Professional Documents
Culture Documents
INSTRUCTIONS:
PLEASE SHOW YOUR CALCULATIONS CLEARLY AND INDICATE YOUR ANSWERS
CLEARLY.
YOU CAN USE FINANCIAL CALCULATOR, OR EXCEL, OR SOLVE THE PROBLEMS
MANUALLY.
IF REQUIRED, USE UP TO 6 DECIMAL PLACES FOR CALCULATIONS
PROBLEM NO. 8
Your firm is considering purchasing a machine with the following annual, end-of-year, book
investment accounts. Depreciation is calculated using 10 per cent reducing balance (i.e. instead of
depreciating the machine by the same amount each year, we depreciate the residual value of the
investment by 10 per cent):
Purchase date
Gross
invest
ment
Less:
deprec
iation
for
year
Net
invest
ment
22,000
22,000
Year 1
Year 2
Year 3
Year 4
22,000
22,000
22,000
22,000
2,200
1,980
1,782
1,603.8
19,800
17,820
16,038
14,434.
2
The machine generates, on average, 4,300 per year in additional net income.
Required:
What is the average accounting return for this machine?
Particulars
Net income
Depreciation
Accounting profits
Year 1
4,300
(2,200)
2,100
Year 2
4,300
(1,980)
2,320
Year 3
4,300
(1,782)
2,518
Amount in
Year 4
4,300
(1,604)
2,969
2,477
Average investment
($22,000 + NIL disposal value)/2
24,200
22.52 %
PROBLEM NO. 9
Cash flows (dinar)
Year
Project A
Project B
5,500
3,500
2,500
3,000
3,000
1,500
3,500
1,000
Required:
Compute the internal rate of return for the cash flows of the above two projects:
Answer:
Year
0
1
2
3
Project
A
-5,500.00
2,500.00
3,000.00
3,500.00
NPV
Project
B
-3,500.00
3,000.00
1,500.00
1,000.00
Present
value
factors
10% 35%
1.000 1.000
0.909 0.741
0.826 0.444
0.751 0.406
Present Value
(Project A)
10%
5,500.00
2,272.73
2,479.34
2,629.60
1,881.67
IRR (Project A)
= 10% + [(1,881.67/(1,881.67+892.27)] (35% - 10%)
2
35%
- 5,500.00
1,851.85
1,333.33
1,422.55
-892.27
Present Value
(Project B)
10%
35%
- 3,500.00 - 3,500.00
2,727.27
2,222.22
1,239.67
666.67
751.31
406.44
1,218.26
- 204.67
= 26.96% (answer)
IRR (Project B)
= 10% + [(1,218.26/(1,218.26+204.67)] (35% - 10%)
= 31.40% (answer)
PROBLEM NO. 10
Suppose the following two independent investment opportunities are available to
Greenplain Ltd. The appropriate discount rate is 13 per cent.
Year
Project Alpha ()
Project Beta ()
600
1,980
370
290
660
1,940
540
1,570
Requirement 1:
Compute the profitability index for each of the two projects.
Answer:
Year
0
1
2
3
NPV
Project
Alpha ()
(600.00)
370.00
660.00
540.00
Project Beta
()
(1,980.00)
290.00
1,940.00
1,570.00
Discount
factor - 13%
1.000
0.885
0.783
0.693
Present value
(Alpha)
(600.00)
327.43
516.88
374.25
618.56
Present value
(Beta)
(1,980.00)
256.64
1,519.30
1,088.09
884.03
Profitability index
Project Alpha
Project Beta
NPV
Initial investment
618.56
600.00
884.03
1,980
Profitability index
(1 + NPV/ Initial investment)
2.03
1.45
Requirement 2:
Which project(s) should Greenplain accept, based on the profitability index rule?
Answer
Based on the profitability index, Green Plain Co. Should accept Project Alpha.
CHAPTER 7
PROBLEM NO. 11
Your firm is contemplating the purchase of a new 941,000 computer-based order entry
system. The system will be depreciated using reducing balance at 20 per cent per annum over
its five-year life. It will be worth 106,000 at the end of that time. You will save 376,000
before taxes per year in order processing costs, and you will be able to reduce working capital
by 141,000 (this is a one-time reduction).
Required:
If the tax rate is 28 per cent, what is the IRR for this project?
Particulars
Initial investment
Reduction in working capital
Saving before taxes
Tax on cash profits (28%)
Year 0
(941,000.00
)
141,000.00
Year 1
Year 2
376,000.00
Year 3
Year 4
376,000.00
376,000.00
376,000.00
(105,280.00
) (105,280.00) (105,280.00)
(105,280.00)
Year 5
376,000.00
(105,280.00)
52,696.00
42,156.80
33,725.44
26,980.35
21,584.28
106,000.00
56,657.13
(800,000.00
)
1.000
(800,000.00
)
467,153.36
PV @ 10%
NPV @ 10%
Discount factors @ 30%
1.000
(800,000.00
)
(743.50)
PV @ 10%
NPV @ 10%
W-1 Depreciation
schedule
323,416.00
Amount
Balance B/Fwd
Dep. (20% reducing bal.)
Dep. (20% reducing bal.)
Dep. (20% reducing bal.)
Dep. (20% reducing bal.)
Dep. (20% reducing bal.)
W-2 Gain/(Loss) on sale
Cost
Total depreciation for 05 years
Net book value
Sales proceeds
312,876.80
297,700.35
454,961.41
1.000
0.909
0.826
0.751
0.683
0.621
0.683
0.909
0.826
0.751
294,014.55
258,575.87
228,734.37
203,333.35
282,495.24
0.769
0.592
0.455
0.350
0.269
248,781.54
185,134.20
138,573.25
104,233.17
122,534.33
Tax saving @
28%
941,000.00
188,200.00
150,560.00
120,448.00
96,358.40
77,086.72
52,696.00
42,156.80
33,725.44
26,980.35
21,584.28
Year 1
Year 2
Year 3
Year 4
Year 5
941,000.00
632,653.12
308,346.88
106,000.00
Gain/(Loss) on sale
Tax saving - Loss on disposal
304,445.44
(202,346.88)
56,657.13
0.621
IRR Calculation
= 10% + [(467,153.36/ (467,153.36+ 743.50)] (30% - 20%)
= 29.97% (Rounded to 30% approx) answer
PROBLEM NO. 12
Dog Up! Franks is looking at a new sausage system with an installed cost of 632,000. This cost
will be depreciated straight-line to zero over the projects eight-year life, at the end of which the
sausage system can be scrapped for 54,000. The sausage system will save the firm 129,000 per
year in pre-tax operating costs, and the system requires an initial investment in net working capital
of 19,000.
Required:
If the tax rate is 34 per cent and the discount rate is 9 per cent, what is the NPV of this project?
Initial investment
Amount
Sausage system
(632,000.00)
6
Working capital
(19,000.00)
471,250.00
Salvage value
54,000 [(1+0.09) ^-8]
27,108.00
148,670.10
(9,216.72)
632,000.00
(632,000.00
0.00
54,000.00
54,000.00
18,360.00
PROBLEM NO. 13
Etonic SA is considering an investment of 260,000 in an asset with an economic life of five
years. The firm estimates that the nominal annual cash revenues and expenses at the end of
the first year will be 205,000 and 41,000, respectively. Both revenues and expenses will
grow thereafter at the annual inflation rate of 4 per cent. Etonic will use the 20 per cent
reducing-balance method to depreciate its asset over five years. The salvage value of the
asset is estimated to be 29,000 in nominal terms at that time. The one-time net working
capital investment of 12,000 is required immediately, and will be recovered at the end of the
project. All corporate cash flows are subject to a 26 per cent tax rate.
Required:
What is the projects total nominal cash flow from assets for each year?
Answer
Particulars
Initial investment
Working capital
Annual cash revenues
(Inflated @ 4%)
Year 0
(260,000.00
)
(12,000.00)
Year 1
Year 2
Year 3
Year 4
Year 5
205,000.00
213,200.00
221,728.00
230,597.12
239,821.00
(41,000.00
)
(42,640.00
)
(44,345.60
)
(46,119.42
)
(47,964.20
)
164,000.00
(42,640.00
)
170,560.00
(44,345.60
)
177,382.40
(46,119.42
)
184,477.70
(47,964.20
)
191,856.80
(49,882.77
)
12,000.00
29,000.00
13,520.00
10,816.00
8,652.80
6,922.24
5,537.79
(14,611.17
)
134,880.00
137,030.40
139,915.78
143,435.74
173,900.66
(272,000.00
)
Amount
Balance B/Fwd
260,000.00
52,000.00
Tax saving
@ 26%
13,520.00
Year of
cash flow
Year 1
Year 2
41,600.00
10,816.00
33,280.00
8,652.80
Year 3
26,624.00
6,922.24
Year 4
21,299.20
5,537.79
Year 5
260,000.00
(174,803.20)
85,196.80
29,000.00
(56,196.80)
- 14,611.17
CHAPTER 15
PROBLEM NO. 14
ABC AG and XYZ AG are identical firms in all respects except for their capital structure. ABC is
all equity financed with NKr 336,000 in equity shares. XYZ uses both shares and perpetual debt;
its equity is worth NKr 168,000 and the interest rate on its debt is 11 per cent. Both firms expect
EBIT to be NKr 82,000. Ignore taxes.
Requirement 1:
Knut owns NKr 28,000 worth of XYZs shares. What rate of return is he expecting?
Percentage equity held by Knut
(28,000/168,000)
16.67%
EBIT
82,000.00
(18,480.00
)
63,520.00
10,586.67
37.81 %
Requirement 2:
Calculate the total cash flow Knut could generate by investing in ABC for exactly the same
rate of return.
To get the same holding in ABC, Knut require 56,011.20 to invest i.e., (336,000 16.67%)
EBIT of ABC
Interest
82,000
NIL
Net income
82,000
Share of dividend
(56,011.20 37.81%)
Requirement 3:
(a)
What is the WACC for ABC?
The WACC for ABC will be same as its cost of equity i.e., 12.37% because it has no debt
(b
) What is the WACC for XYZ?
borrow at 13 per cent. Bruce currently has no debt, and its cost of equity is 23 per cent.
Assume the tax rate is 33 per cent.
Required:
EBIT
109,000
(35,970)
73,030
11
23%
Value of firm
(73,030 / 23%)
317,521.74
What will the value be if Bruce borrows 54,000 and uses the proceeds to repurchase
shares?
Answer
Value of firm without debt (Unlevered)
Add: Present value of tax shield on debt
(54,000 33%)
Revised value of firm
317,521.74
17,820.00_
335,341.74
PROBLEM NO. 16
Tool Manufacturing has an expected EBIT of 36,000 in perpetuity and a tax rate of 28 per
cent. The firm has 55,000 in outstanding debt at an interest rate of 9 per cent, and its
unlevered cost of capital is 10 per cent.
Required:
(a
) What is the value of the firm according to MM Proposition I with taxes?
Value of unlevered
EBIT
36,000
(10,080)
25,920
Cost of capital
10%____
12
259,200
15,400
274,600
(b Should Tool change its debtequity ratio if the goal is to maximize the
) value of the firm? Explain.
Answer
Current debt equity ratio is 25% [55,000 / (274,600 - 55000)]. To maximise the value of
firm the company may further change its debt equity ratio by increasing debt as long as the
present value of tax benefits arising on debt outweighs the present value of interest expense.
PROBLEM NO. 17
Alpha and Beta are identical in every way except their capital structures. Alpha NV, an allequity firm, has 4,300 shares of equity outstanding, currently worth 27 per share. Beta NV
uses leverage in its capital structure. The market value of Betas debt is 32,000, and its cost
of debt is 9 per cent. Each firm is expected to have earnings before interest of 54,000 in
perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 9 per cent per
year.
Requirement 1:
What is the value of Alpha NV?
Answer:
4,300 shares 27 per share = 116,100
Requirement 2:
What is the value of Beta NV?
Market value of debt
32,000
116,100
Value of Beta NV
148,100
13
Requirement 3:
What is the market value of Beta NVs equity?
(148,100 32,000) = 116,100
*Note: In the absence of taxes, value of levered firm will be equal to the market value of
unlevered equity plus market value of levered debt.
Requirement 4:
How much will it cost to purchase 14 per cent of each firms equity?
As market value of Alpha NV and Beta NV equity is same i.e., 116,100, it will cost 16,254
each (116,100 14%) to purchase the equity of both firms.
Requirement 5:
Assuming each firm meets its earnings estimates, what will be the euro return to each
position in requirement 4 over the next year?
EBIT
54,000
54,000
(2,880)
54,000
51,120
7,560
7,156.80
Construct an investment strategy in which an investor purchases 14 percent of Alphas equity and
replicates both the cost and euro return of purchasing 14 per cent of Betas equity.
Cost to purchase Alpha equity is 16,254 each and the euro return is Aplha is 7,560.
Therefore, the investor would borrow 6,192 (7,156.80 7,560) / (7.560/116,100) at the rate of 9% and
use the remaining amount to purchase Betas stock i,e., 10,062 (16,254 6,192)
14
The equity of Beta NV is comparatively more riskier than the equity of beta. This is because of
the presence of risk arising as a result of debt. Debt increases financial risk and equity stock
owners would, in turn, demand more risk premium to compensate for this risk. This reduces
overall cost of capital (WACC) and hence the companys worth (present value of future cash
flows) .
CHAPTER 10
PROBLEM NO. 18
You want to create a portfolio equally as risky as the market, and you have 1,500,000 to invest.
Asset
Investment ()
Equity A
285,000
0.87
Equity B
450,000
1.22
Equity C
439,406.25
1.6
Risk-free asset
325,593.75
Total
1,500,000
Required:
Calculate the Risk-free asset.
Answer
Stock A weight = (285,000 / 1,500,000) = 19%
Stock B weight = (450,000 / 1,500,000) = 30%
To make the portfolio as risky as market, the beta should be equal to 1.
Hence
p = 1.0 = (0.19 0.87) + (0.30 1.22) + C (1.6) + RF (0)
Solving for C,
15
1- 0.5313 = 1.6C
= 0.2929375
Therefore, investment in stock C,
0.39625 * 1,500,000 = 439,406.25
Risk free asset
1 = 0.19 + 0.30 + 0.2929375 + Risk free asset (RF)
RF = 0.2170625
Thus,
1,500,000 * 0.2170625
= 325,593.75
PROBLEM NO. 19
Consider the following information about I and II:
Probability
of state
State of
of
economy economy
Recession
.16
Normal
.70
Irrational
.14
exuberance
Rate of return if
state occurs
I
.07
.36
II
-.23
.15
.25
.43
The market risk premium is 10 per cent, and the risk-free rate is 4 per cent.
Required:
16
(a
) Compute the I and standard deviation of security I?
Using CAPM to find I
E (RI) = .16(.07) + .70(.36) + .14(.25) = .2982 or 29.82%
Therefore, I
0.2982 = 0.04 risk free rate + 0.10 I
I = 2.582
Standard deviation
I 2= 0.16 (.07 .2982)2 + 0.70 (.36 .2982)2 + 0.14(.25 .2982)2
= 0.008332 + 0.002673 + 0.000325
I2 = 0.01133
Standard deviation = (Under root of variance) = 10.64%
(b)Compute the II and standard deviation of security II?
Using CAPM to find I
E (RI) = .16(-0.23) + .70(.15) + .14(.43) = .1284 or 12.84%
Therefore, I
0.1284 = 0.04 risk free rate + 0.10 I
I = 0.884
Standard deviation
I 2= 0.16 (-0.23 .1284)2 + 0.70 (.15 .1284)2 + 0.14(.43 .1284)2
= 0.020552 + 0.000327 + 0.012734
I2 = 0.033613
Standard deviation = (Under root of variance) = 18.33%
17