MODULE 1

1.
a. Compute the future value of $1,000 compounded annually for 10 years at 8 percent. (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Future value $ 2,158.92

b. Compute the future value of $1,000 compounded annually for 10 years at 11 percent. (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Future value $ 2,839.42

c. Compute the future value of $1,000 compounded annually for 15 years at 8 percent. (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Future value $ 3,172.17

Explanation:
To find the FV of a lump sum, we use:

FV = PV(1 + r)t

a.
0 10

$1,000 FV

FV = $1,000(1.08)10 = $2,158.92

b.
0 10

$1,000 FV

FV = $1,000(1.11)10 = $2,839.42
c.
0 15

$1,000 FV

FV = $1,000(1.08)15 = $3,172.17

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 10 8% $1,000
N I/Y PV PMT FV
Solve for $2,158.92

Enter 10 11% $1,000

N I/Y PV PMT FV
Solve for $2,839.42

Enter 15 8% $1,000
N I/Y PV PMT FV
Solve for $3,172.17

2.
For each of the following, compute the present value (Do not round intermediate calculations and
round your answers to 2 decimal places, e.g., 32.16.):

Present Value Years Interest Rate Future value

$ 7,479.89 12 6% $ 15,051
33,850.13 3 12 47,557
28,794.41 28 13 882,073
 31,299.87 30 10 546,164

Explanation:
To find the PV of a lump sum, we use:

PV = FV / (1 + r)t

0 12

$15,051
PV

PV = $15,051 / (1.06)12 = $7,479.89

0 3

PV $47,557

PV = $47,557 / (1.12)3 = $33,850.13

0 28

$882,07
PV
3

PV = $882,073 / (1.13)28 = $28,794.41

0 30

PV $546,164

PV = $546,164 / (1.10)30 = $31,299.87

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.
 Enter 12 6% $15,051
N I/Y PV PMT FV
Solve for $7,479.89

Enter 3 12% $47,557

N I/Y PV PMT FV
Solve for $33,850.13

Enter 28 13% $882,073

N I/Y PV PMT FV
Solve for $28,794.41

Enter 30 10% $546,164

N I/Y PV PMT FV
Solve for $31,299.87

3.
Solve for the unknown interest rate in each of the following (Do not round intermediate calculations
and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.):

Present Value Years Interest Rate Future Value

$ 330 4 6.34 % $ 422
450 18 7.19 1,571
48,000 19 9.45 266,917
47,261 25 12.00 803,425

EXPLANATION:
We can use either the FV or the PV formula. Both will give the same answer since they are the inverse of
each other. We will use the FV formula, that is:

FV = PV(1 + r)t
Solving for r, we get:

r = (FV / PV)1/t – 1

0 4

$422
–$330

FV = $422 = $330(1 + r)4; r = ($422 / $330)1/4 – 1 = 6.34%

0 18

–$450 $1,571

FV = $1,571 = $450(1 + r)18; r = ($1,571 / $450)1/18 – 1 = 7.19%

0 19

–$48,000 $266,917

FV = $266,917 = $48,000(1 + r)19; r = ($266,917 / $48,000)1/19 – 1 = 9.45%

0 25

$803,42
–$47,261
5

FV = $803,425 = $47,261(1 + r)25; r = ($803,425 / $47,261)1/25 – 1 = 12.00%

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 4 $330 ±$422

N I/Y PV PMT FV
Solve for 6.34%
Enter 18 $450 ±$1,571
N I/Y PV PMT FV
Solve for 7.19%

Enter 19 $48,000 ±$266,917

N I/Y PV PMT FV
Solve for 9.45%

Enter 25 $47,261 ±$803,425

N I/Y PV PMT FV
Solve for 12.00%

4.
Solve for the unknown number of years in each of the following (Do not round intermediate
calculations and round your answers to 2 decimal places, e.g., 32.16.):

Present Value Years Interest Rate Future Value

$ 490 9.84 10% $ 1,252
740 7.80 11 1,670
17,700 16.86 16 216,050
20,800 20.74 13 262,330

EXPLANATION:
We can use either the FV or the PV formula. Both will give the same answer since they are the inverse of
each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

0 ?
 $1,25
–$490
2

FV = $1,252 = $490(1.10)t; t = ln($1,252 / $490) / ln 1.10 = 9.84 years

0 ?

–$740 $1,670

FV = $1,670 = $740(1.11)t; t = ln($1,670 / $740) / ln 1.11 = 7.80 years

0 ?

–$17,700 $216,050

FV = $216,050 = $17,700(1.16)t; t = ln($216,050 / $17,700) / ln 1.16 = 16.86 years

0 ?

–$20,800 $262,330

FV = $262,330 = $20,800(1.13)t; t = ln($262,330 / $20,800) / ln 1.13 = 20.74 years

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 10% $490 ±$1,252

N I/Y PV PMT FV
Solve for 9.84

Enter 11% $740 ±$1,670

N I/Y PV PMT FV
Solve for 7.80
 Enter 16% $17,700 ±$216,050
N I/Y PV PMT FV
Solve for 16.86

Enter 13% $20,800 ±$262,330

N I/Y PV PMT FV
Solve for 20.74

5.
An investor purchasing a British consol is entitled to receive annual payments from the British
government forever.

What is the price of a consol that pays $200 annually if the next payment occurs one year from today?
The market interest rate is 5.1 percent. (Round your answer to 2 decimal places, e.g., 32.16.)

Price $ 3,921.57

EXPLANATION:
0 1 ∞

PV $200 $200 $200 $200 $200 $200 $200 $200 $200

A consol is a perpetuity. To find the PV of a perpetuity, we use the equation:

PV = C / r
PV = $200 / .051
PV = $3,921.57

6.
Wilkinson Co. has identified an investment project with the following cash flows:
 Year Cash Flow
1 $ 810
2 1,110
3 1,370
4 1,500

If the discount rate is 11 percent, what is the present value of these cash flows? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 3,620.46

If the discount rate is 17 percent, what is the present value of these cash flows? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 3,159.04

If the discount rate is 25 percent, what is the present value of these cash flows? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 2,674.24

EXPLANATION:
The time line is:

0 1 2 3 4

PV $810 $1,110 $1,370 $1,500

To find the PV of a lump sum, we use:

PV = FV / (1 + r)t

PV@11% = $810 / 1.11 + $1,110 / 1.112 + $1,370 / 1.113 + $1,500 / 1.114 = $3,620.46

PV@17% = $810 / 1.17 + $1,110 / 1.172 + $1,370 / 1.173 + $1,500 / 1.174 = $3,159.04
PV@25% = $810 / 1.25 + $1,110 / 1.252 + $1,370 / 1.253 + $1,500 / 1.254 = $2,674.24

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

CFo $0 CFo $0 CFo $0

C01 $810 C01 $810 C01 $810
F01 1 F01 1 F01 1
C02 $1,110 C02 $1,110 C02 $1,110
F02 1 F02 1 F02 1
C03 $1,370 C03 $1,370 C03 $1,370
F03 1 F03 1 F03 1
C04 $1,500 C04 $1,500 C04 $1,500
F04 1 F04 1 F04 1
I = 11 I = 17 I = 25
NPV CPT NPV CPT NPV CPT
$3,620.46 $3,159.04 $2,674.24

7.
An investment offers $6,600 per year for 10 years, with the first payment occurring one year from now.

If the required return is 5 percent, what is the value of the investment today? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 50,963.45

What would the value today be if the payments occurred for 35 years? (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 108,069.68

What would the value today be if the payments occurred for 65 years? (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 126,463.06

What would the value today be if the payments occurred forever? (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 132,000.00

EXPLANATION:
To find the PVA, we use the equation:

PVA = C({1 − [1 / (1 + r)t]} / r )

0 1 10

PV $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600

PVA@10 yrs: PVA = $6,600{[1 − (1 / 1.0510)] / .05} = $50,963.45

0 1 35

PV $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600

PVA@35 yrs: PVA = $6,600{[1 − (1 / 1.0535)] / .05} = $108,069.68

0 1 65

PV $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600

PVA@65 yrs: PVA = $6,600{[1 − (1 / 1.0565)] / .05} = $126,463.06

To find the PV of a perpetuity, we use the equation:

PV = C / r

0 1 ∞

PV $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600 $6,600

PV = $6,600 / .05
PV = $132,000.00

Notice that as the length of the annuity payments increases, the present value of the annuity approaches
the present value of the perpetuity. The present value of the 65-year annuity and the present value of the
perpetuity imply that the value today of all perpetuity payments beyond 65 years is only $5,536.94.

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 10 5% $6,600
N I/Y PV PMT FV
Solve for $50,963.45

Enter 35 5% $6,600
N I/Y PV PMT FV
Solve for $108,069.68

Enter 65 5% $6,600
N I/Y PV PMT FV
Solve for $126,463.06

8.
The Perpetual Life Insurance Co. is trying to sell you an investment policy that will pay you and your
heirs $12,500 per year forever.
If the required return on this investment is 4.7 percent, how much will you pay for the policy? (Round
your answer to 2 decimal places, e.g., 32.16.)

Present value $ 265,957.45

Suppose the Perpetual Life Insurance Co. told you the policy costs $270,000. At what interest rate would
this be a fair deal? (Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Interest rate 4.63 %

EXPLANATION:
The time line is:

0 1 ∞

$12,50 $12,50 $12,50 $12,50 $12,50

PV $12,500 $12,500 $12,500 $12,500
0 0 0 0 0

This cash flow is a perpetuity. To find the PV of a perpetuity, we use the equation:

PV = C / r
PV = $12,500 / .047
PV = $265,957.45

To find the interest rate that equates the perpetuity cash flows with the PV of the cash flows, we can use
the PV of a perpetuity equation:

PV = C / r

0 1 ∞

–$270,000 $12,50 $12,50 $12,50 $12,50 $12,50

$12,500 $12,500 $12,500 $12,500
0 0 0 0 0

$270,000 = $12,500 / r

We can now solve for the interest rate as follows:

r = $12,500 / $270,000
r = .0463, or 4.63%

9.
Find the EAR in each of the following cases (Use 365 days a year. Do not round intermediate
calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.):

Stated Rate (APR) Number of Times Compounded Effective Rate (EAR)

8.3% Quarterly 8.56 %
17.3 Monthly 18.74
13.3 Daily 14.22
10.3 Infinite 10.85
EXPLANATION:
For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m − 1

EAR = [1 + (.083 / 4)]4 – 1 = .0856, or 8.56%

EAR = [1 + (.173 / 12)]12 – 1 = .1874, or 18.74%

EAR = [1 + (.133 / 365)]365 – 1 = .1422, or 14.22%

To find the EAR with continuous compounding, we use the equation:

EAR = er − 1
EAR = e.103 – 1 = .1085, or 10.85%

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 8.3% 4
NOM EFF C/Y
Solve for 8.56%
 Enter 17.3% 12
NOM EFF C/Y
Solve for 18.74%

Enter 13.3% 365

NOM EFF C/Y
Solve for 14.22%

10.
Find the APR in each of the following cases (Do not round intermediate calculations and enter your
answers as a percent rounded to 2 decimal places, e.g., 32.16.):

APR Number of Times Compounded EAR

11.38 % Semiannually 11.7%
11.93 Monthly 12.6
9.81 Weekly 10.3
13.10 Infinite 14.0

EXPLANATION:
Here, we are given the EAR and need to find the APR. Using the equation for discrete compounding:

EAR = [1 + (APR / m)]m − 1

We can now solve for the APR. Doing so, we get:

APR = m[(1 + EAR)1/m – 1]

EAR = .117 = [1 + (APR / 2)]2 – 1 APR = 2[(1.117)1/2 – 1] = .1138, or 11.38%

EAR = .126 = [1 + (APR / 12)]12 – 1 APR = 12[(1.126)1/12 – 1] = .1193, or 11.93%

EAR = .103 = [1 + (APR / 52)]52 – 1 APR = 52[(1.103)1/52 – 1] = .0981, or 9.81%

Solving the continuous compounding EAR equation:

EAR = er − 1
We get:

APR = ln(1 + EAR)

APR = ln(1 + .140)
APR = .1310, or 13.10%

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 11.7% 2
NOM EFF C/Y
Solve for 11.38%

Enter 12.6% 12
NOM EFF C/Y
Solve for 11.93%

Enter 10.3% 52
NOM EFF C/Y
Solve for 9.81%

11.
First National Bank charges 13.9 percent compounded monthly on its business loans. First United Bank
charges 14.2 percent compounded semiannually.

Calculate the EAR for First National Bank and First United Bank. (Do not round intermediate
calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

EAR
First National 14.82 %
First United 14.70 %
As a potential borrower, to which bank would you go for a new loan?

First United Bank

EXPLANATION:
For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1

So, for each bank, the EAR is:

First National: EAR = [1 + (.139 / 12)]12 – 1 = .1482, or 14.82%

First United: EAR = [1 + (.142 / 2)]2 – 1 = .1470, or 14.70%

A higher APR does not necessarily mean the higher EAR. The number of compounding periods within a
year will also affect the EAR.

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 13.9% 12
NOM EFF C/Y
Solve for 14.82%

Enter 14.2% 2
NOM EFF C/Y
Solve for 14.70%

12.
One of your customers is delinquent on his accounts payable balance. You’ve mutually agreed to a
repayment schedule of $500 per month. You will charge 1.95 percent per month interest on the overdue
balance.
If the current balance is $18,500, how long will it take for the account to be paid off? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Months for account to be paid off 66.19 months

EXPLANATION:
The time line is:

0 1 ?

–$18,500 $500 $500 $500 $500 $500 $500 $500 $500 $500

Here, we need to find the length of an annuity. We know the interest rate, the PV, and the payments.
Using the PVA equation:

PVA = C({1 − [1 / (1 + r)t]} / r)

$18,500 = $500{[1 – (1 / 1.0195t)] / .0195}

Now, we solve for t:

1/1.0195t = 1 – [($18,500)(.0195) / ($500)]

1.0195t = 1/(.2785) = 3.5907
t = ln 3.5907 / ln 1.0195 = 66.19 months

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 1.95% $18,500 ±$500

N I/Y PV PMT FV
Solve for 66.19

13.
You are planning to save for retirement over the next 35 years. To do this, you will invest $870 per month
in a stock account and $470 per month in a bond account. The return of the stock account is expected to
be 10.7 percent, and the bond account will earn 6.7 percent. When you retire, you will combine your
money into an account with an annual return of 7.7 percent. Assume the returns are expressed as APRs.

How much can you withdraw each month from your account assuming a 30-year withdrawal period? (Do
not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Withdraw $ 33,872.36 per month

EXPLANATION:
Although the stock and bond accounts have different interest rates, we can draw one time line, but we
need to remember to apply different interest rates. The time line is:

0 1 420 421 780

Stock $870 $870 $870 $870 $870

C C C
Bond $470 $470 $470 $470 $470

We need to find the annuity payment in retirement. Our retirement savings end at the same time the
retirement withdrawals begin, so the PV of the retirement withdrawals will be the FV of the retirement
savings. So, we find the FV of the stock account and the FV of the bond account and add the two FVs.

Stock account: FVA = $870[{[1 + (.107 / 12)]420 – 1} / (.107 / 12)] = $3,962,571.64

Bond account: FVA = $470[{[1 + (.067 / 12)]420 – 1} / (.067 / 12)] = $788,374.89

So, the total amount saved at retirement is:

Amount saved at retirement = $3,962,571.64 + 788,374.89

Amount saved at retirement = $4,750,946.52

Solving for the withdrawal amount in retirement using the PVA equation gives us:

PVA = $4,750,946.52 = C[1 – {1 / [1 + (.077 / 12)]360}] / (.077 / 12)

C = $4,750,946.52 / 140.2603
C = $33,872.36 withdrawal per month
Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Stock account:

Enter 420 10.7% / 12 $870

N I/Y PV PMT FV
Solve for $3,962,571.64

Bond account:

Enter 420 6.7% / 12 $470

N I/Y PV PMT FV
Solve for $788,374.89

Savings at retirement = $3,962,571.64 + 788,374.89 = $4,750,946.52

Enter 360 7.7% / 12 $4,750,946.52

N I/Y PV PMT FV
Solve for $33,872.36

14.
Mark Weinstein has been working on an advanced technology in laser eye surgery. His technology will
be available in the near term. He anticipates his first annual cash flow from the technology to be
$176,000 received two years from today. Subsequent annual cash flows will grow at 3.6 percent in
perpetuity.

What is the present value of the technology if the discount rate is 9 percent? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 2,990,146.11

EXPLANATION:
This is a growing perpetuity. The present value of a growing perpetuity is:

PV = C / (r – g)
PV = $176,000 / (.09 – .036)
PV = $3,259,259.26

It is important to recognize that when dealing with annuities or perpetuities, the present value equation
calculates the present value one period before the first payment. In this case, since the first payment is in
two years, we have calculated the present value one year from now. To find the value today, we simply
discount this value as a lump sum. Doing so, we find the value of the cash flow stream today is:

PV = FV / (1 + r)t
PV = $3,259,259.26 / (1 + .09)1
PV = $2,990,146.11

15.
A prestigious investment bank designed a new security that pays a quarterly dividend of $4.70 in
perpetuity. The first dividend occurs one quarter from today.

What is the price of the security if the APR is 7.3 percent, compounded quarterly? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Price $ 256.83

EXPLANATION:
The dividend payments are made quarterly, so we must use the quarterly interest rate. The quarterly
interest rate is:

Quarterly rate = APR / 4

Quarterly rate = .073 / 4
Quarterly rate = .01825

The time line is:

0 1 ∞

PV $4.70 $4.70 $4.70 $4.70 $4.70 $4.70 $4.70 $4.70 $4.70

Using the present value equation for a perpetuity, we find the value today of the dividends paid must be:

PV = C / r
PV = $4.70 / .01825
PV = $257.53

16.
What is the present value of an annuity of $5,800 per year, with the first cash flow received three years
from today and the last one received 25 years from today? Use a discount rate of 6 percent. (Do not
round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 63,509.79

EXPLANATION:
The time line is:

0 1 2 3 4 5 6 7 25

PV $5,800 $5,800 $5,800 $5,800 $5,800 $5,800 $5,800

We can use the PVA annuity equation. The annuity has 23 payments, not 22 payments. Since there is a
payment made in Year 3, the annuity actually begins in Year 2. So, the value of the annuity in Year 2 is:

PVA = C({1 − [1 / (1 + r)t]} / r)

PVA = $5,800({1 – [1 / (1 + .06)23]} / .06)
PVA = $71,359.60

This is the value of the annuity one period before the first payment, or Year 2. So, the value of the cash
flows today is:

PV = FV / (1 + r)t
PV = $71,359.60 / (1 + .06)2
PV = $63,509.79

Calculator Solution:
Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 23 6% $5,800
N I/Y PV PMT FV
Solve for $71,359.60

Enter 2 6% $71,359.60
N I/Y PV PMT FV
Solve for $63,509.79

17.
Southern California Publishing Company is trying to decide whether to revise its popular
textbook, Financial Psychoanalysis Made Simple. The company has estimated that the revision will cost
$95,000. Cash flows from increased sales will be $22,000 the first year. These cash flows will increase
by 5 percent per year. The book will go out of print six years from now. Assume that the initial cost is paid
now and revenues are received at the end of each year.

If the company requires a return of 12 percent for such an investment, calculate the present value of the
cash inflows of the project. (Do not round intermediate calculations and round your answer to 2
decimal places, e.g., 32.16.)

Present value $ 100,906.41

EXPLANATION:
The cash flows are a growing annuity, so the present value is:

PV = C {[1 / (r – g)] – [1 / (r – g)] × [(1 + g) / (1 + r)]t}

PV = $22,000{[1 / (.12 – .05)] – [1 / (.12 – .05)] × [(1 + .05) / (1 + .12)] 6}
PV = $100,906.41

The company should accept the project since the cost is less than the PV of the increased cash flows.

18.
You’re prepared to make monthly payments of $370, beginning at the end of this month, into an account
that pays 7.8 percent interest compounded monthly.

How many payments will you have made when your account balance reaches $28,000? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Number of payments 104.51

EXPLANATION:
The time line is:

0 1 ?

–$28,000
$370 $370 $370 $370 $370 $370 $370 $370 $370

Here, we are given the FVA, the interest rate, and the amount of the annuity. We need to solve for the
number of payments. Using the FVA equation:

FVA = $28,000 = $370({[1 + (.078 / 12)]t – 1} / (.078 / 12))

Solving for t, we get:

1.00650t = 1 + [($28,000) (.078 / 12) / ($370)]

t = ln 1.49189 / ln 1.00650
t = 61.75 payments

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 7.8% / 12 ±$370 $28,000

N I/Y PV PMT FV
Solve for 61.75

19.
You just won the TVM Lottery. You will receive $1 million today plus another 10 annual payments that
increase by $510,000 per year. Thus, in one year you receive $1.51 million. In two years, you get $2.02
million, and so on.

If the appropriate interest rate is 6.1 percent, what is the present value of your winnings? (Enter your
answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations
and round your answer to 2 decimal places, e.g., 32.16.)

Present value $ 27,058,617.30

EXPLANATION:
The time line is:

0 1 2 3 4 5 6 7 8 9 10

$5.08 $5.59
$1M $1.51M $2.02M $2.53M $3.04M $3.55M $4.06M $4.57M $6.1M
M M

To solve this problem, we simply need to find the PV of each lump sum and add them together. It is
important to note that the first cash flow of $1 million occurs today, so we do not need to discount that
cash flow. The PV of the lottery winnings is:

PV = $1,000,000 + $1,510,000 / 1.061 + $2,020,000 / 1.0612 + $2,530,000 / 1.0613 + $3,040,000 /

1.0614+ $3,550,000 / 1.0615 + $4,060,000 / 1.0616 + $4,570,000 / 1.0617 + $5,080,000 / 1.0618
+ $5,590,000 / 1.0619 + $6,100,000 / 1.06110

PV = $27,058,617.30

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

CF0 $1,000,000
C01 $1,510,000
F01 1
C02 $2,020,000
F02 1
 C03 $2,530,000
F03 1
C04 $3,040,000
F04 1
C05 $3,550,000
F05 1
C06 $4,060,000
F06 1
C07 $4,570,000
F07 1
C08 $5,080,000
F08 1
C09 $5,590,000
F09 1
C10 $6,100,000
F10 1
I = 6.1%
NPV CPT
$27,058,617.30

20.
An insurance company is offering a new policy to its customers. Typically the policy is bought by a parent
or grandparent for a child at the child’s birth. The details of the policy are as follows: The purchaser (say,
the parent) makes the following six payments to the insurance company:

First birthday $ 920

Second birthday $ 920
Third birthday $ 1,020
Fourth birthday $ 850
Fifth birthday $ 1,120
Sixth birthday $ 950

After the child’s sixth birthday, no more payments are made. When the child reaches age 65, he or she
receives $420,000. If the relevant interest rate is 13 percent for the first six years and 7 percent for all
subsequent years, what would the value of the deposits be when the policy matures? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Future value $ 431,500.29

EXPLANATION:
We need to find the FV of the premiums to compare with the cash payment promised at age 65. We have
to find the value of the premiums at Year 6 first since the interest rate changes at that time. So:

FV1 = $920(1.13)5 = $1,695.04

FV2 = $920(1.13)4 = $1,500.04

FV3 = $1,020(1.13)3 = $1,471.75

FV4 = $850(1.13)2 = $1,085.37

FV5 = $1,120(1.13)1 = $1,265.60

Value at Year 6 = $1,695.04 + 1,500.04 + 1,471.75 + 1,085.37 + 1,265.60 + 950

Value at Year 6 = $7,967.80

Finding the FV of this lump sum at the child’s 65th birthday:

FV = $7,967.80(1.07)59
FV = $431,500.29

The policy is not worth buying; the future value of the policy is $431,500.29, but the policy contract will
pay off $420,000. The premiums are worth $11,500.29 more than the policy payoff.

Note, we could also compare the PV of the two cash flows. The PV of the premiums is:

PV = $920 / 1.13 + $920 / 1.132 + $1,020 / 1.133 + $850 / 1.134 + $1,120 / 1.135 + $950 / 1.136
PV = $3,827.08

And the value today of the $420,000 at age 65 is:

PV = $420,000 / 1.0759
PV = $7,755.44
PV = $7,755.44 / 1.136
PV = $3,725.08

The premiums still have the higher cash flow. At time zero, the difference is $102.00. Whenever you are
comparing two or more cash flow streams, the cash flow with the highest value at one time will have the
highest value at any other time.

Here is a question for you: Suppose you invest $102.00, the difference in the cash flows at time zero, for
six years at an interest rate of 13 percent, and then for 59 years at a 7 percent interest rate. How much
will it be worth? Without doing calculations, you know it will be worth $11,500.29, the difference in the
cash flows at time 65!

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Value at Year 6:

Enter 5 13% $920

N I/Y PV PMT FV
Solve for $1,695.04

Enter 4 13% $920

N I/Y PV PMT FV
Solve for $1,500.04

Enter 3 13% $1,020

N I/Y PV PMT FV
Solve for $1,471.75

Enter 2 13% $850

N I/Y PV PMT FV
Solve for $1,085.37

Enter 1 13% $1,120

 N I/Y PV PMT FV
Solve for $1,265.60

So, at Year 6, the value is: $1,695.04 + 1,500.04 + 1,471.75 + 1,085.37 + 1,265.60 + 950 = $7,967.80

At Year 65, the value is:

Enter 59 7% $7,967.80
N I/Y PV PMT FV
Solve for $431,500.29

The policy is not worth buying; the future value of the payments is $431,500.29 but the policy contract
will pay off $420,000.

MODULE 2
1.
Which statement concerning the net present value (NPV) of an investment or a financing project is correct?
A financing project should be accepted if, and only if, the NPV is exactly equal to zero.
An investment project should be accepted only if the NPV is equal to the initial cash flow.
Any type of project should be accepted if the NPV is positive and rejected if it is negative .
Any type of project with greater total cash inflows than total cash outflows, should always be accepted.
An investment project that has positive cash flows for every time period after the initial investment should be accepted.

2.
The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the:
cash period.
net working capital period.
payback period.
profitability index.
discounted payback period.

3.
An investment is acceptable if the payback period:
is less than some pre-specified period of time.
exceeds the life of the investment.
is negative.
is equal to or greater than some pre-specified period of time.
is equal to, and only if it is equal to, the investment’s life.

4.
The length of time required for a project's discounted cash flows to equal the initial cost of the project is called the:
net present value.
discounted net present value.
payback period.
discounted profitability index.
discounted payback period.

5.
Maxwell Software, Inc., has the following mutually exclusive projects.

Year Project A Project B

–$21,000 –$24,000
0
1 12,500 13,500
2 9,000 10,000
3 3,000 9,000

a-1. Calculate the payback period for each project. (Do not round intermediate calculations and
round your answers to 3 decimal places, e.g., 32.161.)

Payback period
Project A 1.944 years
Project B 2.056 years
a-2. Which, if either, of these projects should be chosen?

Project A

b-1. What is the NPV for each project if the appropriate discount rate is 17 percent? (A negative
answer should be indicated by a minus sign. Do not round intermediate calculations and
round your answers to 2 decimal places, e.g., 32.16.)

NPV
Project A $ -1,868.51
Project B $ 462.93

b-2. Which, if either, of these projects should be chosen if the appropriate discount rate is 17 percent?

Project B
Explanation:
a. The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the
initial investment.

Project A:

Cumulative cash flows Year 1 = $12,500 = $12,500

Cumulative cash flows Year 2 = $12,500 + 9,000 = $21,500

Companies can calculate a more precise value using fractional years. To calculate the fractional payback
period, find the fraction of Year 2’s cash flows that is needed for the company to have cumulative
undiscounted cash flows of $21,000. Divide the difference between the initial investment and the
cumulative undiscounted cash flows as of Year 1 by the undiscounted cash flow of Year 2.

Payback period = 1 + ($21,000 – 12,500) / $9,000

Payback period = 1.944 years

Project B:

Cumulative cash flows Year 1 = $13,500 = $13,500

Cumulative cash flows Year 2 = $13,500 + 10,000 = $23,500
Cumulative cash flows Year 3 = $13,500 + 10,000 + 9,000 = $32,500

To calculate the fractional payback period, find the fraction of Year 3’s cash flows that is needed for the
company to have cumulative undiscounted cash flows of $24,000. Divide the difference between the initial
investment and the cumulative undiscounted cash flows as of year 2 by the undiscounted cash flow of Year
3.

Payback period = 2 + ($24,000 – 13,500 – 10,000) / $9,000

Payback period = 2.056 years

Since Project A has a shorter payback period than Project B has, the company should choose Project A.

b.Discount each project’s cash flows at 17 percent. Choose the project with the highest NPV.

Project A:
NPV = –$21,000 + $12,500 / 1.17 + $9,000 / 1.17 2 + $3,000 / 1.173
NPV = –$1,868.51

Project B:
NPV = –$24,000 + $13,500 / 1.17 + $10,000 / 1.17 2 + $9,000 / 1.173
NPV = $462.93

The firm should choose Project B since it has a higher NPV than Project A.

6.
An investment project provides cash inflows of $720 per year for eight years.

What is the project payback period if the initial cost is $1,925? (Enter 0 if the project never pays back.
Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Payback period 2.67 years

What is the project payback period if the initial cost is $3,750? (Enter 0 if the project never pays
back. Do not round intermediate calculations and round your answer to 2 decimal places, e.g.,
32.16.)

Payback period 5.21 years

What is the project payback period if the initial cost is $5,800? (Enter 0 if the project never pays
back. Do not round intermediate calculations and round your answer to 2 decimal places, e.g.,
32.16.)

Payback period 0 years

Explanation:
To calculate the payback period, we need to find the time that the project has taken to recover its initial
investment. The cash flows in this problem are an annuity, so the calculation is simpler. If the initial cost
is $1,925, the payback period is:

Payback = 2 + ($485 / $720)

Payback = 2.67 years

There is a shortcut to calculate the payback period if the future cash flows are an annuity. Just divide the
initial cost by the annual cash flow. For the $1,925 cost, the payback period is:

Payback = $1,925 / $720

Payback = 2.67 years

For an initial cost of $3,750, the payback period is:

Payback = $3,750 / $720

Payback = 5.21 years

The payback period for an initial cost of $5,800 is a little trickier. Notice that the total cash inflows after
eight years will be:

Total cash inflows = 8($720)

Total cash inflows = $5,760

If the initial cost is $5,800, the project never pays back. Notice that if you use the shortcut for annuity
cash flows, you get:

Payback = $5,800 / $720

Payback = 8.06 years

This answer does not make sense since the cash flows stop after eight years, so there is no payback
period.
7.
The discount rate that makes the net present value of an investment exactly equal to zero is called the:
external rate of return.
internal rate of return.
average accounting return.
profitability index.
equalizer.

8.
A financing project is acceptable if its IRR is:
exactly equal to its net present value (NPV).
exactly equal to zero.
greater than the discount rate.
less than the discount rate.
negative.

9.
The possibility that more than one discount rate will make the NPV of an investment equal to zero presents the problem referred to as:
net present value profiling.
operational ambiguity.
the mutually exclusive investment decision.
issues of scale.
multiple rates of return.

10.
The present value of an investment's future cash flows divided by the initial cost of the investment is called the:
net present value.
internal rate of return.
average accounting return.
profitability index.
profile period.

11.
If a project has a net present value equal to zero, then:
the initial cost of the project exceeds the present value of the project’s subsequent cash flows.
the internal rate of return exceeds the discount rate.
the project produces cash inflows that exceed the minimum required inflows.
any delay in receiving the projected cash inflows will cause the project’s NPV to be negative.
the discount rate exceeds the internal rate of return.

12.
Matt is analyzing two mutually exclusive projects of similar size. Both projects have 5-year lives. Project A has an NPV of $18,389, a
payback period of 2.38 years, an IRR of 15.9 percent, and a discount rate of 13.6 percent. Project B has an NPV of $19,748, a payback
period of 2.69 years, an IRR of 13.4 percent, and a discount rate of 12.8 percent. He can afford to fund either project, but not both. Matt
should accept:
Project A because of its payback period.
both projects as they both have positive NPVs.
Project B based on its NPV.
Project A because of its IRR.
neither project based on their IRRs.

13.
The two fatal flaws of the internal rate of return decision rule are the:
arbitrary determination of a discount rate and the failure to consider initial expenditures.
arbitrary determination of a discount rate and the failure to correctly analyze mutually exclusive investment projects.
arbitrary determination of a discount rate and the multiple rate of return problem.
failure to consider initial expenditures and failure to correctly analyze mutually exclusive investment projects.
failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem.

14.
An investment cost $10,000 with expected cash flows of $3,000 a year for 5 years. At what discount rate will the project’s IRR equal its
discount rate?
15.24%
27.22%
0%
16.67%
21.08%
0 = −$10,000 + $3,000 × ({1 - [1 / (1 + IRR)5]} / IRR); IRR = 15.24%
15.
Vital Silence, Inc., has a project with the following cash flows:

Year Cash Flow

0 –$28,900
1 12,900
2 15,900
3 11,900

The required return is 14 percent. What is the IRR for this project? (Do not round intermediate
calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

IRR 19.51 %

Should the firm accept the project?

Accept
Explanation:
The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that
defines the IRR for this project is:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$28,900 + $12,900 / (1 + IRR) + $15,900 / (1 + IRR)2 + $11,900 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 19.51%

Since the IRR is greater than the required return we would accept the project.

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.
 CFo –$28,900
C01 $12,900
F01 1
C02 $15,900
F02 1
C03 $11,900
F03 1
IRR CPT
19.51%

16.
Bill plans to open a self-serve grooming center in a storefront. The grooming equipment will cost
$395,000, to be paid immediately. Bill expects aftertax cash inflows of $86,000 annually for six years,
after which he plans to scrap the equipment and retire to the beaches of Nevis. The first cash inflow
occurs at the end of the first year. Assume the required return is 11 percent.

What is the project’s profitability index (PI)? (Do not round intermediate calculations. Round your
answer to 3 decimal places, e.g., 32.161.)

PI .921

Explanation:
The profitability index is defined as the PV of the cash inflows divided by the PV of the cash outflows.
The cash flows from this project are an annuity, so the equation for the profitability index is:

PI = C(PVIFAR,t) / C0
PI = $86,000(PVIFA11%,6) / $395,000
PI = .921

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.
 CFo 0
C01 $86,000
F01 6
I = 11%
NPV CPT
$363,826.26

PI = $363,826.26 / $395,000 = .921

17.
Wii Brothers, a game manufacturer, has a new idea for an adventure game. It can market the game
either as a traditional board game or as an interactive DVD, but not both. Consider the following cash
flows of the two mutually exclusive projects for the company. Assume the discount rate is 10 percent.

Year Board Game DVD

–
0 –$1,600 3,500
$
1 770 2,150
2 1,350 1,650
3 290 1,200

a. What is the payback period for each project? (Do not round intermediate calculations and round
your answers to 2 decimal places, e.g., 32.16.)

Payback period
Board game 1.61 years
DVD 1.82 years

b. What is the NPV for each project? (Do not round intermediate calculations and round your
answers to 2 decimal places, e.g., 32.16.)

NPV
 Board game $ 433.58
DVD $ 719.76

c. What is the IRR for each project? (Do not round intermediate calculations and enter your
answers as a percent rounded to 2 decimal places, e.g., 32.16.)

IRR
Board game 26.30 %
DVD 22.65 %

d. What is the incremental IRR? (Do not round intermediate calculations and enter your answer as
a percent rounded to 2 decimal places, e.g., 32.16.)

Incremental IRR 19.43 %

Explanation:
a.
The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the
initial investment.

Board game:

Cumulative cash flows Year 1 = $770 = $770

Cumulative cash flows Year 2 = $770 + 1,350 = $2,120

Payback period = 1 + ($1,600 – 770) / $1,350

Payback period = 1.61 years

DVD:

Cumulative cash flows Year 1 = $2,150 = $2,150

Cumulative cash flows Year 2 = $2,150 + 1,650 = $3,800

Payback period = 1 + ($3,500 – 2,150) / $1,650

Payback period = 1.82 years

Since the board game has a shorter payback period than the DVD project, the company should choose
the board game.

b.
The NPV is the sum of the present value of the cash flows from the project, so the NPV of each project
will be:

Board game:

NPV = –$1,600 + $770 / 1.10 + $1,350 / 1.102 + $290 / 1.103

NPV = $433.58

DVD:

NPV = –$3,500 + $2,150 / 1.10 + $1,650/ 1.10 2 + $1,200 / 1.103

NPV = $719.76

Since the NPV of the DVD is greater than the NPV of the board game, choose the DVD.

c.
The IRR is the interest rate that makes the NPV of a project equal to zero. So, the IRR of each project is:

Board game:

0 = –$1,600 + $770 / (1 + IRR) + $1,350 / (1 + IRR)2 + $290 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 26.30%

DVD:

0 = –$3,500 + $2,150 / (1 + IRR) + $1,650 / (1 + IRR) 2 + $1,200 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 22.65%
Since the IRR of the board game is greater than the IRR of the DVD, IRR implies we choose the board
game. Note that this is the choice when evaluating only the IRR of each project. The IRR decision rule is
flawed because there is a scale problem. That is, the DVD has a greater initial investment than does the
board game. This problem is corrected by calculating the IRR of the incremental cash flows, or by
evaluating the NPV of each project.

d.
To calculate the incremental IRR, we subtract the smaller project’s cash flows from the larger project’s
cash flows. In this case, we subtract the board game cash flows from the DVD cash flows. The
incremental IRR is the IRR of these incremental cash flows. So, the incremental cash flows of the DVD
are:

Year 0 Year 1 Year 2 Year 3

D
3,500 $1,65 $1,20
V –$ $ 2,150
0 0
D
B
oa
rd 1,600
– 770 1,350 290
ga
m
e

D
V
D
–
Bo 1,900
–$ $ 1,380 $300 $910
ar
d
ga
m
e

Setting the present value of these incremental cash flows equal to zero, we find the incremental IRR is:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$1,900 + $1,380 / (1 + IRR) + $300 / (1 + IRR)2 + $910 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

Incremental IRR = 19.43%

For investing-type projects, accept the larger project when the incremental IRR is greater than the
discount rate. Since the incremental incremental IRR, 19.43 percent, is greater than the required rate of
return of 10 percent, choose the DVD project.

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

b.
Board game DVD
CFo –$1,600 CFo –$3,500
C01 $770 C01 $2,150
F01 1 F01 1
C02 $1,350 C02 $1,650
F02 1 F02 1
C03 $290 C03 $1,200
F03 1 F03 1
I = 10% I = 10%
NPV CPT NPV CPT
$433.58 $719.76

c.
Board game DVD
CFo –$1,600 CFo –$3,500
C01 $770 C01 $2,150
F01 1 F01 1
C02 $1,350 C02 $1,650
F02 1 F02 1
C03 $290 C03 $1,200
 F03 1 F03 1
IRR CPT IRR CPT
26.30% 22.65%

d.
Incremental cash flows
CFo –$1,900
C01 $1,380
F01 1
C02 $300
F02 1
C03 $910
F03 1
IRR CPT
19.43%

18.
The treasurer of Amaro Canned Fruits, Inc., has projected the cash flows of projects A, B, and C as follows:

Year Project A Project B Project C

0 − $190,000 − $320,000 − $190,000
1 142,000 236,000 152,000
2 142,000 236,000 122,000

Suppose the relevant discount rate is 11 percent per year.

a. Compute the profitability index for each of the three projects. (Do not round intermediate calculations. Round your answers to 2
decimal places, e.g., 32.16.)

Profitability index
Project A 1.28
Project B 1.26
 Project C 1.24

b. Compute the NPV for each of the three projects. (Do not round intermediate calculations. Round your answers to 2 decimal
places, e.g., 32.16.)

NPV
Project A $ 53,178.31
Project B $ 84,155.51
Project C $ 45,954.87

c. Suppose these three projects are independent. Which project(s) should Amaro accept based on the profitability index rule?

Project A, Project B, Project C

d. Suppose these three projects are mutually exclusive. Which project(s) should Amaro accept based on the profitability index rule?

Project A

e. Suppose Amaro’s budget for these projects is $510,000. The projects are not divisible. Which project(s) should Amaro accept?

Project B, Project A

Explanation:
a.
The profitability index is the PV of the future cash flows divided by the initial investment. The profitability index for each project is:

PIA = [$142,000 / 1.11 + $142,000 / 1.112] / $190,000

PIA = 1.28

PIB = [$236,000 / 1.11 + $236,000 / 1.112] / $320,000

PIB = 1.26

PIC = [$152,000 / 1.11 + $122,000 / 1.112] / $190,000

PIC = 1.24
b.
The NPV of each project is:

NPVA = –$190,000 + $142,000 / 1.11 + $142,000 / 1.112

NPVA = $53,178.31

NPVB = –$320,000 + $236,000 / 1.11 + $236,000 / 1.112

NPVB = $84,155.51

NPVC = –$190,000 + $152,000 / 1.11 + $122,000 / 1.112

NPVC = $45,954.87

c.
Accept projects A, B, and C. Since the projects are independent, accept all three projects because the respective profitability index of each
is greater than one.

d.
Accept Project B. Since the projects are mutually exclusive, choose the project with the highest PI, while taking into account the scale of
the project. Because Projects A and C have the same initial investment, the problem of scale does not arise when comparing the
profitability indices. Based on the profitability index rule, Project C can be eliminated because its PI is less than the PI of Project A.
Because of the problem of scale, we cannot compare the PIs of Projects A and B. However, we can calculate the PI of the incremental
cash flows of the two projects, which are:

Project C0 C1 C2
B –A −$130,000 $94,000 $94,000

When calculating incremental cash flows, remember to subtract the cash flows of the project with the smaller initial cash outflow from those
of the project with the larger initial cash outflow. This procedure insures that the incremental initial cash outflow will be negative. The
incremental PI calculation is:

PI(B – A) = [$94,000 / 1.11 + $94,000 / 1.112] / $130,000

PI(B – A) = 1.238

The company should accept Project B since the PI of the incremental cash flows is greater than one.

e.
Remember that the NPV is additive across projects. Since we can spend $510,000, we could take two of the projects. In this case, we
should take the two projects with the highest NPVs, which are Project B and Project A.

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to complete the calculation.

a.
Project A Project B Project C
CFo 0 CFo 0 CFo 0
C01 $142,000 C01 $236,000 C01 $152,000
F01 1 F01 1 F01 1
C02 $142,000 C02 $236,000 C02 $122,000
F02 1 F02 1 F02 1
I = 11% I = 11% I = 11%
NPV CPT NPV CPT NPV CPT
$243,178.31 $404,155.51 $235,954.87

PIA = $243,178.31 / $190,000 = 1.28

PIB = $404,155.51 / $320,000 = 1.26
PIC = $235,954.87 / $190,000 = 1.24

b.
Project A Project B Project C
CFo –$190,000 CFo –$320,000 CFo –$190,000
C01 $142,000 C01 $236,000 C01 $152,000
F01 1 F01 1 F01 1
C02 $142,000 C02 $236,000 C02 $122,000
F02 1 F02 1 F02 1
I = 11% I = 11% I = 11%
NPV CPT NPV CPT NPV CPT
$53,178.31 $84,155.51 $45,954.87

19.
Consider the following cash flows of two mutually exclusive projects for Tokyo Rubber Company. Assume
the discount rate for both projects is 8 percent.

Solvent
Year Dry Prepreg Prepreg
0 –$1,810,000 –$ 805,000
1 1,111,000 430,000
2 922,000 710,000
3 761,000 412,000

a. What is the payback period for both projects? (Do not round intermediate calculations. Round
your answers to 2 decimal places, e.g., 32.16.)

Payback period
Dry Prepeg 1.76 years
Solvent Prepeg 1.53 years

b. What is the NPV for both projects? (Do not round intermediate calculations. Round your answers
to 2 decimal places, e.g., 32.16.)

NPV
Dry Prepeg $ 613,276.43
Solvent Prepeg $ 528,917.59

c. What is the IRR for both projects? (Do not round intermediate calculations and enter your
answers as a percent rounded to 2 decimal places, e.g., 32.16.)

IRR
Dry Prepeg 27.32 %
Solvent Prepeg 41.39 %

d. Calculate the incremental IRR for the cash flows. (Do not round intermediate calculations and
enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
 Incremental IRR 13.38 %

Explanation:
a.
The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the
initial investment.

Dry Prepeg:

Cumulative cash flows Year 1 = $1,111,000 = $1,111,000

Cumulative cash flows Year 2 = $1,111,000 + 922,000 = $2,033,000

Payback period = 1 + ($699,000 / $922,000)

Payback period = 1.76 years

Solvent Prepeg:

Cumulative cash flows Year 1 = $430,000 = $430,000

Cumulative cash flows Year 2 = $430,000 + 710,000 = $1,140,000

Payback period = 1 + ($375,000 / $710,000)

Payback period = 1.53 years

Since the solvent prepeg has a shorter payback period than the dry prepeg, the company should choose
the solvent prepeg. Remember the payback period does not necessarily rank projects correctly.

b.
The NPV of each project is:

NPVDry prepeg = –$1,810,000 + $1,111,000 / 1.08 + $922,000 / 1.08 2 + $761,000 / 1.083

NPVDry prepeg = $613,276.43

NPVSolvent prepeg = –$805,000 + $430,000 / 1.08 + $710,000 / 1.08 2 + $412,000 / 1.083

NPVSolvent prepeg = $528,917.59

The NPV criteria implies accepting the dry prepeg because it has the highest NPV.

c.
The IRR is the interest rate that makes the NPV of the project equal to zero. So, the IRR of the dry
prepeg is:

0 = –$1,810,000 + $1,111,000 / (1 + IRR) + $922,000 / (1 + IRR) 2 + $761,000 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRRDry prepeg = 27.32%

And the IRR of the solvent prepeg is:

0 = –$805,000 + $430,000 / (1 + IRR) + $710,000 / (1 + IRR) 2 + $412,000 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRRSolvent prepeg = 41.39%

The IRR criteria implies accepting the solvent prepeg because it has the highest IRR. Remember the
IRR does not necessarily rank projects correctly.

d.
Incremental IRR analysis is necessary. The solvent prepeg has a higher IRR, but is relatively smaller in
terms of investment and NPV. In calculating the incremental cash flows, we subtract the cash flows from
the project with the smaller initial investment from the cash flows of the project with the large initial
investment, so the incremental cash flows are:

Year 0 Year 1 Year 2 Year 3

Dr
y 1,810,0 1,111,0 922,00 761,00
–$ $ $ $
prep 00 00 0 0
eg
Sol
vent – 430,00 710,00 412,00
prep 805,000 0 0 0
eg

Dr – 681,00 212,00 349,00

y 1,005,0 0 0 0
prep 00
eg –
Solv
ent
prep
eg

Setting the present value of these incremental cash flows equal to zero, we find the incremental IRR is:

0 = –$1,005,000 + $681,000 / (1 + IRR) + $212,000 / (1 + IRR) 2 + $349,000 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

Incremental IRR = 13.38%

For investing-type projects, we accept the larger project when the incremental IRR is greater than the
discount rate. Since the incremental IRR, 13.38 percent, is greater than the required rate of return of 8
percent, we choose the dry prepeg.

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

b.
Dry prepeg Solvent prepeg
CFo –$1,810,000 CFo –$805,000
C01 $1,111,000 C01 $430,000
F01 1 F01 1
C02 $922,000 C02 $710,000
F02 1 F02 1
C03 $761,000 C03 $412,000
F03 1 F03 1
I = 8% I = 8%
NPV CPT NPV CPT
$613,276.43 $528,917.59
c.
Dry prepeg Solvent prepeg
CFo –$1,810,000 CFo –$805,000
C01 $1,111,000 C01 $430,000
F01 1 F01 1
C02 $922,000 C02 $710,000
F02 1 F02 1
C03 $761,000 C03 $412,000
F03 1 F03 1
IRR CPT IRR CPT
27.32% 41.39%

d.

CFo –$1,005,000
C01 $681,000
F01 1
C02 $212,000
F02 1
C03 $349,000
F03 1
IRR CPT
13.38%

20.
The Yurdone Corporation wants to set up a private cemetery business. According to the CFO, Barry M.
Deep, business is "looking up". As a result, the cemetery project will provide a net cash inflow of $94,000
for the firm during the first year, and the cash flows are projected to grow at a rate of 3 percent per year
forever. The project requires an initial investment of $1,470,000.

a-1. What is the NPV for the project if the required return is 12 percent? (A negative amount should be
indicated by a minus sign. Do not round intermediate calculations and round your answer to
2 decimal places, e.g., 32.16.)
 NPV $ -425,552.00

a-2. If the company requires a return of 12 percent on such undertakings, should the firm accept or reject
the project?

Reject

b. The company is somewhat unsure about the assumption of a growth rate of 3 percent in its cash
flows. At what constant growth rate would the company just break even if it still required a return of
12 percent on investment? (Do not round intermediate calculations and enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)

Constant growth rate 5.60 %

Explanation:
a.
Here the cash inflows of the project go on forever, which is a perpetuity. Unlike ordinary perpetuity cash
flows, the cash flows here grow at a constant rate forever, which is a growing perpetuity. The PV of the
future cash flows from the project is:

PV of cash inflows = C1 / (R – g)
PV of cash inflows = $94,000 / (.12 – .03)
PV of cash inflows = $1,044,444.44

NPV is the PV of the inflows minus the PV of the outflows, so the NPV is:

NPV of the project = –$1,470,000 + 1,044,444.44

NPV of the project = –$425,555.56

The NPV is negative, so we would reject the project.

b.
Here we want to know the minimum growth rate in cash flows necessary to accept the project. The
minimum growth rate is the growth rate at which we would have a zero NPV. The equation for a zero
NPV, using the equation for the PV of a growing perpetuity is:

0 = –$1,470,000 + $94,000 / (.12 – g)

Solving for g, we get:

g = .0561, or 5.61%

MODULE 3
1. The changes in a firm's future cash flows that are a direct consequence of accepting a project are called _____ cash flows.
incremental
stand-alone
opportunity
net present value
erosion

2.A cost that has already been paid, or the liability to pay has already been incurred, is a(n):
salvage value expense.
net working capital expense.
sunk cost.
opportunity cost.
erosion cost.

3.
A decrease in a firm’s current cash flows resulting from the implementation of a new project is referred to as:
salvage value expenses.
net working capital expenses.
sunk costs.
opportunity costs.
erosion costs.

4.
The cash flow from a project is computed as the:
net operating cash flow generated by the project, less any sunk costs and erosion costs.
sum of the incremental operating cash flow and aftertax salvage value of the project.
net income generated by the project, plus the annual depreciation expense.
sum of the incremental operating cash flow, capital spending, and net working capital cash flows incurred by the project.
sum of the sunk costs, opportunity costs, and erosion costs of the project.

5.
Which one of the following should be excluded from the analysis of a project?
erosion costs
incremental fixed costs
incremental variable costs
sunk costs
opportunity costs

6.
The salvage value of an asset creates an aftertax cash flow in an amount equal to the:
sales price of the asset.
sales price minus the book value.
sales price minus the tax due based on the sales price minus the book value.
sales price plus the tax due based on the sales price minus the book value.
sales price plus the tax due based on the book value minus the sales price.

7.
Flatte Restaurant is considering the purchase of a $9,200 soufflé maker. The soufflé maker has an
economic life of five years and will be fully depreciated by the straight-line method. The machine will
produce 1,600 soufflés per year, with each costing $2.40 to make and priced at $4.85. Assume that the
discount rate is 10 percent and the tax rate is 40 percent.

What is the NPV of the project? (Do not round intermediate calculations and round your answer to 2
decimal places, e.g., 32.16.)

NPV $ 2,505.95

Should the company make the purchase?

Yes
Explanation:
Using the tax shield approach to calculating OCF, we get:

OCF = (Sales − Costs)(1 − tC) + tCDepreciation

OCF = [($4.85 × 1,600) − ($2.40 × 1,600)](1 − .40) + .40($9,200 / 5)
OCF = $3,088.00

So, the NPV of the project is:

NPV = −$9,200 + $3,088.00(PVIFA10%,5)
NPV = $2,505.95

8.
Down Under Boomerang, Inc., is considering a new three-year expansion project that requires an initial
fixed asset investment of $2.79 million. The fixed asset will be depreciated straight-line to zero over its
three-year tax life. The project is estimated to generate $2,110,000 in annual sales, with costs of
$805,000. The tax rate is 35 percent and the required return is 12 percent. The project requires an initial
investment in net working capital of $330,000, and the fixed asset will have a market value of $225,000
at the end of the project.

What is the project's Year 0 net cash flow? Year 1? Year 2? Year 3? (Do not round intermediate
calculations. A negative answer should be indicated by a minus sign.)

Years Cash Flow

Year 0 $ -3,120,000.00
Year 1 $ 1,173,750.00
Year 2 $ 1,173,750.00
Year 3 $ 1,650,000.00

What is the NPV? (Do not round intermediate calculations and round your answer to 2 decimal
places, e.g., 32.16.)

NPV $ 38,134.79

Explanation:
The Year 0 cash flow is the investment in fixed assets, plus the initial investment in net working capital,
or:

Year 0 = −$2,790,000 − 330,000

Year 0 = –$3,120,000

The cash outflow at the beginning of the project will increase because of the spending on NWC. At the
end of the project, the company will recover the NWC, so it will be a cash inflow. The sale of the
equipment will result in a cash inflow, but we also must account for the taxes that will be paid on this
sale. So, the cash flows for each year of the project will be:
OCF = (Sales − Costs)(1 − tc) + tc(Depreciation)
OCF = ($2,110,000 − 805,000)(1 − .35) + .35($2,790,000 / 3)
OCF = $1,173,750

In Years 1 and 2, the only cash flow is the OCF. In Year 3, the total cash flow will include the recovery of
the NWC and the aftertax salvage value, so:

Year 3 = $1,173,750 + 330,000 + 225,000 + (0 − $225,000)(.35)

Year 3 = $1,650,000

And the NPV of the project is:

NPV = −$3,120,000 + $1,173,750(PVIFA12%,2) + ($1,650,000 / 1.123)

NPV = $38,134.79

9.
Your firm is contemplating the purchase of a new $615,000 computer-based order entry system. The
system will be depreciated straight-line to zero over its five-year life. It will be worth $67,000 at the end of
that time. You will save $245,000 before taxes per year in order processing costs, and you will be able to
reduce working capital by $82,000 (this is a one-time reduction). If the tax rate is 30 percent, what is the
IRR for this project? (Do not round intermediate calculations and enter your answer as a percent
rounded to 2 decimal places, e.g., 32.16.)

IRR 26.48 %

Explanation:
First, we will calculate the annual depreciation of the new equipment. It will be:

Annual depreciation charge = $615,000 / 5

Annual depreciation charge = $123,000

The aftertax salvage value of the equipment is:

Aftertax salvage value = $67,000(1 − .30)

Aftertax salvage value = $46,900

Using the tax shield approach, the OCF is:

OCF = $245,000(1 − .30) + .30($123,000)
OCF = $208,400

Now we can find the project IRR. There is an unusual feature that is a part of this project. Accepting this
project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction
in NWC implies that when the project ends, we will have to increase NWC. So, at the end of the project,
we will have a cash outflow to restore the NWC to its level before the project. We also must include the
aftertax salvage value at the end of the project. The IRR of the project is:

NPV = 0 = −$615,000 + 82,000 + $208,400(PVIFAIRR%,4) + [($208,400 + 46,900 − 82,000) / (1 + IRR)5]

IRR = 26.48%

10.
An asset used in a four-year project falls in the five-year MACRS class for tax purposes. The asset has
an acquisition cost of $6,140,000 and will be sold for $1,340,000 at the end of the project. If the tax rate
is 30 percent, what is the aftertax salvage value of the asset? Refer to the MACRS schedule. (Do not
round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16. Enter
your answer in dollars, not millions of dollars, e.g., 1,234,567.)

Aftertax salvage value $ 1,256,297.60

Explanation:
To find the BV at the end of four years, we need to find the accumulated depreciation for the first four
years. We could calculate a table with the depreciation each year, but an easier way is to add the
MACRS depreciation amounts for each of the first four years and multiply this percentage times the cost
of the asset. We can then subtract this from the asset cost. Doing so, we get:

BV4 = $6,140,000 − 6,140,000(.2000 + .3200 + .1920 + .1152)

BV4 = $1,060,992

The asset is sold at a gain to book value, so this gain is taxable.

Aftertax salvage value = $1,340,000 + ($1,060,992 − 1,340,000)(.30)

Aftertax salvage value = $1,256,297.60
11.
The annual annuity stream of payments with the same present value as a project's costs is called the project's _____ cost.
incremental
sunk
opportunity
erosion
equivalent annual

12.
The equivalent annual cost method is useful in determining:
the annual operating cost of a machine if the annual maintenance is performed versus when the maintenance is not performed as
recommended.
the tax shield benefits of depreciation given the purchase of new assets for a project.
operating cash flows for cost-cutting projects of equal duration.
which one of two machines to acquire given equal machine lives but unequal machine costs.
which one of two machines to purchase when the machines are mutually exclusive, have different machine lives, and will be
replaced once they are worn out.

13.
You are evaluating two different silicon wafer milling machines. The Techron I costs $210,000, has a
three-year life, and has pretax operating costs of $53,000 per year. The Techron II costs $370,000, has a
five-year life, and has pretax operating costs of $26,000 per year. For both milling machines, use
straight-line depreciation to zero over the project’s life and assume a salvage value of $30,000. If your
tax rate is 34 percent and your discount rate is 8 percent, compute the EAC for both machines. (A
negative answer should be indicated by a minus sign. Do not round intermediate calculations and
round your answers to 2 decimal places, e.g., 32.16.)

EAC
Techron I $ -86,567.97
Techron II $ -81,293.85

Which do you prefer?

Techron II
Explanation:
We will need the aftertax salvage value of the equipment to compute the EAC. Even though the
equipment for each product has a different initial cost, both have the same salvage value. The aftertax
salvage value for both cases is:

Aftertax salvage value = $30,000(1 − .34)

Aftertax salvage value = $19,800

To calculate the EAC, we first need the OCF and NPV of each option. The OCF and NPV for Techron I is:

OCF = −$53,000(1 − .34) + .34($210,000 / 3)

OCF = −$11,180

NPV = −$210,000 − $11,180(PVIFA8%,3) + ($19,800 / 1.083)

NPV = −$223,094.07

EAC = −$223,094.07 / (PVIFA8%,3)

EAC = −$86,567.97

And the OCF and NPV for Techron II is:

OCF = −$26,000(1 − .34) + .34($370,000 / 5)

OCF = $8,000

NPV = −$370,000 + $8,000(PVIFA8%,5) + ($19,800 / 1.085)

NPV = −$324,582.77

EAC = −$324,582.77 / (PVIFA8%,5)

EAC = −$81,293.85

The two milling machines have unequal lives, so they can only be compared by expressing both on an
equivalent annual basis, which is what the EAC method does. Thus, you prefer the Techron II because it
has the lower (less negative) annual cost.

14.
Hagar Industrial Systems Company (HISC) is trying to decide between two different conveyor belt
systems. System A costs $244,000, has a four-year life, and requires $76,000 in pretax annual operating
costs. System B costs $342,000, has a six-year life, and requires $70,000 in pretax annual operating
costs. Both systems are to be depreciated straight-line to zero over their lives and will have zero salvage
value. Whichever system is chosen, it will not be replaced when it wears out. The tax rate is 35 percent
and the discount rate is 10 percent.

Calculate the NPV for both conveyor belt systems. (Do not round intermediate calculations
and round your answer to 2 decimal places, e.g., 32.16. A negative answer should be indicated by
a minus sign.)

NPV
System A $ -334,914.73
System B $ -453,276.91

Which system should the firm choose?

System A
Explanation:
If we are trying to decide between two projects that will not be replaced when they wear out, the proper
capital budgeting method to use is NPV. Both projects only have costs associated with them, not sales,
so we will use these to calculate the NPV of each project. Using the tax shield approach to calculate the
OCF, the NPV of System A is:

OCFA = −$76,000(1 − .35) + .35($244,000 / 4)

OCFA = −$28,050

NPVA = −$244,000 − $28,050(PVIFA10%,4)

NPVA = −$332,914.73

And the NPV of System B is:

OCFB = −$70,000(1 − .35) + .35($342,000 / 6)

OCFB = −$25,550

NPVB = −$342,000 − $25,550(PVIFA10%,6)

NPVB = −$453,276.91

If the system will not be replaced when it wears out, then System A should be chosen, because it has the
less negative NPV.
15.
A proposed cost-saving device has an installed cost of $750,000. The device will be used in a five-year
project but is classified as three-year MACRS property for tax purposes. The required initial net working
capital investment is $57,000, the marginal tax rate is 34 percent, and the project discount rate is 10
percent. The device has an estimated Year 5 salvage value of $82,000. What level of pretax cost savings
do we require for this project to be profitable? MACRS schedule. (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)

Pretax cost savings $ 210,515.84

Explanation:
To find the initial pretax cost savings necessary to buy the new machine, we should use the tax shield
approach to find the OCF. We begin by calculating the depreciation each year using the MACRS
depreciation schedule. The depreciation each year is:

D1 = $750,000(.3333) = $249,975
D2 = $750,000(.4445) = $333,375
D3 = $750,000(.1481) = $111,075
D4 = $750,000(.0741) = $55,575

Using the tax shield approach, the OCF each year is:

OCF1 = (S − C)(1 − .34) + .34($249,975)

OCF2 = (S − C)(1 − .34) + .34($333,375)
OCF3 = (S − C)(1 − .34) + .34($111,075)
OCF4 = (S − C)(1 − .34) + .34($55,575)
OCF5 = (S − C)(1 − .34)

Now we need the aftertax salvage value of the equipment. The aftertax salvage value is:

After-tax salvage value = $82,000(1 − .34) = $54,120

To find the necessary cost reduction, we must realize that we can split the cash flows each year. The
OCF in any given year is the cost reduction (S – C) times one minus the tax rate, which is an annuity for
the project life, and the depreciation tax shield. To calculate the necessary cost reduction, we would
require a zero NPV. The equation for the NPV of the project is:
NPV = 0 = −$750,000 − 57,000 + (S − C)(.66)(PVIFA 10%,5) + .34($249,975 / 1.10 + $333,375 / 1.102
+ $111,075 / 1.103 + $55,575 / 1.104) + ($57,000 + 54,120) / 1.105

Solving this equation for the sales minus costs, we get:

(S − C)(.66)(PVIFA10%,5) = $525,782.94
(S − C) = $210,151.84

16.
Another utilization of cash flow analysis is setting the bid price on a project. To calculate the bid price, we
set the project NPV equal to zero and find the required price. Thus the bid price represents a financial
break-even level for the project. Guthrie Enterprises needs someone to supply it with 154,000 cartons of
machine screws per year to support its manufacturing needs over the next five years, and you’ve
decided to bid on the contract. It will cost you $1,940,000 to install the equipment necessary to start
production; you’ll depreciate this cost straight-line to zero over the project’s life. You estimate that in five
years this equipment can be salvaged for $164,000. Your fixed production costs will be $279,000 per
year, and your variable production costs should be $9.90 per carton. You also need an initial investment
in net working capital of $144,000. If your tax rate is 39 percent and you require a return of 13 percent on
your investment, what bid price per carton should you submit? (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)

Bid price $ 16.01

Explanation:
To find the bid price, we need to calculate all other cash flows for the project, and then solve for the bid
price. The aftertax salvage value of the equipment is:

Aftertax salvage value = $164,000(1 − .39)

Aftertax salvage value = $100,040

Now we can solve for the necessary OCF that will give the project a zero NPV. The equation for the NPV
of the project is:

NPV = 0 = −$1,940,000 − 144,000 + OCF(PVIFA 13%,5) + [($144,000 + 100,040) / 1.135]

Solving for the OCF, we find the OCF that makes the project NPV equal to zero is:

OCF = $1,951,544.87 / PVIFA13%,5

OCF = $554,852.59

The easiest way to calculate the bid price is the tax shield approach, so:

OCF = $554,852.59 = [(P − v)Q − FC](1 − tc) + tcD

$554,852.59 = [(P − $9.90)(154,000) − $279,000](1 − .39) + .39($1,940,000 / 5)
P = $16.01

17.
Another utilization of cash flow analysis is setting the bid price on a project. To calculate the bid price, we
set the project NPV equal to zero and find the required price. Thus the bid price represents a financial
break-even level for the project. Guthrie Enterprises needs someone to supply it with 142,000 cartons of
machine screws per year to support its manufacturing needs over the next five years, and you’ve
decided to bid on the contract. It will cost you $1,820,000 to install the equipment necessary to start
production; you’ll depreciate this cost straight-line to zero over the project’s life. You estimate that in five
years this equipment can be salvaged for $152,000. Your fixed production costs will be $267,000 per
year, and your variable production costs should be $8.70 per carton. You also need an initial investment
in net working capital of $132,000. The tax rate is 35 percent and you require a return of 12 percent on
your investment. Assume that the price per carton is $16.20.

a. Calculate the project NPV. (Do not round intermediate calculations and round your answer to 2
decimal places, e.g., 32.16.)

NPV $ 508,008.02

b. What is the minimum number of cartons per year that can be supplied and still break even? (Do not
round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

Quantity of cartons 113,092

c. What is the highest fixed costs that could be incurred and still break even? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Fixed costs $ 483,809.80

Explanation:
The aftertax salvage value of the equipment is:

Aftertax salvage value = $152,000(1 – .35)

Aftertax salvage value = $98,800

a.
The cash flow at Time 0 for all three parts of this question will be:

Capital
spendin –$ 1,820,000
g
Chang
e in –$ 132,000
NWC

Total
cash –$ 1,952,000
flow

Using the bottom up approach to calculating the OCF, we get:

Assume price per unit = $16.20 and units/year = 142,000

Year 1 Year 2 Year 3 Year 4 Year 5

2,300,4 2,300,4 2,300,4 2,300,4 2,300,4
Sales $ $ $ $ $
00 00 00 00 00
Varia
1,235,4 1,235,4 1,235,4 1,235,4 1,235,4
ble
00 00 00 00 00
costs
Fixed
267,000 267,000 267,000 267,000 267,000
costs
Depre
364,000 364,000 364,000 364,000 364,000
ciation

EBIT $ 434,000 $ 434,000 $ 434,000 $ 434,000 $ 434,000

Taxes 151,900 151,900 151,900 151,900 151,900
(35%)

Net
$ 282,100 $ 282,100 $ 282,100 $ 282,100 $ 282,100
Income
Depre
364,000 364,000 364,000 364,000 364,000
ciation

Oper
ating $ 646,100 $ 646,100 $ 646,100 $ 646,100 $ 646,100
CF

Oper
ating $ 646,100 $ 646,100 $ 646,100 $ 646,100 $ 646,100
CF
Chan
ge in 132,000
NWC
Capit
al
98,800
spendi
ng

Total
$ 646,100 $ 646,100 $ 646,100 $ 646,100 $ 876,900
CF

With these cash flows, the NPV of the project is:

NPV = –$1,820,000 – 132,000 + $646,100(PVIFA12%,5) + [($132,000 + 98,800) / 1.125]

NPV = $508,008.02

If the actual price is above the bid price that results in a zero NPV, the project will have a positive NPV.
As for the cartons sold, if the number of cartons sold increases, the NPV will increase, and if the costs
increase, the NPV will decrease.
b.
To find the minimum number of cartons sold to still breakeven, we need to use the tax shield approach to
calculating OCF, and solve the problem similar to finding a bid price. Using the initial cash flow and
salvage value we already calculated, the equation for a zero NPV of the project is:

NPV = 0 = –$1,820,000 – 132,000 + OCF(PVIFA12%,5) + [($132,000 + 98,800) / 1.125]

So, the necessary OCF for a zero NPV is:

OCF = $1,821,037.88 / PVIFA12%,5 = $505,173.63

Now we can use the tax shield approach to solve for the minimum quantity as follows:

OCF = $505,173.63 = [(P – v)Q – FC ](1 – tc) + tcD

$505,173.63 = [($16.20 – 8.70)Q – 267,000](1 – .35) + .35($1,820,000 / 5)
Q = 113,092

Year 1 Year 2 Year 3 Year 4 Year 5

1,832,09 1,832,09 1,832,09 1,832,09 1,832,09
Sales $ $ $ $ $
0.83 0.83 0.83 0.83 0.83
Varia
983,900. 983,900. 983,900. 983,901. 983,901.
ble
63 63 63 00 00
costs
Fixed 267,000. 267,000. 267,000. 267,000. 267,000.
costs 00 00 00 00 00
Depre 364,000. 364,000. 364,000. 364,000. 364,000.
ciation 00 00 00 00 00

217,190. 217,190. 217,190. 217,190. 217,190.

EBIT $ $ $ $ $
20 20 20 20 20
Taxes 76,016.5 76,016.5 76,016.5 76,016.5 76,016.5
(35%) 7 7 7 7 7

Net 141,173. 141,173. 141,173. 141,173. 141,173.

$ $ $ $ $
Income 63 63 63 63 63
Depre 364,000. 364,000. 364,000. 364,000. 364,000.
ciation 00 00 00 00 00
 Opera 505,173. 505,173. 505,173. 505,173. 505,173.
$ $ $ $ $
ting CF 63 63 63 63 63

Opera 505,173. 505,173. 505,173. 505,173. 505,173.

$ $ $ $ $
ting CF 63 63 63 63 63
Chan
132,000.
ge in
00
NWC
Capit
al 98,800.0
spendi 0
ng

Total 505,173. 505,173. 505,173. 505,173. 735,973.

$ $ $ $ $
CF 63 63 63 63 63

NPV = –$1,820,000 – 132,000 + $505,173.63(PVIFA 12%,5) + [($132,000 + 98,800) / 1.125] ≈ $0

Note that the NPV is not exactly equal to zero because we had to round the number of cartons sold; you
cannot sell one-half of a carton.

c.
To find the highest level of fixed costs and still breakeven, we need to use the tax shield approach to
calculating OCF, and solve the problem similar to finding a bid price. Using the initial cash flow and
salvage value we already calculated, the equation for a zero NPV of the project is:

NPV = 0 = –$1,820,000 – 132,000 + OCF(PVIFA12%,5) + [($132,000 + 98,800) / 1.125]

OCF = $1,821,037.88 / PVIFA12%,5 = $505,173.63

Notice this is the same OCF we calculated in part b. Now we can use the tax shield approach to solve for
the maximum level of fixed costs as follows:

OCF = $505,173.63 = [(P – v)Q – FC ](1 – tC) + tCD

$505,173.63 = [($16.20 – $8.70)(142,000) – FC](1 – .35) + .35($1,820,000 / 5)
FC = $483,809.80

As a check, we can calculate the NPV of the project with this quantity. The calculations are:

Year 1 Year 2 Year 3 Year 4 Year 5

2,300,4 2,300,4 2,300,4 2,300,4 2,300,4
Sales $ $ $ $ $
00.00 00.00 00.00 00.00 00.00
Varia
1,235,4 1,235,4 1,235,4 1,235,4 1,235,4
ble
00.00 00.00 00.00 00.00 00.00
costs
Fixed 483,809 483,809 483,809 483,809 483,809
costs .80 .80 .80 .80 .80
Depre 364,000 364,000 364,000 364,000 364,000
ciation .00 .00 .00 .00 .00

217,190 217,190 217,190 217,190 217,190

EBIT $ $ $ $ $
.20 .20 .20 .20 .20
Taxes 76,016. 76,016. 76,016. 76,016. 76,016.
(35%) 57 57 57 57 57

Net 141,173 141,173 141,173 141,173 141,173

$ $ $ $ $
Income .63 .63 .63 .63 .63
Depre 364,000 364,000 364,000 364,000 364,000
ciation .00 .00 .00 .00 .00

Oper
505,173 505,173 505,173 505,173 505,173
ating $ $ $ $ $
.63 .63 .63 .63 .63
CF

Oper
505,173 505,173 505,173 505,173 505,173
ating $ $ $ $ $
.63 .63 .63 .63 .63
CF
Chan
132,000
ge in
.00
NWC
Capit 98,800.
al 00
spendi
ng

Total 505,173 505,173 505,173 505,173 735,973

$ $ $ $ $
CF .63 .63 .63 .63 .63

NPV = –$1,820,000 – 132,000 + $505,173.63(PVIFA 12%,5) + [($132,000 + 98,800) / 1.125] ≈ $0

18.
Your company has been approached to bid on a contract to sell 3,800 voice recognition (VR) computer
keyboards a year for four years. Due to technological improvements, beyond that time they will be
outdated and no sales will be possible. The equipment necessary for the production will cost $3.4 million
and will be depreciated on a straight-line basis to a zero salvage value. Production will require an
investment in net working capital of $91,000 to be returned at the end of the project, and the equipment
can be sold for $271,000 at the end of production. Fixed costs are $636,000 per year, and variable costs
are $151 per unit. In addition to the contract, you feel your company can sell 9,100, 10,000, 12,100, and
9,400 additional units to companies in other countries over the next four years, respectively, at a price of
$290. This price is fixed. The tax rate is 35 percent, and the required return is 9 percent. Additionally, the
president of the company will undertake the project only if it has an NPV of $100,000.

What bid price should you set for the contract? (Do not round intermediate calculations and round
your answer to 2 decimal places, e.g., 32.16.)

Bid price $ 252.43

Explanation:
We need to find the bid price for a project, but the project has extra cash flows. Since we don’t already
produce the keyboard, the sales of the keyboard outside the contract are relevant cash flows. Since we
know the extra sales number and price, we can calculate the cash flows generated by these sales. The
cash flow generated from the sale of the keyboard outside the contract is:

Year 1 Year 2 Year 3 Year 4

Sale
$ 2,639,000 $ 2,900,000 $ 3,509,000 $ 2,726,000
s
Vari 1,374,100 1,510,000 1,827,100 1,419,400
able
costs

EBT $ 1,264,900 $ 1,390,000 $ 1,681,900 $ 1,306,600

Tax 442,715 486,500 588,665 457,310

Net
incom
e $ 822,185 $ 903,500 $ 1,093,235 $ 849,290
(and
OCF)

So, the addition to NPV of these market sales is:

NPV of market sales = $822,185 / 1.09 + $903,500 / 1.09 2 + $1,093,235 / 1.093 + $849,290 / 1.094
NPV of market sales = $2,960,592.49

You may have noticed that we did not include the initial cash outlay, depreciation, or fixed costs in the
calculation of cash flows from the market sales. The reason is that it is irrelevant whether or not we
include these here. Remember that we are not only trying to determine the bid price, but we are also
determining whether or not the project is feasible. In other words, we are trying to calculate the NPV of
the project, not just the NPV of the bid price. We will include these cash flows in the bid price calculation.
The reason we stated earlier that whether we included these costs in this initial calculation was irrelevant
is that you will come up with the same bid price if you include these costs in this calculation, or if you
include them in the bid price calculation.

Next, we need to calculate the aftertax salvage value, which is:

Aftertax salvage value = $271,000(1 − .35)

Aftertax salvage value = $176,150

Instead of solving for a zero NPV as is usual in setting a bid price, the company president requires an
NPV of $100,000, so we will solve for an NPV of that amount. The NPV equation for this project is
(remember to include the NWC cash flow at the beginning of the project, and the NWC recovery at the
end):
NPV = $100,000 = −$3,400,000 − 91,000 + 2,960,592.49 + OCF(PVIFA 9%,4)
+ [($176,150 + 91,000) / 1.094]

Solving for the OCF, we get:

OCF = $441,151.71 / PVIFA9%,4

OCF = $136,169.71

Now we can solve for the bid price as follows:

OCF = $136,169.71 = [(P − v)Q − FC ](1 − tc) + tcD

$136,169.71 = [(P − $151)(3,800) − $636,000](1 − .35) + .35($3,400,000 / 4)
P = $253.05

MODULE 4
1. A bond that makes no coupon payments and is initially priced at a deep discount is called a _____ bond.
Treasury
municipal
floating-rate
junk
zero coupon

2.
The principal amount of a bond that is repaid at the end of the loan term is called the bond's:
coupon.
face value.
maturity.
yield to maturity.
coupon rate.
3.The annual interest paid by a bond divided by the bond’s face value is called the:
coupon.
face value.
maturity.
yield to maturity.
coupon rate.

4.The rate of return required by investors in the market for owning a bond is called the:
coupon.
face value.
maturity.
yield to maturity.
coupon rate.

5.All else constant, a coupon bond that is selling at a premium, must have:
a coupon rate that is equal to the yield to maturity.
a market price that is less than par value.
semi1nnual interest payments.
a yield to maturity that is less than the coupon rate.
a coupon rate that is less than the yield to maturity.

6. Microhard has issued a bond with the following characteristics:

Par: $1,000
Time to maturity: 9 years
Coupon rate: 12 percent
Semiannual payments

Calculate the price of this bond if the YTM is (Do not round intermediate calculations and round your
answers to 2 decimal places, e.g., 32.16.):

Price of the Bond

 $
a. 12 percent 1,000.00 ±1%

$
b. 14 percent 899.41 ±1%

$
c. 10 percent 1,116.90 ±0.1%

Explanation:
The price of any bond is the PV of the interest payments, plus the PV of the par value. Notice this
problem assumes a semiannual coupon. The price of the bond at each YTM will be:

a.
P = $60({1 − [1 / (1 + .060)18]} / .060) + $1,000[1 / (1 + .060)18]
P = $1,000.00

When the YTM and the coupon rate are equal, the bond will sell at par.

b.
P = $60({1 − [1 / (1 + .070)18]} / .070) + $1,000[1 / (1 + .070)18]
P = $899.41

When the YTM is greater than the coupon rate, the bond will sell at a discount.

c.
P = $60({1 − [1 / (1 + .050)18]} / .050) + $1,000[1 / (1 + .050)18]
P = $1,116.90

When the YTM is less than the coupon rate, the bond will sell at a premium.

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.
a.
Enter 18 6.0% $60 $1,000
N I/Y PV PMT FV
Solve for $1,000.00

b.
Enter 18 7.0% $60 $1,000
N I/Y PV PMT FV
Solve for $899.41

c.
Enter 18 5.0% $60 $1,000
N I/Y PV PMT FV
Solve for $1,116.90

7. Even though most corporate bonds in the United States make coupon payments semiannually,
bonds issued elsewhere often have annual coupon payments. Suppose a German company issues a
bond with a par value of €1,000, 15 years to maturity, and a coupon rate of 6.5 percent paid annually.

If the yield to maturity is 7.6 percent, what is the current price of the bond? (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)

€
Bond price 903.50 ±1%

Explanation:
The price of any bond is the PV of the interest payments, plus the PV of the par value. The fact that the
bond is denominated in euros is irrelevant. Notice this problem assumes an annual coupon. The price of
the bond will be:

P = €65({1 – [1 / (1 + .076)15]} / .076) + €1,000[1 / (1 + .076)15]

P = €903.50
Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 15 7.6% €65 €1,000

N I/Y PV PMT FV
Solve for €903.50

8. Watters Umbrella Corp. issued 15-year bonds 2 years ago at a coupon rate of 6 percent. The
bonds make semiannual payments. If these bonds currently sell for 97 percent of par value, what is the
YTM? (Do not round intermediate calculations and enter your answer as a percent rounded to 2
decimal places, e.g., 32.16.)

%
YTM 6.34 ±1%

Explanation:
Here we are finding the YTM of a semiannual coupon bond. The bond price equation is:

P = $970 = $30(PVIFAR%,26) + $1,000(PVIFR%,26)

Since we cannot solve the equation directly for R, using a spreadsheet, a financial calculator, or trial and
error, we find:

R = 3.171%

Since the coupon payments are semiannual, this is the semiannual interest rate. The YTM is the APR of
the bond, so:

YTM = 2 × 3.171%
YTM = 6.34%

Calculator Solution:
Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 26 ±$970 $30 $1,000

N I/Y PV PMT FV
Solve for 3.171%

3.171% × 2 = 6.34%

9. Laurel, Inc., and Hardy Corp. both have 10 percent coupon bonds outstanding, with semiannual
interest payments, and both are priced at par value. The Laurel, Inc., bond has six years to maturity,
whereas the Hardy Corp. bond has 19 years to maturity.

If interest rates suddenly rise by 2 percent, what is the percentage change in the price of these
bonds? (A negative answer should be indicated by a minus sign. Do not round intermediate
calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Percentage change in price of Laurel -8.38 ±1%

%
Percentage change in price of Hardy -14.85 ±1%

If interest rates were to suddenly fall by 2 percent instead, what would the percentage change in the
price of these bonds be then? (Do not round intermediate calculations and enter your answers as a
percent rounded to 2 decimal places, e.g., 32.16.)

%
Percentage change in price of Laurel 9.39 ±1%

%
Percentage change in price of Hardy 19.37 ±1%
Explanation:
Any bond that sells at par has a YTM equal to the coupon rate. Both bonds sell at par, so the initial YTM
on both bonds is the coupon rate, 10 percent. If the YTM suddenly rises to 12 percent:

PLaurel = $50(PVIFA6.0%,12) + $1,000(PVIF6.0%,12) = $916.16

PHardy = $50(PVIFA6.0%,38) + $1,000(PVIF6.0%,38) = $851.54

The percentage change in price is calculated as:

Percentage change in price = (New price – Original price) / Original price

($916.16 – 1,000) /
ΔPLaurel% = = –.0838, or –8.38%
$1,000
($851.54 – 1,000) /
ΔPHardy% = = –.1485, or –14.85%
$1,000

If the YTM suddenly falls to 8 percent:

PLaurel = $50(PVIFA4.0%,12) + $1,000(PVIF4.0%,12) = $1,093.85

PHardy = $50(PVIFA4.0%,38) + $1,000(PVIF4.0%,38) = $1,193.68

($1,093.85 – 1,000) /
ΔPLaurel% = = +.0939, or +9.39%
$1,000
($1,193.68 – 1,000) /
ΔPHardy% = = +.1937, or +19.37%
$1,000

All else the same, the longer the maturity of a bond, the greater is its price sensitivity to changes in
interest rates. Notice also that for the same interest rate change, the gain from a decline in interest rates
is larger than the loss from the same magnitude change. For a plain vanilla bond, this is always true.

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.
If both bonds sell at par, the initial YTM on both bonds is the coupon rate, 10 percent. If the YTM
suddenly rises to 12 percent:

PLaurel
Enter 12 6.0% $50 $1,000
N I/Y PV PMT FV
Solve for $916.16

ΔPLaurel% = ($916.16 – 1,000) / $1,000 = –.0838, or –8.38%

PHardy
Enter 38 6.0% $50 $1,000
N I/Y PV PMT FV
Solve for $851.54

ΔPHardy% = ($851.54 – 1,000) / $1,000 = –.1485, or –14.85%

If the YTM suddenly falls to 8 percent:

PLaurel
Enter 12 4.0% $50 $1,000
N I/Y PV PMT FV
Solve for $1,093.85

ΔPLaurel% = ($1,093.85 – 1,000) / $1,000 = +.0939, or +9.39%

PHardy
Enter 38 4.0% $50 $1,000
N I/Y PV PMT FV
Solve for $1,193.68

ΔPHardy% = ($1,193.68 – 1,000) / $1,000 = +.1937, or +19.37%

All else the same, the longer the maturity of a bond, the greater is its price sensitivity to changes in
interest rates.
10. Hacker Software has 11 percent coupon bonds on the market with 19 years to maturity. The
bonds make semiannual payments and currently sell for 108.3 percent of par.

What is the current yield on the bonds? (Do not round intermediate calculations. Enter your answer
as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Current yield 10.16 ±1%

What is the YTM? (Do not round intermediate calculations. Enter your answer as a percent
rounded to 2 decimal places, e.g., 32.16.)

%
YTM 10.01 ±1%

What is the effective annual yield? (Do not round intermediate calculations. Enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)

%
Effective annual yield 10.27 ±1%

Explanation:
The bond price equation for this bond is:

P0 = $1,083 = $55(PVIFAR%,38) + $1,000(PVIFR%,38)

Using a spreadsheet, financial calculator, or trial and error we find:

R = 5.007%

This is the semiannual interest rate, so the YTM is:

YTM = 2 × 5.007%
YTM = 10.01%
The current yield is:

Current yield = Annual coupon payment / Price

Current yield = $110 / $1,083
Current yield = .1016, or 10.16%

The effective annual yield is the same as the EAR, so using the EAR equation from the previous chapter:

Effective annual yield = (1 + .05007)2 – 1

Effective annual yield = .1027, or 10.27%

Calculator Solution:

Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

Enter 38 ±$1,083 $55 $1,000

N I/Y PV PMT FV
Solve for 5.007%

YTM = 5.007% × 2 = 10.01%

MODULE 5
1. The Starr Co. just paid a dividend of $1.75 per share on its stock. The dividends are expected to
grow at a constant rate of 4 percent per year, indefinitely. Investors require a return of 11 percent
on the stock.

What is the current price? (Do not round intermediate calculations and round your answer to 2
decimal places, e.g., 32.16.)

$
Current price 26.00 ±1%
What will the price be in three years? (Do not round intermediate calculations and round your
answer to 2 decimal places, e.g., 32.16.)

$
Stock price 29.25 ±1%

What will the price be in 18 years? (Do not round intermediate calculations and round your answer
to 2 decimal places, e.g., 32.16.)

$
Stock price 52.67 ±1%

Explanation:
The constant dividend growth model is:

Pt = Dt × (1 + g) / (R − g)

So, the price of the stock today is:

P0 = D0(1 + g) / (R − g)
P0 = $1.75(1.04) / (.11 − .04)
P0 = $26.00

The dividend at Year 4 is the dividend today times the FVIF for the growth rate in dividends and four
years, so:

P3 = D3(1 + g) / (R − g)
P3 = D0(1 + g)4 / (R − g)
P3 = $1.75(1.04)4 / (.11 − .04)
P3 = $29.25

We can do the same thing to find the dividend in Year 19, which gives us the price in Year 18, so:

P18 = D18(1 + g) / (R − g)
P18 = D0(1 + g)19 / (R − g)
P18 = $1.75(1.04)19 / (.11 − .04)
P18 = $52.67
There is another feature of the constant dividend growth model: The stock price grows at the dividend
growth rate. So, if we know the stock price today, we can find the future value for any time in the future
we want to calculate the stock price. In this problem, we want to know the stock price in three years, and
we have already calculated the stock price today. The stock price in three years will be:

P3 = P0(1 + g)3
P3 = $26.00(1 + .04)3
P3 = $29.25

And the stock price in 18 years will be:

P18 = P0(1 + g)18

P18 = $26.00(1 + .04)18
P18 = $52.67

2. The next dividend payment by ECY, Inc., will be $1.64 per share. The dividends are anticipated
to maintain a growth rate of 8 percent, forever. The stock currently sells for $31 per share.

What is the required return? (Do not round intermediate calculations and enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)

%
Required 13.29 ±1%
return

Explanation:
We need to find the required return of the stock. Using the constant growth model, we can solve the
equation for R. Doing so, we find:

R = (D1 / P0) + g
R = ($1.64 / $31.00) + .08
R = .1329, or 13.29%

3. Ayden, Inc., has an issue of preferred stock outstanding that pays a dividend of $5.15 every year,
in perpetuity. This issue currently sells for $92 per share.
What is the required return? (Do not round intermediate calculations and enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)

%
Required 5.60 ±1%
return

Explanation:
The price of a share of preferred stock is the dividend divided by the required return. This is the same
equation as the constant growth model, with a dividend growth rate of zero percent. Remember that most
preferred stock pays a fixed dividend, so the growth rate is zero. Using this equation, we find the price
per share of the preferred stock is:

R = D / P0
R = $5.15 / $92
R = .0560, or 5.60%

4. Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over
the next nine years, because the firm needs to plow back its earnings to fuel growth. The
company will pay a dividend of $15 per share in 10 years and will increase the dividend by 6
percent per year thereafter. If the required return on this stock is 12 percent, what is the current
share price? (Do not round intermediate calculations and round your answer to 2 decimal
places, e.g., 32.16.)

$
Current share price 90.15 ±1%

Explanation:
Here we have a stock that pays no dividends for 9 years. Once the stock begins paying dividends, it will
have a constant growth rate of dividends. We can use the constant growth model at that point. It is
important to remember that the general form of the constant dividend growth formula is:

Pt = [Dt × (1 + g)] / (R − g)

This means that since we will use the dividend in Year 10, we will be finding the stock price in Year 9. The
dividend growth model is similar to the PVA and the PV of a perpetuity: The equation gives you the PV
one period before the first payment. So, the price of the stock in Year 9 will be:

P9 = D10 / (R − g)
P9 = $15 / (.120 − .06)
P9 = $250.00

The price of the stock today is the PV of the stock price in the future. We simply discount the future stock
price at the required return. The price of the stock today will be:

P0 = $250.00 / 1.129
P0 = $90.15

5. Antiques R Us is a mature manufacturing firm. The company just paid a dividend of $8.90, but
management expects to reduce the payout by 4 percent per year, indefinitely. If you require a return
of 14 percent on this stock, what will you pay for a share today? (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)

$
Current share price 47.47 ±1%

Explanation:
The constant growth model can be applied even if the dividends are declining by a constant percentage,
just make sure to recognize the negative growth. So, the price of the stock today will be:

P0 = D0(1 + g) / (R − g)
P0 = $8.90(1 − .04) / [.14 − (−.04)]
P0 = $47.47

6. Next year's annual dividend divided by the current stock price is called the:
yield to maturity.
total yield.
dividend yield.
capital gains yield.
earnings yield.

7. If a stock pays a constant annual dividend then the stock can be valued using the:
fixed coupon bond present value formula.
present value of an annuity due formula.
payout ratio formula.
present value of an ordinary annuity formula.
perpetuity present value formula.

8.
In the formula, P3 = Div / R - g, the dividend is for period:
two.
five.
four.
three.
one.

9.The underlying assumption of the dividend growth model is that a stock is worth:
the same amount to every investor regardless of their desired rate of return.
the present value of the future income that the stock is expected to generate.
an amount computed as the next annual dividend divided by the market rate of return.
the same amount as any other stock that pays the same current dividend and has the same required rate of return.
an amount computed as the next annual dividend divided by the required rate of return.

10.
The total return on a stock is equal to the:

dividend yield minus the capital gains yield.

dividend growth rate minus the dividend yield.
dividend yield plus the dividend growth rate.
growth rate of the dividends.
dividend divided by the sum of the dividend yield and capital gains yield.

11.
Bucksnort, Inc., has an odd dividend policy. The company has just paid a dividend of $8 per share and
has announced that it will increase the dividend by $4 per share for each of the next five years, and then
never pay another dividend. If you require a return of 11 percent on the company’s stock, how much will
you pay for a share today? (Do not round intermediate calculations and round your answer to 2
decimal places, e.g., 32.16.)

$
Current share price 70.85 ±1%

Explanation:
The price of a stock is the PV of the future dividends. This stock is paying five dividends, so the price of
the stock is the PV of these dividends using the required return. The price of the stock is:

P0 = $12 / 1.11 + $16 / 1.112 + $20 / 1.113 + $24 / 1.114 + $28 / 1.115
P0 = $70.85

12.
Consider Pacific Energy Company and U.S. Bluechips, Inc., both of which reported earnings of
$966,000. Without new projects, both firms will continue to generate earnings of $966,000 in perpetuity.
Assume that all earnings are paid as dividends and that both firms require a return of 12 percent.

a. What is the current PE ratio for each company? (Do not round intermediate calculations
and round your answer to 2 decimal places, e.g., 32.16.)

times
PE ratio 8.33 ±1%

b. Pacific Energy Company has a new project that will generate additional earnings of $116,000 each
year in perpetuity. Calculate the new PE ratio of the company. (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)
 times
PE ratio 9.33 ±1%

c. U.S. Bluechips has a new project that will increase earnings by $216,000 in perpetuity. Calculate the
new PE ratio of the firm. (Do not round intermediate calculations and round your answer to 2
decimal places, e.g., 32.16.)

times
PE ratio 10.20 ±1%

Explanation:
a.
We can find the price of all the outstanding company stock by using the dividends the same way we
would value an individual share. Since earnings are equal to dividends, and there is no growth, the value
of the company’s stock today is the present value of a perpetuity, so:

P=D/R
P = $966,000 / .12
P = $8,050,000.00

The price–earnings ratio is the stock price divided by the current earnings, so the price–earnings ratio of
each company with no growth is:

PE = Price / Earnings
PE = $8,050,000.00 / $966,000
PE = 8.33

b.
Since the earnings have increased, the price of the stock will increase. The new price of the outstanding
company stock is:

P=D/R
P = ($966,000 + 116,000) / .12
P = $9,016,666.67
The price–earnings ratio is the stock price divided by the current earnings, so the price–earnings with the
increased earnings is:

PE = Price / Earnings
PE = $9,016,666.67 / $966,000
PE = 9.33 times

c.
Since the earnings have increased, the price of the stock will increase. The new price of the outstanding
company stock is:

P=D/R
P = ($966,000 + 216,000) / .12
P = $9,850,000.00

The price–earnings ratio is the stock price divided by the current earnings, so the price–earnings with the
increased earnings is:

PE = Price / Earnings
PE = $9,850,000.00 / $966,000
PE = 10.20 times

13.
Storico Co. just paid a dividend of $2.05 per share. The company will increase its dividend by 24 percent
next year and will then reduce its dividend growth rate by 6 percentage points per year until it reaches
the industry average of 6 percent dividend growth, after which the company will keep a constant growth
rate forever. If the required return on Storico stock is 10 percent, what will a share of stock sell for
today? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g.,
32.16.)

$
Stock price 74.20 ±1%

Explanation:
Here we have a stock with differential growth, but the dividend growth changes every year for the first
four years. We can find the price of the stock in Year 3 since the dividend growth rate is constant after the
third dividend. The price of the stock in Year 3 will be the dividend in Year 4, divided by the required
return minus the constant dividend growth rate. So, the price in Year 3 will be:

P3 = $2.05(1.24)(1.18)(1.12)(1.06) / (.10 − .06)

P3 = $89.03

The price of the stock today will be the PV of the first three dividends, plus the PV of the stock price in
Year 3, so:

P0 = $2.05(1.24) / (1.10) + $2.05(1.24)(1.18) / 1.10 2 + $2.05(1.24)(1.18)(1.12) / 1.103 + $89.03 / 1.103

P0 = $74.20

14.
The Stambaugh Corporation currently has earnings per share of $9.70. The company has no growth and
pays out all earnings as dividends. It has a new project that will require an investment of $2.25 per share
in one year. The project is only a two-year project, and it will increase earnings in the two years following
the investment by $3.05 and $3.35, respectively. Investors require a return of 12 percent on Stambaugh
stock.

a. What is the value per share of the company’s stock assuming the firm does not undertake the
investment opportunity? (Do not round intermediate calculations and round your answer to 2
decimal places, e.g., 32.16.)

$
Value per share 80.83 ±1%

b. If the company does undertake the investment, what is the value per share now? (Do not round
intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

$
Value per share 83.64 ±1%

c. The company undertakes the investment. What will the price per share be four years from today? (Do
not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
 $
Price per share 80.83 ±1%

Explanation:
a.
If the company does not make any new investments, the stock price will be the present value of the
constant perpetual dividends. In this case, all earnings are paid as dividends, so, applying the perpetuity
equation, we get:

P = Dividend / R
P = $9.70 / .12
P = $80.83

b.
The investment is a one-time investment that creates an increase in EPS for two years. To calculate the
new stock price, we need the cash cow price plus the NPVGO. In this case, the NPVGO is the present
value of the investment plus the present value of the increases in EPS. So, the NPVGO will be:

NPVGO = C1 / (1 + R) + C2 / (1 + R)2 + C3 / (1 + R)3

NPVGO = −$2.25 / 1.12 + $3.05 / 1.122 + $3.35 / 1.123
NPVGO = $2.81

So, the price of the stock if the company undertakes the investment opportunity will be:

P = $80.83 + 2.81
P = $83.64

c.
After the project is over, and the earnings increase no longer exists, the price of the stock will revert back
to $80.83, the value of the company as a cash cow.

15.
Burklin, Inc., has earnings of $18.9 million and is projected to grow at a constant rate of 5 percent forever
because of the benefits gained from the learning curve. Currently, all earnings are paid out as dividends.
The company plans to launch a new project two years from now that would be completely internally
funded and require 25 percent of the earnings that year. The project would start generating revenues one
year after the launch of the project and the earnings from the new project in any year are estimated to be
constant at $7.4 million. The company has 8.4 million shares of stock outstanding.

Estimate the value of the stock. The discount rate is 10 percent. (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)

$
Value of the stock 54.02 ±1%

Explanation:
In this problem, growth is occurring from two different sources: The learning curve and the new project.
We need to separately compute the value from the two different sources. First, we will compute the value
from the learning curve, which will increase at 5 percent. All earnings are paid out as dividends, so we
find the earnings per share are:

EPS1 = Earnings / Total number of outstanding shares

EPS1 = ($18,900,000 × 1.05) / 8,400,000
EPS1 = $2.36

From the NPVGO model:

P = E / (R − g) + NPVGO
P = $2.36 / (.10 − .05) + NPVGO
P = $47.25 + NPVGO

Now we can compute the NPVGO of the new project to be launched two years from now. The earnings
per share two years from now will be:

EPS2 = $2.36(1 +.05)

EPS2 = $2.481

Therefore, the initial investment in the new project will be:

Initial investment = .25($2.481)

Initial investment = $.62

The earnings per share of the new project are a perpetuity, with an annual cash flow of:
Increased EPS from project = $7,400,000 / 8,400,000 shares
Increased EPS from project = $.88

So, the value of all future earnings in Year 2, one year before the company realizes the earnings, is:

PV = $.88 / .10
PV = $8.81

Now, we can find the NPVGO per share of the investment opportunity in Year 2, which will be:

NPVGO2 = −$.62 + 8.81

NPVGO2 = $8.19

The value of the NPVGO today will be:

NPVGO = $8.19 / (1 + .10)2

NPVGO = $6.77

Plugging in the NPVGO model we get:

P = $47.25 + 6.77
P = $54.02

Note that you could also value the company and the project with the values given, and then divide the
final answer by the shares outstanding. The final answer would be the same.

MODULE 6

1.
Suppose a stock had an initial price of $72 per share, paid a dividend of $2.60 per share during the year,
and had an ending share price of $84.

Compute the percentage total return. (Do not round intermediate calculations and enter your answer
as a percent rounded to 2 decimal places, e.g., 32.16.)
 %
Total return 20.28 ±1%

Explanation:
The return of any asset is the increase in price, plus any dividends or cash flows, all divided by the initial
price. The return of this stock is:

R = ($84 – 72 + 2.60) / $72

R = .2028, or 20.28%

2. Suppose a stock had an initial price of $62 per share, paid a dividend of $1.10 per share during
the year, and had an ending share price of $74.

What was the dividend yield and the capital gains yield? (Do not round intermediate calculations and
enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Dividend yield 1.77 ±1%

%
Capital gains yield 19.35 ±1%

Explanation:
The dividend yield is the dividend divided by the price at the beginning of the period, so:

Dividend yield = $1.10 / $62

Dividend yield = .0177, or 1.77%

And the capital gains yield is the increase in price divided by the initial price, so:

Capital gains yield = ($74 – 62) / $62

Capital gains yield = .1935, or 19.35%
3.
Award: 6.25 out of 6.25 points

Show my answer

Returns
Year X Y
1 17 % 22 %
2 31 32
3 – 24 – 29
4 12 16
5 10 23

Using the returns shown above, calculate the arithmetic average return, the variances, and the standard
deviations for X and Y. (Do not round intermediate calculations. Enter your average return and
standard deviation answers as a percent rounded to 2 decimal places, e.g., 32.16. Enter your
variance answers rounded to 5 decimal places, e.g., 32.16161.)

X Y
% %
Average returns 9.20 ±1% 12.80 ±1%

Variances .04117 ±1% .05787 ±1%

% %
Standard deviations 20.29 ±1% 24.06 ±1%

rev: 09_29_2017_QC_CS-103211

Explanation:
The average return is the sum of the returns, divided by the number of returns. The average return for
each stock was:
We calculate the variance of each stock as:

The standard deviation is the square root of the variance, so the standard deviation of each stock is:

σX = (.04117)1/2
σX = .2029, or 20.29%

σY = (.05787)1/2
σY = .2406, or 24.06%

4.
A stock has had returns of 8 percent, 15 percent, 22 percent, −16 percent, 22 percent, and −9 percent
over the last six years.

What are the arithmetic and geometric average returns? (Do not round intermediate calculations and
enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Arithmetic average return 7.00 ±1%

%
Geometric average return 5.93 ±1%

rev: 03_08_2016_QC_CS-44345

Explanation:
The arithmetic average return is the sum of the known returns divided by the number of returns, so:
Arithmetic average return = (.08 + .15 + .22 – .16 + .22 – .09) / 6
Arithmetic average return = .0700, or 7.00%

Using the equation for the geometric return, we find:

Geometric average return = [(1 + R1) × (1 + R2) × … × (1 + RT)]1/T – 1

Geometric average return = [(1 + .08)(1 + .15)(1 + .22)(1 – .16)(1 + .22)(1 – .09)] (1/6) – 1
Geometric average return = .0593, or 5.93%

Remember, the geometric average return will always be less than the arithmetic average return if the
returns have any variation.

5.
What are the portfolio weights for a portfolio that has 152 shares of Stock A that sell for $30 per share
and 120 shares of Stock B that sell for $20 per share? (Do not round intermediate calculations and
round your answers to 4 decimal places, e.g., 32.1616.)

Portfolio weights

Stock A .6552 ±1%

Stock B .3448 ±1%

Explanation:
The portfolio weight of an asset is the total investment in that asset divided by the total portfolio value.
First, we will find the portfolio value, which is:

Portfolio value = 152($30) + 120($20)

Portfolio value = $6,960

The portfolio weight for each stock is the dollar value of the investment in that stock divided by the
portfolio value, or:

WeightA = 152($30) / $6,960

WeightA = .6552

WeightB = 120($20) / $6,960

WeightB = .3448

6.
You own a portfolio that has $2,000 invested in Stock A and $3,000 invested in Stock B. If the expected
returns on these stocks are 9 percent and 12 percent, respectively, what is the expected return on the
portfolio? (Do not round intermediate calculations and enter your answer as a percent rounded to
2 decimal places, e.g., 32.16.)

%
Portfolio expected return 10.80 ±1%

Explanation:
The expected return of a portfolio is the sum of the weight of each asset times the expected return of
each asset. The total value of the portfolio is:

Portfolio value = $2,000 + 3,000

Portfolio value = $5,000

So, the expected return of this portfolio is:

E(RP) = ($2,000 / $5,000)(.09) + ($3,000 / $5,000)(.12)

E(RP) = .1080, or 10.80%

7.
Consider the following information:

Rate of Return if State Occurs

State of Probability of
Economy State of Economy Stock A Stock B Stock C
Boom .15 .31 .41 .21
Good .60 .16 .12 .10
 Poor .20 –.03 –.06 –.04
Bust .05 –.11 –.16 –.08

a. Your portfolio is invested 30 percent each in A and C, and 40 percent in B. What is the expected
return of the portfolio? (Do not round intermediate calculations and enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)

%
Expected return 10.86 ±1%

b-1.What is the variance of this portfolio? (Do not round intermediate calculations and round your
answer to 5 decimal places, e.g., 32.16161.)

Variance .01424 ±1%

b-2.What is the standard deviation? (Do not round intermediate calculations and enter your answer
as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Standard deviation 11.93 ±1%

Explanation:
a.
This portfolio does not have an equal weight in each asset. We first need to find the return of the portfolio
in each state of the economy. To do this, we will multiply the return of each asset by its portfolio weight
and then sum the products to get the portfolio return in each state of the economy. Doing so, we get:

Boom: RP = .30(.31) + .40(.41) + .30(.21) = .3200, or 32.00%

Good: RP = .30(.16) + .40(.12) + .30(.10) = .1260, or 12.60%

Poor: RP = .30(−.03) + .40(−.06) + .30(−.04) = −.0450, or −4.50%

Bust: RP = .30(−.11) + .40(−.16) + .30(−.08) = −.1210, or −12.10%

And the expected return of the portfolio is:

E(RP) = .15(.3200) + .60(.1260) + .20(−.0450) + .05(−.1210)

E(RP) = .1086, or 10.86%

b.
To calculate the standard deviation, we first need to calculate the variance. To find the variance, we find
the squared deviations from the expected return. We then multiply each possible squared deviation by its
probability, and then add all of these up. The result is the variance. So, the variance and standard
deviation of the portfolio are:

σP2 = .15(.3200 − .1086)2 + .60(.1260 − .1086)2 + .20(−.0450 − .1086)2 + .05(−.1210 − .1086)2

σP2 = .01424

σP = .014241/2
σP = .1193, or 11.93%

8.
The expected return on a portfolio:
can be greater than the expected return on the best performing security in the portfolio.
can be less than the expected return on the worst performing security in the portfolio.
is independent of the performance of the overall economy.
is limited by the returns on the individual securities within the portfolio.
is an arithmetic average of the returns of the individual securities when the weights of those securities are unequal.

9.
If a stock portfolio is well diversified, then the portfolio variance:
will equal the variance of the most volatile stock in the portfolio.
may be less than the variance of the least risky stock in the portfolio.
must be equal to or greater than the variance of the least risky stock in the portfolio.
will be a weighted average of the variances of the individual securities in the portfolio.
will be an arithmetic average of the variances of the individual securities in the portfolio.
10.
You are given the following information:

State of Return on Return on

Economy Stock A Stock B
Bear .116 −.059
Normal .101 .162
Bull .087 .247

Assume each state of the economy is equally likely to happen.

Calculate the expected return of each of the following stocks. (Do not round intermediate calculations
and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Expected return
%
Stock A 10.13 ±1%

%
Stock B 11.67 ±1%

Calculate the standard deviation of each of the following stocks. (Do not round intermediate
calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Standard deviation
%
Stock A 1.18 ±1%

%
Stock B 12.90 ±1%
What is the covariance between the returns of the two stocks? (A negative answer should be
indicated by a minus sign. Do not round intermediate calculations and round your answer
to 6 decimal places, e.g., 32.161616.)

Covariance -.001487 ±1%

What is the correlation between the returns of the two stocks? (A negative answer should be indicated
by a minus sign. Do not round intermediate calculations and round your answer to 4 decimal
places, e.g., 32.1616.)

Correlation -.9734 ±1%

Explanation:
The expected return of an asset is the sum of the probability of each state occurring times the rate of
return if that state occurs. So, the expected return of each stock is:

E(RA) = .33(.116) + .33(.101) + .33(.087)

E(RA) = .1013, or 10.13%

E(RB) = .33(–.059) + .33(.162) + .33(.247)

E(RB) = .1167, or 11.67%

To calculate the standard deviation, we first need to calculate the variance. To find the variance, we find
the squared deviations from the expected return. We then multiply each possible squared deviation by its
probability, and then add all of these up. The result is the variance. So, the variance and standard
deviation of Stock A are:

σ2 = .33(.116 – .1013)2 + .33(.101 – .1013)2 + .33(.087 – .1013)2

σ2 = .00014

σ = .000141/2
σ = .0118, or 1.18%

And the standard deviation of Stock B is:

σ2 = .33(– .059 – .1167)2 + .33(.162 – .1167)2 + .33(.247 – .1167)2
σ2 = .01663

σ = .016631/2
σ = .1290, or 12.90%

To find the covariance, we multiply each possible state times the product of each asset's deviation from
the mean in that state. The sum of these products is the covariance. So, the covariance is:

Cov(A,B) = .33(.116 – .1013)( – .059 – .1167) + .33(.101 – .1013)(.162 – .1167)

+ .33(.087 – .1013)(.247 – .1167)
Cov(A,B) = −.001487

And the correlation is:

ρA,B = Cov(A,B) / σAσB

ρA,B = −.001487 / (.0118)(.1290)
ρA,B = −.9734

11.
Suppose the expected returns and standard deviations of Stocks A and B are E(RA) = .085, E(RB) = .145,
σA = .355, and σB = .615.

a-1. Calculate the expected return of a portfolio that is composed of 30 percent Stock A and 70 percent
Stock B when the correlation between the returns on A and B is .45. (Do not round intermediate
calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Expected return 12.70 ±1%

a-2. Calculate the standard deviation of a portfolio that is composed of 30 percent Stock A and 70
percent Stock B when the correlation between the returns on A and B is .45. (Do not round
intermediate calculations and enter your answer as a percent rounded to 2 decimal places,
e.g., 32.16.)
 %
Standard deviation 48.78 ±1%

b. Calculate the standard deviation of a portfolio with the same portfolio weights as in part (a) when the
correlation coefficient between the returns on Stocks A and B is −.45. (Do not round intermediate
calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Standard deviation 39.42 ±1%

Explanation:
a.
The expected return of the portfolio is the sum of the weight of each asset times the expected return of
each asset, so:

E(RP) = XAE(RA) + XBE(RB)

E(RP) = .30(.085) + .70(.145)
E(RP) = .1270, or 12.70%

The variance of a portfolio of two assets can be expressed as:

σ =X σ +X σ + 2XAXBσAσBρA,B

σ =.302(.3552) + .702(.6152) + 2(.30)(.70)(.355)(.615)(.45)

σ =.23794

So, the standard deviation is:

σP = .237941/2
σP = .4878, or 48.78%

b.
σ =X σ + X σ + 2XAXBσAσBρA,B

σ = .302(.3552) + .702(.6152) + 2(.30)(.70)(.355)(.615)(−.45)

σ = .15541

So, the standard deviation is:

σP = .155411/2
σP = .3942, or 39.42%

12.
According to the capital asset pricing model, the expected return on a security is:
negatively and non-linearly related to the security's beta.
negatively and linearly related to the security's beta.
positively and linearly related to the security's variance.
positively and non-linearly related to the security's beta.
positively and linearly related to the security's beta.

13.
A stock has a beta of 1.02, the expected return on the market is 12 percent, and the risk-free rate is 3
percent. What must the expected return on this stock be? (Do not round intermediate calculations
and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Expected return 12.18 ±1%

Explanation:
CAPM states the relationship between the risk of an asset and its expected return. CAPM is:

E(Ri) = Rf + [E(RM) − Rf] × βi

Substituting the values we are given, we find:

E(Ri) = .030 + (.12 − .030)(1.02)

E(Ri) = .1218, or 12.18%

14.
A stock has an expected return of 12.2 percent, the risk-free rate is 6 percent, and the market risk
premium is 10 percent. What must the beta of this stock be? (Do not round intermediate calculations
and round your answer to 2 decimal places, e.g., 32.16.)

Beta of stock .62 ±0.1

Explanation:
We are given the values for the CAPM except for the β of the stock. We need to substitute these values
into the CAPM, and solve for the β of the stock. One important thing we need to realize is that we are
given the market risk premium. The market risk premium is the expected return of the market minus the
risk-free rate. We must be careful not to use this value as the expected return of the market. Using the
CAPM, we find:

E(Ri) = .122 = .060 + .100βi

βi = (.122 − .060) / .100
βi = .62

15.
Stock Y has a beta of 1.4 and an expected return of 16.5 percent. Stock Z has a beta of .7 and an
expected return of 9.8 percent. If the risk-free rate is 5.9 percent and the market risk premium is 6.9
percent, the reward-to-risk ratios for stocks Y and Z are and percent,
7.57 ±1% 5.57 ±1%

respectively. Since the SML reward-to-risk is percent, Stock Y is undervalued and Stock Z is
6.9 ±1%

overvalued. (Do not round intermediate calculations and enter your answers as a percent rounded
to 2 decimal places, e.g., 32.16.)
Explanation:
There are two ways to correctly answer this question. We will work through both. First, we can use the
CAPM. Substituting in the value we are given for each stock, we find:

E(RY) = .059 + .069(1.4)

E(RY) = .1556, or 15.56%

It is given in the problem that the expected return of Stock Y is 16.5 percent, but according to the CAPM,
the return of the stock based on its level of risk should be 15.56 percent. This means the stock return is
too high, given its level of risk. Stock Y plots above the SML and is undervalued. In other words, its price
must increase to decrease the expected return to 15.56 percent.

For Stock Z, we find:

E(RZ) = .059 + .069(.7)

E(RZ) = .1073, or 10.73%

The return given for Stock Z is 9.8 percent, but according to the CAPM, the expected return of the stock
should be 10.73 percent based on its level of risk. Stock Z plots below the SML and is overvalued. In
other words, its price must decrease to increase the expected return to 10.73 percent.

We can also answer this question using the reward-to-risk ratio. All assets must have the same reward-
to-risk ratio, that is, every asset must have the same ratio of the asset risk premium to its beta. This
follows from the linearity of the SML in Figure 11.11 in the textbook. The reward-to-risk ratio is the risk
premium of the asset divided by its β. This is also known as the Treynor ratio or Treynor index. We are
given the market risk premium, and we know the β of the market is one, so the reward-to-risk ratio for the
market is .069, or 6.9 percent. Calculating the reward-to-risk ratio for Stock Y, we find:

Reward-to-risk ratio Y = (.165 – .059) / 1.4

Reward-to-risk ratio Y = .0757, or 7.57%

The reward-to-risk ratio for Stock Y is too high, which means the stock plots above the SML, and the
stock is undervalued. Its price must increase until its reward-to-risk ratio is equal to the market reward-to-
risk ratio. For Stock Z, we find:

Reward-to-risk ratio Z = (.098 – .059) / .7

Reward-to-risk ratio Z = .0557, or 5.57%
The reward-to-risk raito for Stock Z is too low, which means the stock plots below the SML, and the stock
is overvalued. Its price must decrease until its reward-to-risk ratio is equal to the market reward-to-risk
ratio.

16.
Suppose the risk-free rate is 4.8 percent and the market portfolio has an expected return of 11.5 percent.
The market portfolio has a variance of .0442. Portfolio Z has a correlation coefficient with the market of .
34 and a variance of .3345

According to the capital asset pricing model, what is the expected return on Portfolio Z? (Do not round
intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g.,
32.16.)

%
Expected return 11.07 ±1%

Explanation:
First, we need to find the standard deviation of the market and the portfolio, which are:

σM = (.0442)1/2
σM = .2102, or 21.02%

σZ = (.3345)1/2
σZ = .5784, or 57.84%

Now we can use the equation for beta to find the beta of the portfolio, which is:

βZ = (ρZ,M)(σZ) / σM
βZ = (.34)(.5784) / .2102
βZ = .94

Now, we can use the CAPM to find the expected return of the portfolio, which is:
E(RZ) = Rf + βZ[E(RM) − Rf]
E(RZ) = .048 + .94(.115 − .048)
E(RZ) = .1107, or 11.07%

MODULE 7

1.
If the CAPM is used to estimate the cost of equity capital, the expected excess market return is equal to the:
return on the stock minus the risk-free rate.
difference between the return on the market and the risk-free rate.
beta times the market risk premium.
beta times the risk-free rate.
market rate of return.

2.
The Consolidated Transfer Co. is an all-equity financed firm. The beta is .75, the market risk premium is 7.78 percent and the risk-free rate
is 3.84 percent. What is the expected return on Consolidated stock?
6.80%
8.22%
9.54%
9.68%
8.46%
RS = .0384 + .75(.0778) = .0968, or 9.68%

3.
The Dybvig Corporation’s common stock has a beta of 1.8. If the risk-free rate is 5.8 percent and the
expected return on the market is 12 percent, what is Dybvig’s cost of equity capital? (Do not round
intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g.,
32.16.)
 %
Cost of equity capital 16.96 ±1%

Explanation:
With the information given, we can find the cost of equity using the CAPM. The cost of equity is:

RS = .058 + 1.8(.12 – .058)

RS = .1696, or 16.96%

4.
Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 18 years
to maturity that is quoted at 106 percent of face value. The issue makes semiannual payments and has a
coupon rate of 5 percent.

What is the company's pretax cost of debt? (Do not round intermediate calculations and enter your
answer as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Pretax cost of debt 4.51 ±1%

If the tax rate is 35 percent, what is the aftertax cost of debt? (Do not round intermediate calculations
and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Aftertax cost of debt 2.93 ±1%

Explanation:
The pretax cost of debt is the YTM of the company's bonds, so:

P0 = $1,060 = $25(PVIFAR%,36) + $1,000(PVIFR%,36)

R = 2.255%

RB = 2 × 2.255%
RB = 4.51%

And the aftertax cost of debt is:

Aftertax cost of debt = 4.51%(1 – .35)

Aftertax cost of debt = 2.93%

5.
Shanken Corp. issued a 10-year, 6 percent semiannual bond 2 years ago. The bond currently sells for 95
percent of its face value. The company's tax rate is 35 percent.

a. What is the pretax cost of debt? (Do not round intermediate calculations and enter your answer
as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Pretax cost of debt 6.82 ±1%

b. What is the aftertax cost of debt? (Do not round intermediate calculations and enter your answer
as a percent rounded to 2 decimal places, e.g., 32.16.)

%
Aftertax cost of debt 4.43 ±1%

c. Which is more relevant, the pretax or the aftertax cost of debt?

Aftertax cost of debt

Explanation:
a.
The pretax cost of debt is the YTM of the company's bonds, so:

P0 = $950 = $30(PVIFAR%,16) + $1,000(PVIFR%,16)

R = 3.411%
YTM = 2 × 3.411%
YTM = 6.82%

b.
The aftertax cost of debt is:

RD = 6.82%(1 – .35)
RD = 4.43%

c.
The aftertax rate is more relevant because that is the actual cost to the company.

6.
Shanken Corp. issued a 10-year, 8 percent semiannual bond 3 years ago. The bond currently sells for 96
percent of its face value. The book value of the debt issue is $50 million. In addition, the company has a
second debt issue on the market, a zero coupon bond with 10 years left to maturity; the book value of
this issue is $30 million and the bonds sell for 55 percent of par. The company’s tax rate is 35 percent.

What is the company's total book value of debt? (Do not round intermediate calculations and enter
your answer in dollars, not millions of dollars, e.g., 1,234,567.)

$
Total book value 80,000,000 ±0.01%

What is the company's total market value of debt? (Do not round intermediate calculations and enter
your answer in dollars, not millions of dollars, e.g., 1,234,567.)

$
Total market value 64,500,000 ±0.01%

What is your best estimate of the aftertax cost of debt? (Do not round intermediate calculations and
enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
 %
Cost of debt 5.25 ±1%

Explanation:
The book value of debt is the total par value of all outstanding debt, so:

BVB = $50,000,000 + 30,000,000

BVB = $80,000,000

To find the market value of debt, we find the price of the bonds and multiply by the number of bonds.
Alternatively, we can multiply the price quote of the bond times the par value of the bonds. Doing so, we
find:

B = .96($50,000,000) + .55($30,000,000)
B = $64,500,000

The pretax cost of debt is the YTM of the company's bonds, so:

P0 = $960 = $40(PVIFAR%,14) + $1,000(PVIFR%,14)

R = 4.388%

YTM = 2 × 4.388%
YTM = 8.78%

The aftertax cost of debt is:

RD = 8.78%(1 – .35)
RD = 5.70%

The YTM of the zero coupon bonds is:

PZ = $550 = $1,000(PVIFR%,20)
R = 3.034%

YTM = 2 × 3.034%
YTM = 6.07%

So, the aftertax cost of the zero coupon bonds is:

Aftertax cost of debt = 6.07%(1 – .35)
Aftertax cost of debt = 3.94%

The aftertax cost of debt for the company is the weighted average of the aftertax cost of debt for all
outstanding bond issues. We need to use the market value weights of the bonds. The total aftertax cost
of debt for the company is:

Aftertax cost of debt = .0570[.96($50.00 / $64.50)] + .0394[.55($30.00 / $64.50)]

Aftertax cost of debt = .0525, or 5.25%

7. When computing the weighted average cost of capital, which of these are adjusted for taxes?
cost of equity
cost of preferred stock
both the cost of equity and the cost of preferred stock
the costs of all forms of financing
cost of debt

8.
The weighted average cost of capital for a firm is the:
discount rate which the firm should apply to all of the projects it undertakes.
overall rate which the firm must earn on its existing assets to maintain its value.
rate the firm should expect to pay on its next bond issue.
maximum rate which the firm should require on any projects it undertakes.
rate of return that the firm's preferred stockholders should expect to earn over the long term.

9.
A firm’s WACC can be correctly used to discount the expected cash flows of a new project when that project:
has the same level of risk as the firm’s current operations.
will be financed solely with new debt and internal equity.
will be managed by the firm’s current managers.
will be financed with the same proportions of debt and equity as those currently used by the overall firm.
will be financed solely with internal equity.
10.
The problem that results from using the overall firm's beta in discounting projects of differing risk levels is the:
acceptance of too many high-risk projects.
rejection of too many low risk projects.
rejection of too many high-risk projects.
acceptance of too many low risk projects.
acceptance of too many high-risk projects and rejection of too many low risk projects.

11.
Sound Systems (SS) has 200,000 shares of common stock outstanding at a market price of $37 a share. SS recently paid an annual
dividend in the amount of $1.20 per share. The dividend growth rate is 4 percent. SS also has 4,500 bonds outstanding with a face value of
$1,000 per bond that are selling at 99 percent of par. The bonds have a 6 percent coupon and a 6.7 percent yield to maturity. If the tax rate
is 34 percent, what is the weighted average cost of capital?
5.33%
5.87%
6.49%
6.26%
7.28%
Debt: 4,500 ×$1,000 ×.99 = $4.455m
Common: 200,000 ×$37 = $7.4m
Total = $4.455 + $7.4m = $11.855m

Re = [($1.20 ×1.04) / $37] + .04 = .07373

RWACC = ($7.4m / 11.855m × .07373) + [$4.455m / $11.855m × .067 × (1 - .34)] = .0626, or 6.26%

12.
Mullineaux Corporation has a target capital structure of 65 percent common stock and 35 percent debt.
Its cost of equity is 16 percent, and the cost of debt is 10 percent. The relevant tax rate is 30 percent.

What is the company’s WACC? (Do not round intermediate calculations and enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)
 %
WACC 12.85 ±1%

Explanation:
Using the equation to calculate the WACC, we find:

RWACC = .65(.16) + .35(.10)(1 − .30)

RWACC = .1285, or 12.85%

13.
Miller Manufacturing has a target debt–equity ratio of .55. Its cost of equity is 15 percent, and its cost of
debt is 7 percent. If the tax rate is 35 percent, what is the company’s WACC? (Do not round
intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g.,
32.16.)

%
WACC 11.29 ±1%

Explanation:
Here we need to use the debt–equity ratio to calculate the WACC. Doing so, we find:

RWACC = .15(1 / 1.55) + .07(.55 / 1.55)(1 – .35)

RWACC = .1129, or 11.29%

Question 1 (of 15)

14.
Kose, Inc., has a target debt–equity ratio of 1.40. Its WACC is 9.5 percent, and the tax rate is 35 percent.

a. If the company’s cost of equity is 12 percent, what is its pretax cost of debt? (Do not round
intermediate calculations and enter your answer as a percent rounded to 2 decimal places,
 e.g., 32.16.)

%
Cost of debt 11.87 ±1%

b. If instead you know that the aftertax cost of debt is 5.5 percent, what is the cost of equity? (Do not
round intermediate calculations and enter your answer as a percent rounded to 2 decimal
places, e.g., 32.16.)

%
Cost of equity 15.10 ±1%

Explanation:
a.
Using the equation to calculate WACC, we find:

RWACC = .095 = (1 / 2.40)(.12) + (1.40 / 2.40)(1 – .35)RD

RB = .1187, or 11.87%

b.
Using the equation to calculate WACC, we find:

RWACC = .095 = (1 / 2.40)RE + (1.40 / 2.40)(.055)

RS = .1510, or 15.10%

15.
You are given the following information for Huntington Power Co. Assume the company’s tax rate is 40
percent.

Debt: 8,000 7.5 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity,
selling for 104 percent of par; the bonds make semiannual payments.

Common stock: 470,000 shares outstanding, selling for $65 per share; the beta is 1.08.

Market: 8 percent market risk premium and 5.5 percent risk-free rate.
What is the company's WACC? (Do not round intermediate calculations and enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)

%
WACC 12.03 ±1%

Explanation:
We will begin by finding the market value of each type of financing. We find:

B = 8,000($1,000)(1.04)
B = $8,320,000

S = 470,000($65)
S = $30,550,000

And the total market value of the firm is:

V = $8,320,000 + 30,550,000
V = $38,870,000

Now, we can find the cost of equity using the CAPM. The cost of equity is:

RS = .055 + 1.08(.08)
RS = .1414, or 14.14%

The cost of debt is the YTM of the bonds, so:

P0 = $1,040 = $37.50(PVIFAR%,50) + $1,000(PVIFR%,50)

R = 3.577%

YTM = 3.577% × 2
YTM = 7.15%

And the aftertax cost of debt is:

RB = (1 – .40)(.0715)
RB = .0429, or 4.29%
Now we have all of the components to calculate the WACC. The WACC is:

RWACC = .0429($8,320,000 / $38,870,000) + .1414($30,550,000 / $38,870,000)

RWACC = .1203, or 12.03%

Notice that we didn’t include the (1 – TC) term in the WACC equation. We used the aftertax cost of debt in
the equation, so the term is not needed here.

TEST 1 – MIDTERM

1.
What is the future value of $2,992 invested for 12 years at 6.00 percent compounded annually?
$6,020.49
$1,423.95
$5,659.26
$6,044.64
$5,996.35
Future value = $2,992 x (1 + .06000)12 = $6,020.49

Enter 12 6.00 -2,992

N I/Y PV PMT FV
Solve for 6,020.49

2.
Some time ago, Julie purchased eleven acres of land costing $15,190. Today, that land is valued at $33,283. How long has she owned this
land if the price of the land has been increasing at 4 percent per year?
20.00 years
20.13 years
19.67 years
19.51 years
19.72 years
$33,283 = $15,190 x (1 + .04)t; t = 20.00 years
Enter 4 -15,190 33,283
N I/Y PV PMT FV
Solve for 20.00

3.
Thirty-five years ago, your father invested $2,000. Today that investment is worth $98,407. What rate of return has your father earned on
his investment?
10.94%
11.33%
10.50%
11.77%
9.99%
$98,407 = $2,000 ×(1 + r)35; r = .1177, or 11.77%

4.
Phil can afford $170 a month for 5 years for a car loan. If the interest rate is 4.8 percent compounded monthly, how much can he afford to
borrow to purchase a car?
rev: 10_26_2013_QC_37910
$9,052.31
$8,027.45
$10,200.00
$8,976.00
$9,233.35

5.
A trust has been established to fund scholarships in perpetuity. The next annual distribution will be $1,200 and future payments will
increase by 3 percent per year. What is the value of this trust at a discount rate of 7.4 percent?
$17,189.19
$19,960.00
$27,272.73
$24,609.11
$30,388.18
PV Growing perpetuity = $1,200 / (.074 − .03) = $27,272.73

6.
What is the effective annual rate if your credit card charges you 10.64 percent compounded daily? (Assume a 365-day year.)
10.79%
11.22%
11.95%
11.48%
12.01%
EAR = [1 + (.1064 / 365)]365 - 1 = 11.22%

7.
Janet saves $3,000 a year at an interest rate of 4.2 percent. What will her savings be worth at the end of 35 years?
$229,317.82
$230,702.57
$230,040.06
$234,868.92
$236,063.66
AFV = $3,000 ×{[(1 + .042)35 - 1] / .042} = $230,040.06

8.
You are borrowing $5,200 at 7.8 percent, compounded monthly. The monthly loan payment is $141.88. How many loan payments must you
make before the loan is paid in full?
30
36
40
42
48
$5,200 = $141.88 ×[(1 - {1 / [1 + (.078 / 12)]T}) / (.078 / 12)] ln1.3127 = T × ln1.0065 T = 42
9.
Assume you graduate with $31,300 in student loans at an interest rate of 5.25 percent, compounded monthly. If you want to have this debt
paid in full within three years, how much must you pay each month?
$871.30
$873.65
$876.79
$941.61
$980.40
$31,300 = C × [(1 - {1 / [1 + (.0525 / 12)] 3 × 12}) / (.0525 / 12)]; C = $941.61

10.
Scott has been offered a 10-year job at a starting salary of $65,000 and guaranteed annual raises of 5 percent. What is the current value of
this offer at a discount rate of 7 percent?
$638,724.17
$602,409.91
$558,845.85
$630,500.00
$525,000.00
PV = $65,000 × [(1 - {[(1 + .05) / (1 + .07)]10}) / (.07 - .05)] = $558,845.85

11.
Project A is opening a bakery at 10 Center Street. Project B is opening a specialty coffee shop at the same address. Both projects have
unconventional cash flows, that is, both projects have positive and negative cash flows that occur following the initial investment. When
trying to decide which project to accept, given sufficient funding to accept either, you should rely most heavily on the _____ method of
analysis.
profitability index
internal rate of return
payback
net present value
discounted payback
12.
The two fatal flaws of the internal rate of return decision rule are the:
arbitrary determination of a discount rate and the failure to consider initial expenditures.
arbitrary determination of a discount rate and the failure to correctly analyze mutually exclusive investment projects.
arbitrary determination of a discount rate and the multiple rate of return problem.
failure to consider initial expenditures and failure to correctly analyze mutually exclusive investment projects.
failure to correctly analyze mutually exclusive investment projects and the multiple rate of return problem.

13.
You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are trying to decide whether to fix
them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) _____ cost.
opportunity
fixed
incremental
sunk
relevant

14.
Lucie is reviewing a project with an initial cost of $38,700 and cash inflows of $9,800, $16,400, and $21,700 for Years 1 to 3, respectively.
Should the project be accepted if it has been assigned a required return of 9.75 percent? Why or why not?
yes; because the IRR exceeds the required return by .34 percent
yes; because the IRR is less than the required return by .28 percent
yes; because the IRR is exceeds the required return by .46 percent
no; because the IRR exceeds the required return by .43 percent
no; because the IRR is only 9.69 percent
0 = −$38,700 + $9,800 / (1 + IRR) + $16,400 / (1 + IRR)2 + $21,700 / (1 + IRR)3; IRR = 10.09% Excess return = 10.09% - 9.75% = .34%

15.
Roy’s Welding projects cash flows of $13,500, $20,400, and $32,900 for Years 1 to 3 for a project with an initial cost of $45,000. What is
the profitability index given an assigned discount rate of 15 percent?
rev: 02_13_2016_QC_CS-41450
.92
 .97
1.03
1.08
1.14
PI = ($13,500 / 1.15 + $20,400 / 1.152 + $32,900 / 1.153) / $45,000 = 1.08

16.
Champion Bakers uses specialized ovens to bake its bread. One oven costs $850,000 and lasts about 3 years before it needs to be
replaced. The annual operating cost per oven is $11,000. What is the equivalent annual cost of an oven if the required rate of return is 9
percent? (Round your answer to whole dollars)
$-348,536
$-346,797
$-352,523
$-324,438
$-340,533

1
1–
NPV = – $850,000 – $11,000 (1+ 0.09)3
= $-877,844
× 0.09

1
1–
$-877,844 = EAC × (1+ 0.09)3 ; EAC = $-346,797

17.
Maxwell Software, Inc., has the following mutually exclusive projects.

Year Project A Project B

–$26,000 –$29,000
0
1 15,000 16,000
2 11,500 10,000
3 3,500 11,500
a-1. Calculate the payback period for each project. (Do not round intermediate calculations and
round your answers to 3 decimal places, e.g., 32.161.)

Payback period
years
Project A 1.957 ±1%

years
Project B 2.261 ±1%

a-2. Which, if either, of these projects should be chosen?

Project A

b-1. What is the NPV for each project if the appropriate discount rate is 13 percent? (A negative
answer should be indicated by a minus sign. Do not round intermediate calculations and
round your answers to 2 decimal places, e.g., 32.16.)

NPV
$
Project A -1,293.80 ±.1%

$
Project B 960.84 ±1%

b-2. Which, if either, of these projects should be chosen if the appropriate discount rate is 13 percent?

Project B

Explanation:
a. The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the
initial investment.
Project A:

Cumulative cash flows Year 1 = $15,000 = $15,000

Cumulative cash flows Year 2 = $15,000 + 11,500 = $26,500

Companies can calculate a more precise value using fractional years. To calculate the fractional payback
period, find the fraction of Year 2’s cash flows that is needed for the company to have cumulative
undiscounted cash flows of $26,000. Divide the difference between the initial investment and the
cumulative undiscounted cash flows as of Year 1 by the undiscounted cash flow of Year 2.

Payback period = 1 + ($26,000 – 15,000) / $11,500

Payback period = 1.957 years

Project B:

Cumulative cash flows Year 1 = $16,000 = $16,000

Cumulative cash flows Year 2 = $16,000 + 10,000 = $26,000
Cumulative cash flows Year 3 = $16,000 + 10,000 + 11,500 = $37,500

To calculate the fractional payback period, find the fraction of Year 3’s cash flows that is needed for the
company to have cumulative undiscounted cash flows of $29,000. Divide the difference between the initial
investment and the cumulative undiscounted cash flows as of year 2 by the undiscounted cash flow of Year
3.

Payback period = 2 + ($29,000 – 16,000 – 10,000) / $11,500

Payback period = 2.261 years

Since Project A has a shorter payback period than Project B has, the company should choose Project A.

b.Discount each project’s cash flows at 13 percent. Choose the project with the highest NPV.

Project A:
NPV = –$26,000 + $15,000 / 1.13 + $11,500 / 1.13 2 + $3,500 / 1.133
NPV = –$1,293.80

Project B:
NPV = –$29,000 + $16,000 / 1.13 + $10,000 / 1.13 2 + $11,500 / 1.133
NPV = $960.84

The firm should choose Project B since it has a higher NPV than Project A.
18.
Flatte Restaurant is considering the purchase of a $10,500 soufflé maker. The soufflé maker has an
economic life of four years and will be fully depreciated by the straight-line method. The machine will
produce 2,250 soufflés per year, with each costing $2.70 to make and priced at $6.00. Assume that the
discount rate is 15 percent and the tax rate is 34 percent.

What is the NPV of the project? (Do not round intermediate calculations and round your answer to 2
decimal places, e.g., 32.16.)

$
NPV 6,038.89 ±0.1%

Should the company make the purchase?

Yes

Explanation:
Using the tax shield approach to calculating OCF, we get:

OCF = (Sales − Costs)(1 − tC) + tCDepreciation

OCF = [($6.00 × 2,250) − ($2.70 × 2,250)](1 − .34) + .34($10,500 / 4)
OCF = $5,793.00

So, the NPV of the project is:

NPV = −$10,500 + $5,793.00(PVIFA 15%,4)

NPV = $6,038.89

19.
Howell Petroleum is considering a new project that complements its existing business. The machine
required for the project costs $3.84 million. The marketing department predicts that sales related to the
project will be $2.54 million per year for the next four years, after which the market will cease to exist.
The machine will be depreciated down to zero over its four-year economic life using the straight-line
method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent
of sales. Howell also needs to add net working capital of $190,000 immediately. The additional net
working capital will be recovered in full at the end of the project’s life. The corporate tax rate is 38
percent. The required rate of return for the project is 15 percent.

What is the value of the NPV for this project? (Enter your answer in dollars, not millions of dollars,
e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal
places, e.g., 32.16.)

$
NPV 492,144.17 ±0.1%

Should the company proceed with the project?

Yes

Explanation:
We will begin by calculating the initial cash outlay, that is, the cash flow at Time 0. To undertake the
project, we will have to purchase the equipment and increase net working capital. So, the cash outlay
today for the project will be:

Equipme
–$ 3,840,000
nt
NWC – 190,000

Total –$ 4,030,000

Using the bottom-up approach to calculating the operating cash flow, we find the operating cash flow
each year will be:

Sales $ 2,540,000
Costs 635,000
Depreci
960,000
ation
 EBT $ 945,000
Tax 359,100

Net
$ 585,900
income

The operating cash flow is:

OCF = Net income + Depreciation

OCF = $585,900 + 960,000
OCF = $1,545,900

To find the NPV of the project, we add the present value of the project cash flows. We must be sure to
add back the net working capital at the end of the project life, since we are assuming the net working
capital will be recovered. So, the project NPV is:

NPV = −$4,030,000 + $1,545,900(PVIFA15%,4) + $190,000 / 1.154

NPV = $492,144.17

20.
Another utilization of cash flow analysis is setting the bid price on a project. To calculate the bid price, we
set the project NPV equal to zero and find the required price. Thus the bid price represents a financial
break-even level for the project. Guthrie Enterprises needs someone to supply it with 155,000 cartons of
machine screws per year to support its manufacturing needs over the next five years, and you’ve
decided to bid on the contract. It will cost you $1,950,000 to install the equipment necessary to start
production; you’ll depreciate this cost straight-line to zero over the project’s life. You estimate that in five
years this equipment can be salvaged for $165,000. Your fixed production costs will be $280,000 per
year, and your variable production costs should be $10.00 per carton. You also need an initial investment
in net working capital of $145,000. If your tax rate is 40 percent and you require a return of 14 percent on
your investment, what bid price per carton should you submit? (Do not round intermediate
calculations and round your answer to 2 decimal places, e.g., 32.16.)
 $
Bid price 16.29 ±1%

Explanation:
To find the bid price, we need to calculate all other cash flows for the project, and then solve for the bid
price. The aftertax salvage value of the equipment is:

Aftertax salvage value = $165,000(1 − .40)

Aftertax salvage value = $99,000

Now we can solve for the necessary OCF that will give the project a zero NPV. The equation for the NPV
of the project is:

NPV = 0 = −$1,950,000 − 145,000 + OCF(PVIFA 14%,5) + [($145,000 + 99,000) / 1.145]

Solving for the OCF, we find the OCF that makes the project NPV equal to zero is:

OCF = $1,968,274.05 / PVIFA14%,5

OCF = $573,325.84

The easiest way to calculate the bid price is the tax shield approach, so:

OCF = $573,325.84 = [(P − v)Q − FC](1 − tc) + tcD

$573,325.84 = [(P − $10.00)(155,000) − $280,000](1 − .40) + .40($1,950,000 / 5)
P = $16.29