Finance Assignment 3

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1 Chapter Nine (9-10) The earnings, dividends, and stock price of Motortech Inc. are expected to grow at 4% per year in the future. Motortech’s common stock sells for $38 per share, its last dividend was $2.80, and the company will pay a dividend of $2.91 at the end of the current year. g=4% P 0 =38 D 0 =2.80 D 1 =2.91 a. Using the dividend growth approach, what is its cost of equity? D 1 P 0 + g 2.91 38 + 0.04 r s =0.1166= 11.66% b. If the firm’s beta is 1.3, the risk-free rate is 5%, and the expected return on the market is 9%, what will be the firm’s cost of equity using the CAPM approach? r s =r RF +(r M - r RF )*b i r s =0.05+(0.09-0.05)*1.3 r s =0.05+0.04*1.3 r s =0.05+0.052 r s =0.102= 10.2% c. If the firm’s bonds earn a return on 8%, what will r s be using the bond-yield-plus-risk- premium approach? (Hint: use the midpoint of the risk premium range). RP:3%-5% Midpoint=4% r s =r d +RP r s =0.08+0.04 r s =0.12= 12% d. On the basis of the results of parts a through c, what would you estimate Motortech’s cost of equity to be? Method Estimate CAPM 10.2% Dividend Growth 11.66% Rd+RP 12% Average (10.2+11.66+12)/3= 11.29%

2 (9-12) Spencer Supply’s stock is currently selling for $60 a share. The firm is expected to earn $5.40 per share this year and to pay a year-end dividend of $3.60. P 0 =$60 EPS=$5.40 D 1 =$3.60 a. If investors require a 9% return, what rate of growth must be expected for Spencer? r s = D 1 P 0 + g 0.09 = 3.60 60 + g 0.09=0.06+g 0.09-0.06=g 0.03 =g b. If Spencer reinvests earnings in projects with average returns equal to the stock’s expected rate of return, what will be next year’s EPS? 5.40(1+0.03) = 5.562 (9-14) Suppose a company will issue new 15-year debt with a par value of $1000 and a coupon rate of 6%, paid annually. The tax rate is 30%. If the flotation cost is 3% of the issue proceeds, what is the after-tax cost of debt? PMT=1000*.06=60 N:15 PV: 1000(1-0.03)= -970 PMT: 60(1-0.3)=42 FV:1000 [COMP] I/Y: 4.4789

3 (9-16) Central Mechanical has opened a new business unit that manufactures portable classrooms for schools and office space for construction sites. The company’s original business has a 9% cost of capital. It now wishes to estimate the cost of capital for its new business unit. Below is data the company’s financial analyst gathered on other companies that also manufacture portable classroom and office space. New business unit comparables Beta Company A 1.35 Company B 1.45 Company C 1.10 Average (1.35+1.45+1.10)/3=1.3 Ten-year government bonds yield 3.05% , and the market risk premium is 5.5% . Bankers advised Central mechanical that borrowing costs would be 7% on the new business. Other factors of note are that Central mechanical is a private company, and its shares are not easily bought and sold, and while the long-term demand for portables seems good, current economic conditions are currently making investors more risk averse. a. Estimate the divisional cost of capital using the CAPM and cost of debt plus subjective risk premium methods. You will want to add between 1% and 3% to your answer due to the lack of liquidity in the company’s shares. CAPM: r s+ =r RF +β s (RP M ) r s =r d +RP (RP=between 3%=5%. More risk=5) CAPM: r s =0.0305+1.3(0.055) r s =0.07+0.05 CAPM: r s =0.0305+0.0715 r s =0.12=12% CAPM: r s =0.102= 10.2% Average: 10.2%+12%/2=11.1% Lack of liquidity: + 3.0% 14.1% b. Independent of part a, should you accept a project for the new business unit based on an expected rate of return of 12.5% give the company’s cost of capital on its existing business is 9% and is 14.10% for the new business unit/ no calculations are needed just explain.

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4 Decision to accept or reject is based on the new business unit cost of capital of 14.10%, which is higher then the expected rate of return of 12.5%. Therefore, the project should be rejected. (9-17) On January 1, the total market value of Finestone Countertops Co. was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm’s present market value capital structure, shown here, is considered to be optimal. There is no short-term debt. Debt $30,000,000 Common Equity $30,000,000 Total Capital $60,000,000 New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The shareholders required rate of return consist of a dividend yield of 4% and an expected constant growth rate of 8%. The corporate tax rate is 30%. a. To maintain the present capital structure, how much of the new investment must be financed by common equity? Finestone Countertops Co. currently invests with 50% debt and 50% common equity, to maintain this structure 15 million must be financed by common equity. W d = 30,000,000 60,000,000 =0.5 W s = 30,000,000 60,000,000 =0.5 30,000,000 *0.5=15million 30,000,000 *0.5=15million b. Assume that there is sufficient cash flow such Finestone can maintain its target capital structure without issuing additional share of equity. What is the WACC? r s = D 1 P 0 + g r s = 0.04 + 0.08 =0.12 r d =I/Y WACC=w d r d (1-T)+w s r s PMT:0.08(1000)=80 WACC=0.5(0.08)(1-0.3)+0.5(0.12) FV:1000 WACC=0.5(0.056)+0.06 PV:1000 WACC=0.028+0.06

5 N:10 WACC= 0.088 I/Y:8% c. Suppose now that there is not enough internal cash flow and that the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC? Issuing new shares of stock requires companies to account for flotation costs. This additional cost will cause the cost of common equity to go up, increasing the WACC.

6 Chapter Ten (10-4) A project has an initial cost of $40,000, expected net cash inflows of $9,000 per year for 7 years, and a cost of capital of 11%. What is the project’s NPV? What is the project’s PI? CF 0 = -40,000 [ENT] PI = NPV + CF 0 CF 0 CF 1-7 = 9,000 [x,y] 7 [ENT] [2ndF] [CFi] RATE(I/Y)=11 PI = 2409.77 + 40000 40000 PI = 42409.77 40000 [COMP] NET_PV= 2409.77 PI = 1.06024 (10-14) Ewert Exploration Company is considering two mutually exclusive plans for extracting oil on property for which it has mineral rights. Both plans call for the expenditure of $10 million to drill development wells. Under Plan A, al the oil will be extracted in 1 year, producing a cash flow at t=1 of $12 million , while under Plan B, cash flows will be $1.75 million per year for 20 years. a. What are the annual incremental cash flows that will be available to Ewert Exploration if it undertakes Plan B rather than* Pan A? *In millions *See Excel file FINA211_KPANK_ASSIGNMENT_3 Ewert Exploration will receive ($10.25 million) in year one, followed by $1.75 million in years 2 to 20. Years Plan A Plan B Plan B-A 0 -10 -10 0 1 12 1.75 -10.25 2 0 1.75 1.75 3 0 1.75 1.75 …. … … … 20 0 1.75 1.75

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7 b. If the firm accepts Plan A, then invests the extra cash generated at the end of Year 1, what rate of return (reinvestment rate) would cause the cash flows from reinvestment to equal the cash flows from Plan B? NPV A =NPV B *in millions Plan B 0 [ENT] -10.25 [ENT] 1.75 [x,y] 19 [ENT] [2ndF] [CFi] [COMP] RATE(I/Y)= 16.0665 c. Suppose a company has a cost of capital of 10%. Is it logical to assume that it would take on all available independent projects (of average risk) with returns greater than 10%? Furthermore, if all available projects with returns greater than 10% have been taken, would this mean that cash flows from past investments would have an opportunity cost of only 10%, because all the firm could do with these cash flows would be to replace money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a projects cash flows? It is logical to assume that a company would take on all available independent projects that have a return greater than 10% if their cost of capital was 10%. However, there are conditions to be met in order to assume this. Firstly, projects must be equal risk and secondly the weight structure used to calculate WACC has to be similar (risk and weights must be similar).

8 d. Construct NPV profiles for Plans A and B, identify each project’s IRR, and indicate the cross-over rate of return. NPV A -10 [ENT] -10 [ENT] -10 [ENT] 12 [ENT] [2ndF] [CFi] 12 [ENT] [2ndF] [CFi] 12 [ENT] [2ndF] [CFi RATE(I/Y)= 0 [ENT] RATE(I/Y)= 5 [ENT] …. RATE(I/Y)= 25 [ENT] [COMP] NPV=2 [COMP] NPV=1.42857 …. [COMP] NPV=-0.4 NPV B -10 [ENT] -10 [ENT] -10 [ENT] 1.75 [x,y] 20 [ENT] 1.75 [x,y] 20 [ENT] 1.75 [x,y] 20 [ENT] [2ndF] [CFi] [2ndF] [CFi] [2ndF] [CFi] RATE(I/Y)= 0 [ENT] RATE(I/Y)= 5 [ENT] …. RATE(I/Y)= 25 [ENT] [COMP] NPV=25 [COMP] NPV=11.8089 …. [COMP] NPV=-3.0807 *See Excel file FINA211_KPANK_ASSIGNMENT_3 IRR A IRR B -10 [ENT] -10 [ENT] 12 [ENT] [2ndF] [CFi] 1.75 [x,y] 20 [ENT] [2ndF] [CFi] NET_PV= 0 [ENT] NET_PV= 0 [ENT] [COMP] RATE(I/Y)= 20 [COMP] RATE(I/Y)= 16.7031 Cross-over Rate 0 [ENT] -10.25 [ENT] 1.75 [x,y] 19 [ENT][2ndF] [CFi] [COMP] RATE(I/Y)= 16.0665 WACC NPV A NPV B 0 2 25 5 1.42857 11.808868 10 0.909091 4.898736 15 0.43478 0.953830 20 0 -1.478235 25 -0.4 -3.08070

9 (10-18) Filkins Fabric Company is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: machine 190-3, which as a cost of $190,000, a 3 year expected life, and after-tax cash flows of $87,000 per year. Machin 360-6 has a cost of $360,000 a 6-year life, and after-tax cash flows of $98,300 per year. Knitting machine prices are not expected to rise, because inflation will be offset by cheaper components (microprocessors) used in the machines. Assume that Filkins’s cost of capital is 14%. Should the firm replace its old knitting machine, and if so, which new machine should it use? What is the equivalent annual annuity for each machine? Machine 190-3 CF 0 : -190,000 [ENT] I/Y=14 CF 1-3 : 87,000 [ENT] [2ndF] [CFi] N=3 RATE(I/Y)= 14 [ENT] FV=0 [COMP] NPV=11981.99 PV=11981.99 [COMP] PMT= 5161.02 = EAA Machine 360-6 CF 0 : -360,000 [ENT] I/Y=14 CF 1-6 : 98,300 [ENT] [2ndF] [CFi] N=6 RATE(I/Y)= 14 [ENT] FV=0 [COMP] NPV=22256.02 PV=22256.02 [COMP] PMT= 5723.30 =EAA Filkins should replace its old machine with Machine 360-6. (10-22) Your division is considering two investment projects, each of which requires an up-front expenditure of $25 million. You estimate that the cost of capital is 10% and that the investments will produce the following after-tax cash flows (in millions of dollars): Year Project A Project B 1 5 20 2 10 10 3 15 8 4 20 6 a. What is the regular payback period for each project? Payback period= ¿ of years before fullrecovery + unrecovered cost @ start of year cash flow during fullrecovery year

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10 Payback Period A : 2 + 10 15 = 2.667 years Payback Period B : 1 + 5 10 = ¿ 1.5 years b. What is the discounted payback period for each project? Discount Payback Period A : 3 + 0.92037 13.66027 = 3.067 years Discounted Payback Period B : 1 + 6.818182 8.264463 = 1.825 years c. If the two projects are independent and the cost of capital is 10%, which project or projects should the firm undertake? NPV A =12.7399 NPV B =11.55488 *Obtained from part b Year CF A Cumulative CF B Cumulative 0 -25 -25 -25 -25 1 5 -20 20 -5 2 10 -10 10 5 3 15 5 8 13 4 20 25 6 19 Year CF A Discounted CF Cumulative 0 -25 -25 -25 1 5 4.54545 -20.45455 2 10 8.26446 -12.19009 3 15 11.26972 -0.92037 4 20 13.66027 12.7399 Year CF B Discounted CF Cumulative 0 -25 -25 -25 1 20 18.181818 -6.818182 2 10 8.264463 1.446281 3 8 6.010518 7.456799 4 6 4.098081 11.55488

11 Since the projects are independent of each other, the firm can undertake both projects because NPV is greater than 0 for both. *See calculations in Excel sheet for Q22 (b) d. If the two projects are mutually exclusive and the cost of capital is 5%, which project should the firm undertake? CF A CF B -25 [ENT] -25 [ENT] 5 [ENT] 20 [ENT] 10 [ENT] 10 [ENT] 15 [ENT] 8 [ENT] 20 [ENT] [2ndF] [CFi] 6 [ENT] [2ndF] [CFi] RATE(I/Y)=5 RATE(I/Y)=5 [COMP] NET_PV=18.24381302 [COMP] NET_PV=14.96482947 The firm should undertake project A if the cost of capital is 5% because the NPV is higher than project B. e. If the two projects are mutually exclusive and the cost of capital is 15%, which project should the firm undertake? -25 [ENT] -25 [ENT] 5 [ENT] 20 [ENT] 10 [ENT] 10 [ENT] 15 [ENT] 8 [ENT] 20 [ENT] [2ndF] [CFi] 6 [ENT] [2ndF] [CFi] RATE(I/Y)=15 RATE(I/Y)=15 [COMP] NET_PV=8.207071158 [COMP] NET_PV=8.643390354 The firm should undertake project B if the cost of capital is 15% because the NPV is higher than project A.

12 f. What is the crossover rate? 0 [ENT] -15 [ENT] 0 [ENT] 7 [ENT] 14 [ENT] [2ndF] [CFi] NET_PV =0 [COMP] RATE(I/Y)=13.52543857 Crossover Rate= 13.53% g. If the cost of capital is 10%, what is the modified IRR (MIRR) of each project? PV=5 PV=10 PV=15 N=3 N=2 N=1 I/Y=10 I/Y=10 I/Y=10 PMT=0 PMT=0 PMT=0 [COMP] FV=6.655 [COMP] FV=12.1 [COMP] FV=16.5 Inflows A: 6.655+12.10+16.50+20 FV of A Inflows: 55.255 Outflows A: -25 PV=-25 FV=55.255 PMT=0 N=4 [COMP] I/Y=21.92924754 MIRR A = 21.93% Year CF A CF B CF A -CF B 0 -25 -25 0 1 5 20 -15 2 10 10 0 3 15 8 7 4 20 6 14

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13 PV=20 PV=10 PV=8 N=3 N=2 N=1 I/Y=10 I/Y=10 I/Y=10 PMT=0 PMT=0 PMT=0 [COMP] FV=26.62 [COMP] FV=12.1 [COMP] FV=8.8 Inflows A: 26.62+12.10+8.8+6 FV of A Inflows: 53.52 Outflows A: -25 PV=-25 FV=53.52 PMT=0 N=4 [COMP] I/Y=20.96062552 MIRR B = 20.96%

14 Chapter 11 (11-6) How do simulation analysis and scenario analysis differ in the way they treat bad and very good outcomes? What does this imply about using each technique to evaluate project riskiness? Simulation analysis presents outcomes as probability distributions (output NPV) that are continuous for each variable which provides an assessment on all possible outcomes. Scenario analysis provides a limited number of outcomes typically worst case, base case, and best case scenarios. Each technique will successfully evaluate project riskiness but one is more in depth and costly but thoroughly tests outcomes prior the project. Scenario analysis only provides limited risk information to the company but would be less time consuming and more affordable for the company. (11-8) Although Chen Company’s milling machine is old, it is still in relatively good and would last for another 10 years. It is inefficient compared to modern standards, though and so the company is considering replacing it. The new milling machine, at a cost of $110,000 delivered and installed, would also last for 10 years and would produce after tax cash flows labour savings and CCA tax savings of $19,000 per year. It would have zero salvage value at the end of its life. The project cost of capital is 10% and its tax rate is 25%. Should Chen buy the new machine? CF 0 =-110,000 [ENT] CF 1-10 =19,000 [x,y] 10 [ENT] [2ndF] [CFi] RATE I/Y=10 [COMP] NET_NPV=6,746.78 Chen should accept the project because NPV>0. (11-10) Campbell Company is evaluating the proposed acquisition of a new milling machine. The machines base price is $120,000 and it would cost another $9500 to modify it for special use. The machine falls into class 8 with a 20% CCA rate, and it would be sold after 4 years for $60,000. The machine would require an increase in net working capital (inventory) of $7500. The milling machine would have no effect on revenues, but it is expected to save the firm $31,000 per year in before-tax operating costs, mainly labour. Campbell’s tax rate is 30%. C : 129,500 t : 0.3 n : 4 NOWC: $7,500 r : 0.11 d : 0.2 s : 60,000 CF : 31,000 a. What is the total initial investment for capital budgeting purposes ? (that is, what is the Time 0 net cash flow ?)

15 C 0 =-129,500-7,500 Initial investment= 137,000 b. What is the PV of the project cash flows using an 11% cost of capital? After tax savings=$31,000(1-0.3) CF 0 : 0 [ENT] After tax savings =$21,700 CF 1-4 : 21,700 [ENT] [2ndF] [CFi] RATE I/Y=11 NET_NPV= 67,323.07 c. What is the PV of the CCA tax shield? ( CdT r + d x 1 + 0.5 r 1 + r ¿ −( SdT r + d x 1 ( 1 + r ) n ) ( 129,500 )( 0.2 )( 0.3 ) ( 0.11 + 0.2 ) x 1 +( 0.5 )( 0.11 ) ( 1 + 0.11 ) ¿ −( ( 60,000 )( 0.2 )( 0.3 ) 0.11 + 0.2 x 1 ( 1 + 0.11 ) 4 ) ( 7770 0.31 ∗ 1.055 1.11 ¿ −( 3600 0.31 ∗ 1 1.51807041 ) ( 25064.51613 ∗ 0.95045045 )−( 11612.90323 ∗ 0.658730974 ) ( 23822.58063 )−( 7649.779056 ) PV of CCATS=$ 16,172.80157 d. What is the PV of the additional Year 4 cash flow? FV=$60,000+7,500=67,500 I/Y:11 N:4 PMT:0 [COMP] PV= 44,464.34075 e. If the project ‘s cost of capital is 11%, should the machine be purchased?

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16 -137,000+67,323.07+16,172.80157+44,464.34075 NPV= -9039.78768 The machine should not be purchased because the NPV is less than 0. (11-22) Metro Bottling Company is contemplating replacing one of its bottling machines with a newer and more efficient one. A just completed consultant’s report, which cost Metro $12,000, provided the following rationale for the purchase. The old machine has current value of $265,000 and a remaining useful life of 6 years . If metro keeps the machine for another 6 years it should be able to sell it at that time for $ 20,000 . The new machine has a purchase price of $1,175,00 , an estimated useful life of 6 years, and estimated salvage value of $145,000 . Installation will cost $ 15,000 . The new machine will economize on electric power usage and labour and repair costs, as well as reduce the number of defective bottles. A total annual savings of $264,000 will be realized if the new machine is installed. The new machine will initially free up $7,000 in working capital. Both machines fall into CCA Class 43, which has a 30% CCA rate. The company’s tax rate is 25%, and it has a WACC of 12%. Should the company purchase the new bottling machine? C : 1,175,000+15,000-265,000=925,000 t : 0.25 n : 6 NOWC: $7,000 r : 0.12 d : 0.3 s :145,000- 20,000=125,000 CF : 264,000 PVCCATS= ( 925,000 )( 0.3 )( 0.25 ) ( 0.12 + 0.3 ) x 1 +( 0.5 )( 0.12 ) ( 1 + 0.12 ) ¿ −( ( 125,000 )( 0.3 )( 0.25 ) 0.12 + 0.3 x 1 ( 1 + 0.12 ) 6 ) 69,375 0.42 x 1.06 1.12 − 9,375 0.42 x 1 ( 1.973822685 ) ( 165178.5714 ∗ 0.946428571 )−( 22321.42857 ∗ 0.506631121 ) ( 156329.7193 )−( 11308.73038 ) PVCCATS=145020.9889 CF 0 =-925,000+7,000=-918,000+145,020.9889=-772979.0111 CF 1-5 =264,000(1-0.25)=198,000 CF 6 =125,000-7,000+198,000=316,000 RATE I/Y=12 NET_PV= $100,862.1113

17 The company should purchase the new bottling machine because the NPV is greater than 0.

Finance Assignment 3

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