.937) + 0.1304(5.76/11.937) + 0.0472(1.537/11.937) = 0.1318

or 8.5%

Notice that we didn't include the (1 - tC) term in the WACC equation. We used the
aftertax cost of debt in
the equation, so the term is not needed here.
Filer Manufacturing has 6 million shares of common stock outstanding. The current
share price is $72, and the book value per share is $7. Filer Manufacturing also has
two bond issues outstanding. The first bond issue has a face value of $70 million, has
a 7 percent coupon, and sells for 97 percent of par. The second issue has a face value
of $50 million, has a 8 percent coupon, and sells for 106 percent of par. The first
issue matures in 22 years, the second in 6 years.

The most recent dividend was $4.4 and the dividend growth rate is 6 percent.
Assume that the overall cost of debt is the weighted average of that implied by the
two outstanding debt issues. Both bonds make semiannual payments. The tax rate is
35 percent.

Required:
What is the company's WACC? (Do not round your intermediate calculations.)

10.75%
The market value of equity is the share price times the number of shares, so:

MVE = 6,000,000($72) = $432,000,000

Using the relationship that the total market value of debt is the price quote times the par
value of the bond, we find the market value of debt is:

MVD = 0.97($70,000,000) + 1.06($50,000,000) = $120,900,000

This makes the total market value of the company:

V = $432,000,000 + 120,900,000 = $552,900,000

And the market value weights of equity and debt are:

E/V = $432,000,000/$552,900,000 = 0.7813

D/V = 1 - E/V = 0.2187

Next, we will find the cost of equity for the company. The information provided allows
us to solve for the cost of equity using the dividend growth model, so:

RE = [$4.4(1.06)/$72] + 0.06 = 0.1248 or 12.48%

Next, we need to find the YTM on both bond issues. Doing so, we find:

P1 = $970 = $35(PVIFAR%,22) + $1,000(PVIFR%,22)

R = 3.638%

YTM = 3.638% × 2 = 7.28%

P2 = $1,060 = $40(PVIFAR%,6) + $1,000(PVIFR%,6)

R =3.383%

YTM = 3.383% × 2 = 6.77%

To find the weighted average aftertax cost of debt, we need the weight of each bond as a
percentage of the total debt. We find:

wD1 = 0.97($70,000,000)/$120,900,000 = 0.5616

wD2 = 1.06($50,000,000)/$120,900,000 = 0.4384

Now we can multiply the weighted average cost of debt times one minus the tax rate to
find the weighted
average aftertax cost of debt. This gives us:

RD = (1 - 0.35)[(0.5616)(0.0728) + (0.4384)(0.0677)] = 0.0458 or 4.58%

Using these costs we have found and the weight of debt we calculated earlier, the WACC
is:

WACC = 0.7813(0.1248) + 0.2187(0.0458) = 0.1075 or 10.75%

1. Holdup Bank has an issue of preferred stock with a $5 stated dividend that just
sold for $92 per share. What is the bank's cost of preferred stock?
Cost of Preferred Stock:
Rp = D1/P0
Rp = 5/92
Rp = 0.0543 OR 5.43%
2. The City Street Corporation's common stock has a beta of 1.2. The risk-free rate
is 3.5% and the expected return on the market is 13 percent. What is the firm's cost
of equity?
Cost of Equity:
Re = ERf + B(ERm - ERf)
Re = 0.035 + 1.2(0.13-0.035)
Re = 0.035 + 1.2(0.095)
Re = 0.149 OR 14.9%
3. Titan Mining Corporation has 14 million shares of common stock outstanding,
900,000 shares of preferred stock outstanding that pays a 9% annual dividend and
210,000, 10% semiannual bonds outstanding. The common stock currently sells for
$34 per share and has a beta of 1.15, the preferred stock currently sells for $80 per
share, and the bonds have 17 years to maturity and sell for 91% of par. The market
risk premium is 11.5%, T-bills are yielding 7.5%, and the firm's tax rate is 32%.
What discount rate should the firm apply to a new project's cash flows if the project
has the same risk as the firm's typical project?
WACC = (E/V)RE + (P/V)RP + (D/V)RD(1-TC)

E= 14M x $34 = $476M

P= 900,000 x $80 = $72M
D= (210,000/1,000) x $910 = $191,000
V=E+P+D = 548,191,000

B=1.15

MRP=11.5%
Rf=TBill=7.5%
Tax Rate=32%

RE = Rf+B(Rm-Rf) = 0.075+1.15(0.115-0.075) = 12.1%

RP = D1/P0 = 7.2/80 = 9%
RD = YTM (PV=-910, PMT=50, FV=1,000) = 11.2%

WACC = (476M/548.191M)12.1% + (72M/548.191M)9% +

(191,000/548.191M)11.2%(1-0.32)
= 11.69%
4. Kelso Electric is debating whether to use a leveraged or an unleveraged capital
structure. The all-equity capital structure would consist of 40,000 shares of stock.
The debt and equity option would consist of 25,000 shares of stock plus $280,000 of
debt with an interest rate of 7%. What is the break-even level of EBIT between
these two options? The company's tax rate is 35%.
EBIT(1-T)/#shares = (EBIT - int exp)(1-T)/#shares
EBIT(1-0.35)/40,000 = (EBIT - 19,600)(1-0.35)/25,000
.65EBIT/40,000 = (.65EBIT - 12,740)/25,000
.65EBIT = 1.04EBIT - 20,384
.39EBIT = 20,384
EBIT = 52,266.67
You are considering two independent projects. Project A has an initial cost of
$125,000 and cash inflows of $46,000, $79,000, and $51,000 for years 1 to 3,
respectively. Project B costs $135,000 with expected cash inflows for years 1 to 3 of
$50,000, $30,000, and $100,000, respectively. The required return for both projects
is 16 percent. Based on IRR, you should:

-Accept both projects.

-Accept Project B and reject Project A.
-Accept either one of the projects, but not both
-Accept Project A and reject Project B.
-Reject both projects.
Accept Project A and reject Project B.

NPVA = 0 = -$125,000 + $46,000 / (1 + IRR) + $79,000 / (1 + IRR)^2 + $51,000 / (1 +

IRR)^3

IRRA = 18.86 percent

NPVB = 0 = -$135,000 + $50,000 / (1 + IRR) + $30,000 / (1 + IRR)^2 + $100,000 / (1 +

IRR)^3

IRRA = 13.78 percent

Which one of the following methods determines the amount of the change a proposed
project will have on the value of a firm?
Net present value
You are comparing two mutually exclusive projects. The crossover point is 12.3
percent. You have determined that you should accept project A if the required
return is 13.1 percent. This implies you should:
Always accept Project A if the required return exceeds the crossover rate.
A project will produce cash inflows of $3,100 a year for 3 years with a final cash
inflow of $4,400 in Year 4. The project's initial cost is $10,400. What is the net
present value if the required rate of return is 16 percent?
-$1,007.66

NPV = -$10,400 + $3,100([1 - (1 / 1.16^3)] / .16) + $4,400 / (1 + .16)^4

NPV = -$1,007.66
Which one of the following will decrease the net present value of a project?
Increasing the project's initial cost at time zero.
A project has cash flows of -$119,000, $52,800, $60,200, and $33,100 for years 0 to 3,
respectively. The required rate of return is 12 percent. Based on the net present
value of _____, you should _____ the project.
-$306.15; reject
NPV = -$119,000 + $52,800 / 1.12 + $60,200 / 1.12^2 + $33,100 / 1.12^3

NPV = -$306.15

Because the NPV is negative, the project should be rejected.

A firm evaluates all of its projects by applying the IRR rule. The current proposed
project has cash flows of -$27,048, $16,850, $15,700, and $4,300 for years 0 to 3,
respectively. The required return is 19 percent. What is the project IRR? Should the
project be accepted or rejected?
21.08 percent; accept
NPV= 0 = -$27,048 + $16,850 / (1 + IRR) + $15,700 / (1 + IRR)^2 + $4,300 / (1 +
IRR)^3

IRR = 21.08 percent

This is an investment project so the project should be accepted because the IRR exceeds
the required return.
The internal rate of return is defined as the:
Discount rate which causes the net present value of a project to equal zero.
Which one of the following is the best example of two mutually exclusive projects?
Waiting until a machine finishes molding Product A before being able to mold
Product B.
In actual practice, managers most frequently use which two types of investment
criteria?
IRR and NPV.
Which of the following are advantages of the payback method of project analysis?
Liquidity bias, ease of use.
Samuelson Electronics has a required payback period of three years for all of its
projects. Currently, the firm is analyzing two independent projects. Project A has
an expected payback period of 2.8 years and a net present value of $6,800. Project B
has an expected payback period of 3.1 years with a net present value of $28,400.
Which projects should be accepted based on the payback decision rule?.
Project A only.
00:0201:34
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Only $3.99/month
The internal rate of return:
is easy to understand.
You are considering two mutually exclusive projects. Project A has cash flows of -
$72,000, $21,400, $22,900, and $56,300 for years 0 to 3, respectively. Project B has
cash flows of -$81,000, $20,100, $22,200, and $74,800 for years 0 to 3, respectively.
Both projects have a required 2.5-year payback period. Should you accept or reject
these projects based on payback analysis?.
Accept Project A and reject Project B.

Payback A = 2 + ($72,000 - 21,400 - 22,900) / $56,300 = 2.49 years

Payback B = 2 + ($81,000 - 20,100 - 22,200) / $74,800 = 2.52 years

To be accepted the project must pay back in 2.5 years or less. Accept A and reject B.
Net present value
Is the best method of analyzing mutually exclusive projects.
If a firm accepts Project A it will not be feasible to also accept Project B because
both projects would require the simultaneous and exclusive use of the same piece of
machinery. These projects are considered to be:
Mutually exclusive.
Swenson's is considering two mutually exclusive projects, Projects A and B, and has
determined that the crossover rate for these projects is 11.7 percent. Given this you
know that:
-Both projects have a zero NPV at a discount rate of 11.7 percent.
The project that is preferred at a discount rate of 11 percent will be the opposite
project of that preferred at a discount rate of 12 percent.
You are considering an investment that costs $152,000 and has projected cash flows
of $71,800, $86,900, and -$11,200 for years 1 to 3, respectively. If the required rate
of return is 15.5 percent, should you accept the investment based solely on the
internal rate of return rule? Why or why not?

-You cannot apply the IRR rule in this case

Since the cash flow direction changes twice, there are two IRRs. Thus, the IRR rule
cannot be used to determine acceptance or rejection.
Assume an investment has cash flows of -$30,000, $21,750, $18,500, and $12,500 for
years 0 to 3, respectively. What is the NPV if the required return is 13 percent? Should
the project be accepted or rejected?

$12,399.13; accept

NPV = -$30,000 + $21,750 / 1.13 + $18,500 / 1.13^2 + $12,500 / 1.13^3

NPV = $12,399.13
Because the NPV is positive, the project should be accepted.
Southern Chicken is considering two projects. Project A consists of creating an
outdoor eating area on the unused portion of the restaurant's property. Project B
would use that outdoor space for creating a drive-thru service window. When trying
to decide which project to accept, the firm should rely most heavily on which one of
the following analytical methods?

- Net present value.

A project has a required payback period of three years. Which one of the following
statements is correct concerning the payback analysis of this project?
The cash flow in year two is valued just as highly as the cash flow in year one.
A project has an initial cash outflow of $39,800 and produces cash inflows of
$18,304, $19,516, and $14,280 for years 1 through 3, respectively. What is the NPV
at a discount rate of 11 percent?
$2,971.13

NPV = -$39,800 + $18,304 / 1.11 + $19,516 / 1.11^2 + $14,280 / 1.11^3

NPV = $2,971.13
An investment project provides cash flows of $1,190 per year for 10 years. If the
initial cost is $8,000, what is the payback period?

6.72 years

Payback = $8,000 / $1,190 = 6.72 years

You are considering two mutually exclusive projects. Project A has cash flows of -
$87,000, $32,600, $35,900, and $43,400 for years 0 to 3, respectively. Project B has
cash flows of -$85,000, $14,700, $21,200, and $89,800 for years 0 to 3, respectively.
Project A has a required return of 9 percent while Project B's required return is 11
percent. Which project(s), if either, should you accept based on net present value?

Reject Project A and accept Project B

NPVA = -$87,000 + $32,600 / 1.09 + $35,900 / 1.09^2 + $43,400 / 1.09^3

NPVA = $6,637.33

NPVB = -$85,000 + $14,700 / 1.11 + $21,200 / 1.11^2 + $89,800 / 1.11^3

NPVB = $11,110.62

Since the projects are mutually exclusive, accept the project with the larger, positive
NPV.
Alicia is considering adding toys to her gift shop. She estimates the cost of new
inventory will be $9,500 and remodeling expenses will be $1,300. Toy sales are
expected to produce net cash inflows of $3,300, $4,900, $4,400, and $4,100 over the
next four years, respectively. Should Alicia add toys to her store if she assigns a
three-year payback period to this project? Why or why not?
Yes; The payback period is 2.59 years.

Payback = 2 + ($9,500 + 1,300 - 3,300 - 4,900) / $4,400 = 2.59 years

Since the payback period is less than the requirement, the project should be accepted.
A project has a net present value of zero. Which one of the following best describes
this project?
The project's cash inflows equal its cash outflows in current dollar terms.
You are considering a project with an initial cost of $8,600. What is the payback
period for this project if the cash inflows are $2,100, $3,140, $3,800, and $4,500 a
year over the next four years, respectively?
2.88 years

Payback = 2 + ($8,600 - 2,100 - 3,140) / $3,800 = 2.88 years

The IRR that causes the net present value of the differences between two project's
cash flows to equal zero is called the:

Crossover rate.
If a project has a net present value equal to zero, then:
The project earns a return exactly equal to the discount rate.
Mutually exclusive projects are best defined as competing projects that:
Both require the total use of the same limited resource.
The Dry Dock is considering a project with an initial cost of $118,400. The project's
cash inflows for years 1 through 3 are $37,200, $54,600, and $46,900, respectively.
What is the IRR of this project?
8.04 percent

NPV = 0 = -$118,400 + $37,200 / (1 + IRR) + $54,600 / (1 + IRR)^2 + $46,900 / (1 +

IRR)^3

IRR = 8.04 percent

Graphing the crossover point helps explain:
How decisions concerning mutually exclusive projects are derived.