Chapter 4

Question 5: Estimating stock value

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Select the red highlighted items below for tips and suggestions to complete this problem.

Assumptions
Dividend growth rate 5%
Capitalization Rate 15%

Expected Future Values Present Values

Horizon Cumulative Future
Period Dividend Price Dividends Price Total
0 $100.00 $100
1 10.00 0.00 100.00 100
2 0.00 100.00 100
3 0.00 100.00 100
4 0.00 100.00 100
10 162.89 100.00 100
20 265.33 100.00 100
50 1,146.74 100.00 100
100 13,150.13 100.00 100

Copyright © 2005 McGraw-Hill/Irwin

 Principles of Corporate Finance

Question 4-6
Calculate growth rates and expected rates of return

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In March 2001, Fly Paper's stock sold for about $73. Security analysts were forecasting a long-term
earnings growth rate of 8.5 percent. The company was paying dividends of $1.68 per share.
(a) Assume dividends are expected to grow along with earnings at 8.5% per year in perpetuity. What rate
of return were investors expecting?
(b) Fly Paper was expected to earn about 12 percent on book equity and to pay out about 50 percent of
earnings as dividends. What do these forecasts imply for g? For r? Use the perpetual-growth DCF formula.

Solution
Question 4-6
Instructions
Enter formulas to solve this problem. Please work with the perpetual-growth DCF formula.
(a) Assume dividends are expected to grow along with earnings at 8.5% per year in perpetuity. What rate
of return were investors expecting?

Assumptions
Price $73
Dividend $1.68
Growth rate 8.50%

Rate of return (r) FORMULA

(b) Fly Paper was expected to earn about 12 percent on book equity and to pay out about 50 percent of
earnings as dividends. What do these forecasts imply for g? For r? Use the perpetual-growth DCF formula.

Assumptions
Return on equity 12%
Plowback ratio 50%

Growth rate (g) FORMULA

Rate of return (r) FORMULA

Copyright © 2003 McGraw-Hill/Irwin and KMT Software, Inc. FAST Workbooks by Brealey and Myers Problem: 4-5
 Principles of Corporate Finance

Question 4-7
Estimating stock value

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Consider the following three stocks:

(a) Stock A is expected to provide a dividend of $10 a share forever.
(b) Stock B is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 4 percent
a year forever.
(c) Stock C is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 20
percent a year for 5 years (I.e., until year 6) and zero thereafter.
If the market capitalization rate for each stock is 10 percent, which stock is the most valuable? What if the
capitalization rate is 7 percent?

Solution
Question 4-7
Instructions
Enter formulas to estimate the value of the stock under the three scenarios (parts (a) through (c).

(a) Stock A is expected to provide a dividend of $10 a share forever.

Capitalization rate 10% 7%

Stock value FORMULA FORMULA

(b) Stock B is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 4 percent
a year forever.

Capitalization rate 10% 7%

Stock value FORMULA FORMULA

(c) Stock C is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 20
percent a year for 5 years (I.e., until year 6) and zero thereafter.

Expected
Years Dividend
1 $5.00
2 $6.00
3 $7.20
4 $8.64
5 $10.37
6 $12.44

Capitalization rate 10% 7%

Stock value FORMULA FORMULA

If the market capitalization rate for each stock is 10 percent, which stock is the most valuable? What if the
capitalization rate is 7 percent?

Copyright © 2003 McGraw-Hill/Irwin and KMT Software, Inc. FAST Workbooks by Brealey and Myers Problem: 4-7
 Principles of Corporate Finance

Question 5-4
Calculate the NPV and IRR of two mutually exclusive projects

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Consider the following two mutually exclusive projects:

CASH FLOWS ($)

Project C0 C1 C2 C3
A -100 60 60 0
B -100 0 0 140

(a) Calculate the NPV of each project for discount rates of 0, 10, and 20 percent.
(b) What is the IRR for each project
(c) In what circumstances should the company accept project A?
(d) Calculate the NPV of the incremental investment (B-A) for discount rates of 0, 10, and 20 percent.

Solution
Question 5-4
Instructions
Use the Excel NPV and IRR functions to solve this problem.
(a) Calculate the NPV of each project for discount rates of 0, 10, and 20 percent.

Net Present Values RATES

Project 0% 10% 20%
A FORMULA FORMULA FORMULA
B FORMULA FORMULA FORMULA

(b) What is the IRR for each project

Project IRR
A FORMULA
B FORMULA

(c) In what circumstances should the company accept project A?

(d) Calculate the NPV of the incremental investment (B-A) for discount rates of 0, 10, and 20 percent.

CASH FLOWS ($)

(B-A) C0 C1 C2 C3
FORMULA FORMULA FORMULA FORMULA
Net Present Values RATES
Project (B-A) 0% 10% 20%
NPV FORMULA FORMULA FORMULA

Copyright © 2003 McGraw-Hill/Irwin and KMT Software, Inc. FAST Workbooks by Brealey and Myers Problem: 5-7
 Principles of Corporate Finance

Question 5-8
Prioritize capital budget projects

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Borghia Pharmaceuticals has 1 million allocated for capital expenditures. Which of the following projects
should the company accept to stay within the 1 million budget? How much does the budget limit cost the
company in terms of market value? The opportunity cost of capital for each project is 11 percent.

Investment NPV
Project (Thousands) (Thousands) IRR (%)
1 200 66 17.2
2 200 -4 10.7
3 250 43 16.6
4 100 14 12.1
5 100 7 11.8
6 350 63 18
7 400 48 13.5

Solution
Question 5-8
Instructions
Calculate the profitability index for each of the projects. Then enter the investment amount for each project you
want to undertake, keeping in mind the 1 million capital budget.

Profitability
Project Index Investment
1 FORMULA FORMULA
2 FORMULA
3 FORMULA FORMULA
4 FORMULA FORMULA
5 FORMULA FORMULA
6 FORMULA FORMULA
7 FORMULA
Total $0

How much does the budget limit cost the company in terms of market value?

Total of positive NPVs FORMULA

Less total of NPVs from accepted projects FORMULA
Difference in NPVs #VALUE!

Copyright © 2003 McGraw-Hill/Irwin and KMT Software, Inc. FAST Workbooks by Brealey and Myers Problem: 5-13
 Principles of Corporate Finance

Question 6-4
Determine the value of a tax shield

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Mrs. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for
$400,000. Of this sum, $50,000 is described by the supplier as an installation cost. Mrs. Potts does not
know whether the Internal Revenue Service (IRS) will permit the company to treat this cost as a tax-
deductible current expense or as a capital investment. In the latter case, the company could depreciate the
$50,000 using the 5-year MACRS tax depreciation schedule. The tax rate is 35 percent and the opportunity
cost of capital is 5 percent. How will the IRS's decision affect the after-tax cost of the kiln?

Solution
Question 6-4
Instructions
Use the assumptions below and the MACRS percentages to develop a solution to this question.
Assumptions
Installation cost $50,000
Tax rate 35%
Opportunity cost 5%

MACRS percentages Annual Tax

Years Percentages Depreciation Shield
1 20% FORMULA FORMULA
2 32% FORMULA FORMULA
3 19.2% FORMULA FORMULA
4 11.52% FORMULA FORMULA
5 11.52% FORMULA FORMULA
6 5.76% FORMULA FORMULA

Value of tax shield if:

Installations costs expensed year 1 FORMULA

Value of tax shield if:

Capitalized and depreciated FORMULA

Copyright © 2003 McGraw-Hill/Irwin and KMT Software, Inc. FAST Workbooks by Brealey and Myers Problem: 6-6
 Principles of Corporate Finance

Question 6-5
Analyze capital projects under different tax scenarios

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A project requires an initial investment of $100,000 and is expected to produce a cash inflow before
tax of $26,000 per year for five years. Company A has substantial accumulated tax losses and is
unlikely to pay taxes in the foreseeable future. Company B pays corporate taxes at a rate of 35 percent and
can depreciate the investment for tax purposes using the five-year tax depreciation schedule.
Suppose the opportunity cost of capital is 8 percent. Ignore inflation.
(a) Calculate project NPV for each company.
(b) What is the IRR of the after-tax cash flows for each company? What does comparison of the
IRRs suggest is the effective corporate tax rate?

Solution
Question 6-5
Instructions
Use the following assumptions to solve this problem. Use the MS Excel NPV and IRR functions and
enter your own formulas to solve for the unknowns.
Assumptions
Projected cash flows:
Initial investment ($100,000)
Year 1 $26,000
Year 2 $26,000
Year 3 $26,000
Year 4 $26,000
Year 5 $26,000
Company B tax rate 35%

Opportunity cost 8%

Depreciation schedule:
Year 1 20%
Year 2 32%
Year 3 19.20%
Year 4 11.52%
Year 5 11.52%
Year 6 5.76%

(a) Calculate project NPV for each company.

Company A NPV FORMULA

Company B NPV:
Projected cash flows Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Cash in
Depreciation ($20,000) ($32,000) ($19,200) ($11,520) ($11,520) ($5,760)
Taxable income ($20,000) ($32,000) ($19,200) ($11,520) ($11,520) ($5,760)
Tax ($7,000) ($11,200) ($6,720) ($4,032) ($4,032) ($2,016)
Net income ($13,000) ($20,800) ($12,480) ($7,488) ($7,488) ($3,744)
Cash flow FORMULA FORMULA FORMULA FORMULA FORMULA FORMULA

Company B NPV ($100,000.00)

(b) What is the IRR of the after-tax cash flows for each company? What does comparison of the
IRRs suggest is the effective corporate tax rate?

IRR for A FORMULA

IRR for B FORMULA

Effective tax rate 0.0%

Copyright © 2003 McGraw-Hill/Irwin and KMT Software, Inc. FAST Workbooks by Brealey and Myers Problem: 6-7
 Principles of Corporate Finance

Question 6-14
Evaluate alternative capital asset decisions

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Hayden Inc. has a number of copiers that were bought four years ago for $20,000. Currently maintenance
costs $2,000 a year, but the maintenance agreement expires at the end of two years and thereafter the
annual maintenance charge will rise to $8,000. The machines have a current resale value of $8,000, but at
the end of year 2 their value will have fallen to $3,500. By the end of year 6 the machines will be valueless
and would be scrapped.
Hayden is considering replacing the copiers with new machines that would do essentially the same job. These
machines cost $25,000, and the company can take out an eight-year maintenance contract for $1,000 a year.
The machines have no value by the end of the eight years and would be scrapped.
Both machines are depreciated by using seven-year MACRS and the tax rate is 35 percent. Assume for simplicity
that the inflation rate is zero. The real cost of capital is 7 percent.
When should Hayden replace its copiers?

Solution
Question 6-14
Instructions
Use the assumptions below to meet the requirements of this question. The net cash flows for each copier
have been calculated for you and are shown below. Parts A through D below have been structured to
help you develop the solution.
Assumptions
Current Copier Net Cash Flows: New Copier Projected Net Cash Flows
Net * Net *
Years Cash Flow Years Cash Flow
1 -675 0 -25,000
2 -675 1 600
3 -4,575 2 1,493
4 -4,889 3 880
5 -5,200 4 443
6 -5,200 5 131
6 131
7 131
* After taxes 8 -261
Cost of capital 7%
Income tax rate 35%
A. What is the present value of each copier?
Present value of current copier FORMULA
Equivalent annual cost #VALUE!
Present value of new copier FORMULA
B. If you replace the current copier now, what will be the present value of the decision?
Assumptions
Book value $6,248
Resale value $8,000
Present value FORMULA
Equivalent annual cost #VALUE!
C. If your replace the copier in 2 years, what will be the present value of the decision?
Assumptions
Book value $2,676
Resale value $3,500
Present value FORMULA
Equivalent annual cost #VALUE!
D. If you replace the copier in 6 years, what will be the present value of the decision? Assume a zero book and
resale value.
Present value FORMULA
Equivalent annual cost FORMULA

When should the copier be replaced?

Copyright © 2003 McGraw-Hill/Irwin and KMT Software, Inc. FAST Workbooks by Brealey and Myers Problem: 6-15