ISL 333E FINANCE

Problem Session
PROBLEM Ch2/Q5
The Klaven Corporation has operating income (EBIT) of $750,000. The
company’s depreciation expense is $200,000. Klaven is 100 % equity
financed, and it faces a 40% tax rate. Assume that the firm has no amortization
expense. What are its net income, its net cash flow, and its operating cash
flow?
PROBLEM Ch3/Q12
Bailey Corporation’s financial statements (dollars and shares are in millions) are
provided here.
Balance Sheets as of December 31
2012 2011
Assets
Cash and equivalents $14,000 $13,000
Accounts receivable 30,000 25,000
Inventories 28,125 21,000
Total current assets $72,125 $59,000
Net plant and equipment 50,000 47,000
Total assets $122,125 $106,000
Liabilities and Equity
Accounts payable $10,800 $9,000
Notes payable 6,700 5,150
Accruals 7,600 6,000
Total current liabilities $25,100 $20,150
Long term bonds 15,000 15,000
Total debt $40,100 $35,150
Common stock (5,000 shares) 50,000 50,000
Retaining earnings 32,025 20,850
Common equity $82,025 $70,850
Total liabilities and equity $122,125 $106,000
PROBLEM Ch3/Q12
Income Statement for Year Ending December 31, 2012
Sales $214,000
Operating costs excluding depreciation and amortization 170,000
EBITDA $ 44,000
Deprecition & amortization 5,000
EBIT $ 39,000
Interest 1,750
EBT $ 37,250
Taxes (40%) 14,900
Net income $ 22,350
Dividends paid $ 11,175

a. What was net operating working capital for 2011 and 2012?
b. What was Bailey’s 2012 free cash flow?
c. Constuct Bailey’s 2012 statement of stockholders’ equity.
d. What was Bailey’s 2012 EVA? Assume that its weighted average
cost of capital is 10%?
PROBLEM Ch3/Q15
Financial information for Powell Panther Corporation is shown here.
Powell Panther Corporation: Income Statements for Year Ending December31
(Millions of Dollars) 2012 2011
Sales $1,200.0 $1,000.0
Operating costs excluding depreciation 1,020.0 850.0
EBITDA $ 180.0 $ 150.0
Depreciation 30.0 25.0
Earnings before interest and taxes $ 150.0 $ 125.0
Less: Interest 21.7 20.2
Earnings before taxes $ 128.3 $ 104.8
Taxes (40%) 51.3 41.9
Net income available to common stockholders $ 77.0 $ 62.9
Common dividends $ 60.5 $ 46.4
PROBLEM Ch3/Q15
Powell Panther Corporation: Balance Sheets as of December 31
(Millions of Dollars) 2012 2011
ASSETS
Cash and marketable securities $ 12.0 $ 10.0
Accounts receivable 180.0 150.0
Inventories 180.0 200.0
Total current assets $ 372.0 $ 360.0
Net plant and equipment 300.0 250.0
Total assets $ 672.0 $ 610.0
LIABILITIES AND EQUITY
Accounts payable $ 108.0 $ 90.0
Notes payable 67.0 51.5
Accruals 72.0 60.0
Total current liabilities $ 247.0 $ 201.5
Long-term bonds 150.0 150.0
Total debt $ 397.0 $ 351.5
Common stock (50 million shares) 50.0 50.0
Retained earnings 225.0 208.5
Common equity $ 275.0 $ 258.5
Total liabilities and equity $ 672.0 $ 610.0
PROBLEM Ch3/Q15

a. What was net operating working capital for 2011 and 2012?

b. What was the 2012 free cash flow?

c. How would you explain the large increase in 2012 dividends?

PROBLEM Ch3/Q16
Laiho Industries’ 2011 and 2012 balance sheets (in thousands of dollars) are
shown.
2012 2011
Cash $ 102,850 $ 89,725
Accounts receivable 103,365 85,527
Inventories 38,444 34,982
Total current assets $ 244,659 $ 210,234
Net fixed assets 67,165 42,436
Total assets $ 311,824 $ 252,670

Accounts payable $ 30,761 $ 23,109

Accruals 30,477 22,656
Notes payable 16,717 14,217
Total current liabilities $ 77,955 $ 59,982
Long-term debts 76,264 63,914
Total liabilities $ 154,219 $ 123,896
Common stock 100,000 90,000
Retained earnings 57,605 38,774
Total Common equity $ 157,605 $ 128,774
Total liabilities and equity $ 311,824 $ 252,670
PROBLEM Ch3/Q16
a. Sales for 2012 were $455,150,000, and EBITDA was 15% of
sales. Furthermore, depreciation and amortization were 11% of net
fixed assets, interest was $8,575,000, the corporate tax rate was
40%,
and Laiho pays 40% of its net income as dividends. Given this
information, construct the firm’s 2012 income statement.

b. Construct the statement of stockholders’ equity for the year

ending December 31, 2012, and the 2012 statement of cash flows.

c. Calculate 2011 and 2012 net operating working capital (NOWC)

and 2012 free cash flow (FCF).

d. If Laiho increased its dividend payout ratio, what effect would

this have on corporate taxes paid? What effect would this have on
taxes paid by the company’s shareholders?
PROBLEM Ch4/Q21
Complete the balance sheet and sales information using the following
financial data:
Debt –to-asset ratio: 50%
Current ratio: 1.8x
Total assets turnover: 1.5
Days sales outstanding: 36.5 daysa
Gross profit margin on sales: (Sales-Cost of goods sold)/Sales=25%
Inventory turnover ratio: 5x
aCalculation is based on a 365-day year.

Balance Sheet
Cash Accounts payable
Accounts receivable Long-term debt 60,000
Inventories Common stock
Fixed assets Retained earnings 97,500
Total assets $300,000 Total liabilities and equity
Sales Cost of goods sold
PROBLEM Ch4/Q22

Data for Barry Computer Company and its industry averages

follow.
a. Calculate the indicated ratios for Barry.
b. Construct the DuPont equation for both Barry and the
industry.
c. Outline Barry’s strengths and weaknesses as revealed by
your analysis.
d. Suppose Barry had doubled its sales as well as its
inventories, accounts receivable, and common equity during
2012. How would that information affect the validity of your ratio
analysis? (Hint: Think about averages and the effects of rapid
growth on ratios if averages are not used. No calculations are
needed.)
PROBLEM Ch4/Q22

Barry Computer Company:

Balance Sheet as of December 31, 2012 (In Thousands)

Cash $77,500 Accounts payable $129,000

Receivables 336,000 Notes payable 84,000
Inventories 241,500 Other current liabilities 117,000
Total current assets $655,000 Total current liabilities $330,000
Net fixed assets 292,500 Long-term debt 256,500
Common equity 361,000
Total assets $947,500 Total liabilities and equity $947,500
PROBLEM Ch4/Q22
Barry Computer Company: Income Statement for Year Ended December
31, 2012 (In Thousands)

Sales $1,607,500
Cost of goods sold
Materials $717,000
Labor 453,000
Heat, light, and power 68,000
Indirect labor 113,000
Depreciation 41,500 1,392,500
Gross profit $ 215,000
Selling expenses 115,000
General and administrative expenses 30,000
Earnings before interest and taxes (EBIT) $ 70,000
Interest expense 24,500
Earnings before taxes (EBT) $ 45,500
Federal and state income taxes (40%) 18,200
Net income $ 27,300
PROBLEM Ch4/Q22

RATIO BARRY INDUSTRY AVERAGE

Current 2.0x
Quick 1.3x
Days sales outstandinga 35 days
Inventory turnover 6.7x
Total assets turnover 3.0x
Profit Margin 1.2%
ROA 3.6%
ROE 9.0%
Total debt/total assets 60.0%
a Calculation is based on a 365-day year.
PROBLEM Ch17/Q1
Carter Corporation’s sales are expected to increase from $5 million in 2012 to
$6 million in 2013, or by 20%. Its assets totaled $3 million at the end of 2012.
Carter is at full capacity, so its assets must grow in proportion to projected
sales. At the end of 2012, current liabilities are $1 million, consisting of
$250,000 of accounts payable, $500,000 of notes payable, and $250,000 of
accrued liabilities. Its profit margin is forecasted to be 5%, and the forecasted
retention ratio is 30%. Use the AFN equation to forecast the additional funds
Carter will need for the coming year.
PROBLEM Ch17/Q7
At the end of last year, Roberts Inc. reported the following income statement
(in millions of dollars):

Sales $3,000
Operating costs excluding depreciation 2,450
EBITDA $ 550
Depreciation 250
EBIT $ 300
Interest 125
EBT $ 175
Taxes (40%) 70
Net income $ 105
PROBLEM Ch17/Q7
Looking ahead to the following year, the company’s CFO has assembled this
following information:

• Year-end sales are expected to be 10% higher than the $3 billion in sales
generated last year.
• Year-end operating costs, excluding depreciation, are expected to equal
80% of year-end sales.
• Depreciation is expected to increase at the same rate as sales.
• Interest costs are expected to remain unchanged.
• The tax rate is expected to remain at 40%.

On the basis of this information, what will be the forecast for Roberts’ year-end
net income?
PROBLEM Ch17/Q13
Morrissey Technologies Inc.’s 2012 financial statements are shown here.
Morrissey Technologies Inc.: Balance Sheet as of December 31, 2012

Cash $ 180,000 Accounts payable $ 360,000

Receivables 360,000 Notes payable 56,000
Inventories 720,000 Accrued liabilities 180,000
Total current assets $1,260,000 Total current liabilities $ 596,000
Long-term debt 100,000
Fixed assets 1,440,000 Common stock 1,800,000
Retained earnings 204,000
Total assets $2,700,000 Total liabilities& eq. $2,700,000
PROBLEM Ch17/Q13
Morrissey Technologies Inc.:
Income Statement for December 31,2012

Sales $3,600,000
Operating costs including depr. 3,279,720
EBIT $ 320,280
Interest 20,280
EBT $ 300,000
Taxes (40%) 120,000
Net income $ 180,000

Per Share Data:

Common stock price $24.00
Earnings per share (EPS) $ 1.80
Dividends per share (DPS) $ 1.08
PROBLEM Ch17/Q13
Suppose that in 2013, sales increase by 10% over 2012 sales.
The firm currently has 100,000 shares outstanding. It expects
to maintain its 2012 dividend payout ratio and believes that its
assets should grow at the same rate as sales. The firm has no
excess capacity. However, the firm would like to reduce its
Operating costs/ Sales ratio to 87.5% and increase its total
debt-to-assets ratio to 30%. (It believes that its current debt
ratio is too low relative to the industry average.) The firm will
raise 30% of 2013 forecasted interest-bearing debt as notes
payable, and it will issue long-term bonds for the remainder.
The firm forecasts that its before-tax cost of debt (which
includes both short-term and long-term debt) is 12.5%. Assume
that any common stock issuances or repurchases can be made
at the firm’s current stock price of $45.
PROBLEM Ch17/Q13
a. Construct the forecasted financial statements assuming that
these changes are amde. What are the firm’s forecasted notes
payable and long-term debt balances? What is the forecasted
addition to retained earnings?
b. If the profit margin remains at 5% and the dividend payout
ratio remains at 60%, at what growth rate in sales will the
additional financing
requirements be exactly zero? In other words, what is the firm’s
sustainable growth rate? (Hint: Set AFN equal to zero and
solve for g.)
PROBLEM Ch17/Q14
Krogh Lumber’s 2012 financial statements are shown here.
Krogh Lumber: Balance Sheet as of December 31, 2012
(Thousands of Dollars)
Cash $ 1,800 Accounts payable $ 7,200
Receivables 10,800 Notes payable 3,472
Inventories 12,600 Accrued liabilities 2,520
Total current assets $25,200 Total current liabilities $13,192
Mortgage bonds 5,000
Net fixed assets 21,600 Common stock 2,000
Retained earnings 26,608
Total assets $46,800 Total liabilities and eq. $46,800
PROBLEM Ch17/Q14
Krogh Lumber: Income Statement for December 31, 2001
(Thousands of Dollars)
Sales $36,000
Operating costs including depreciation 30,783
Earnings before interest and taxes $ 5,217
Interest 1,017
Earnings before taxes $ 4,200
Taxes (40%) 1,680
Net income $ 2,520
Dividends (60%) $1,512
Addition to retained earnings 1,008
PROBLEM Ch17/Q14
a. Assume that the company was operating at full capacity in 2012 with
regard to all items except fixed assets; fixed assets in 2012 were being
utilized to only 75% of capacity. By what percentage could 2013 sales
increase over 2012 sales without the need for an increase in fixed
assets?
b. Now suppose 2013 sales increase by 25% over 2012 sales. Assume
that Krogh cannot sell any fixed assets. All assets other than fixed
assets will grow at the same rate as sales; however, after reviewing
industry averages, the firm would like to reduce its Operating costs/
Sales ratio to 82% and increase its debt-to-assets ratio to 42%. The firm
will maintain its 60% dividend payout ratio, and it currently has 1 million
shares outstanding. The firm plans to raise 35% of its 2013 interest-
bearing debt as notes payable, and it will issue bonds for the remainder.
Its before-tax cost of debt is 11%. Any stock issuance or repurchases will
be made at the firm’s current stock price of $40. Develop Krogh’s
projected financial statements. What are the balances of notes payable,
bonds, common stock, and retained earnings?
PROBLEM Ch5/Q35

You want to buy a house that costs $100,000. You have $10,000 for a
down payment, but your credit is such that mortgage companies will
not lend you the required $90,000. However, the realtor persuades the
seller to take a $90,000 mortgage (called a seller take-back mortgage)
at a rate of 7%, provided the loan is paid off in full in 3 years. You
expect to inherit $100,000 in 3 years; but right now all you have is
$10,000, and you can afford to make payments of no more than
$7,500 per year given your salary. (The loan would call for monthly
payments, but assume end-of-year annual payments to simplify
things.)
PROBLEM Ch5/Q35

a. If the loan was amortized over 3 years, how large would each
annual payment be? Could you afford those payments?
b. If the loan was amortized over 30 years, what would each
payment be? Could you afford those payments?
c. To satisfy the seller, the 30-year mortgage loan would be written
as a balloon note, which means that at the end of the third year,
you would have to make the regular payment plus the remaining
balance on the loan. What would the loan balance be at the end of
Year 3, and what would the balloon payment be?
PROBLEM Ch5/Q40

A father is planning a savings program to put his daughter through

college. She is 13, she plans to enroll at the university in 5 years, and
she should graduate 4 years later. Currently, the annual cost (for
everything— food, clothing, tuition, books, transportation, and so forth)
is $15,000, but these costs are expected to increase by 5% annually.
The college requires that this amount be paid at the start of the year.
She now has $7,500 in a college savings account that pays 6%
annually. Her father will make 6 equal annual deposits into her
account;the first deposit today and the sixth on the day she starts
college. How large must each of the six payments be?
PROBLEM Ch5/Q40

[Hint: Calculate the cost (inflated at 5%) for each year of college
and find the total present value of those costs, discounted at
6%, as of the day she enters college. Then find the
compounded value of her initial $7,500 on that same day. The
difference between the PV of costs and the amount that would
be in the savings account must be made up by the father’s
deposits, so find the six equal payments (starting immediately)
that will compound to the required amount.]
PROBLEM Ch6/Q14

Suppose 2-year Treasury bonds yield 4.5%, while 1-year bonds yiels 3%. r* is
1%, and the maturity risk premium is zero.
a. Using the expectations theory, what is the yield on a 1-year bond 1-year
from now?
b. What is the expected inflation rate in Year 1? Year 2?
PROBLEM Ch6/Q15

Assume that the real risk–free rate is 2% and that the maturity risk premium is
zero. If a 1-year Treasury bond yield is 5% and and a 2-year Treasury bond
yields 7%, what is the 1-year interest rate date is expected for Year 2? What
inflation rate is expected during Year 2? Comment on why the average interest
rate during the 2-year period differs from the 1-year interest rate expected for
Year 2.
PROBLEM Ch6/Q17

A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond

yields 6.4%, and a 10-year corporate bond yields 8.4%. The market
expect that inflation will average 2.5% over the next 10 years (IP10 =
2.5%). Assume that there is no maturity risk premium (MRP = 0) and
that the annual real risk-free rate, r*, will remain constant over the next
10 years. (Hint: Remember that the default risk premium and the
liquidity Premium are zero for Treasury securities: DRP = LP = 0.) A 5-
year corporate bond has the same default risk Premium and the
liquidity Premium as the 10-year corporate bond described. What is
the yield on this 5-year corporate bond?
PROBLEM Ch7/Q6
An investor has two bonds in her portfolio, Bond C and Bond Z. Each bond
matures in 4 years, has a face value of $1000, and has a yield to maturity of
9.6%. Bond C pays a 10% annual coupon, while bond Z is a zero coupon
bond.
a. Assuming that the yield to maturity of each bond remains at 9.6% over the
next years, calculate the price of the bonds at each of the following years to
maturity. (from 0 to 4)
b. Plot the time path of the prices for each bond.
PROBLEM Ch7/Q10

Hooper Pricing Inc. has bonds outstanding with 9 years left to maturity. The
bonds have an 8% annual coupon rate and were issued 1 year ago at their par
value of $1000. However, due to change in interest rates, the bond’s market
price has fallen to $901.40. The capital gains yield last year was -9.86%.
PROBLEM Ch7/Q10
a. What is the yield to maturity?
b. For the coming year, what are the expected current and capital gains
yields?
c. Will the actual realized yields be equal to the expected yields if interest rates
change? If not, how will they differ?
PROBLEM Ch8/Q6

Stocks X and Y have the following probability distributions of

expected future returns:

Probability X Y
0.1 -10 -35
0.2 2 0
0.4 12 20
0.2 20 25
0.1 38 45
PROBLEM Ch8/Q6
a) Calculate the expected rate of return ry, for Stock Y (rx = 12%).

b) Calculate the standard deviation of expected returns, σx, for Stock X (σy =

20.35%). Now calculate the coefficient of variation for Stock Y. Is it possible

that most investors will regard Stock Y as being less risky than Stock X?

Explain.
PROBLEM Ch8/Q13
Consider the following information for three stocks, Stocks X, Y, and Z.
The returns on the three stocks are positively correlated, but they are
not perfectly correlated. (That is, each of the correlation coefficients is
between 0 and 1.)

Stock Expected Standard Beta

Return Deviation
X 9.00% 15% 0.8
Y 10.75% 15% 1.2
Z 12.50% 15% 1.6

Fund Q has one-third of its funds invested in each of the three stocks.
The risk-free rate is 5.5%, and the market is in equilibrium. (That is,
required returns equal expected returns.)
PROBLEM Ch8/Q13
a. What is the market risk premium (rM-rRF)?
b. What is the beta of Fund Q?
c. What is the required return of Fund Q?
d. Would you expect the standard deviation of Fund Q to be less than 15%,
equal to 15%, or greater than 15%? Explain.
PROBLEM Ch9/Q15
Dozier Corporation is a fast-growing supplier of office products. Analysts
project the following free cash flows (FCFs) during the next 3 years, after
which FCF is expected to grow at a constant 7% rate. Dozier’s WACC is 13%.
1. year -$20
2. year $30
3. year $40
PROBLEM Ch9/Q15
a. What is Dozier’s horizon, or continuing, value? (Hint: Find the value of all
free cash flows beyond Year 3 discounted back to Year 3.)
b. What is the firm’s value today?
c. Suppose Dozier has $100 million of debt and 10 million shares of stock
outstanding. What is your estimate of current price per share?
PROBLEM Ch9/Q17
Your broker offers to sell you some shares of Bahnsen&Co. common stock
that paid a dividend of $2.00 yesterday. Bahnsen’s dividend is expected to
grow at 5% per year for the next 3 years. If you buy the stock, you plan to hold
it for 3 years and then sell it. The appropriate discount rate is 12%.
PROBLEM Ch9/Q17
a. Find the expected dividend for each of the next 3 years; this
is, calculate D1, D2 and D3. Note that D0= $2.00
b. Given that the first dividend payment will occur 1 year from
now, find the present value of the dividend stream; that is,
calculate the PVs of D1, D2 and D3 and then sum these PVs.

c. You expect the price of the stock 3 years from now to be

$34.73; that is, you expect P3 to equal $34.73. Discounted at a

12% rate, what is the present value of this expected future stock

price? In other words, calculate the PV of $34.73.

PROBLEM Ch9/Q17

d. If you plan to buy the stock, hold it for 3 years, and then sell it

for $34.73, what is the most you should pay for it today?

e. Use Equation 9-2 to calculate the present value of this stock.

Assume that g= 5% and that it is constant.

f. Is the value of this stock dependent upon how long you plan

to hold it? In other words, if your planned holding period was 2

years or 5 years rather than 3 years, would this affect the value

of the stock today, P0? Explain.

PROBLEM Ch10/Q18

Adams Corporation is considering four average-risk projects with the following

costs and rates of return:

Project Cost Expected Rate of

Return
1 $2000 16.00%
2 $3000 15.00%
3 $5000 13.75%
4 $2000 12.50%
PROBLEM Ch10/Q18
The company estimates that it can issue debt at a rate of rd=10%, and its tax
rate is 30%. It can issue preferred stock that pays a constant dividend of $5.00
per year at $49.00 per share. Also, its common stock currently sells for $36.00
per share; the next expected dividend, D1, is $3.50; and the dividend is
expected to grow at a constant rate of 6% per year.
PROBLEM Ch10/Q18
The target capital structure consists of 75% common stock, 15% debt, and
10% preferred stock.
a. What is the cost of each of the capital components?
b. What is Adams’ WACC?
c. Only projects with expected returns that exceed WACC will be accepted.
Which projects should Adams accept?
PROBLEM Ch11/Q17
A company has a 12% WACC and is considering two mutually exclusive
investments (that cannot be repeated) with the following cash flows:

0 1 2 3 4 5 6 7

Project A -$300 -$387 -$193 -$100 $600 $600 $850 -$180

Project B -$405 $134 $134 $134 $134 $134 $134 $0

a. What is each Project’s NPV?

b. What is each Project’s IRR?
c. What is each Project’s MIRR? (Hint: Consider Period 7 as the end of
Project B’s life.)
d. From your answers to Parts a, b, and c, which projects would be
selected? If the WACC was 18%, which Project would be selected?
PROBLEM Ch12/Q16
The Fernandez Company has an opportunity to invest in one
of two mutually exclusive machines that will produce a
product the company will need for the next 8 years. Machine
A costs $10 million but will provide after-tax inflows of $4
million per year of 4 years. If Machine A was replaced, its cost
would be $12 million due to inflation and its cash inflows
would increase to $4.2 million due to production efficiencies.
Machine B costs $15 million and will provide after-tax inflows
of $3.5 million per year for 8 years. If the WACC is 10%,
which machine should be acquired? Explain.
PROBLEM Ch13/Q6
The Bush Oil Company is deciding whether to drill for oil on a tract of
land that the company owns. The company estimates that the project
will cost $8 million today. Bush estimates that once drilled, the oil will
generate positive cash flows of $4 million a year at the end of each of
the next 4 years. While the company is fairly confident about its cash
flow forecast, it recognizes that if it waits 2 years, it will have more
information about the local geology as well as the price of oil. Bush
estimates that if it waits 2 years, the project will cost $9 million.
Moreover, if it waits 2 years, there is a 90% chance that the cash flows
will be $4.2 million a year for 4 years, and there is a 10% chance that
the cash flows will be $2.2 million a year for 4 years. Assume that all
cash flows are discounted at 10%.
PROBLEM Ch13/Q6
a. If the company chooses to drill today, what is the project’s expected net

present value?

b. Would it make sense to wait 2 years before deciding whether to drill?

Explain.

c. What is the value of the investment timing option?

d. What disadvantages might arise from delaying a project such as this drilling

project?