For Chapter 8, Know how to do this question.

8-24     LG 4, 5, 6:  Integrative–Determining Relevant Cash Flows

Company replacing grinder.  Existing grinder purchased 2 years ago for $60,000, depreciated using 5 year MACRS.  Existing grinder has usable life of 5 more years. 

            New grinder costs $105,000, $5,000 installation cost.  5yr usable life, MACRS depreciation.

            Existing grinder can be sold for $70,000.

            If buy new grinder, working capital increases by $12,000.

            At end of 5 years, existing grinder worth 0, new grinder could be sold for $29,000.

            Firm in 40% tax bracket.

Profits before depreciation and taxes

Year     New     Existing Grinder

1          43,000             26,000

2          43,000             24,000

3          43,000             22,000

4          43,000             20,000

5          43,000             18,000

 

Questions

A.  Calculate initial investment if replace grinder.

B.  Determine incremental cash flows from replacing grinder.

C.  Determine terminal cash flow at end of year 5 if replacing grinder.

D.  Show all cash flows on a time line.

 

 

For Chapter 9, know the following:

Use the following for the next 6 questions.

Required Rate of Return is 7%.

Year     Expected After Tax Net Cash Flow

0                      (800)

1                      100

2                      200

3                      300

4                      100

5                      200

6                      300

 

1.  What is the payback?

2.  What is the discounted payback?

3.  What is the NPV?

4.  What is the IRR?

5.  What is the Modified IRR?

6.  What is the Profitability Ratio?

 

Also note, accept project if NPV>0, IRR>cost of capital, Profitability ratio > 1.  Modified IRR > cost of capital.  IRR assumes reinvestment occurs at projects rate of return, NPV and Modified IRR assume reinvestment occurs at firm’s cost of capital.

 

Chapter 11

For chapter 11, know how to do this question.

Firm is in 40% tax bracket.

Debt:  Firm can raise unlimited amount of debt by selling $1000 par value 8% annual coupon 20 year bonds.  To sell, $30 discount per bond will be given and firm must pay flotation costs of $30 per bond.

 

Preferred stock:            Firm can sell 8% preferred stock at $95 per share.  Cost of issuing stock is $5 per share.

 

Common Stock:  Common stock is currently selling at $90 per share.  Firm will pay $7 dividend per share next year.  Dividends have been growing at 6% and is expected to continue.  Stock must be underpriced by $7 to sell and flotation costs will be $5 per share.

 

Retained Earnings:  Will have $100,000 available in the next year.  When these earnings are exhausted, new common stock will be issued as the form of common stock equity financing.

 

A.  Calculated specific cost of each source of financing.

B.  Assume capital weights are 30% debt, 20% preferred stock, 50% equity.

            (1)  Calculate single break point associated with firms financial situation.(This occurs when retained earnings are used up.)

            (2)   Calculate weighted average cost of capital below break point calculated above.

            (3)  Calculate weighted average cost of capital above break point calculated above.

 

Chapter 8 answers

8-24     LG 4, 5, 6:  Integrative–Determining Relevant Cash Flows

 

a.         Initial investment:

Installed cost of new asset                        =

Cost of new asset                                          $105,000

+    Installation costs                                                  5,000

Total cost of new asset                                                          $110,000

 

-     After-tax proceeds from sale of old asset       =

Proceeds from sale of old asset                         (70,000)

+    Tax on sale of old asset*                                    16,480

Total proceeds from sale of old asset                                        (53,520)

+    Change in working capital                                                                     12,000

Initial investment                                                                                  $68,480

 

*     Book value of old asset:

[1 - (.20 + .32)] x $60,000                         =   $28,800

 

$70,000 - $28,800    =    $41,200 gain on sale of asset

 

$31,200 recaptured depreciation x .40        =    $12,480

$10,000 capital gain x .40                           =       4,000

Total tax of sale of asset                              =    $16,480

 

 

 

 

 

 

 

 

 

 

b.

                                 Calculation of Operating Cash Inflows                                   

Profits Before                                                                                      Operating

Depreciation     Depre-      Net Profits                           Net Profits         Cash

Year                 and Taxes      ciation     Before Taxes        Taxes        After Taxes      Inflows

New Grinder

1      $43,000        $22,000        $21,000            $ 8,400        $12,600       $34,600

2        43,000          35,200            7,800               3,120            4,680         39,880

3        43,000          20,900          22,100               8,840          13,260         34,160

4        43,000          13,200          29,800             11,920          17,880         31,080

5        43,000          13,200          29,800             11,920          17,880         31,080

6             --0-            5,500           -5,500              -2,200           -3,300           2,200

 

Existing Grinder

1      $26,000        $11,400        $14,600             $5,840         $ 8,760       $20,160

2        24,000            7,200          16,800               6,720          10,080         17,280

3        22,000            7,200          14,800               5,920            8,880         16,080

4        20,000            3,000          17,000               6,800          10,200         13,200

5        18,000                -0-          18,000               7,200          10,800         10,800

6              -0-                -0-                -0-                   -0-                -0-               -0-

 

                              Calculation of Incremental Cash Inflows                                   

                                                                                                           Incremental Operating

Year                             New Grinder                Existing Grinder                  Cash Flow             

1                     $34,600                          $20,160                          $14,440

2                       39,880                            17,280                            22,600

3                       34,160                            16,080                            18,080

4                       31,080                            13,200                            17,880

5                       31,080                            10,800                            20,280

6                         2,200                                  -0-                              2,200

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

c.         Terminal Cash Flow:

After-tax proceeds from sale of new asset                        =

Proceeds from sale of new asset                               $29,000

-     Tax on sale of new asset*                                           ( 9,400)

Total proceeds from sale of new asset                                       19,600

-     After-tax proceeds from sale of old asset       =

Proceeds from sale of old asset                                            0

+    Tax on sale of old asset                                                        0

Total proceeds from sale of old asset                                                  0

+    Change in net working capital                                                                 12,000

Terminal cash flow                                                                                     $31,600

 

*     Book value of asset at end of year 5      =    $ 5,500

$29,000 - $5,500                                 =   $23,500   recaptured depreciation

$23,500 x .40                                      =    $ 9,400

 

d.         Year 5 Relevant Cash Flow:

Operating cash flow                             $20,280

Terminal cash flow               31,600

Total inflow                       $51,880

 

            0                1                      2                   3                   4                   5                   6

 


 

      -68,480         14,400            22,600            18,080          17,880         51,880          2,200

 

 

 

Chapter 9 answers

1.  4.5

2.  5.34 Discounted cash flows are 93.45, 174.68, 244.89, 76.28, 142.59, 199.90

3.  131.82

4.  11.65

5.  9.75               PV = -800, N = 6, FV = 1,398.41, PMT = 0, solve for I/Y.  Remember, find fv of all cash flows for end of year 6.  FV = 100(1.07)^5 + 200(1.07)^4 + 300(1.07)^3 + 100(1.07)^2 + 200(1.07) + 300

6.  1.1648 

 

Chapter 11 answers

 

11-16   LG 2, 3, 4, 5:  Calculation of Specific Costs, WACC, and WMCC

 

a.         Debt:  (approximate)

 

Plug numbers in your calculator

            kd = 8.64%

ki   =    kd  x (1 - t)

ki   =    8.64% x (1 - .40)

ki   =    5.1%

 

Preferred Stock:

 

Kp = D/N = 7.60/90 = 8.44%

 

 

Common Stock:

 

kn = Dj/Nn + g

ks = 7/78 + .06 = .1497 or 14.97%

 

 

Retained Earnings:

Kr = D1/P0 + g

= 7/90 + .06 = 13.78%

 

 

b.         Breaking point     =  AFj/Wi     

 

(1)     BP common equity = 100,000/.5 = 200,000

 

 

Target Capital                        Cost of                    Weighted

Type of Capital          Structure %                  Capital Source                    Cost    

(2)     WACC equal to or below $200,000 BP:

Long-term debt               .30                                5.1%                            1.53%

Preferred stock                .20                                8.4%                            1.68%

Common stock equity      .50                              13.8%                            6.90%

                                                                                                WACC            =         10.11%

 

(3)     WACC above $200,000 BP:

Long-term debt               .30                                5.1%                            1.53%

Preferred stock                .20                                8.4%                            1.68%

Common stock equity      .50                              15.0%                            7.50%

                                                                                                WACC            =         10.71%