ACF 103 2014 Revision Qns and Solns

Chapter 3
1. What is the total present value of the following series of cash flows, discounted at 10%?
End of year Cash flow
1 $1,000
2 1,000
3 -2,000
4 3,000
Answer:
PV = $1,000(PVIFA10%,2) + (-$2,000)(PVIF10%,3)+$3,000(PVIF1%,4)
= $1,000(1.736) - $2,000(0.751) + $3,000(0.683)
= $1,736 - $1,502 + $2,049 = $2,283

3. At your brother's 20th birthday party, he asks you how much he would have to deposit at the
end of every quarter to finance a $8,500 motorcycle on his 25th birthday. He plans to put the
money in a 12% savings account that compounds interest quarterly.
Answer:
The future value interest factor of an ordinary annuity of $1 per month for 20 quarters (five
years) at 3% per quarter (12% per year) is 26.870.

Then $8,500/26.870 = $316.34 must be deposited at the end of each quarter.

4. Text book Ch 3 question # 9 (p.66)

Answer:
Year Amount PV Factor at 14% Present Value
1 $1,200 0.877 $1,052.40
2 2,000 0.769 1,538.00
3 2,400 0.675 1,620.00
4 1,900 0.592 1,124.80
5 1,600 0.519 830.40
Subtotal (a) ................................. $6,165.60
1–10 (annuity)* 1,400 5.216 $7,302.40
1–5 (annuity)* 1,400 3.433 –4,806.20
Subtotal (b) ................................. $2,496.20
Total Present Value (a + b) ................................. $8,661.80

Alternatively, to get sub-total (b):

5-10 (annuity) 1,400 (5.216 – 3.433) 2,496.20

6. Text book Ch 3 question # 13 (p.67)

Answer:
$190,000 = PMT (PVIFA17%, 20) = PMT(5.628)

PMT = $190,000/5.628 = $33,760

7. It is January 1 and you have made a New Year's resolution to invest $5,000 in a savings
account at the end of every year for the next 30 years. If your money is compounded at an
average annual rate of 9%, how much will you have accumulated at the end of 30 years?
Answer:
FVA30 = PMT(FVIFA9%,30),
FVA30 = $5,000(136.308) = $681,540
8. Congratulations! You have just won first prize in a raffle and must choose between $50,000
in cash today or an annuity of $12,000 a year for five years. (The annuity payments would
come to you at the end of each year.) Which of these two choices is worth more, assuming a
7% discount rate? Show your calculations.
Answer:
PVA5 = PMT(PVIFA7%,5),
($12,000)(4.100) = $49,200
The annuity is worth less than the $50,000 in cash today.

Chapter 4
1. Delphi Products Corporation currently pays a dividend of $2.50 per share, and this dividend
is expected to grow at a 12% annual rate for three years, and then at an 8% p.a. rate forever.
What value would you place on the stock if an 18% rate of return was required?

Phases 1 and 2: Present Value of Dividends to Be Received Over First 6 Years

End of Present Value Calculation Present Value

Year (Dividend × PVIF18%,t) of Dividend
1 $2.50 (1.12)1 = $2.80 × 0.847 = $ 2.37
2
2 2.50 (1.12) = 3.14 × 0.718 = 2.25
3 2.50 (1.12)3 = 3.51 × 0.609 = 2.14
6.76

Phase 3: Present Value of Constant Growth Component

Dividend at the end of year 4 = $3.51(1.08) = $3.79

Value of stock at the end of year 3 = D4/(ke + g) = $ 3.79/(0.18 – 0.08) = $37.90

Present value of $37.90 at end of year 3= ($37.90) (PVIF18%,3)

= ($37.90)(0.609) = $23.08

Present Value of Stock

V = $6.76 + $23.08 = $29.84

2. The 9-percent-coupon-rate bonds of the Melbourne Mining Company have exactly

15 years remaining to maturity. The current market value of one of these $1,000-parvalue
bonds is $700. Interest is paid semiannually. Melanie Gibson places a nominal
annual required rate of return of l4 percent on these bonds. What dollar intrinsic value
should Melanie place on one of these bonds (assuming semiannual discounting)?

V = (I/2)(PVIFA7%, 30) + $1,000(PVIF7%, 30)

= $45(12.409) + $1,000(0.131)
= $558.41 + $131 = $689.41

Chapter 5
1. Salt Lake City Services, Inc., provides maintenance services for commercial buildings.
Currently, the beta on its common stock is 1.08. The risk-free rate is now l0%, and
the expected return on the market portfolio is 15%. It is January l, and the company
is expected to pay a $2 per share dividend at the end of the year, and the dividend is
expected to grow at a compound annual rate of l1% for many years to come. Based
 on the CAPM and other assumptions you might make, what dollar value would you place
on one share of this common stock?

Required return = Rf + (Rm - Rf)β

= 0.10 + (0.15 – 0.10)(1.08)
= 0.10 + .054 = 0.154 or 15.4%

Assuming that the dividend growth model is appropriate, we get

V = D1/(ke – g) = $2/(0.154 –0.11) = $2/0.044 = $45.45

2. Sorbond Industries has a beta of 1.45. The risk-free rate is 8% and the expected
return on the market portfolio is 13%. The company currently pays a dividend of
$2 a share, and investors expect it to experience a growth in dividends of l0% per annum for
many years to come'
a. What is the stock's required rate of return according to the CAPM?
b. What is the stock's present market price per share, assuming this required return?

a.Required return = Rf + (Rm – Rf)β

= 0.08 + (0.13 – 0.08)1.45
= 15.25%

b. Using the dividend growth model, we would have

P0 = D1/(ke – g)
= 2(1.10)/(0.1525 – 0.10)
= $41.90

Chapters 8-11, Gitman Chs 14-5

1. Hobbit Enterprises expects credit sales of $400 million next year. If the firm can invest
funds at the rate of 10% a year, what is the value of collecting accounts payable three days
earlier (use a 365-day year)?

Answer: Sales per day = $400,000,000/365 = $1,095,890

Benefit = ($1,095,890)(0.10)(3) = $328,767

2. Chou Dou Fu receives an average of $600,000 a day in payments from its franchisees
through the mail. The average time it takes to have funds available at its bank is eight days
from the postmark date. The firm has asked you to evaluate the following three alternatives.
Which offers the greatest financial benefit to Chou Dou Fu? (Assume that the firm can earn
10% annually on its marketable securities investments.)

a. Bank Shanghai offers concentration banking that will reduce the time to have funds
available from eight to five days. Bank Shanghai charges a fee of $105,000 annually to set
up and administer the system.
b. Kaifeng Bank offers a system that will reduce the time to available funds to four days.
Kaifeng Bank requires a $1,500,000 compensating balance in order to administer the
system.
c. Bank of Henan offers to set up an Electronic Funds Transfer system that will reduce the
time to available funds to two days. Bank of Henan charges an annual fee of $300,000 for
this service.

Answer:
a. Bank Shanghai
Cash Available = Time Saved x Collections per Day
= 3 days x $600,000 = $1,800,000
Financial Benefit = Reduction in Cash x Opportunity Cost
= $1,800,000 x 0.10 = $180,000 benefit
Gain on change = $180,000 - 105,000 = $75,000 net gain

b. Kaifeng Bank
Additional Cash = Time Saved x Collections per Day
= 4 days x $600,000 = $2,400,000
Cash Available = $2,400,000 - $1,500,000 Compensating Balance
= $900,000
Financial Benefit = Reduction in Cash x Opportunity Cost
= $900,000 x 0.10 = $90,000 benefit
Gain on change = $90,000 net gain

c. Bank of Henan
Cash Available = Time Saved x Collections per Day
= 6 days x $600,000 = $3,600,000
Financial Benefit = Reduction in Cash x Opportunity Cost
= $3,600,000 x 0.10 = $360,000 benefit
Loss on change = $360,000 - 300,000 = $60,000 gain

Choose b, the system offered by Kaifeng Bank.

3. Indo Processing Corp uses 20,000 gallons of solvent a year. The cost of carrying the
solvents is $1.62 a gallon per year, while the cost per order is $200. What would the
average inventory level if Indio wished to maintain a 400 gallon safety stock?

EOQ = √2(O)(S)/C = √2(200)(20,000)/1.62 = 2,222

Ave inventory = 2,222/2 + 400 = 1,511

4. Alexis Limited uses 1,200 units of a product per year on a continuous basis. The product has
a fixed cost of $70 per order and its carrying cost is $3 per unit per year. It takes five days to
receive a shipment after an order is placed, and the firm wishes to hold in inventory 10 days’
usage as a safety stock.
a. Calculate the EOQ.
b. Determine the average level of inventory.
c. Determine the reorder point.

Answer:
EOQ, reorder point and safety stock
a. EOQ = √(2SO)/C
= √(2 x 1,200 x 70)/3
= 236.6
= 237 units

b. Daily usage = Yearly usage / Days in operation = 1,200 / 365 = 3.29

Average level of inventory = Minimum inventory +
= 3.29 × 10 + 237/2 = 151.4 units
c. Reorder point = (Lead time + Safety stock) in days × Daily usage
 = (5 + 10) × 3.29 = 49.35 units = 50 units

Chapter 13
1. Your firm is considering two mutually exclusive projects, P and Q, that would each require
an initial cash outflow of $10,000. They would generate the following incremental, after-tax,
operating cash flows:

Project P Project Q
Year 1 $5,000 $3,000
Year 2 4,000 4,000
Year 3 3,000 6,000

If the firm's required rate of return is 12%, which would you select?

Project P CF PVIF12%,3 PV Project Q CF PVIF12%,3 PV

Year ) -$10,000 1.0000 -$10,000 -$10,000 1.0000 -$10,000
Year 1 $5,000 0.893 4,465 $3,000 0.893 2,679
Year 2 4,000 0.797 3,188 4,000 0.797 3,188
Year 3 3,000 0.712 2,136 6,000 0.712 4,272
Net Present Value -211 139
Select Project Q

2. A firm is considering two mutually exclusive investment alternatives, both of which cost
$5,000. The firm's hurdle rate is 12%. The after-tax cash flows associated with each
investment are:

Year Investment A Investment B

1 $2,000 $1,000
2 1,500 1,500
3 1,500 2,000
4 1,000 3,000
For each alternative, calculate the payback period, the net present value, and the profitability
index. Which alternative (if any) should be selected?
Answer:
Alternative A:
Payback: $2,000 + $1,500 + $1,500 = $5,000 (3 years)

NPV at 12% = ($2,000)(0.893) + ($1,500)(0.797) + ($1,500)(0.712) + ($1,000)(0.636) -

$5,000 = -$314.50

PI = (1,786 + 1,196 + 1,068 + 636)/5,000 = 0.94

Alternative B:
Payback: $1,000 + $1,500 + $2,000 + $500 = $5,000
(3 + 500/3000 = 3.167 years)

NPV at 12 percent = ($1,000)(0.893) + ($1,500)(0.797)

+ ($2,000)(0.712) + ($3,000)(0.636) - $5,000 = $420.50

PI = (893 + 1,196 + 1,424 + 1,908)/5,000 = 1.08

Option B is the BEST alternative as it INCREASES shareholder wealth.

3. The Capital City Company (CCC) is considering the purchase of a new laundromat to
replace the one currently being used. The present machine is expected to last another seven
years and have no salvage value. The laundromat in current use has a book value of $700
and can be sold today for $400. CCC pays $300 a year maintenance on the press. The new
laundromat will cost $1,500. It is expected to last seven years, at which time it will be sold
for $100. The maintenance cost of the new machine is expected to be $150 a year. CCC
depreciates its assets on the straight-line basis and pays 30% taxes. If its opportunity cost of
funds is 10%, should it buy the new machine?
Answer:
Initial cost $1,500
less sale of old machine -400
loss on sale 700 – 400 = 300
tax recovered 300 x 0.30 = + 90
$1,190

Annual savings after tax = ($300 - $150)(0.70)

= $105

Change in depreciation = ($1,500 - $100)/7 - $700/7 = $100 per yr

Tax saving on depr. change = ($100)(0.30)
= $30

NPV at 10% = ($105 + $30)(4.868) + ($100)(0.513) - $1,190 = -$481.52

Since the NPV is negative, we would REJECT this project at this time.

4. A firm is considering the following projects, all of which are independent of one another.
Available funds are limited to $2 million in this capital budgeting period, but future periods
will have no capital budget constraints.
Present Value of
Project Initial Outlay Cash Inflows
1 $1,300,000 $1,200,000
2 1,000,000 1,250,000
3 800,000 900,000
4 600,000 700,000
5 500,000 550,000
6 400,000 470,000
7 300,000 280,000
8 100,000 105,000

Which projects should be accepted without exceeding the budget?

Answer:
Project Profitability Index Cumulative Investment
2 1,250,000/1,000,000 = 1.25 $1,000,000
6 470,000/400,000 = 1.18 1,400,000
4 700,000/600,000 = 1.17 2,000,000
3 900,000/800,000 = 1.13 2,800,000
5 550,000/500,000 = 1.10 3,300,000
8 105,000/100,000 = 1.05 3,400,000
7 280,000/300,000 = 0.93 Reject
1 1,200,000/1,300,000 = 0.92 Reject
 Projects 2, 6, and 4 should be accepted; they exhaust the budget.

5. Text book Ch 13 #9 p.348. See also Ch 12 #3 p.320

Period8%PVIF Rockbuilt PV Bulldog PV Savings PV

0 1.000 $(74,000) (74,000) $ (59,000) (59,000) $(15,000) (15,000)
1 .926 (2,000) (1,852) (3,000) (2,778) 1,000 926
2 .857 (2,000) (1,714) (4,500) (3,857) 2,500 2,142
3 .794 (2,000) (1,588) (6,000) (4,764) 4,000 3,176
4 .735 (2,000) (1,470) (22,500) (16,538) 20,500 15,068
5 .681 (13,000) (8,853) (9,000) (6,129) (4,000) (2,724)
6 .630 (4,000) (2,520) (10,500) (6,615) 6,500 4,095
7 .583 (4,000) (2,332) (12,000) (6,996) 8,000 4,664
8 .540 5,000* 2,700 (8,500)** (4,590) 13,500 7,290
PV of cash flows at 8% $(91,629) $(111,267) $ 19,637
* $4,000 maintenance cost plus salvage value of $9,000.
** $13,500 maintenance cost plus salvage value of $5,000.
The Rockbuilt bid should be accepted as the lower maintenance and rebuilding expenses
more than offset its higher cost.
b.
Amount of cash outflow:

Period15%PVIFRockbuilt PV Bulldog PV Savings PV

0 1.000 $(74,000) (74,000) $ (59,000) (59,000) $(15,000) (15,000)
1 .870 (2,000) (1,740) (3,000) (2,610) 1,000 870
2 .756 (2,000) (1,512) (4,500) (3,402) 2,500 1,890
3 .658 (2,000) (1,316) (6,000) (3,948) 4,000 2,632
4 .572 (2,000) (1,144) (22,500) (12,870) 20,500 11,726
5 .497 (13,000) (6,461) (9,000) (4,473) (4,000) (1,988)
6 .432 (4,000) (1,728) (10,500) (4,536) 6,500 2,808
7 .376 (4,000) (1,504) (12,000) (4,512) 8,000 3,008
8 .327 5,000* 1,635 (8,500)** (2,780) 13,500 4,415
Present value of
cash flows at 15% $(87,770) $(98,131) $ 10,361
* $4,000 maintenance cost plus salvage value of $9,000.
** $13,500 maintenance cost plus salvage value of $5,000.

No. With a higher discount rate, more distant cash outflows become less important relative
to the initial outlay. But, the lower maintenance and rebuilding expenses related to the
Rockbuilt bid continue to be more than its higher cost.

Chapter 15
1. Text book Ch 15 #5 p.412

(1) (2) (1) × (2)

After-tax Cost Proportion of Total Financing WACC
Debentures 7.8% 37.5% 2.93%
Preferred Stock 12.0 12.5 1.50
Common Stock 17.0 50.0 8.50
100.0% 12.93% = ko

2. Using the capital-asset pricing model, determine the required return on equity for the
following situations:

Situation Expected return Risk free rate Beta

1 15% 10% 1.00
2 18 14 0.70
3 15 8 1.20
4 17 11 0.80
5 16 10 1.90

What generalisations can you make?

Equation: Rf + ( Rm – Rf )ß
Situation Return Required
1 10% + (15% – 10%) 1.00 15.0%
2 14% + (18% – 14%) 0.70 16.8
3 8% + (15% – 8%) 1.20 16.4
4 11% + (17% – 11%) 0.80 15.8
5 10% + (16% – 10%) 1.90 21.4

The greater the risk-free rate, the greater the expected return on the market portfolio, and the
greater the beta, the greater will be the required return on equity, all other things being the
same. In addition, the greater the market risk premium (Rm – Rf ) , the greater the required
return, all other things being the same.

3. K-Far Stores has launched an expansion program that should result in the saturation of
the Bay Area marketing region of California in six years. As a result, the company is
predicting a growth in earnings of 12% for three years and 6% thereafter forever. The
company expects to increase its annual dividend per share, most recently $2, in keeping
with this growth pattern. What is the expected market price of the stock if the required rate
of return is 15%?
If the current market price of the stock is $25, is the stock under-priced, or over-priced?

Period Dividend 15% PVIF PV

0 2.00
1 2(1.12) 2.24 0.870 1.95
2 2.24(1.12) 2.51 0.756 1.90
3 2.51(1.12) 2.81 0.658 1.85
4 2.81(1.06) 2.98 5.70

P3 = D4/(ke – g) = 2.98/(0.15 – 0.06) = 33.11 x 0.658 = 21.79

Value of stock now = 27.49

Stock is under-priced because you can buy it for less than its intrinsic value.
Chapter 16
1. Majong Corporation currently has 1,000,000 shares of common stock outstanding at a
market price of $20 a share, and $20 million in 9% bonds. The company needs to raise $10
million in order to implement a series of investment projects. This amount can be raised by
either (1) issuing 500,000 new shares of common at $20 a share, or (2) selling bonds with an
11% yield. If the firm's tax rate is 30%, and the EBIT with the new projects is projected at
$6 million, which alternative will result in the highest earnings per share?

Issue new shares = 1,500,000 total outstanding

EBIT = 6,000,000
Less interest 1,800,000
EBT 4,200,000
Tax 1,260,000
Earnings 2,940,000
EPS = 2,940,000/1,500,000 = $1.96

New debt = 10,000,000

Interest (10%) = 1,100,000
+ existing (8%)= 1,800,000
Total interest = 2,900,000

EBIT = 6,000,000
Less interest = 2,900,000
EBT = 3,100,000
Tax = 930,000
Earnings = 2,170,000
EPS = 2,170,000/1,000,000 = $2.17

2. The Crazy Horse Hotel has a capacity to stable 50 horses. The fee for stabling a horse
is $100 per month. Maintenance, depreciation, and other fixed operating costs total
$1,200 per month. Variable operating costs per horse are $12 per month for hay and
bedding and $8 per month for grain.
a. Determine the monthly operating break-even point (in horses stabled).
b. Compute the monthly operating profit if an average of 40 horses are stabled.

a. QBE = $1,200/($100 – $20) = 15 horses

b. EBIT = 40($100 – $20) – $1,200 = $2,000

3. Pan Guo has fixed costs of $120,000 directly attributable to producing a particular product.
The product sells for $3 a unit and variable costs are $2.40.

What is the break-even point in units produced?

If the firm sold 250,000 units last year and expects volume to increase by 5%, what
percentage increase in profits would Pan Guo see with this increase in volume?

What is the Degree of Operating Leverage (DOL) at 250,000 units? At 262,500 units?

Answer:
QBE = $120,000/($3 - $2.40) = 200,000 units.

At volume of 250,000 units:

 Profit = (250,000)($3) - $120,000 – (250,000)($2.40) = $30,000

At volume of 262,500 units:

Profit = (262,500)($3) - $120,000 – (262,5000)($2.40) = $37,500

Therefore, the percentage increase in profit equals ($37,500 - $30,000)/$30,000 = 25%

DOL250,000 = (EBIT + FC) / EBIT = ($30,000 + $120,000)/$30,000 = 5.00.

DOL262,500 = (EBIT + FC) / EBIT = ($37,500 + $120,000)/$37,500 = 4.2.

Chapter 17
1. Jiang Chan Corporation has earnings before interest and taxes of $4.5 million and a 30% tax
rate. It is able to borrow at an interest rate of 12%, whereas its equity capitalization rate in
the absence of borrowing is 16%. The earnings of the company are not expected to grow,
and all earnings are paid out to shareholders in the form of dividends. In the presence of
corporate but no personal taxes, what is the value of the company in an M&M world with no
financial leverage? With $5 million in debt? With $10 million in debt?

Answer:
Value of firm if unlevered:
Earnings before interest and taxes $ 4,500,000
Interest 0
Earnings before taxes $ 4,500,000
Taxes (40%) 1,350,000
Earnings after taxes $ 3,150,000
Equity capitalization rate, ke ÷ 0.16
Value of the firm (unlevered) $19,687,500

Value with $5 million in debt:

Value of levered firm = Value of firm if unlevered + PV of tax-shield benefits of debt
= $19,687,500 + ($5,000,000) (0.30)
= $21,187,500
Value with $10 million in debt:
= $19,687,500 + ($10,000,000)(0.30)
= $22,687,500

Due to the tax subsidy, the firm is able to increase its value in a linear manner with more
debt.

2. A firm with no debt has a current market value of $50 million. It borrows $10 million at
12%. Management estimates the present value of associated bankruptcy and agency costs at
$2.5 million. If the company's tax rate is 30%, what is its new market value?

Answer::
Market value = $50,000,000 - $2,500,000 + ($10,000,000)(0.12)(0.30)/0.12
= $50,500,000

The new market value increases because of a $3 million tax-shield benefit, but is then
reduced by a $2.5 million increase in bankruptcy and agency costs.

3. Giant Tricycles Ltd., has $2 million in earnings before interest and taxes. Currently it is all-
 equity-financed. It can issue $4 million in perpetual debt at 15% interest in order to
repurchase stock, thereby recapitalising the corporation. There are no personal taxes.
a. If the corporate tax rate is 30%, what is the income available to all security
holders if the company remains all-equity-financed? If it is recapitalised?
b. What is the present value of the debt tax-shield benefits?
c. The equity capitalization rate for the company's common stock is 20% while it
remains all-equity-financed.
(i) What is the value of the firm if it remains all-equity financed?

(ii) What is the firm's value if it is recapitalised?

a. All-equity Debt and Equity

EBIT $2,000,000 $2,000,000
Interest to debt holders 0 600,000
EBT $2,000,000 $ 1,400,000
Taxes (30%) 600,000 420,000
Incomes available to common shareholders $ 1,400,000 $ 980,000
Income to debt holders plus income
available to shareholders $1,400,000 $1,580,000

b. Present value of tax-shield benefits = (B)(t c) = ($4,000,000)(0.30) = $1,200,000

c. Value of all-equity financed firm = EAT/ke = $1,400,000/(0.20) = $7,000,000
Value of recapitalized firm = $7,000,000 + $1,200,000 = $8,200,000