(FM) Financial Management Lab Questions and Problems

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SUNEL 1-5 1-6 1-7 1-8 1-9 Mini Case b. The company is spending $500 million to open a new plant and expand operations in China. No profits will be produced by the Chinese operation for 4 years, so earnings will be depreéssed during this period versus what they would have been had the decision not been made to expand in that market. Discuss how ESC’s shareholders might view each of these actions, and how the actions might affect the share price. Edmund Enterprises recently made a large investment to upgrade its technology. While these improvements won't have much of an impact on performance in the short run, they are expected to reduce future costs significantly. What impact will this investment have on Edmund Enterprises’ earnings per share this year? What impact might this investment have on the company’s intrinsic value and share price? Describe the different ways in which capital can be transferred from suppliers of capital to those who are demanding capital. What are financial intermediaries, and what economic functions do they perform? Suppose the population of Area Y is relatively young while that of Area O is relatively old, but everything else about the two areas is equal. a. Would interest rates likely be the same or different in the two areas? Explain. b. Would a trend toward nationwide branching by banks and trust companies, and the development of nationwide diversified financial corporations, affect your answer to part a? Suppose a new government was elected in Ottawa and its first order of business was to take away the independence of the Bank of Canada and to force the BoC to greatly expand the money supply. What effect would this have on the level of interest rates immediately after the announcement? Is an initial public offering an example of a primary or a secondary market transaction? Identify and briefly compare the two primary stock exchanges in Canada today. Assume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Sergei Turganev, a professional hockey player who has just come to Canada from Russia. Turganev is a highly ranked hockey player who would like to start a company to produce and market apparel with his signature. He also expects to invest substantial amounts of money through Balik and Kiefer. Turganev is very bright, and he would like to understand in general terms what will happen to his money. Your boss has developed the following set of questions that you must answer to explain the Canadian financial system to Turganev. a. Why is corporate finance important to all managers? b. What are the organizational forms a company might have as it evolves from a start-up to a major corporation? List the advantages and disadvantages of each form. ¢. How do corporations go public and continue to grow? What are agency problems? What is corporate governance? d. What should be the primary objective of managers? (1) Do firms have any responsibilities to society at large? (2) Is share price maximization good or bad for society? (3) Should firms behave ethically? What three aspects of cash flows affect the value of any investment? What are free cash flows? What is the weighted average cost of capital? How do free cash flows and the weighted average cost of capital interact to determine a firm's value? Who are the providers (savers) and users (borrowers) of capital? How is capital trans- ferred between savers and borrowers? j What do we call the price that a borrower must pay for debt capital? What is the price of equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? F@ o - 23

22 Chapter 1 An Overview of Financial Management and the Financial Environment 1A 1-2 1-3 [} A firm’s fundamental, or intrinsic, value is defined by: FCF, FCE, Value = + e = T wWacol T 0% WACQ)? FCF, FCE, +t 1+ WACC)3 ( * ( 1 + WACCO)® Transfers of capital between borrowers and savers take place (1) by direct transfers of money and securities; (2) by transfers through investment banks, which act as middlemen; and (3) by transfers through financial intermediaries, which create new securities. Capital is allocated through the price system—a price must be paid to “rent” money. Lenders charge interest on funds they lend, while equity investors receive dividends and capital gains in return for letting firms use their money. Four fundamental factors affect the cost of money: (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation. ‘ There are many different types of financial securities. Primitive securities represent claims on cash flows, such as stocks and bonds. Derivatives are claims‘ on other traded securities, such as options. Major financial institutions include commercial banks, trust companies, credit unions, pen- sion funds, life insurance companies, mutual funds, hedge funds, and private equity funds. One result of ongoing regulatory changes has been a blurring of the distinctions between the different financial institutions. The trend in Canada has been towards firms that offer a wide range of financial services, including investment banking, brokerage operations, insurance, and commercial banking. There are many different types of financial markets. Each market serves a different region or deals with a different type of security. Physical asset markets, also called tangible or real asset markets, are those for products such as wheat, autos, and real estate. Financial asset markets are for primitive securities and derivative securities. Spot markets and futures markets are terms that refer to whether the assets are bought or sold for “on-the-spot” delivery or for delivery at some future date. Money markets are the markets for debt securities with maturities of less than 1 year. Capital markets are the markets for long-term debt and corporate shares. Primary markets are the markets in which corporations raise new- capital. Secondary markets are markets in which existing, already outstanding securities are traded among investors. Questions Define each of the following terms; . P e o ot Proprietorship; partnership; corporation Limited partnership; limited liability partnership; professional corporation Shareholder wealth maximization Money market; capital market; primary market; secondary market Private markets; public markets; derivatives Investment banker; financial intermediary Mutual fund; money market fund Production opportunities; time preferences for consumption Foreign trade deficit What are the three principal forms of business organization? What are the advantages and disadvantages of each? What is a firm’s fundamental, or intrinsic, value? What might cause a firm’s intrinsic value to be different than its actual market value? The president of Eastern Semiconductor Corporation (ESC) made this statement in the com- pany’s annual report: “ESC’s primary goal is to increase the value of our common share- holders” equity.” Later in the report, the following announcements were made: a. The company contributed $1.5 million to the symphony orchestra in Toronto, Ontario, its headquarters’ city. : : NEL

Questions 5 ° Operating long-term assets are the long-term assets used to support operations, such as net plant and equipment. They do not include any long-term investments that pay interest or dividends. ° Total net operating capital (which means the same as operating capital and net oper- ating assets) is the sum of net operating working capital and operating long-term assets. It is the total amount of capital needed to run the business. e INOPAT is net operating profit after taxes. It is the after-tax profit a company would have if it had no debt and no investments in nonoperating assets. Because it excludes the effects of financial decisions, it is a better measure of operating performance than is net income. Free cash flow (FCF) is the amount of cash flow remaining after a company makes the asset investments necessary to support operations. In other words, FCF is the amount of cash flow available for distribution to investors, so the value of a company is directly related to its ability to generate free cash flow. FCF is defined as NOPAT minus the net investment in operating capital. : © Market Value Added (MVA) represents the difference between the total market value of a firm and the total amount of investor-supplied capital. If the market values of debt and preferred stock equal their values as reported on the financial statements, then MVA is the difference between the market value of a firm’s stock and the amount of equity its shareholders have supplied. ° Economic Value Added (EVA) is the difference between after-tax operating profit and the total dollar cost of capital, including the cost of equity capital. EVA is an estimate of the value created by management during the year, and it differs substantially from accounting profit because no charge for the use of equity capital is reflected in accounting profit. * Interestincome received by a corporation is taxed as ordinary income; however, common stock dividends received by one Canadian corporation from another are excluded from taxable income. ' ° Because interest paid by a corporation is a deductible expense while dividends are not, our tax system favours debt over equity financing. ¢ Ordinary corporate operating losses can be carried back to each of the preceding 3 years and forward for the next 20 years and used to offset taxable income in those years. ° InCanada, tax rates are progressive—the higher one’s income, the larger the percentage paid in taxes. e Assefs such as stocks, bonds, and real estate are defined as capital assets. If a capital asset is sold for more than its cost, the profit is called a capital gain. If the asset is sold for a loss, it is called a capital loss. * Adividend tax credit can be used to reduce the taxes that individuals have to pay on eligible dividends from Canadian corporations. This dividend tax credit partly offsets the double taxation effect that would otherwise occur. Questions 2-1 Define each of the following terms: Annual report; balance sheet; income statement Common shareholders’ equity, or net worth; retained earnings Statement of retained earnings; statement of cash flows Depreciation; amortization; EBITDA Operating current assets; operating current liabilities; net operating working capital; total net operating capital Accounting profit; net cash flow; NOPAT; free cash flow Market Value Added; Economic Value Added Progressive tax; taxable income; marginal and average tax rates Capital gain or loss; tax loss carryback and carryforward oo o Foorag e 2-2 What four statements are contained in most annual reports? 2-3 If a “typical” firm reports $20 million of retained earnings on its balance sheet, can the firm definitely pay a $20 million cash dividend? 2-4 What is operating capital, and why is it important?

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52 Chapter 2 .- Fivnunciol Statgments, Cash Flow, and Taxes 2-5 . 2-6 2-7 CR-1 Net Income, Cash Flow, and EVA Easy Problems 1-6 2-1 Personal After-Tax Yield 2-2 . Income Statement 2-3 Income Statement 2-4 Net Cash Flow 2-5 Statement of Retained Earnings 2-6 Cash Flow Statement Intermediate Problems 7-11 2-7 Personal After-Tax Return ‘Explain the difference between NOPAT and net income. Which is a better measure of the performance of a company’s operations? What is free cash flow? Why is it the most important measure of cash flow? If you were starting a business, what tax considerations might cause you to prefer to set it up as a proprietorship or a partnership rather than as a corporation? Concept Review Problem Full solutions are provided at www.nelson.com/brigham3ce. Last year Custom Furniture had $6,500,000 in operating income (EBIT). The company had a net depreciation expense of $1,000,000 and an interest expense of $1,000,000; its corporate tax rate was 30%. The company has $14,000,000 in operating current assets and $4,000,000 in operating current liabilities; it has $15,000,000 in net plant and equipment. It estimates that it has an after-tax cost of capital of 10%. Assume that Custom Furniture’s only noncash item was depreciation. What was the company’s net income for the year? What was the company’s net cash flow? What was the company’s net operating profit after taxes (NOPAT)? Calculate net operating working capital and total net operating capital for the current year. e. If total net operating capital in the previous year was $24,000,000, what was the com- pany’s free cash flow (FCF) for the year? f. What was the company’s Economic Value Added (EVA)? e oe Problems Answers fo odd-numbered problems appeor in Appendix A, Note: By the time this book is published, Parliament may have changed rates and/or other . provisions of current tax law—as noted in the chapter, such changes occur fairly often. Work all problems on the assumption that the information in the chapter is applicable. An investor recently purchased a corporate bond which yields 5%. The investor is in the 30% tax bracket. What is the bond’s after-tax yield? Little Books Inc. recently reported $3.5 million of net income. Its EBIT was $7 million, and its tax rate was 30%. What was its interest expense? Pearson Brothers recently reported an EBITDA of $7.5 million and net income of $1.6 million. It had $2.0 million of interest expense, and its corporate tax rate was 30%. What was its charge for depreciation and amortization? Kendall Corners Inc. recently reported net income of $3.1 million and depreciation of $250,000. What was its net cash flow? Assume it had no amortization expense. In its most recent financial sfatements, Newhouse Inc. reported $50 million of net income and $810 million of retained earnings. The previous retained earnings were $780 million. How much in dividends was paid to shareholders during the year? Based on the following information, what are Ever Green'’s cash flows from operations? The company reported profits of $18,000 and claimed amortization of $4,000, while accounts receivable increased by $4,000, inventories decreased by $8,000, and accounts payable increased by $4,000. Karen, a resident of Nova Scotia, has $10,000 to invest for one year. She has found two alternatives: a bond that will provide interest income at year-end of $400, and a common stock whose price is $50 and is expected to increase by $2.00. Ignoring risk and other factors, how much money will Karen have after taxes from each investment? Use Tables 2-8 and 2-9 and assume that Karen has taxable income of $65,000. ’ NEL

%,. L ol 2-8 Cash Flows 2-9 Cash Flows 2-10 tncome and Cash Flow Analysis 2-11 Free Cash Flow Challenging Problems 12-17 . NEL 2-12 Free Cash Flow Problems Companies X and Y are very similar. Both have sales of $5,000,000, and COGS are 65% of sales. Both companies have operating expense of $700,000 and are taxed at 26%. However, X and Y will be claiming $60,000 and $120,000 each respectively in depreciation expense. Calculate ‘each company’s net cash flow, and explain specifically the difference in the cash flows. The Moore Corporation has operating income (EBIT) of $750,000. The company’s deprecia- tion expense is $200,000. Moore is 100% equity financed, and it faces a 40% tax rate. What is the company’s net income? What is its net cash flow? The Berndt Corporation expects to have sales of $20 million. Costs other than depreciation are expected to be 75% of sales, and depreciation is expected to be $2.5 million. All sales rev- enwes will be collected in cash, and costs other than depreciation must be paid for during the year. Berndt's tax rate is 30%. Berndt has no debt. a. Setup an income statement. What is Berndt’s expected net cash flow? b. Suppose that Berndt's depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow? c. Now suppose that Berndt's depreciation was reduced by 50%. How would profit and net cash flow be affected? ' d. If this were your company, would you prefer your depreciation expense to be doubled or halved? Why? Financial information on Marine Tech Corporation is presented below. During the year, Marine Tech made a net investment in operating capital of $30 million. If the company’s share price is $22, it has 10 million shares outstanding, and its tax rate is 30%, does Marine Tech have sufficient free cash flow to repurchase 10% of its shares? Marine Tech Corporation Income Statement ($ ™M) Sales ‘ $320 Operating costs ‘ 220 Depreciation 20 EBIT ' 80 Interest expense 10 Earnings before tax 70 Tax (30%) 21 Earnings after tax $ 49 Using Rhodes Corporation’s financial statements (shown below), answer the following questions. What is the net operating profit after taxes (NOPAT) for 20157 What are the amounts of net operating working capital for both years? What are the amounts of total net operating capital for both years? What is the free cash flow for 20157 ' What is the ROIC for 20157 How much of the FCF did Rhodes use for each of the following purposes: after-tax interest, net debt repayments, dividends, net stock repurchases, and net purchases of short-term investments? (Hint: Remember that a net use can be negative.) RS R O Rhodes Corporation: Income Statements for Year Ending December 31 (Millions of Dollars) 2015 2014 Sales ’ $11,000 $10,000 Operating costs excluding depreciation 9,360 8,500 Depreciation and amortization 380 360 Earnings before interest and taxes 1,260 1,140 Less interest 120 100 Pre-tax income . 1,140 1,040 Taxes (40%) ' 456 416 Net income available to common shareholders $ 684 $ 624 Common dividends $ 220 $ 200 53

Questions 81 do not appear on the balance sheet. At the same time, the liability associated with the lease obligation may not be shown as debt. Therefore, leasing can artificially improve both the turnover and the debt ratios. 7. It is difficult to generalize about whether a particular ratio is “good” or “bad.” For example, a high current ratio may indicate a strong liquidity position, which is good, or excess cash, which is bad (because excess cash in the bank is a nonearning asset). Similarly, a high fixed assets turnover ratio may denote either that a firm uses its assets efficiently or that it is undercapitalized and cannot afford to buy enough assets. In summary, conducting ratio analysis in a mechanical, unthinking manner is dan- gerous, but when ratio analysis is used intelligently and with good judgment, it can provide useful insights into a firm’s operations and identify the right questions to ask. 1. List three types of users of ratio andlysis. Would the different users emphasize the same or different types of ratios? 2. List several potential problems with ratio analysis. Summary The main purpose of this chapter was to discuss techniques used by investors and managers to analyze financial statements. The key concepts covered are listed below. e Liquidity ratios show the relationship of a firm’s current assets to its current liabilities, and thus its ability to meet maturing debts. Two commonly used liquidity ratios are the current ratio and the quick, or acid test, ratio. o Asset management ratios measure how effectively a firm is managing its assets. These ratios include inventory turnover, days sales outstanding, average payable period, fixed assets turnover, and total assets turnover. e Debt management ratios reveal (1) the extent to which the firm is financed with debt and (2) its likelihood of defaulting on its debt obligations. They include the debt ratio, debt-to-equity ratio, times-interest-earned ratio, and EBITDA coverage ratio. e Profitability ratios show the combined effects of liquidity, asset management, and debt management policies on operating results. They include the net profit margin, the basic earning power ratio, the return on total assets, and the return on common equity. e Market value ratios relate the firm’s stock price to its earnings, cash flow, and book value per share, thus giving managerrent an indication of what investors think of the company’s past performance and future prospects. These include the price/earnings ratio, price/cash flow ratio, and the market/book ratio. e Trend analysis, where one plots a ratio over time, is important, because it reveals whether the firm’s condition has been improving or deteriorating over time. ¢ The DuPont equation is designed to show how the profit margin on sales, the assets turnover ratio, and the use of debt interact to determine the rate of return on equity. The firm’s management can use the DuPont system to analyze ways of improving performance. e Benchmarking is the process of comparing a particular company with a group of sim- ilax, successful companies. T e Ratio analysis has limitations, but used with care and judgment, it can be very helpful. Questions 3-1 Define each of the following térms: a. Liquidity ratios: current ratio; quick, or acid test, ratio b. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO); average payables period; fixed assets turnover ratio; total assets turnover ratio NEL

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82 Chapter 3 Analysis of Financig! Statements ‘c. Financial leverage: debt ratio; timesdnteresbearned (TIE) ratio; EBITDA coverage ratio d. Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return on . total assets (ROA); return on common equity (ROE) e. Market value ratios: price/earnings (P/E) ratio; price/cash flow ratio; market/book (M/B) ratio; book value per share : f. Trend analysis; comparative ratio analysis; benchmarking g. DuPont equation; window dressing; seasonal effects on ratios 3-2 Financial ratio analysis is conducted by managers, equity investors, long-term creditors, and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios? 3-3 Over the past year, M.D. Ryngaert & Co. has realized an increase in its current ratio and a drop in its total assets turnover ratio. However, the company’s sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes? 3-4 Profit margins and turnover ratios vary from one industry to another. What differences would you expect to find between a grocery chain such as Safeway and a steel company? Think particularly about the turnover ratios, the profit margin, and the DuPont equation. 3-5 How might (a) seasonal factors and (b) different growth rates distort a comparative ratio analysis? Give some examples. How might these problems be alleviated? 3-6 Why is it sometimes misleading to compare a company’s financial ratios with those of other firms that operate in the same industry? Concept Review Problems | : Full solutions are provided at www.nelson.com/brigham3ce. CR-1 Argent Corporation has $60 million in current liabilities, $150 million in total liabilities, and Debt Ratio $210 million in total common equity. Argent has no preferred stock. Argent’s total debt is $120 million. What is the debt-to-assets ratio? What is the debt-to-equity ratio? CR-2 The following data apply to Jacobus and Associates (millions of dollars): Ratio Analysis Cash and marketable securities ~$100.00 Fixed assets $283.50 Sales $1,000.00 Net income -7 $70.00 Quick ratio . 2.0% Current ratio ‘ 3.0X DSO 40.55 days ROE 15% Jacobus has no preferred stock—only common equity, current liabilities, and long-term debt. a. Find Jacobus’s (1) accounts receivable, (2) current liabilities, (3) current assets, (4) total assets, (5) ROA, (6) common equity, and (7) long-term debt. b. Inparta, you should have found Jacobus’s accounts receivable (A/R) = $111.1 million. If Jacobus could redtce its DSO from 40.55 days to 30.4 days while holding other things constant, how much cash would it generate? If this cash were used to buy back common shares (at book value), thus reducing the amount of common equity, how would this affect (1) the ROE, (2) the ROA, and (3) the total debt/total assets ratio? Problems Easy Answers fo odd-numbered problems appear in Appendix A. Problems 1-5 3-1 Grey Brothers hasa DSO of 27 days. The company’s average daily sales are $35,000. What is Days Sales Outstanding the level of its accounts receivable? Assume there are 365 days in a year. 3-2 Brite-Lite Bulbs has an equity multiplier of 3.2. The corhpany’s assets are financed with some Debt Ratio combination of long-term debt and common equity. What is the company’s debt ratio? NEL

3-3 Market/Book Ratio 3-4 Price/Earnings Ratio 3-5 Average Payables Period Intermediate Problems 6-:-31 3 DuPont Analysis 37 Current and Quick Ratios 3-8 Profit Margin and Debt Ratio 3-9 Current and Quick Ratios 3-10 Timesnterest-Earned Ratio 317 ROE 3-12 Current Ratio 3-13 TIE Ratio Challenging Problems 14-18 3-14 DSO and Accounts Receivable 3-15 Balance Sheet Analysis NEL Problems A company’s stock price is $12 per share, and it has $7 million in total assets. Its balance sheet shows $1 million it current liabilities, $2.5 million in long-term debt, and $3.5 million in common equity. It has 500,000 common shares outstanding. What is the company’s market/book ratio? A company has an EPS of $1.50, a cash flow per share of $3.00, and a price/cash flow ratio of 8.0 times. What is its P/E ratio? Davison Truck Repairs has sales of $3,500,000 and cost of goods sold of $2,800,000. The com- pany believes it is possible to delay payment by 6 days and not offend its suppliers. Will the company’s accounts payable increase or decrease, and by how much if it takes on average 6 days loriger to pay its bills? -6 Gardial & Son has an ROA of 12%, a 5% profit margin, and a return on equity equal to 20%. What is the company’s total asset turnover? What is the firm’s equity multiplier? Acme Bearings has current assets of $5 million. The company’s current ratio is 2.5, and its quick ratio is 1.4. What is the firm’s level of current liabilities? What is the firm’s level of inventories? Assume you are given the following relationships for the Haslam Corporation: Sales/total assets 1.2X Return on assets (ROA) 4% Return on equity (ROE) 7% Calculate Haslam’s profit margin and debt ratio. The Nelson Company has $1,312,500 in current assets and $525,000 in current liabilities. Its initial inventory level is $375,000, and it will raise funds from additional notes payable and use them to increase inventory. How much can Nelson's short-term debt (notes payable) increase without pushing its current ratio below 2.0? What will be the firm’s quick ratio after Nelson has raised the maximum amount of short-term funds? Cayman Auto has $600,000 of debt outstanding, and it pays an interest rate of 8% annually: Cayman Auto’s annual sales are $3 million, its average tax rate is 25%, and its net profit margin is 3%. If the company does not maintain a TIE ratio of at least 5 times, its bank will refuse to renew the loan, and bankruptcy will result. What is Cayman Auto’s TIE ratio? Selected information is provided for Tiny Bubbles Bath Company: 2013 2014 2015 Sales $2,600,000 $3,000,000 $4,000,000 Assets $2,000,000 $2,250,000 $3,000,000 - Net income $ 207,000 $ 222,000 $ 245,000 Total equity $ 800,000 $ 800,000 $ 860,000 Calculate ROE-from 2013 to 2015 and evaluate whether you think this company’s ROE growth is sustainable. - ACR Corp. has $1,312,500 in current assets and $525,000 in current liabilities. Its initial inven- tory level is $375,000, and it will raise funds from additional notes payable and use them to increase inventory. How much can it increase its short-term debt (notes payable) without pushing its current ratio below 2.0? Maple Leaf Printing has $5 billion in assets, and its tax rate is 30%. Its basic earning power (BEP) ratio is 10%, and its return on assets (ROA) is 5%. What is Maple Leaf Printing’s times-interest-earned (TIE) ratio? Rite-on-Time Trucking currently has $750,000 in accounts receivable, and its days’ sales out- standing (DSO) is 55 days. It wants to reduce its DSO to 35 days by pressuring more of its cus- tomers to pay their bills on time. If this policy is adopted, the company’s average sales will fall by 15%. What will be the level of accounts receivable following the change? Assume a 365-day year. In the table that follows, complete the balance sheet and sales information for J. White Industries using the following financial data: Quick ratio: 0.80X Total assets turnover: 1.5X Days sales outstanding: 36.5 days® 83 : "‘"‘TA

84 Chapter 3 3-16 Comprehensive Ratio Calculations 3-17 Analysis of Financial Statements Cross profit margin on sales: (Sales ~ Cost of goods sold) /Sales = 25% Inventory turnover ratio: 3.75X Avérage payables period: 89.22 days *Calculation is based on a 365-day year. Balance Sheet Cash Accounts receivable 1 Inventories Fixed assets Total assets $400,000 Sales 365-day year. Accounts payable Long-term debt 50,000 Common stock Retained earnings Total liabilities and equity Cost of goods sold Data for Lozano Chip Company and its industry averages follow. a. Calculate the indicated ratios for Lozano. b. Construct the extended Du Pont equation for both Lozano and the industry. ¢ Outline Lozano's strengths and weaknesses as revealed by your analysis. Lozano Chip Company: Balance Sheet as at December 31, 2015 (Thousands of Dollars) Anvil Metal Works (AMW) had a quick ratio of 1.1, a current ratio of 2.5, an inventory turn- over of 4 times, gross profit margin of 10%, total current assets of $810,000; and cash and marketable securities of $120,000. What were AMW’s annual sales and its DSO? Assume a Cash $ 225,000 Accounts payable $ 601,866 Receivables 1,575,000 Notes payable 326,634 Inventories 1,125,000 Other current liabilities 525,000 Total current assets 2,925,000 Total current liabilities 1,453,500 Net fixed assets 1,350,000 Long-term debt 1,068,750 ' Common equity 1,752,750 Total assets $4,275,000 Total liabilities and equity $4,275,000 Lozano Chip Company: Income Statement for Year Ended December 31, 2015 (Thousands of Dollars) ' Sales $7,500,000 Cost of goods sold 6,375,000 Selling, general, and administrative expenses 825,000 Earnings before interest and taxes (EBIT) 300,000 Interest expense 111,631 Barnings before taxes (EBT) 188,369 Taxes (30%) . 56,511 Net income $ 131,858 Ratio Lozano Industry Average Current assets/Current liabilities 2.0 X Days sales outstanding (365-day year) 35.0 days COGS/Inventory 6.7 X Sales /Fixed assets 12.1 X Sales/Total assets 3.0 Net income/Sales 1.2% Net income/Total assets 3.6% Net income/Common equity 9.0% Total debt/Total assets 30.0% Total liabilities/Total assets 60.0% NEL

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Problems 3-18 The Lee Corporation’s forecasted 2015 financial statements follow, along with some industry Comprehensive average ratios. ’ Ratio Analysis 3. Calculate Lee’s 2015 forecasted ratios, compare them with the industry average data, b. What do you think would happen to Lee's ratios if the company initiated Coét—cutting Leée Corporation: Forecasted Balance Sheet as at December 31, 2015 Cash $ 72,000 Accounts receivable 439,000 Inventories 694,000 Total current assets 1,205,000 Fixed assets : _ 631,000 Total assets $ 1,836,000 ‘Accounts payable $ 332,000 Note payable 100,000 Accruals 170,000 Total current liabilities 602,000 - Long-term debt 404,290 Common stock 575,000 Retained earnings 254,710 Total liabilities and equity $ 1,836,000 Lee Corporation: Forecasted Income Statement for 2015 Sales - ' $ 6,350,000 Cost of goods sold 5,270,000 Selling, general, and administrative expenses 500,000 Depreciation . 240,000 Earnings before taxes (EBT) ) 340,000 Taxes (30%) 102,000 , Net income $ 238,000 Per-Share Data EPS $9.52 Cash dividends per share ’ $1.90 P/E - 5% Market price (average) $47.60 Number of shares outstanding 25,000 - Industry Financial Ratios (2015) Quick ratio 1.0X% Current ratio 2.7X Inventory turnover® 7.0% Days sales outstanding® 32 days Fixed assets turnover® ’ 13.0% Total assets turnover? 2.6% Return on assets : 9.1% Return on equity 18.2% Debt ratio 50.0% Profit margin on sales : 3.5% P/E 6.0% P/cash flow 35% *Industry average ratios have been constant for the past 4 years. ®Based on year-end balance sheet figures. “Calculation is based on a 365-day year. NEL

6-2 6-4 6-5 CR-1 Bond Valuation OB B FT IR e AL TP 186 Chapter 6 Bonds, Bond Valuation, and Interest Rates o Corporate bonds have default risk. If an issuer defaults, investors receive less than the promised return on the bond. Therefore, investors should evaluate a bond’s default risk ‘before making a purchase. ° Bonds are assigned ratings that reflect the probability of their going into default. The highest rating is AAA, and they go down to D. The higher a bond’s rating, the lower its risk and therefore its interest rate. e The relationship between the yields on securities and the securities’ maturities is known as the term structure of interest rates, and the yield curve is a graph of this relationship. s The shape of the yield curve depends on two key factors: (1) expectations about future inflation and (2) perceptions about the relative risk of securities with different maturities. e The yield curve is normally upward sloping—this is called a normal yield curve. However, the curve can slope downward (an inverted yield curve) if the inflation rate is expected to decline. The yield curve also can be flat, which means that interest rates on short-, medium-, and long-term maturities are the same. o The expectations theory states that yields on long-term bonds reflect expected future . interest rates. Web Extension 6C discusses this theory. Questions *6-1 Define each of the following terms: Bond; Government of Canada bond; corporate bond; foreign bond Par value; maturity date; coupon payment; coupon interest rate Floating-rate bond; zero coupon bond Call provision; retractable bond; sinking fund Convertible bond; warrant; income bond; real return bond Premium bond; discount bond Current yield (on a bond); yield to maturity (YIM); yield to call (YTC) Reinvestment risk; interest rate risk; default risk Indentures; mortgage bond; debenture; subordinated debenture Agency bond; junk bond; 1nvestment—grade ‘bond Real risk-free rate of interest, r*; nominal risk-free rate of interest, ryp Inflation premium (IP); default rlsk premmm (DRP); liquidity; liquidity premium (LP) . Interest rate risk; maturity risk premium (MRP); reinvestment rate risk Term structure of interest rates; yield curve “Normal” yield curve; inverted (“abnormal”) yield curve “The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices.” Is this statement true or false? Explain. The rate of return you would get if you bought a bond and held it to its maturity dateis called the bond’s yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond’s price and to its YTM? Does the length of time to maturity affect the extent to which a given change in interest rates will affect the bond’s price? If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain. A sinking fund can be set up in one of two ways. Discuss the advantages and disadvantages of each procedure from the viewpoint of both the firm and its bondholders. Concept Review Problem Full solutions are provided at www.nelson.com/brigham3ce. The Pennington Corporation issued a new series of bonds on January 1, 1991. The bonds were sold at par ($1,000), had a 12% coupon, and matured in 30 years, on December 31, 2020. Coupon payments are made semiannually (on June 30 and December 31). NEL

Easy Problems 1-6 6-1 Bond Valuation with Annual Payments 6-2 Yield to Maturity for Annual Payments 6-3 Current Yield for Annual Payments 6-4 Determinant of Interest Rates 6-5 Default Risk Premium 6-6 Maturity Risk Premium Intermediate Problems 7-22 6-7 Bond Valuation with Semiannual Payments 6-8 Yield to Maturity and Call with Semiannual Payments 6-9 Zero Coupon Bond Valuation and Maturity Dates 6-10 Yield to Maturity and Required Returns 6-11 Yield to Call and Realized Rates of Return Problems a. What was the YTM on January 1, 1991? b. What was-the price of the bonds on January 1, 1996, 5 years later, assuming that interest rates had fallen to 10%? c. Find the current yield, capital gains yield, and total return on January 1, 1992, given the price as determined in part b. d. On July 1, 2014, 6Y, years before maturity, Pennington’s bonds sold for $916.42. What were the YTM, the current yield, and the capital gains yield? e. Now, assume that you plan to purchase an outstanding Pennington bond on March 1, 2014, when the going rate of interest given its risk is 15.5%. How large a cheque must you writé to complete the transaction? Problems Answers {o odd-numbered problems appear in Appendix A ]ackson Corporation’s bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the current market price of these bonds? Temex bonds have 7 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The bonds sell at a price of $930. What is their yield to maturity? Cold Stone’s bonds have 12 years remaining to maturity. The bonds have a face value of $1,000 and a yield to maturity of 8%. They pay interest annually and have a 6% coupon rate. What is their current yield? The real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year government securities? What is the yield on 3-year government securities? A government bond that matures in 10 years has a yiéld of 6%. A 10-year corporate bond has ayield of 9%. Assume that the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the corporate bond? The real risk-free rate is 2%, and inflation is expected to be 2.5% for the next 2 years. A 2-year government security yields 4.9%. What is the maturity risk premium for the 2-year security? Flipflop Footwear has issued bonds that have a 10% coupon rate, payable semiannually. The bonds mature in 6 years and have a face value of $1,000 and a yield to maturlty of 5%. What is the price of the bonds? Digicomp’s bonds will mature in 8 years. The bonds have a face value of $1,000 and a 7% coupon rate, paid semiannually. The price of the bonds is $1,110. The bonds are callable in 3 years at a call price of $1,050. What is their yield to maturity? What is their yield to call? Anthony has a choice of one of two bonds to purchase: a 5-year, $1,000 face value bond with 6% coupons, paid semiannually, or a 5-year, $1,000 face value zero coupon. Both have a yield to maturity of 5.5%. a. How much will each bond cost? b. How much would Anthony pay for similar bonds, assuming a flat y1e1d curve, if they were available in maturity dates of 10 years? 15 years? c. Explain why the zero coupon bond prices change more than the regular bonds. The Brownstone Corporation bonds have 10 years remaining to maturity. Interest is paid annually; the bonds have a $1,000 par value; and the coupon interest rate is 9%. a. What is the yield to maturity at a current market price of (1) $875 or (2) $1,080? b. Would you pay $875 for one of these bonds if you thought that the approprxate rate of interest was 10%-—that is, if ry = 10%? Explain your answer. Four years ago, Guard Co. sold a 20-year bond issue with a 7% annual coupon rate and a 9% call premium. Today, Guard Co. called the bonds. The bonds originally were sold at their face value of $1,000. Compute the realized rate of return for investors who purchased the bonds when they were issued and who surrender them today in exchange for the call price. 187

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188 Chapter 6 6-12 Bond Yields and Rates of Return 6-13 Yield to Maturity and Current Yield 6-14 Current Yield with Semiannual Payments 6-15 Yield to Call, Yield to Maturity, and Market Rates 6-16 Interest Rate Sensitivity 6-17 Bond Value as Maturity Approaches 6-18 Determinants of Interest Rates 6-19 Maturity Risk Premiums 6-20 Capital Gain/Loss Bonds, Bond Valuation, and Interest Rates A 10-year, 12% semiannual coupon bond with a par value of $1,000 may be called in 4 years ata call price of $1,060. The bond sells for $1,100. (Assume that the bond has just been issued.) a. What is the bond’s yield to maturity? b. What is the bond’s current yield? c. What is the bond’s capital gain or loss yield? d. What is the bond's yield to call? You just purchased a bond that matures in 12 years. The bond has a face value of $1,000 and has an 6% annual coupon. The bond has a current yield of 6.4%. What is the bond’s yield to maturity? ' A bond that matures in 6 years selis for $1,090. The bond has a face value of $1,000 and a yield to maturity of 5.2328%. The bond pays coupons semiannually. What is the bond’s current yield? Waterman's 14% coupon rate, semiannual payment, $1,000 par value bonds that mature in 22 years are callable 4 years from now at a price of $1,090. The bonds sell at a price of $1,410 and the yield curve is flat. Assuming that interest rates in the economy are expected to remain at their current level, what is the best estimate of the nominal interest rate on new bonds? Abond trader purchased each of the following bonds ata yield to maturity of 9%. Immediately after she purchased the bonds, interest rates fell to 8%. What is the percentage change in the price of each bond after the decline in interest rates? Fill in the following table: (Assiume semiannual compounding.) Price @ 9% Price @ 8% Percentage Change 10-year, 10% coupon 10-year zero 20-year zero An investor has two bonds in his portfolio. Each bond matures in 4 years, has a face value of $1,000, and has a yield to maturity equal to 6.5%. One bond, Bond C, has a 10% coupon (paid semiannually); the other bond, Bond Z, is a zero coupon bond. Assuming that the yield to maturity of each bond remains at 6.5% over the next 4 years, what will be the price of each of the bonds at the following time periods? Fill in the following table: (Assume semiannual compounding.) ' ' e Price of Bond C Price of Bond Z = W No= O The real risk-free rate is 2%. Inflation is expected to be 3% this year, 4% next year, and 3.5% thereafter. The maturity risk premium is estimated to be 0.0005 X (t — 1), where t = number of years to maturity. What is the nominal interest rate on a 7-year government security? (Hint: Average the expected inflation rates to determine the inflation premium, IP.) Assume that the real risk-free rate, r*, is 3% and that inflation is expected to be 8% in Year 1, 5% in Year 2, and 4% thereafter. Assume also that all government securities are highly liquid and free of default risk. If 2-year and 5-year government bonds both yield 10%, what is the difference in the maturity risk premiums (MRPs) on the two notes; that is, what is MRPs minus MRP,? Faber Overdrive Autoparts issued at par value a 15-year 6% semiannual coupon bond, face value $1,000. At the end of 2 years the market yield increased to 7%. One year later, the market yield was 8%. If you purchased the bond at the end of Year 2 and sold it one year later, how much was your capital gain or loss? NEL

6-21 Zero Coupon Bond 6-22 Bond Valuation Challenging Problems 23-24 ' 6-23 Bond Valuation 6-24 Bond Valuation and Changes in Maturity and Required Returns © 625 ‘ield to Maturity nd Yield to Call Problems Castle Company’s pension fund projected that a significant number of its employees would take advantage of a retirement program the company plans to offer in 10 years. Anticipating maturity value is $18,000,000. What is their total cost (price) to Castle today? Bond X is noncallable, has 20 years to maturity, a 9% annual coupon, and a $1,000 par value. Your required return on Bond X is 10%, and if you buy it you plan to hold it for 5 years. You, and the market, have expectations that in 5 years the yield to maturity on a 15-year bond with similar risk will be 8.5%. How much should you be willing to pay for Bond X today? Maritime Construction needs to borrow $50 million for 5 years. The company estimates that the real rate of return is currently 2%, expected inflation per annum for the period is 3%, and the risk premium on its bonds 15 2.5%. The nominal risk-free rate is currently 5%. The com- pany has three financing options: L. 5-year, 7% coupon rate bonds (paid annually); 2. b-year zero coupon bonds; (annual compounding); 3. 5-year variable rate bonds (paid annually) at 4 coupon rate of LIBOR + 1.5%. Forecasted LIBOR rates are shown below. The variable rate bonds will be issued at par. Year LIBOR 1 3% 2 4% 3 4.5% 4 5% 5 5% a. What is the face value of the bonds (i.e., the total dollar amount of bonds) that need to be issued under the three options? What is the YTM on the variable rate bonds, assuming the above LIBOR rates? . Why is the required rate of return different on the floating rate bonds than on both the fixed-rate bonds? d. Briefly describe the benefits and drawbacks of issuing each type of security from the company treasurer’s perspective, Suppose Level 10 Systems sold an issue of bonds with a 15-year maturity, a $1,000 par value, a 6% coupon rate, and semiannual interest payments. a. Six years after the bonds were issued, the going rate of interest on bonds such as these fell to 5%. At what price would the bonds sell? - b. Suppose that, 6 years after the initial offering, the going interest rate had risen to 8%. At what price would the bonds sell? ¢ Suppose that the conditions in part a existed—that is, interest rates fel] to 5% 6 years after the issue date. Suppose further that the interest rate remained at 5% for the next 9 years. What would happen to the price of the bonds over time? Arnot International’s bonds have a current market price of $1,150. The bonds have a 7% annual coupon payment, a $1,000 face value, and 10 years left until maturity. The bonds may be called in 5 years at 107% of face value (call price = $1,070). a. What is the yield to maturity? b. Whatis the yield to call, if they are called in 5 years? ¢. Which yield might investors expect to earn on these bonds, and why? d. point. Thus, in Year 6 they may be called at 106% of face value, in Year 7 they may be called at 105% of face value, and so on. If the yield curve is horizontal and interest rates remain at their current level, when is the latest that investors might expect the firm to call

262 Chapter 8 Stocks, Stock Valuation, and Stock Market Equilibrium 8-1 8-2 ~ CR-1 Constant Growth Stock Valuation CR-2 Supernormal Growth Stock Valuation Easy Problems 1-6 8-1 DPS Calculation ° The marginal investor is a representative investor whose actions reflect the beliefs of those people who are currently trading a stock. It is the marginal investor who deter- . mines a stock’s price. : ° Equilibrium is the condition under which the expected return on a security as seen by the marginal investor is just equal to its required return, ; = r,. Also, the stock’s intrinsic value must be equal to its market price, P, = P, ° The efficient markets hypothesis (EMH) holds (1) that stocks are always in equilibrium and (2) that it is impossible for an investor who does not have inside information to consistently “beat the market.” Therefore, according to the EMH, stocks are always fairly valued (P, = Py), the required return on a stock is equal to its expected return (r, = ), and all stocks’ expected returns plot on the SML. Questions Define each of the following terms: Proxy; proxy fight; takeover; preemptive right; dual-class shares Closely held stock; publicly owned stock Intrinsic value (Py); market price (P,) Required rate of return, ry; expected rate of return, t; actual, or realized, rate of return, I Capital gains yield; dividend yield; expected total return Normal, or constant, growth; supernormal, or nonconstant, growth; zero growth stock Preferred stock Equilibrium; efficient markets hypothesis (EMH); three forms of EMH 5 e e o Two investors are evaluating Cogeco Cable’s stock for possible purchase. They agree on the expected value of D, and also on the expected future dividend growth rate. Furthermore, they agree on the risk of the stock. However, one investor normally holds stocks for 2 years, while the other normally holds stocks for 10 years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for Cogeco Cable’s stock. True or false? Explain. A bond that pays interest forever and has no maturity date is a perpetual bond. In what respect is a perpetual bond similar to a no-growth common stock, and to a share of preferred stock? Concept Review Problems Full solutions are provided at www.nelson.com/brigham3ce. Smith Co.’s current stock price is $84.80, and its last dividend was $3.20. In view of Smith’s strong financial position and its subsequent low risk, its required rate of return is only 10%. If dividends are expected to grow at a constant rate, g, in the future, and if r, is expected to remain at 10%, what is Smith’s expected stock price 5 years from now? Secure Systems Inc. is experiencing a period of rapid growth. Earnings and dividends are expected to grow at a rate of 18% during the next 2 years, at 14% in the third year, and at a constant rate of 5% thereafter. Snyder’s last dividend was $1.15, and the required rate of return on the stock is 12%. a. Calculate the value of the stock today. b. Calculate P; and P,. ‘ c. Calculate the dividend yield and capital gains yield for Years 1,2, and 3. Problems Answers to edd-numbered problems appear in Appendix A. Rident Corp. just paid a dividend of $1.50 a share (i.e,, D, = $1.50). The dividend is expected to grow 5% a year for the next 3 years, and then 10% a year thereafter. What is the expected dividend per share for each of the next 5 years? NEL

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8-2 Constant Growth Valuation 8-3 Constant Growth Valuation 8-4 Preferred Stock Valuation , 8-5 " Nonconstant Growth Valuation 8-6 Constant Growih Valuation Infermediate Problems 7-20 8-7 Constant Growth Rate, g 8-8 Constant Growth Valuation 8-9 Preferred Stock Rate of Return lining Growth Stock Valuation 8-11 Constant Growth Valuation 8-12 lonconstant Growth Valuation 8-13 Rates of Return and Equilibrium 8-14 »nconstant Growth Stock Yaluation Problems . Boehm Incorporated is expected to pay a $1.50 per share dividend at the end of the year (le., D, = $1.50). The dividend Is expected to grow at a constant rate of 6% a year. The required rate of return on the stock, r,, is 13%. What is the value per share of the company’s stock? Addon Manufacturing’s stock currently sells for $22 a share. The stock just paid a dividend of $1.20 a share (i.e., Dy = $1.20). The dividend is expected to grow at a constant rate of 10% a year. What stock price is expected 1 year from now? What is the required rate of return on the company’s stock? Basil Pet Products has, preferred stock outstanding that pays a dividend of $5 at the end of each year. The preferred stock sells for $50 a share. What is the preferred stock’s required rate of return? A company currently pays a dividend of $2 per share, D, = $2. It is estimated that the com- pany’s dividend will grow at a rate of 149% per year for the next 2 years, then the dividend will grow at a constant rate of 7% thereafter. The company’s stock has a beta equal to 1.8, the risk-free rate is 4.5%, and the market risk premium is 4%. What is your estimate of the stock’s current price? A stock’s most recent dividend was $1.80. The dividend is expected to grow by 6% and investors require an 11% return for holding the shares. a. What is the value of the stock? b. What proportion of the stock’s value is derived from the first five years of dividends? A stock is trading at $28 per share. The stock is expected to have a year-end dividend of $0.84 per share, which is expected to grow at some constant rate g throughout time. The stock’s required rate of return is 9%. If you are an analyst who believes in efficient markets, what is your forecast of g? Crisp Cookware’s common stock is expected to pay a dividend of $3 a share at the end of the year. The stock has a beta equal to 0.8. The risk-free rate is 5.2%, and the market risk premium is 6%. The stock’s dividend is expected to grow at some constant rate g The stock currently sells for $40 a share. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3 years? (That is, what is P3?) What will be the nominal rate of return on a preferred stock with a $25 par value, a stated dividend of 7% of par, and a current market price of (a) $16, (b) $21, (c) $25, and (d) $377 Brushy Mountain Mining Company’s ore reserves are being depleted, so its sales are falling. Also, its pit is getting deeper each year, so its costs are rising. As a result, the company’s earnings and dividends are declining at the constant rate of 4% per year. If Dy = $5 and s = 15%, what is the value of Brushy Mountain’s stock? What must be a company’s dividend growth rate for its stock to have an expected value of $13.25, assuming its most recently paid dividend was $0.50 and the stock’s required return is 10%? again in year 3 in the amount of $0.80 per share. The dividend will then be expected to grow by 20% per year for the following 2 years, then growing at a long run rate of 4% thereafter. If the stock’s required return is 11%, what is the value of Rosendale’s stock at present? The beta coefficient for Stock C is be = 0.4, whereas that for Stock D is bp = —0.3. (Stock D’s beta is negative, indicating that its rate of return rises whenever returns on most other stocks fall. There are very few negative beta stocks, although collection agency stocks are sometimes cited as an example.) a. Iftherisk-freerate is 4% and the expected rate of return on an average stock is 13%, what are the required rates of return on Stocks C and D? b. For Stock C, suppose the current price, Py, is $30; the next expected dividend, D,, is $1.00; and the stock’s expected constant growth rate is 4%. Is the stock in equilibrium? Explain, and describe what will happen if the stock is not in equilibrium. Assume that the average firm in your company’s industry is expected to grow at a constant rate of 6% and that its dividend yield is 7%. Your company is about as risky as the average firm in the industry, but it has just successfully completed some R&D work that leads you 263

264 Chapier 8 8-15 Nonconstant Growth Sfoqk Valuation 8-16 Preferred Stock Valuation 8-17 Return on Common Stock 8-18 Constant Growth Stock Valuation 8-19 Equilibrium Stock Price 8-20 Nonconstant Growth Challenging Problems 21-24 8-21 Constant Growth Stock Valuation Stocks, Stock Valuation, and Stock Market Equilibrium to expect that its earnings and dividends will grow at a rate of 50% [D, =Dyl + g) = Dy(1.50)] this year and 25% the following year, after which growth should match the 6% industry average rate. The last dividend paid was $1. What is the value per share of your firm’s stock? Simpkins Ltd. is expanding rapidly, and it currently needs to retain all of its earnings; hence it does not pay any dividends. However, investors expect Simpkins to begin paying divi- dends, with the first dividend of $0.50 coming 3 years from today. The dividend should grow rapidly—at a rate of 80% per year—during Years 4 and 5. After Year 5, the company should grow at a constant rate of 7% per year. If the required return on the stock is 16%, what is the value of the stock today? Rolen Riders issued preferred stock with a stated dividend of 6% of par. Preferred stock of this type currently yields 7%, and the par value is $25. Assume dividends are paid annually. a. What is the value of Rolén’s preferred stock? b. Suppose interest rate levels rise to the point where the preferred stock now yields 9%. What would be the value of Rolen’s preferred stock? Youbuy a share of Bavarian Auto Parts Corp. stock for $33.44. You expect it to pay dividends of $3.01, $3.311, and $3.6421 in Years 1, 2, and 3, respectively, and you expect to sell it at a price of $44.51 at the end of 3 years. a. Calculate the growth rate in dividends. b. Calculate the expected dividend yield. ¢. Assuming that the calculated growth rate is expected to continue, what is this stock’s expected total rate of return? Investors require a 15% rate of return on Brooks Sisters’ stock (r, = 15%). a. What will be Brooks Sisters’ stock value if the most recent dividend was $2 and if investors expect dividends to grow at a constant compound annual rate of (1) —5%, (2) 0%, (3) 5%, and (4) 10%? b. Using data from part a, what is the Gordon (constant growth) model value for Brooks Sisters’ stock if the required rate of return is 15% and the expected growth rate is (1) 15% or (2) 20%? Are these reasonable results? Explain. ¢ Isitreasonable to expect that a constant growth stock would have g>r? The risk-free rate of return, ryy, is 5%; the required rate of return on the market, Iy is 8%; and Schuler Company’s stock has a beta coefficient of 1.5, ' . a. If the dividend expected during the coming year, is $2.25, and if g = a constant 5%, at what price should Schuler’s stock sell? b. Now, suppose the Bank of Canada increases the money supply, causing the risk-free rate to drop.to 4% and 1y, to fall to 7%. What would this do to the price of the stock? ¢. Inaddition to the change in part b, suppose investors’ risk aversion declines; this fact, combined with the declinein rgg, causes 1y, to fall to 6.5%. At what price would Schuler’s stock sell? d. Now, suppose Schuler has a change in management. The new group institutes policies that increase the expected constant growth rate to 5.5%. Also, the new management stabilizes sales and profits, and thus causes the beta coefficient to decline from 1.5 to 1.3. Assume that rgp and ry; are equal to the values in part c. After all these changes, what is Schuler’s new equilibrium price? (Note: D, goes to $2.26.) Mitts Cosmetics Co.’s stock price is $58.88, and it recently paid a $2 dividend. This dividend is expected to grow by 25% for the next 3 years, and then grow forever at a constant rate, g; and ry = 12%. At what constant rate is the stock expected to grow after Year 3? You are analyzing Jillian’s Jewellery (J]) stock for a possible purchase. JJ just paid a dividend of $1.50 yesterday. You expect the dividend to grow at the rate of 6% per year for the next 3 years; if you buy the stock, you plan to hold it for 3 years and then sell it. a. What dividends do you expect for JJ stock over the next 3 years? In other words, calcu- late Dy, D,, and D,. b. JJ's stock has a required return of 13% and so this is the rate you'll use to discount divi- dends. Find the present value of the dividend stream; that is, calculate the PV of D, D, and D,, and then sum these PVs.

Spreadsheet Problem c. JJ stock should trade for $27.05 3 years from now (i.e., you expect P, = $27.05). Discounted at a 13% rate, what is the present value of this expected future stock price? In other words, calculate the PV of $27.05. d. If you plan to buy the stock, hold jt for 3 years, and then sell it for $27.05, what is the most you should pay for it? e Use the constant growth model to calculate the present value of this stock. Assume that g = 6% and is constant. f. fIs the value of this stock dependent on how long you plan to hold it? In other words, if your planned holding period were 2 years or 5 years rather than 3 years, would this affect the value of the stock today, Py? Explain your answer. 8-22 Reizenstein Technologies (RT) has just developed a solar panel capable of generating 200% ““'Nonconstant Growth Stock Valuation 8-23 Nonconstant Growth Stock Valuation 8-24 Corporate Valuation Model 8-25 Build a Model; sernormal Growth and Corporate Valuation more electricity than any solar panel currently on the market. As a result, RT is expected to experience a 15% annual growth rate for the next 5 years. By the end of 5 years, other firms will have developed comparable technology, and RT’s growth rate will slow to 5% per year indefinitely. Shareholders require a return of 12% on RT's stock. The most recent annual dividend, which was paid yesterday, was $1.75 per share. a. Calculate RT’s expected dividends for t = 1,t=2,t=3,t=4 andt=5. b. Calculate the estimated intrinsic value of the stock today, P, ¢ Calculate the expected dividend yield (D;/Py), the capital gains yield expected during the first year, and the expected total return (dividend yield plus capital gains yield) during the first year. (Assume that Py = Py, and recognize that the capital gains yield is equal to the total return minus the dividend yield.) Also calculate these same three yields for t =5 (e.g., D,/ Ps). Conroy Consulting Corporation (CCC) has been growing at a rate of 30% per year in recent years. This same nonconstant growth rate is expected to last for another 2 years. a. IfDy=$250,r, =12%, and 81 = 7%, then what is CCCs stock worth today? What are its expected dividend yield and capital gains yield at this time? b. Now assume that CCCs period of nonconstant growth is to last another 5 years rather than 2 years. How would this affect its price, dividend yield, and capital gains yield? Answer in words only. ¢ What will CCCs dividend yield and capital gains yield be once its period of nonconstant growth ends? (Hint: These values will be the same regardless of whether you examine the case of 2 or 5 years of nonconstant growth, and the calculations are very easy.) d. Of what interest to investors is the relationship over time between dividend yield and capital gains yield? Assume that today is December 31,2015, and the following information applies to Pacific Sky Airline: : ° After-tax operating profit [EBIT(1-T), also called NOPAT] for 2016 is expected to be $500 million, * The net capital expenditures for 2016 are expected to be $100 million (depreciation has already been deducted to arrive at the $100 million). No change is expected in net operating working capital. The free cash flow is expected to grow at a constant rate of 6% per year. The required rate of return on equity is 14%. The WACC is 10%. The market value of the company’s debt is $3 billion, 200 million shares of stock are outstanding. ¢ o e & o o Using the free cash flow approach, what should the company’s intrinsic stock price be today? (Note: Chapter 2 discussed how to calculate free cash flow.) Spreadsheet Problem Start with the partial model in the file Ch 08 Build a Model xIsx from the textbook’s website, Rework Problem 8-23, parts a, b, and ¢, using a spreadsheet model. For part b, calculate the price, dividend yield, and capital gains yield as called for in the problem.

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(FM) Financial Management Lab Questions and Problems

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