Chapter 1

Question 1-1
Define each of the following terms:
a. Proprietorship: When a business is owned and managed by a single individual
b. Partnership: When a business is owned and by more than one person, forming an entity
c. Corporation: A legal entity which is formed under the statutory laws is a separate entity and has a distinct
identity from its owners
d. Limited Partnership: A type of Partnership where there are 2 types of partners; limited and general
partners. Liability of the limited partners is limited to only his or her investment in the partnership firm.
Whereas the general partners has unlimited liability and full control over the partnership.
e. Limited Liability Partnership: In this type of partnership, the liability of all the partners is limited to the
amount of investments each one of them has made in the firm. It combines the limited liability advantages of
a corporation and the tax benefit of a partnership.
f. Professional Corporation: formed by professionals such as doctors, lawyers, accountants with the aim to
provide a way for the members to avoid certain unlimited liabilities yet be accountable for professional
liability
g. Stockholder Wealth Maximization: Primary goal of most companies. The management of a corporation is
given the property of the shareholders and is expected to increase its worth. However, the management
should not indulge in any illegal or unlawful activity while attaining its goal of maximizing stockholders’
wealth. Moreover, if the companies are unsuccessful in achieving its goal, they can be sued for it. To
maximize the stockholders’ wealth, the risk and timing of the earnings per share and the cash flows are
studied.
h. Money Market: Market where financial instruments with a maturity period less than a year are traded.
Securities traded in this market comprise short-term and highly liquid mainly involving debt securities.
i. Capital Market: Market where long term financial instruments, who have a maturity period of more than 365
days are traded. Securities traded in these markets are primarily corporate stocks and long-term debts
j. Primary Market: Markets where newly issued stocks and bonds are sold to the public for the very first time
by the issuing corporation. It is a place where organizations raise new capital as the proceeds from sale of
shares is received by the company
k. Secondary Market: Market where already issued and outstanding shares are traded among investors. In
this market, the company does not raise any capital as the proceeds from the sale of securities is not
received by the company, but is received by the investor selling the security.
l. Private Markets: where transactions work out privately between two parties and these transactions are
called private placements. Instruments traded in this market are not liquid and are customised as per the
investors’ preferences.
m. Public Markets: Market in which standardized securities are traded on a recognized stock exchange. These
securities are standardized and more liquid than the instruments traded in the private markets.
n. Derivatives: Securities whose values depend on or are derived from the value of other assets. These
securities refer to trading rights on specific financial instruments. Derivatives contracts also have an
expiration date, after which they cease to be exercised.
o. Investment Banker: Financial Institutions that help companies to raise capital. They advise the company
during Initial Public Offering (IPO) with regards to the design and the appropriate pricing strategy of the
securities. They also act as the underwriters by buying the stocks of the companies and then sell them to the
investors. They also provide other consulting and advisory services such as asset management and
consultation with regards to M&A
p. Financial Service Corporation: Firms which provide financial services to different corporations such as
brokerage, insurance, banking or credit rating.
q. Financial Intermediary: Financial institutions like banks, who borrow directly from the providers of capital in
return of their stocks, bonds, or ownership of saving accounts. The intermediaries then invest these funds
and extend loans to the users or borrowers of the capital
 r. Mutual Fund: Financial Instruments that accepts deposits from many individuals and pool these funds to
invest them in different financial securities
s. Money Market Fund: Funds which invest in short term securities which have a lesser amount of risk
associated with them, for instance, commercial papers and treasury bills.
a. Physical Location Exchanges: Type of trading venue where traders meet in person, and buy and sell
securities in a physical location, usually in a building. The NYSE is a perfect example of physical location
exchange.
b. Computer/Telephone Network: Trading venue where traders do not meet in person to buy and sell shares.
Rather they conduct exchanges over a computer or telephone network. NASDAQ stock market operates on
this model
c. Open Outcry Auction: buyers and sellers of securities meet face to face and communicate verbally and
visually through shouting or using hand signals. When sellers and buyers agree upon the terms of sale with
regards to the quantity and price of goods, they inform the manager who manages the auction.
d. Dealer Market: Market where dealers keep a watch on the inventory of stock and quote the prices at which
they will sell and buy stocks. Any investor willing to sell or purchase the stocks must contact the dealers.
The transaction in these markets take place through the dealer whereas in an auction market, the investors
directly trade in securities.
e. Automated Trading Platform: Automated trading software is a sophisticated trading platform that uses
computer algorithms to monitor markets for certain conditions
f. Electronic Communications Network:
g. Production opportunities; time preferences for consumption
h. Foreign trade deficit

Question 1-2

What are the three principles of business organization? What are the advantages and disadvantages of each?

Form of Business Org Advantages Disadvantages

1. Ease of formation 1. Limited life (no continuity)

Sole proprietorship 2. Subject to few regulations (lower 2. Unlimited liability
compliance costs) 3. Difficult to raise capital to
3. No corporate income taxes (taxed as support growth
personal income)

1. Ease of formation 1. Limited life (no continuity)

Partnership 2. Subject to few regulations (lower 2. Unlimited liability
compliance costs) 3. Difficult to raise capital to
3. No corporate income taxes (taxed as support growth
personal income)
4. Possibility to form limited
partnership

1. Unlimited life 1. Double taxation

Corporation 2. Easy transfer of ownership 2. Cost of set-up and report
3. Limited liability filing
4. Ease of raising capital

Question 1-3
What is a firm’s fundamental value (which is also called its intrinsic value)? What might cause a firm’s intrinsic
value to be different from its actual market value?
A firm’s fundamental value or the intrinsic value is the sum of the present value of all the expected future cash flows.
The future cash flows for each year is discounted at the expected rate to their present values.

Question 1-4
Edmund Corporation recently made a large investment to upgrade its technology. Although 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’s earnings per share this year? What impact might
this investment have on the company's intrinsic value and stock price?
The earnings per share in the current year will decrease for Edmund Corp as a huge investment is made to upgrade its
existing technology. As the total expenses for the year will increase due to the upgrade, it leads to lower EPS.

Since the investment aims at reducing future costs, the intrinsic value of the corporation will increase as the free cash
flows will increase in the future. Since, there will be reduction in costs, the earnings per share will also increase which
may lead to the increase in stock prices. Though the investment doesn’t have an immediate positive effect in the short
run, it will positively affect Edmund Corporation in the long run.

Question 1-5
Describe the ways in which capital can be transferred from suppliers of capital to those who are demanding
capital.

1. Transfer of Capital from Savers to Borrowers:

Direct transfer - business sells its stocks or bonds directly to savers.
Example: A corporation issues commercial paper to an insurance company.
2. Through investment bank that underwrites the issue
Example: In an IPO, seasoned equity offering, or debt placement, a company sells security to an investment
banking house, which then sells security to investors.
3. Through a financial intermediary
Example: An individual deposits money in a bank and gets a certificate of deposit, bank makes commercial
loans to a company (bank gets note from company).

Question 1-6
What are the financial intermediaries, and what economic functions do they perform?
Financial intermediaries are financial institutions which accept deposits from the providers of capital and extend loans
to the borrowers of capital. The financial intermediaries perform an important economic function which is mobilization
and allocation of savings and capital in an effective manner. This enables the markets to become efficient and reduces
the cost involved in doing business which has a positive impact on the overall output of the economy.

Question 1-7
Is an initial public offering an example of a primary or a secondary market transaction?
An initial public offering (IPO) is a type of a primary market transaction. During an IPO, a company decides to go public
and sell shares to the general public for the first time and a primary market is a market where the securities are issued
for the very first time to the public. Thus, it is concluded that an IPO is a type of a primary market transaction.

Question 1-8
Contrast and compare trading in face-to-face auctions, dealer markets, and automated trading platforms.
Face to face trading occurs in an open outcry auction where buyers and sellers of securities meet face to face and
communicate verbally and visually through shouting or using hand signals. When sellers and buyers agree upon the
terms of sale with regards to the quantity and price of goods, they inform the manager who manages the auction.

In a dealers market, dealers keep a watch on the inventory of stock and quote the prices at which they will sell and buy
stocks. Any investor willing to sell or buy the stocks must contact the dealers. The transactions in these markets take
place through the dealer whereas in an auction market, the investors directly trade in securities.

Automated trading platforms with automated matching engines is a type of market where traders buy and sell
securities by posting their orders electronically on an automated trading system. If the order is matched, then the
automated platform automatically carries out the transaction and records the trade. This market eliminates the need for
a physical marketplace as well as for dealers.

Chapter 2
Question 2-1

An investor recently purchased a corporate bond that yields 7.68%. The investor is in the 25% federal-plus-
state tax bracket. What is the bond’s after tax yield to the investor?
After Tax Yield = Pre-tax Yield x (1-Tax Rate)
After Tax Yield = 7.68% x (1-25%)
After Tax Yield = 5.76%

Question 2-2
Corporate bonds issued by Johnson corporation currently yield 8.0%. Municipal bonds of equal risk currently yield
5.5%. At what personal tax rate would an investor be indifferent between these two bonds?

After-Tax Yield on Bonds by JC = After-Tax Yield on Municipal Bonds

8% = 5.5% / (1-Tax Rate)
(1-Tax Rate) = 5.5% / 8%
Tax Rate = 1 - 0.6875
Tax Rate = 31.25%

Question 2-3
Holly’s Art Galleries recently reported $7.9 million of net income. Its EBIT was $13 Million, and its federal tax rate
was 21% (ignore any possible state corporate taxes). What was its interest expense? (Hint: Write out the headings
for an income statement then fill in the known values. Then divide $7,9 million net income by 1 - T = 0.79 to find the
pretax income. The difference between EBIT and taxable income must be the interest expense. Use this procedure
to work some of other problems)

Pre-Tax Income = Net Income / (1 - Tax Rate)

Pre-Tax Income = $7.9 million / (1 - 21%)
Pre-Tax Income = $10,000,000

Interest Expense = EBIT - Pre-Tax Income

Interest Expense = $13 million - $10 million
Interest Expense = $3 million

Question 2-4
Nicholas Health Systems recently reported an EBITDA of $25 million and net income of $15.8 million. It had $2
million of interest expense, and its federal tax rate was 21% (ignore any possible state corporate taxes). What was
its charge for depreciation and amortization?

DA = EBITDA - EBIT
EBIT = Pre-Tax Income + Interest Expense

Pre Tax Income = Net income / (1 - Tax Rate)

Pre Tax Income = $15.8 million / (1 - 21%)
Pre Tax Income = $20 million

EBIT = Pre-Tax Income + Interest Expense

EBIT = $20 million + $2 million
EBIT = $22 million

DA = EBITDA - EBIT
DA = $25 million - $22 million
DA = $3 million

Question 2-5
Kendall Corners Inc. recently reported net income of $3.1 million and depreciation of $500,000. What was its net
cash flow? Assume it had no amortization expense.
Net Cash Flow = Net Income + Depreciation
Net Cash Flow = $3.1 million + $0.5 million
Net Cash Flow = $3.6 million

Question 2-6
In its most recent financial statement, Del-Castillo Inc, reported $70 million of net income and $900 million of
retained earnings. The previous retained earnings were $855 million. How much in dividends did the firm pay to
shareholders during the year?

Increase in Retained Earnings = RECY - REPY

Increase in Retained Earnings = $900 million - $855 million
Increase in Retained Earnings = $ 45 million

Dividend = Net Income - Increase in Retained Earnings

Dividend = $70 million - $45 million
Dividend = $25 million

Question 2-7
Zucker Inc. recently reported $4 million in earnings before interest and taxes (EBIT). Its federal-plus-state tax rate is
25%. What is the free cash flow?

FCF = EBIT x (1 - Tax Rate)

FCF = $4 million x (1 - 25%)
FCF = $ 3 million

Question 2-8
Jenn Translation (JT) Inc. reported $10 million in operating current assets, $15 million in net fixed assets, and $3
million in operating current liabilities. How much total net operating capital does JT have?

Net Operating Working Capital = Asset - Liabilities

Net Operating Working Capital = $10 million - $3 million
Net Operating Working Capital = $7 million

Total Net Operating Capital = NOWC + Fixed Asset

Total Net Operating Capital = $7 million + $15 million
Total Net Operating Capital = $22 million

Question 2-9
Carter Swimming Pools has $16 million in net operating profit after taxes (NOPAT) in the current year. Carter has
$12 million in total net operating assets in the current year and had $10 million in the previous year. What is its free
cash flow?

FCF = NOPAT - Net Investment in Total Operating Capital

Net Investment in Total Operating Capital = TNOCCY - TNOCPY

Net Investment in Total Operating Capital = $12 million - $10 million
Net Investment in Total Operating Capital = $2 million

FCF = NOPAT - Net Investment in Total Operating Capital

FCF = $16 million - $2 million
FCF = $14 million

Question 2-10
The Talley Corporation had taxable operating income of $365,000 (i.e, earnings from operating revenues minus all
operating expenses). Talley also had:
(1) interest charges of $50,000
(2) Dividend received of $15,000
(3) Dividend paid of $25,000

Its federal tax rate was 21% (ignore any possible state corporate taxes). Recall that 50% of dividends received are
tax exempt. What is the taxable income? What is the tax expense? What is the after tax income?

Non-Taxable portion for the dividends = Dividend Received x Tax Exempted Dividends
Non-Taxable portion for the dividends = $15,000 x 50%
Non-Taxable portion for the dividends = $7,500
------------------------------------------------------------------------------------------------------------------------------------------
Taxable Income = Taxable Operating Income + Taxable Dividends - Interest
Taxable Income = $365,000 + $7,500 - $50,000
Taxable Income = $322,500

Tax Expense = Taxable Income x Tax Rate

Tax Expense = $322,500 x 21%
Tax Expense = $67,725
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After Tax Income = Taxable Income - Taxes + $7,500
After Tax Income = $322,500 - $67,725 + $7,500
After Tax Income = $262,275

Question 2-11
The Wendt Corporation reported $50 million of taxable income. Its federal tax rate was 21% (ignore any possible
state corporate taxes).

a. What is the company's federal income tax bill for the year?
Income Tax = Taxable Income x Tax Rate
Income Tax = $50mio x 21%
Income Tax = $10.5mio

b. Assume the firm receives an additional $1 million of interest income from some bonds it owns. What is the
additional tax on this interest income?
Additional Tax = Interest Income x Tax Rate
Additional Tax = $1mio x 21%
Additional Tax = $210,000

c. Now assume that Wendt does not receive the interest income but does receive an additional $1 million as
dividends on some stock it owns. Recall that 50% of dividends received are tax exempt. What is the
additional tax on this dividend income?
Taxable Dividends = Dividend Income x Taxable Dividends Rate
Taxable Dividends = $1mio x 50%
Taxable Dividends = $500,000
 Additional Tax on Dividends = Taxable Dividend x Tax Rate
Additional Tax on Dividends = $500,000 x 21%
Additional Tax on Dividends = $105,000

Question 2-12
The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is chosen among AT&T bonds,
which yield 7.5%, state of Florida muni bonds, which yield 5% (but are not taxable), and AT&T preferred stock, with a
dividend yield of 6%. Shrieve's corporate tax rate is 35%, and 70% of the dividends received are tax exempt. Find the
after-tax rates of return on all three securities.

AT&T Bonds
Yield = 7.5%
After Tax Rate of Return = Yield x (1-Tax Rate)
After Tax Rate of Return = 7.5% x (1-35%)
After Tax Rate of Return = 4.875%

Florida Muni Bonds (No tax)

Yield = 5%

AT&T Preferred Stock

Yield = 6%
Tax Rate of Return = Pre-Tax Return x (1 - exempt rate) xTax Rate
Tax Rate of Return = 6% x (1 - 70%) x 35%
Tax Rate of Return = 0.63%

After Tax Rate of Return = Yield - Tax Rate of Return

After Tax Rate of Return = 6% - 0.63%
After Tax Rate of Return = 5.37%

Question 2-13
The Moore Corporation has operating income (EBIT) of $750,000. The company's depreciation 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?

Net Income = EBIT x (1 - Tax Rate)

Net Income = $750,000 x (1 - 40%)
Net Income = $592,500

Net Cash Flow = Net Income + Depreciation

Net Cash Flow = $592,500 + $200,000
Net Cash Flow = $792,500

Question 2-14
The Berndt corporation expects to have sales of $12 million. Costs other than depreciation are expected to be 75%
of sales, and depreciation is expected to be $1.5 million. All sales revenue will be collected in cash, and costs other
than depreciation must be paid for during the year. Berndt's federal-plus-state tax rate is 40%. Berndt has no debt.

Sales = $12mio
Cost exc. Deprec = 75% Sales
Depreciation = $1.5mio
Tax Rate = 40%

a. Set up an income statement. What is Berndt's expected net cash flow?

COGS = 75% x Sales
COGS = 75% x $12mio
COGS = $9mio

Net Cash Flow = Net Income + Depreciation

Net Cash Flow = $1,185,000 + $1,500,000
Net Cash Flow = $2,685,000
b. Suppose congress changed the tax laws so that Berndt's depreciation expenses doubled. No changes in
operations occurred. what would happen to reported profit and to net cash flow?
New Depreciation = 2 x $1,500,000
New Depreciation = $3,000,000

EBIT = Sales - COGS - New Depreciation

EBIT = $12mio - $9mio - $3mio
EBIT = 0
Net Income = 0

Net Cash Flow = Net Income + New Depreciation

Net Cash Flow = 0 + $3mio
Net Cash Flow = $3mio

c. Now suppose that congress changed the tax laws such that, instead of doubling Berndt's depreciation, it
was reduced by 50%. How would profit and net cash flow be affected?
New Depreciation = 0.5 x $1,500,000
New Depreciation = $750,000

EBIT = Sales - COGS - New Depreciation

EBIT = $12mio - $9mio - $750,000
EBIT = $2,250,000

Net Income = EBIT x (1-Tax Rate)

Net Income = $2.25mio x (1-21%)
Net Income = $1,777,500

Net Cash Flow = Net Income + New Depreciation

Net Cash Flow = $1,777,500 + $750,000
Net Cash Flow = $2,527,500
 d. If this were your company, would you prefer Congress to cause your depreciation expense to be doubled
or halved? Why?
The company would favor higher depreciation as it yields higher net cash flow

Question 2-15

NOPAT = EBIT x (1-Tax Rate)

NOPAT = $80,000 x (1-25%)
NOPAT = $60,000

Chapter 3
Question 3-1
Greene Sisters have a DSO of 20 days. The company's average daily sales are $20,000. What is the level of
its accounts receivable? Assume there are 365 days in a year.

Accounts receivable = DSO x Average Daily Sales

Accounts receivable = 20 Days x $20,000
Accounts receivable = $40,000
Question 3-2
Vigo Vacations has $200 million in total assets, $5 million in notes payable, and $25 million in long-term debt.
What is the debt ratio?

Debt Ratio = Total Debt / Total Asset

Total Debt = $25 million in long-term debt + $5 million in notes payable

Total Debt = $30mio

Total Asset = $200mio

Debt Ratio = $30mio / $200mio

Debt Ratio = 15%

Question 3-3
Winston Washers's stock price is $75 per share. Winston has $10 billion in total assets. Its balance sheet
shows $1 billion in current liabilities, $3 billion in long term debt, and $6 billion in common equity. It has 800
million shares of common stock outstanding. What is Winston's market/book ratio?

Market Capitalization = Stock Price x common stock outstanding

Market Capitalization = $75 x 800mio
Market Capitalization = $60 Bio

Book Value = Asset - Liability

Book Value = $10Bio - ($1Bio + $3Bio)
Book Value = $6Bio

Market/Book Ratio = Market Capitalization / Book Value

Market/Book Ratio = $60Bio / $6Bio
Market/Book Ratio = 10

Question 3-4
Reno Revolvers has an EPS of $1.50, a cash flow per share of $3.00, and a price/cash flow ratio of 8.0. What
is its P/E ratio?

Market Price per Share = FCF per share * (Price/FCF Ratio)

Market Price per Share = $3 * (8)
Market Price per Share = $24

PER = Market Price per Share / EPS

PER = $24 / $1.5
PER = 16

Question 3-5
Needham Pharmaceuticals has a profit margin of 3% and an equity multiplier of 2.0. Its sales are $100 million
and it has total assets of $50 million. What is its ROE?

Total Asset Turnover Ratio = Sales / Total Assets

Total Asset Turnover Ratio = $100mio / $50mio
Total Asset Turnover Ratio = 2

ROE = Profit Margin x Total Asset Turnover Ratio x Equity Multiplier

ROE = 3% x 2 x 2
ROE = 12%

Question 3-6
Gardial & Son has an ROA of 12%, a 5% profit margin, and a return on equity of 20%. What is the company's
total assets turnover? What is the firm's equity multiplier?

Total Asset Turnover Ratio = Profit Margin / Return on Asset

Total Asset Turnover Ratio = 5% / 12%
Total Asset Turnover Ratio = 0.42

Equity Multiplier = ROE/ROA

Equity Multiplier = 20%/12%
Equity Multiplier = 1.67

Question 3-7
Ace Industries has current assets equal to $3million. The company's current ratio is 1.5. and its quick ratio is
1.0. What is the firm's level of current liabilities? what is the firm's level of inventories?

Current Liabilities = Current Asset / Current Ratio

Current Liabilities = $3mio / 1.5
Current Liabilities = $2mio
Quick Asset = Quick Ratio x Current Liabilities
Quick Asset = 1 x $2mio
Quick Asset = $2mio

Inventory = Current Asset - Quick Asset

Inventory = $3mio - $2mio
Inventory = $1mio

Question 3-8
Assume you are given the following relationships for the Haslam Corporation: Sales/Total assets 1.2
Return on assets (ROA) 4%
Return on Equity (ROE) 7%

Calculate Haslam's profit margin and liabilities-to-assets ratio. Suppose half its liabilities are in the form of
debt. Calculate the debt-to-assets ratio.

Profit Margin = ROA / Asset Turnover Ratio

Profit Margin = 4% / 1.2
Profit Margin = 3.33%
-------------------------------------------------------------------------------------------------------------------------------
Equity Multiplier = ROE / ROA
Equity Multiplier = 7% / 4%
Equity Multiplier = 1.75

Liability to Asset Ratio = 1 - (1/Equity Multiplier)

Liability to Asset Ratio = 1 - (1/1.75)
Liability to Asset Ratio = 42.86%
-------------------------------------------------------------------------------------------------------------------------------
Debt to Asset Ratio = Liabilities to Asset Ratio x Percentage of Debt in Total Liabilities
Debt to Asset Ratio = 42.86% x 50%
Debt to Asset Ratio = 21.43%

Question 3-9
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 as 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?

Required Current Ratio = (Current Assets + Increase in Notes Payable) / (Current Liabilities + Increase in Notes
Payable)

Let Increase in Notes Payable = Y

2 = ($1,312,500 + Y) / ($525,000 + Y)
$1,050,000 + 2Y = $1,312,500 + Y
Y = $1,312,500 - $1,050,000
Y = 262,500

New Current Assets = Current Asset + Increase in Notes Payable

New Current Assets = $1,312,500 + 262,500
New Current Assets = $1,575,000

New Current Liabilities = Current Liabilities + Increase in Notes Payable

New Current Liabilities = $525,500 + 262,500
New Current Liabilities = $787,000

New Inventory Level = Current Inventory Level + Increase in Notes Payable

New Inventory Level = $375,000 + 262,500
New Inventory Level = $637,500

Quick Ratio = (New Current Asset - New Current Inventory) / New Current Liabilities
Quick Ratio = ($1,575,000 - $637,500) / $787,000
Quick Ratio = 1.19

Question 3-10
The Morris Corporation has $600,000 of debt outstanding, and it pays an interest rate of 8% annually.
Morris's annual sales are $3 million, its average tax rate is 40%, and its net profit margin on sales is 3%. If the
company does not maintain a TIE ratio of at least 5 to 1, then its bank will refuse to renew the loan and
bankruptcy will result. What is Morris's TIE ratio? (TIE: Times Earned Ratio)

“TIE Ratio = EBIT / Interest Expense”

-------------------------------------------------------------------------------------------------------------------------------

Net Income = Annual Sales * Profit margin on sales

Net Income = $3mio * 3%
Net Income = $90,000

Interest Expense = Annual Interest Rate * Outstanding Debt

Interest Expense = 8% * $600,000
Interest Expense = $48,000

Net Income = (EBIT - Interest Expense) x (1 - Tax Rate)

$90,000 = (EBIT - $48,000) x (1 - 40%)

EBIT = $168,000
-------------------------------------------------------------------------------------------------------------------------------
TIE Ratio = EBIT / Interest Expense
TIE Ratio = $168,000 / $48,000
TIE Ratio = 3.5x

Question 3-11
Complete the balance sheet and sales information in the table that follows for J.White Industries, using the
following financial data:

Total Assets Turnover = 1.5

Gross Profit Margin on Sales = 25% (Sales - COGS / Sales)
Total Liabilities-to-assets ratio = 40%
Quick Ratio = 0.8
Days Sales Outstanding (DSO) = 36.5 Days
Inventory Turnover Ratio = 3.75

Partial Income Statement Information

Sales $600,000
Cost of Goods Sold $450,000
Proft $150,000

Balance Sheet Information

Cash $28,000 Accounts payable $110,000
Accounts receivable $60,000 Long-term debt $50,000
Inventories $120,000 Common stock $140,000
Fixed Assets $192,000 Retained earnings $100,000
Total Assets $400,000 Total liabilities and equity $160,000

Asset Turnover = Sales / Total Assets

1.5 = Sales / $400,000
Sales = $600,000

GPM on Sales = (Sales - COGS / Sales)

25% = ($600,000-COGS)/$600,000
$150,000 = ($600,000-COGS)
COGS = 450,000

Liabilities to Asset Ratio = (AP + Long Term Debt) / $400,000

40% = (AP + $50,000)/$400,000160,000 = (AP + $50,000)
AP = $110,000

Inventory Turnover = COGS/Inventory

3.75 = $450,000 / Inventory
Inventory = $120,000

Days Sales Outstanding = (AR/Sales) x Number of Days

36.5 = AR/$600,000 x 365
AR = $60,000

Total Liabilities = AP + Long Term Debt

Total Liabilities = $160,000

Quick Ratio = Total Current Assets - Inventory / Current Liabilities

0.8 = Total Current Assets - $120,000 / $110,000
88,000 = Total Current Assets - $120,000
Total Current Assets = $208,000

Cash = Total Current Asset - Inventory - accounts receivable

Cash = $208,000 - $120,000 - $60,000
Cash = $28,000

Fixed Asset = Total Asset - Current Asset

Fixed Asset = $400,000 - $208,000
Fixed Asset = $192,000

Common Stock = Total Asset - Total Liabilities - Retained Earnings

Common Stock = $400,000 - $160,000 - $100,000
Common Stock = $140,000

Question 3-12
The Kretovich Company had a quick ratio of 1.4, a current ratio of 3.0, a day sales outstanding of 36.5 (based
on a 365 days year), total current assets of $810,000, and cash and marketable securities of $120,000. What
were Kretivich's annual sales?

Calculate Current Liabilities

Current ratio = Current Asset / Current Liabilities
3.0 = $810,000 / Current Liabilities
Current Liabilities = $270,000

Calculate Inventories
Quick Ratio = (Current Asset - Inventory) / Current Liabilities
1.4 = ( $810,000 - Inventory) / $270,000
Inventory = $432,000

Calculate AR
Current Assets = Cash + Inventory + AR
$810,000 = $120,000 + $432,000 + AR
AR = $258,000

Calculation of Sales
DSO = AR * 365 / Annual Sales
36.5 = $258,000 *365 / Annual Sales
Annual Sales = $2,580,000

Chapter 4
Question 4-1
Question 4-2

Question 4-3

Question 4-4
Question 4-5

Question 4-6
Question 4-7

Question 4-8
 Chapter 5
Question 5-1
Jackson Corporation's bonds have 12 years remaining until 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?

Par Value= $1,000

Annual Coupon Interest Rate = 8%
Yield to maturity = 9%

Annual Coupon Payment = Coupon Rate x Par Value

Annual Coupon Payment = 8% x $1,000
Annual Coupon Payment = $80
Question 5-2
Wilson Corporation's bonds have 12 years remaining until maturity. Interest is paid annually, the bonds have
a $1,000 par value, and the coupon interest rate is 10%. The bonds sell at a price of $850. What is the Yield to
Maturity?

Annual Coupon Payment = Coupon Rate x Par Value

Annual Coupon Payment = 10% x $1000
Annual Coupon Payment = $100

Question 5-3
Heath Food Corporation’s bonds have 7 years remaining until maturity. The bonds have a face value of
$1,000 and a yield to maturity of 8%. They pay interest annually and have a 9% coupon rate. What is their
current yield?

Annual Coupon Payment = Coupon Rate x Par Value

Annual Coupon Payment = 9% x $1000
Annual Coupon Payment = $90
Question 5-4
The real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and 4% during the next two
years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What
is the yield on 3-year Treasury securities?

Average Inflation Rate for 2 Years = (2% + 4%)/2 = 3%

Yield on 2-yr Treasury Securities = r* + IP2 + MRP + DRP + LP

Yield on 2-yr Treasury Securities = 4% + 3% + 0% + 0% + 0%
Yield on 2-yr Treasury Securities = 7%
--------------------------------------------------------------------------------------------------------------------------------------------
Average Inflation Rate for 3 Years = (2% + 4% + 4%)/3 = 3.33%

Yield on 2-yr Treasury Securities = r* + IP2 + MRP + DRP + LP

Yield on 2-yr Treasury Securities = 4% + 3.33% + 0% + 0% + 0%
Yield on 2-yr Treasury Securities = 7.33%

r* = Real risk-free rate

IP2 = Inflation Premium
MRP = Maturity Risk Premium
DRP = Default Risk Premium
LP = Liquidity Premium

Question 5-5
A treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a yield of 8%.
Assume that the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the
corporate bond?

Treasury Bond
Yield on Treasury Securities = r* + IP2 + MRP + DRP + LP
6% = r* + IP2 + MRP + 0+ 0
6% = r* + IP2 + MRP

Corporate Bond
Yield on Corporate Bonds = r* + IP2 + MRP + DRP + LP
8% = 6% + DRP + 0.5%
DRP = 2.5%
Question 5-6
The real risk-free rate is 3%, and inflation is expected to be 2% for the next 2 years. A 2-year Treasury
security yields 7.6%. What is the maturity risk premium for the 2-year security?

Yield on Securities = r* + IP2 + MRP + DRP + LP

7.6% = 3% + 2% + MRP + 0% + 0%
MRP = 2.6%

Question 5-7
Renfro rentals has issued bonds that have a 10% coupon rate, payable semiannually. The bonds mature in 8
years, have a face value of $1,000, and a yield to maturity of 8.5%. What is the price of the bonds?

Coupon Rate = 10% - Payable Semiannually

Maturity = 8 Years (16 Semi Annuals)
Face Value = $1,000
Yield to Maturity = 8.5%

Annual Coupon Payment = Coupon Rate x Par Value x 0.5 (from semi-annually)
Annual Coupon Payment = 10% x $1,000 x 0.5
Annual Coupon Payment = $50

Question 5-8
Thatcher Corporation's bonds will mature in 10 years. The bonds have a face value of $1,000 and an 8%
coupon rate, paid semiannually. The price of the bonds is $1,100. The bonds are callable in 5 years at a call
price of $1,050. What is their yield to maturity? What is their yield to call?

Annual Coupon Payment = Coupon Rate x Par Value x 0.5

Annual Coupon Payment = 8% x $1,000 x 0.5
Annual Coupon Payment = $40
Yield to Maturity = Semi-Annually YTM x 2
Yield to Maturity = 3.31% x 2
Yield to Maturity = 6.62%

Question 5-9
The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual interest plus $1,000 at
maturity. Bond L has a maturity of 15 years, and Bond S has a maturity of 1 year.

Period of MaturityL= 15 Years

Period of MaturityS= 1 Year
Annual Interest = $100

a. What will be the value of each of these bonds when the going rate of interest is 5%? Assume that
there is only one more interest payment to be made on Bond S. Round your answers to the nearest
cent.
Bond Value S = PV(5%,15,-100,-1000,0)
Bond Value S = $1,518.98

Bond Value S = PV(5%,1,-100,-1000,0)

Bond Value S = $1,047.62

b. What will be the value of each of these bonds when the going rate of interest is 7%? Assume that
there is only one more interest payment to be made on Bond S. Round your answers to the nearest
cent.
Bond Value S = PV(7%,15,-100,-1000,0)
Bond Value S = $1.273,24

Bond Value S = PV(7%,1,-100,-1000,0)

Bond Value S = $1.028,04
c. Why does the longer-term (15-year) bond fluctuate more when interest rates change than does the
shorter-term bond (1 year)?
Question 5-10
The Brownstone Corporation bonds have 5 years remaining until maturity. Interest is paid annually; the
bonds have a $1,000 par value; and the coupon interest rate is 9%.

Annual Coupon Payment = Coupon interest rate x par value

Annual Coupon Payment = 9% x $1,000
Annual Coupon Payment = $90

a. What is the yield to maturity at a current market price of (1) $829 or (2) $1,104?

Market Price $829

Yield to Maturity = RATE(9%,90,-829,1000,0)
Yield to Maturity = 13.98%

Market Price $1,104

Yield to Maturity = RATE(9%,90,-1,104,1000,0)
Yield to Maturity = 6.5%

b. Would you pay $829 for one of these bonds if you thought that the appropriate rate of interest was
12% - that is, if rd = 12%?
Bond Value = PV(12%,5,-90,-1000,0)
Bond Value = $891.86

At this rate of interest of 12%, the price of the bond is $891.86, which is greater than $829. Meaning, the
purchase will generate gain

Question 5-11
Goodwynn & Wolf Incorporated (G&W) issued a bond 7 years ago. The bond had a 20 year maturity, a 14%
coupon paid annually, a 9% call premium and was issued at par, $1,000. Today G&W called the bonds. If the
original investors had expected G&W to call the bonds in 7 years, what was the yield to call at the time the
bonds were issued?

Annual Coupon Payment = Coupon Rate x Par Value

Annual Coupon Payment = 14% x $1,000
Annual Coupon Payment = $140

Call Premium = Call Premium Rate x Par Value Bond

Call Premium = 9% x $1,000
Call Premium = $90

Callable Value = Call Premium + Par Value

Callable Value = $90 + $1,000
Callable Value = $1,090

Yield to Call = RATE(7,140,-1000,-1090,0)

Yield to Call = 14.82%
Question 5-12
A 10 year, 12% semiannual coupon bond with a par value of $1,000 may be called in 4 years at a call price of
$1,060. The bond sells for $1,100. (Assume that the bond has just been issued.)

SemiAnnual Coupon Yield = Coupon Rate x Par Value x 0.5

SemiAnnual Coupon Yield = 12 % x $1,000 x 0.5
SemiAnnual Coupon Yield = $60

a. What is the bond's yield to maturity?

SemiAnnual Yield to Maturity = RATE(20,60,-1100,-1000,0)
SemiAnnual Yield to Maturity = 5.18%

Annual Yield to Maturity = 5.18% x 2 = 10.36%

b. What is the bond's current yield?

Annual Coupon Payment = $60 x 2 = $120
Current Yield = Annual Coupon Payment / Bond’s Current Price
Current Yield = $120 / $1,100
Current Yield = 10.91%

c. What is the bond's capital gain or loss yield?

Yield to Maturity = Current Yield + Capital Gain/Loss
10.36% = 10.91% + Capital Gain/Loss
Capital Gain/Loss = -0.55%

d. What is the bond's yield to call?

Semi Annual Yield to Call = RATE(8,60,-1100,-1000,0)
Semi Annual Yield to Call = 5.07%
Annual - Yield to Call = 10.14%

Chapter 6
Question 6-1
Your investment club has only two stocks in its portfolio. $20,000 is invested in a stock with a beta of 0.7 and
$35,000 is invested in a stock with a beta of 1.3. What is the portfolio's beta?

Portfolio Value = $20,000 + $35,000 = $55,000

Weight Stock1 = 20,000 / 55,000 = 0.36

Weight Stock2 = 35,000 / 55,000 = 0.64

Beta = W1B1 + W2B2

Beta = (0.36 x 0.7) + (0.64 x 1.3)
Beta = 1.08

Question 6-2
AA Corporation’s stock has a beta of 0.8. The risk-free rate is 2.5% and the expected return on the market is
14%. What is the required rate of return on AA's stock?

Required Rate of Return = rRF+bi(rM-rRF)

Required Rate of Return = 2.5% +0.8 (14%-2.5%)
Required Rate of Return = 11.7%

Question 6-3
Suppose that the risk free rate is 5% and that the market risk premium is 7%. What is the required return on
(1) the market, (2) a stock with a beta of 1.0, and (3) a stock with a beta of 1.7? Assume that the risk free rate
is 5% and that the market risk premium is 7%.

(1) the market

Required Rate of Return = Market Risk Premium + Risk Free Rate
Required Rate of Return = 7% + 5%
Required Rate of Return = 12%

(2) a stock with a beta of 1.0

Required Rate of Return = rRF+bi(rM)
Required Rate of Return = 5% +1 (7%)
Required Rate of Return = 12%

(2) a stock with a beta of 1.7

Required Rate of Return = rRF+bi(rM)
Required Rate of Return = 5% +1.7 (7%)
Required Rate of Return = 16.9%

Question 6-4
An analyst gathered daily stock returns for February 1 through March 31, calculated the Fama-French factors
for each day in the sample (SMBt and HMLt), and estimated the Fama-French regression model shown in
Equation 6-21. The estimated coefficients were a1=0, b1=1.2, c1=-0.4, and d1=1.3. On April 1, the market
return was 10%, the return on the SMB portfolio (rSMB) was 3.2%, and the return on the HML portfolio (rHML)
was 4.8%. Using the estimated model, what was the stock’s predicted return for April 1?

Question 6-5
 Demand for the Probability of this Rate of return if Expected Return E = B*((C-ER)
Company’s demand occuring this demand
Product occurs (%)

Weak 0,1 -50% -5% 3,77%

Below Average 0,2 -5% -1% 0,54%

Average 0,4 16% 6% 0,08%

Above Average 0,2 25% 5% 0,37%

Strong 0,1 60% 6% 2,36%

Expected Return = (-5%) + (-1%) + (6%) + (5%) + (6%)

Expected Return = 11.4%

SDBond = (3.77% + 0.54% + 0.08% + 0.37% + 2.36%)^0.5

SDBond = 26.69%

Question 6-6

a. Calculate the expected rates of return for the market and stock J

Probability rM ERM rJ ERJ

0,3 15,00% 4,50% 20,00% 6,00%

0,4 9,00% 3,60% 5,00% 2,00%

0,3 18,00% 5,40% 12,00% 3,60%

 Expected RoRM = 4.5%+3.6%+ 5.4%= 13.5%
Expected RoRJ = 6%+2%+3.6% = 11.6%

b. Calculate the Standard Deviation for the Market and Stock J

Probability rM ERM SDM rJ ERJ SDJ

0,3 15,00% 4,50% 0.12% 20,00% 6,00% 0.06%

0,4 9,00% 3,60% 0.09% 5,00% 2,00% 0.05%

0,3 18,00% 5,40% 0.12% 12,00% 3,60% 0.08%

SDM = (0.12%+0.09%+0.12%)^0.5 = 3.85%

SDJ = (0.06%+0.05%+0.08%)^0.5 = 6.22%

Question 6-8
As an equity analyst you are concerned with what will happen to the required return to Universal Toddler
Industries stock as market conditions change. Suppose rRF=5% rM =12% and bUTI = 1.4
a. Under the current conditions what is rUTI, the required rate of return on UTI Stock?
rUTI = rRF + bUTI x ( rM - rRF)
rUTI = 0.05 + 1.4 (12% - 5%)
rUTI = 0.148

b. Now suppose rFR (1) increases to 6% or (2) decreases to 4%. The slope of the SMI remains constant.
How would this affect rM and rUTI?

Risk Free Return Increases to 6% Risk Free Return Decrease to 4%

Market RIsk Premium = Market Risk - Free-Risk Market RIsk Premium = Market Risk - Free-Risk
Rate Rate
Market RIsk Premium = 12% - 5% Market RIsk Premium = 12% - 5%
Market RIsk Premium = 7% Market RIsk Premium = 7%

Market Return = Market Risk Premium + Risk Free Market Return = Market Risk Premium + Risk Free
Return Return
Market Return = 7% + 6% Market Return = 7% + 4%
Market Return = 13% Market Return = 11%

rUTI = rRF + bUTI x ( rM - rRF) rUTI = rRF + bUTI x ( rM - rRF)

rUTI = 0.06 + 1.4 (13% - 5%) rUTI = 0.04 + 1.4 (11% - 4%)
rUTI = 0.06 + 1.4 (13% - 6%) rUTI = 0.04 + 1.4 (11% - 4%)
rUTI = 15.8% rUTI = 13.8%
 c. Now assume rFR remains at 5% but r M (1) increases to 14% or (2) falls to 11%. The slope of the SML
does not remain constant. How would these changes affect rUTI?

Market Risk Increases to 14% Market Risk Decrease to 11%

Market RIsk Premium = Market Risk - Free-Risk Market RIsk Premium = Market Risk - Free-Risk
Rate Rate
Market RIsk Premium = 14% - 5% Market RIsk Premium = 11% - 5%
Market RIsk Premium = 9% Market RIsk Premium = 6%

Market Return = Market Risk Premium + Risk Free Market Return = Market Risk Premium + Risk Free
Return Return
Market Return = 9% + 5% Market Return = 6% + 5%
Market Return = 14% Market Return = 11%

rUTI = rRF + bUTI x ( rM - rRF) rUTI = rRF + bUTI x ( rM - rRF)

rUTI = 0.05 + 1.4 (14% - 5%) rUTI = 0.05 + 1.4 (11% - 4%)
rUTI = 0.05 + 1.4 (14% - 6%) rUTI = 0.05 + 1.4 (11% - 4%)
rUTI = 17.6% rUTI = 13.8%

Question 6-9
Your retirement fund consists of a $5,000 investment in each of 15 different common stocks. The portfolio's
beta is 1.20. Suppose you sell one of the stocks with a beta of 0.8 for $5,000 and use the proceeds to buy
another stock whose beta is 1.6. Calculate your portfolio's new beta.

Old Portfolio Value = $5,000 x 15 = $75,000

Sold Stock Weight = $5,000/$75,000 = 0,067
Unsold Stock Weight= (75,000 - 5,000) / 75,000 = 0.933

Beta Unsold = [Beta old - (Sold Stock Beta x Sold Stock Weight)] / Weight unsold stock
Beta Unsold = [1.2 - (0.8 x 0.067)] / 0.933
Beta Unsold = 1.229

New Stock Weight = Value of New Stock / (Value of New Stock + Value of Old Portofolio)
New Stock Weight = 5,000 / (5,000 + 70,000)
New Stock Weight = 0,067

Beta New Portofolio = (Weight Unsold Stock x Beta Unsold Stock) + (Weight New Stock x Beta New Stock)
Beta New Portofolio = (0.993 x 1.229) + (0.067 x 1.6)
Beta New Portofolio = 1.25
Question 6-10

Stock Investment Beta Investment Weight Beta Fund

(A) (B) (C) (D) = (B/SUM B) (E) = C x D

A 1,5 10% 0,15

400.000

B -0,5 15% -0,075

600.000

C 1.000.000 1,25 25% 0,3125

D 2.000.000 0,75 50% 0,375

Total 0,7625

Rf = rRF + bUTI x ( rM - rRF)

Rf = 0.06 + 0.7625 (14% - 6%)
Rf = 12.1%

Question 6-11
You have a $2 million portfolio consisting of a $100,000 investment in each of 20 different stocks. the portfolio has a
beta equal to 1.1. You are considering selling $100,000 worth of one stock which has a beta equal to 0.9 and using
the proceeds to purchase another stock which has a beta equal to 1.4. What will be the new beta of your portfolio
following this transaction?

Portfolio Value = $100,000 x 20 = $2,000,000

Portfolio Beta = 1.1
Sold Stock Weight = $100,000 / $2,000,000 = 5%
Unsold Stock Weight = 100% - 5% = 95%

Beta Unsold = [Beta Initial - (Sold Stock Beta x Sold Stock Weight)] / Weight unsold stock
Beta Unsold = [1,1 - (0.9 x 5%)] / 95%
Beta Unsold = 1.1105

New Stock Weight = Value of New Stock / (Value of New Stock + Value of Old Portofolio)
New Stock Weight = 100,000 / (100,000 + 1,900,000)
New Stock Weight = 5%
Beta New Portofolio = (Weight Unsold Stock x Beta Unsold Stock) + (Weight New Stock x Beta New Stock)
Beta New Portofolio = (95% x 1.1105) + (5% x 1.4)
Beta New Portofolio = 1.125

Question 6-12
Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of return on an average stock is 13 percent,
and the risk-free rate of return is 7 percent. By how much does the required return on the riskier stock exceed the
required return on the less risky stock?

RR = rRF + bR x ( rM - rRF)
RR = 7% + 1.5 (13% - 7%)
RR = 16%

Rs = rRF + bs x ( rM - rRF)
Rs = 7% + 0.75 (13% - 7%)
Rs = 11.5%

Riskier Stock - Less Risky Stock = 16% - 11.5% = 5.5%

Chapter 7
Question 7-1
Ogier Incorporated currently has $800 millions in sales, which are projected to grow by 10% in Year 1 and 5%
in Year 2. Its operating profitability ratio (OP) is 10%, and its capital requirement ratio (CR) is 80%?
a. What is the projected sales in Years 1 and 2?
Year 0 = $800m
Year 1 = $800m x 110% = $880m
Year 2 = $880m x 105% = $924m
b. What are the projected amounts of net operating profit after taxes (NOPAT) for Years 1 and 2?
NOPAT Year 0 = Sales x ROP = $800m x 10% = $80m
NOPAT Year 1 = Sales x ROP = $880m x 10% = $88m
NOPAT Year 2 = Sales x ROP = $924m x 10% = $92.4m
c. What is the projected amount of Total net operating (OpCap) for Years 1 and 2?
OpCap Year 0 = Sales x CR = $800m x 80% = $640m
OpCap Year 1 = Sales x CR = $880m x 80% = $704m
OpCap Year 2 = Sales x CR = $924m x 80% = $739.2m
 d. What is the projected FCF for year 2?
FCF2 = NOPAT2 - (OpCap2 - OpCap1)
FCF2 = $92.4m - ($739.2m - $704m)
FCF2 = $57.2m

Question 7-2
EMC Corporation has never paid a dividend. Its current free cash flow is $400,000 and is expected to grow at
a constant rate of 5%. The weighted average cost of capital is WACC = 12%. Calculate EMC's value of
operations.
FCF = $400,000
Growth 5%
WACC = 12%

Vop = FCF0 + (1+g) / WACC - g

Vop = $400,000 + (1+5%) / 12% - 5%
Vop = $6,000,000

Question 7-3
Current and projected free cash flows for Radell Global Operations are shown below. Growth is expected to
be constant after 2015, and the weighted average cost of capital is 11%. What is the horizon (continuing)
value in 2016 if growth from 2015 remains constant?

Growth = FCF2021 / FCF2022 -1

Growth = ($707,547 / $667,500) -1
Growth = 6%

Horizon Value = [FCF2021 x (1 + g)] / [WACC - g]

Horizon Value = [$707,547 x (1 + 6%)] / [11% - 6%]
Horizon Value = $15,900m

Question 7-4
JenBritt Incorporated had a free cash flow (FCF) of $80 million in 2019. The firm projects FCF of $200 million
in 2020 and $500 million in 2021. FCF is expected to grow at a constant rate of 4% in 2022 and thereafter. The
weighted average cost of capital is 9%. What is the current (i.e. beginning of 2020) value of operations?

Horizon Value = [FCF2021 x (1 + g)] / [WACC - g]

Horizon Value = [$500m x (1 + 4%)] / [9% - 4%]
Horizon Value = $10,400m

Vop = [FCF2020 ]/ [(1 + WACC)1] + [FCF2021 + HV2021] / [(1+WACC)2]

Vop = [$200m ]/ [(1 + 9%)1] + [$500m + $10,400m] / [(1+9%)2]
Vop = $9,357.80m

Question 7-5
Blunderbluss Manufacturing’s balance sheets report $200 million in total debt, $70 million in short-term
investments, and $50 million in preferred stock. Blunderbluss has 10 million shares of common stock
outstanding. A financial analyst estimated that Blunderbuss’s value of operations is $800 million. What is the
analyst’s estimate of the intrinsic stock price per share?

Intrinsic Value of Stock = Intrinsic Value of Business / No. of Outstanding Shares

Intrinsic Value of Stock = [Vop - (Debt - Short Term Investment) - VPS / No. of Outstanding Shares
Intrinsic Value of Stock = [$800m - ($200m - $70m) - $50m / 10m
Intrinsic Value of Stock = $62

Question 7-6
Thress Industries just paid a dividend of $1.50 a share (i.e., Do = $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?

Question 7-7
Boehm Incorporated is expected to pay a $1.50 per share dividend at the end of this year (i.e. D1 = $1.50).
The dividend is expected to grow at a constant rate of 6% a year. The required rate of return on the stock, rs,
is 13%. What is the estimated value per share of Boehm

Value per Share = Dividend / (rs - g)

Value per Share = $1.5 / (13% - 6%) = $21.43
Question 7-8
Woidtke Manufacturing’s stock currently sells for $22 a share. The stock just paid a dividend of $1.20 a share
(i.e., D0 = $1.2), and the dividend is expected to grow forever at a constant rate of 10% a year. What stock
price is expected 1 year from now? What is the estimated required rate of return on Woidtke’s stock (assume
the market is in equilibrium with the required return equal to the expected return)?

P1 = P0 x (1+g)
P1 = $22 x (1+0.1)
P1 = $24.2

rS = [ D0 x (1+g) / P0 ] + g
rS = [ $1.2 x (1+0.1) / $22 ] + 0.1
rS = 16%

Question 7-9
A company currently pays a dividend of $2 per share, D0 = 2. It is estimated that the company's dividend will
grow at a rate of 20% percent 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 1.2 the risk-free rate is 7.5 percent, and the market
risk premium is 4 percent. What is your estimate of the stock's current price?
Stock required rate of return
rS = rRF + (b x MRP)
rS = 7.5% + (1.2 x 4%)
rS = 12.3%

Dividend in Years to come

D1 = D0 x (1+g)
D1 = $2 x (1+0.2)
D1 = $2.4
D2 = $2.4 x (1+0.2)
D2 = $2.88

Compute Horizon Value at Year 2

HV2 = D2 x (1+g2) / rS - g
HV2 = $2.88 x (1+7%) / 12.3% - 7%
HV2 = $58.11

Calculate Current Stock Price

P0 = [D1/ [(1 + rS)1] +[D2 + HV2]/ [(1 + rS)2
P0 = [$2.4 / (1 + 12.3%)1] + [$2.88 / (1 + 12.3%)2]
P0 = $50.5

Question 7-10
Nick's Enchiladas Incorporated has preferred stock outstanding that pays a dividend of $3 at the end of each
year. The preferred stock sells for $50 a share. What is the stock's required rate of return (assume the market
is in equilibrium with the required return equal to the expected return)? Round the answer to two decimal
places.

rPS = DPS/VPS
rPS = $5 / $50
rPS = 10%

Question 7-11
Brook Corporation's free cash flow for the current year (FCF0) was $4.00 million. Its investors require a 15%
rate of return on Brooks Corporation stock (WACC = 15%). What is the estimated value of the value of
operations if investors expect FCF to grow at a constant annual rate of (1) - 5%, (2) 0%, (3) 5%, or (4) 10%?

Annual Rate -5% Annual Rate 5%

Vop = [FCF0] x (1+g) / (WACC-g) Vop = [FCF0] x (1+g) / (WACC-g)
Vop = [$4mio] x (1+(-5%)) / (15% - (-5%)) Vop = [$4mio] x (1+(5%)) / (15% - (5%))
Vop = $15.83m Vop = $39.38m

Annual Rate 0% Annual Rate 14%

Vop = [FCF0] x (1+g) / (WACC-g) Vop = [FCF0] x (1+g) / (WACC-g)
Vop = [$4mio] x (1+(0%)) / (15% - (0%)) Vop = [$4mio] x (1+(10%)) / (15% - (10%))
Vop = $23.08m Vop = $110m
 Chapter 9
Question 9-1
Calculate the after-tax cost of debt under each of the following conditions:
a. Rd of 13%, tax rate of 0%
After-Tax Cost of Debt = rD x (1 - T)
After-Tax Cost of Debt = 13% x (1 - 0)
After-Tax Cost of Debt = 13%

b. Rd of 13%, tax rate of 20%

After-Tax Cost of Debt = rD x (1 - T)
After-Tax Cost of Debt = 13% x (1 - 0.2)
After-Tax Cost of Debt = 10.4%

c. Rd of 13%, tax rate of 35%

After-Tax Cost of Debt = rD x (1 - T)
After-Tax Cost of Debt = 13% x (1 - 0.35)
After-Tax Cost of Debt = 8.45%
Question 9-2
LL Incorporated’s currently outstanding 11% coupon bonds have a yield to maturity of 8.4%. LL believes it
could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 25%,
what is LL’s after-tax cost of debt?

After-Tax Cost of Debt = rD x (1 - T)

After-Tax Cost of Debt = 8.4% x (1 - 25%)
After-Tax Cost of Debt = 6.3%

Question 9-3
Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $50 a share. The issue is
expected to pay a constant annual dividend of $4.50 a share. Ignoring flotation costs, what is the company's
cost of preferred stock, rps? “F = Floatation Cost”

rPS = DPS / [PPS X (1-F)]

rPS = $4.5 / [$50 X (1-0)]
rPS = 9%

Question 9-4
Burnwood Tech plans to issue some $60 par preferred stock with a 6% dividend. A similar stock is selling on
the market for $70. Burnwood must pay flotation costs of 5% of the issue price. What is the cost of the
preferred stock?

DPS = Par Value x Dividend Rate

DPS = $60 x 6%
DPS = $3.6

rPS = DPS / [PPS X (1-F)]

rPS = $3.6 / [60 X (1-5%)]
rPS = 5.41%

Question 9-5
Summerdahl Resort’s common stock is currently trading at $36 a share. The stock is expected to pay a
dividend of $3.00 a share at the end of the year (D 1 = $3.00), and the dividend is expected to grow at a
constant rate of 5% a year. What is its cost of common equity?

rS = (D1 / P0) + g
rS = ($3 / $36) + 5%
rS = 13.33%

Question 9-6
Booher Book Stores has a beta of 0.8. The yield on a 3-month T-bill is 4% and the yield on a 10-year T-bond is
6%. The market risk premium is 5.5%, and the return on an average stock in the market last year was 15%.
What is the estimated cost of common equity using the CAPM?

rRS = rF + RPM x b
rRS = 6% + 5.5% x 0.8
rRS = 10.4%
Question 9-7
Shi Importer’s balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in
total common equity. Shi’s tax rate is 40%, rd = 6%, rps = 5.8%, and rs = 12%. If Shi has a target capital
structure of 30% debt, 5% preferred stock, and 65% common stock, what is its WACC?

WACC = rd x (1 - T) x Wd + rps x Wps + rs x Ws

WACC = 6% x (1 - 40%) x 30% + 5.8% x 5% + 12% x 65%
WACC = 9.44%

Question 9-8
David Ortiz Motors has a target capital structure of 40% debt and 60% equity. The yield to maturity on the
company's outstanding bonds is 9%, and the company's tax rate is 25%. Ortiz's CFO has calculated the
company's WACC as 9.9%. What is the company's cost of equity capital?

WACC = rd x (1 - T) x Wd + rs x Ws
9.9% = 9% x (1 - 25%) x 40% + rs x 0.6
rs = 12%

Question 9-9
A company's 6% coupon rate, semiannual payment, $1000 par value bond that matures in 30 years sells at a
price of $515.16. The company's federal-plus-state tax rate is 25%. What is the firm's after-tax component
cost of debt for purposes of calculating the WACC?

SemiAnnual Coupon Payment = Par Value x Coupon Rate / 2

SemiAnnual Coupon Payment = $1,000 x 6% / 2
SemiAnnual Coupon Payment = $30

Semiannual Pre-Tax Rate =RATE(60,30,-515.16,-1000,0)

Semiannual Pre-Tax Rate = 6%

Current Rate = 6% x 2 = 12%

After-Tax Cost of Debt = Pre-tax cost of debt x (1 - Tax Rate)

After-Tax Cost of Debt = 12% x (1 - 25%)
After-Tax Cost of Debt = 9%
Question 9-10
The earnings, dividends and stock price of Shelby Inc. are expected to grow at 7% per year in the future.
Shelby's common stock sells for $23 per share, its last dividend was $2.00 and the company will pay a
dividend of $2.14 at the end of the current year.

a. Using the discounted cash flow approach what is the cost of equity? (Answer is 16.3%-show all work
and formulas)
Cost of Equity (rS) = (D1 / P0) +g
Cost of Equity (rS) = ($2.14 / $23) + 7%
Cost of Equity (rS) = 16.3%

b. If the firm's beta is 1.6, the risk free rate is 9% and the expected return on the market is 13%, then
what would be the firm's cost of equity based on the CAPM approach?
Cost of Equity (rS) = rFR + (rM - rRF ) x b
Cost of Equity (rS) = 9% + (13% - 9%) x 1.6
Cost of Equity (rS) = 15.4%

c. if the firm's bonds earn a return of 12% then what would be your estimate of rs using the own bond
yield plus judgmental risk premium approach? (Hint: Use a 4 Risk Premium)
 Cost of Equity (rS) = rd + Judgemental Risk Premium
Cost of Equity (rS) = 12% + 4%
Cost of Equity (rS) = 16%

d. On the basis of the results of parts a through c what would be your estimate of Shelbys cost of
equity?

Averaging between 3 approaches, the estimated Cost of Equity would be 15.9%

Chapter 10
Question 10-1
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%.

a. What is the NPV of the project?

 = NPV(11%,9000,9000,9000,9000,9000,9000,9000) + $(-40,000)
= $42,409.77 + $(-40,000)
= $2,409.77

b. What is the IRR of the project?

=IRR(Cashflow,0) = 12.84%

c. What is the MIRR of the project?

=MIRR(Cashflow,CoC,CoC) = 11.93%

d. What is the PI of the project?

NPV = $42,409.77

Profitability Index = Present Value of Cash Flow / Initial Cost

Profitability Index = $42,409.77 / $40,000
Profitability Index = 1.06

e. What is the Payback Period of the Project?

Payback Period = Initial Cash Flow / Yearly Cash Flow
Payback Period = $40,000 / $9,000
Payback Period = 4.44 Years

f. What is the discounted Payback Period of the Project?

Discounted Payback Period = Year with last negative cumulative cash flow + (Last negative cumulative cash
/ Next year’s cash inflow)
Discounted Payback Period = 6 + (1925 / 2410)
Discounted Payback Period = 6.44

Question 10-7
Your division is considering two investment projects, each of which requires an up-front expenditure of $15 million.
You estimate that the investments will produce the following net cash flows:

a. What are the two projects' net present values, assuming the cost of capital is 5%? 10%? 15%?
=NPV(Rate, Value yr 1, Value yr 2, Value yr 3) + (Upfront Expenditure)
 b. What are the two project's IRRs at the same cost of capital
=IRR(Cashflow,0)

Chapter 11
Question 11-1
Talbot Industries is considering launching a new product. The new manufacturing equipment will cost $17
million, and production and sales will require an initial $5 million investment in net operating working capital.
The company’s tax rate is 40%.
a. What is the initial investment outlay?
Initial investment = Equipment Cost + Investment in NOWC
Initial investment = $17m + $5m
 Initial investment = $22m

b. The company spent and expensed $150,000 on research related to the new product last year. Would
this change your answer? Explain.
Last year expense will be included as sunk cost, thus the investment is still $22m

c. Rather than build a new manufacturing facility, the company plans to install the equipment in a
building it owns but is not now using. The building could be sold for $1.5 million after taxes and real
estate commissions. How would this affect your answer?
Net initial Investment = Initial Investment + Proceeds for sale of the building
Net initial Investment = $22m + $1.5m
Net initial Investment = $23.5m

Question 11-2
The financial staff of Cairn Communications has identified the following information for the first year of the
roll-out of its new proposed service.

Projected sales $18 million

Operating costs (not including depreciation $ 9 million
Depreciation $ 4 million
Interest expense $ 3 million

The company faces a 25% tax rate. What is the project's operating cash flow for the first year (t=1)?

EBIT = Projected Sales - Operating Expense - Depreciation

EBIT = $18m - $9m - $4m
EBIT = $5m

Operating Profit After Tax = EBIT (1 - Tax Rate)

Operating Profit After Tax = $5m (1 - 25%)
Operating Profit After Tax = $3,75m

Cash Flow = OPAT + Depreciation

Cash Flow = $3.75m + $4m
Cash Flow = $7.75m

Question 11-3
Allen Air Lines must liquidate some equipment that is being replaced. The equipment originally cost $12
million of which 75% has been depreciated. The used equipment can be sold today for $4 million and its tax
rate is 25%. What is the equipment after tax net salvage value?

Book Value = Cost of Equipment x (1 - Depreciation Value)

Book Value = $12m x (1 - 75%)
Book Value = $3m
Profit/Loss = Salvage Value - Book Value
Profit/Loss = $4m - $3m
Profit/Loss = $1m

After Tax Salvage Value = Salvage Value - (Profit/Loss x Tax Rate)

After Tax Salvage Value = $4m - ($1m x 25%)
After Tax Salvage Value = $3.75m

Question 11-4
Although the Chen Company's milling machine is old, it is still in relatively good working order and would
last for another 10 years. It is inefficient compared to modern standards, though. The new milling machine
would also last for 10 years and would produce after-tax cash flows (labor savings and depreciation tax
savings) of $19,000 per year. It would have zero salvage value at the end of its life. Should Chen buy the new
machine? at a cost of $110,000 delivered and installed, The project cost of capital is 10%, and its marginal
tax rate is 35%.

=NPV(COST OF CAPITAL, CASHFLOW) - (INITIAL INVESTMENT)

NPV is positive thus, Chen shoud buy the new machine

Question 11-5
Wendy's boss wants to use straight-line depreciation for the new expansion project because he said it will
give higher net income in earlier years and give him a larger bonus. The project will last 4 years and requires
$1,700,000 of equipment. The company could use either straight-line or the 3 year MACRS accelerated
method. Under straight-line depreciation, the cost of the equipment would be depreciated evenly over its 4 -
year-life (ignore the half-year convention for the straight-line method). The applicable MACRS depreciation
rates are 33.33%, 44.45%, 14.81%, and 7.41% as discussed in Appendix 11A. The company's WACC is 10%
and its tax rate is 40%.
a. What would the depreciation expense be each year under each method?
Straight Line Method
Yearly Depreciation = Cost of Equipment / Project Years
Yearly Depreciation = $1,700,000 / 4 Years
Yearly Depreciation = $425,000

MACRS Depreciation rate

Using MACRS Depreciation rate to determine the exact depreciation each year

b. Which depreciation method would produce the higher NPV, and how much higher would it be?
 MACRS would produce higher NPV by $27,043.62

Question 11-6
The Campbell Company is considering adding a robotic paint sprayer to its production line. The sprayer’s
base price is $920,000, and it would cost another $22,000 to install it. The machine falls into the MACRS 3-
year class, and it would be sold after 3 years for $500,000. The MACRS rates for the first three years are
0.3333, 0.4445, and 0.1481. The machine would require an increase in net working capital (inventory) of
$15,500. The sprayer would not change revenues, but it is expected to save the firm $304,000 per year in
before-tax operating costs, mainly labor. Campbell’s marginal tax rate is 25%.

a. What is the Year 0 net cash flow?

CF0 = Sprayer’s Base Price + Installation Cost + Increase in NWC
CF0 = -($920,000) + (-$22,000) + (-$15,500)
CF0 = - $955,500

b. What are the net operating cash flows in Years 1, 2, and 3?

Depreciable Value = Sprayer’s Base Price + Installation Cost
Depreciable Value = ($920,000) + ($22,000)
Depreciable Value = $940,000

Before Tax Operating Cost = $304,000

After Tax Operating Cost = $304,000 x ( 1 - 25%)
After Tax Operating Cost = $228,000

c. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of working capital)?
Book Value = Depreciable Value * (1 - 0.3333 - 0.4445 - 0.1481)
Book Value = $69,654

Tax on Gain = (Salvage Value - Book Value) x Tax Rate

Tax on Gain = ($500,000 - $69,654) x 25%
Tax on Gain = $107,586.50
 Additional CF3 = Salvage Value - Tax on Gain + NWCRec
Additional CF3 = $500,000 - $107,586.50 + 15,500
Additional CF3 = $407,913.50

d. if the project’s cost of capital is 12%, what is the NPV?

Total CF3 = CF3 + Additional CF3
Total CF3 = $262.803,50 + $407,913.50
Total CF3 = $670,717

=NPV(12%, CASHFLOW)