Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.

Basic

1. a. The maximum price that the company should be willing to pay for the fleet of cars with all-
equity funding is the price that makes the NPV of the transaction equal to zero. Discounting the
depreciation tax shield at the risk-free rate, the NPV equation for the project is:

NPV = –Purchase Price + PV[(1 – TC)(EBTD)] + PV(Depreciation Tax Shield)

If we let P equal the purchase price of the fleet, then the NPV is:

NPV = –P + (1 – .21)($245,000)PVIFA13%,5 + (.21)(P/5)PVIFA8%,5

 Setting the NPV equal to zero and solving for the purchase price, we find:

0 = –P + (1 – .21)($245,000)PVIFA13%,5 + (.21)(P/5)PVIFA8%,5
P = $680,760.11 + (P)(.21/5)PVIFA13%,5
P = $680,760.11 + .8323P
.8323P = $680,760.11
P = $817,920.29

b. The adjusted present value (APV) of a project equals the net present value of the project if it
were funded completely by equity plus the net present value of any financing side effects. In
this case, the NPV of financing side effects equals the after-tax present value of the cash flows
resulting from the firm’s debt, so:

APV = NPV(All-Equity) + NPV(Financing Side Effects)

So, the NPV of each part of the APV equation is:

NPV(All-Equity)

NPV = –Purchase Price + PV[(1 – TC)(EBTD)] + PV(Depreciation Tax Shield)

The company paid $675,000 for the fleet of cars. Because this fleet will be fully depreciated
over five years using the straight-line method, annual depreciation expense equals:

Depreciation = $675,000/5
Depreciation = $135,000

So, discounting the depreciation tax shield at the risk-free rate, the NPV of an all-equity project
is:

NPV = –$675,000 + (1 – .21)($245,000)PVIFA13%,5 + (.21)($135,000)PVIFA8%,5

NPV = $118,953.44

NPV(Financing Side Effects)

The net present value of financing side effects equals the after-tax present value of cash flows
resulting from the firm’s debt, so:

NPV = Proceeds – Aftertax PV(Interest Payments) – PV(Principal Payments)

Given a known level of debt, debt cash flows should be discounted at the pre-tax cost of debt
RB. So, the NPV of the financing side effects are:

NPV = $450,000 – (1 – .21)(.08)($450,000)PVIFA8%,5 – $450,000/1.085

NPV = $30,184.89

So, the APV of the project is:

APV = NPV(All-Equity) + NPV(Financing Side Effects)

APV = $118,953.44 + 30,184.89
APV = $149,138.33
2. The adjusted present value (APV) of a project equals the net present value of the project if it were
funded completely by equity plus the net present value of any financing side effects. In this case, the
NPV of financing side effects equals the after-tax present value of the cash flows resulting from the
firm’s debt, so:

APV = NPV(All-Equity) + NPV(Financing Side Effects)

So, the NPV of each part of the APV equation is:

NPV(All-Equity)

NPV = –Purchase Price + PV[(1 – TC)(EBTD)] + PV(Depreciation Tax Shield)

Since the initial investment of $1.2 million will be fully depreciated over four years using the
straight-line method, annual depreciation expense is:

Depreciation = $1,200,000/4
Depreciation = $300,000

NPV = –$1,200,000 + (1 – .25)($426,000)PVIFA13%,4 + (.25)($300,000)PVIFA9.5%,4)

NPV (All-equity) = –$9,320.33

NPV(Financing Side Effects)

The net present value of financing side effects equals the aftertax present value of cash flows
resulting from the firm’s debt. So, the NPV of the financing side effects is:

NPV = Proceeds(Net of flotation) – Aftertax PV(Interest Payments) – PV(Principal Payments)

+ PV(Flotation Cost Tax Shield)

Given a known level of debt, debt cash flows should be discounted at the pre-tax cost of debt, RB.
Since the flotation costs will be amortized over the life of the loan, the annual flotation costs that
will be expensed each year are:

Annual flotation expense = $45,000/4

Annual flotation expense = $11,250

NPV = ($1,200,000 – 45,000) – (1 – .25)(.095)($1,200,000)PVIFA9.5%,4 – $1,200,000/1.0954

+ .25($11,250)PVIFA9.5%,4
NPV = $55,340.32

So, the APV of the project is:

APV = NPV(All-Equity) + NPV(Financing Side Effects)

APV = –$9,320.33 + 55,340.32
APV = $46,019.99
3. a. In order to value a firm’s equity using the flow-to-equity approach, discount the cash flows
available to equity holders at the cost of the firm’s levered equity. The cash flows to equity
holders will be the firm’s net income. Remembering that the company has three stores, we find:

Sales $3,825,000
COGS 2,235,000
G & A costs 1,215,000
Interest 126,000
EBT $249,000
Taxes 54,780
NI $194,220

Since this cash flow will remain the same forever, the present value of cash flows available to
the firm’s equity holders is a perpetuity. We can discount at the levered cost of equity, so, the
value of the company’s equity is:

PV(Flow-to-equity) = $194,220/.19
PV(Flow-to-equity) = $1,022,210.53

b. The value of a firm is equal to the sum of the market values of its debt and equity, or:

VL = B + S

We calculated the value of the company’s equity in part a, so now we need to calculate the
value of debt. The company has a debt-to-equity ratio of .40, which can be written algebraically
as:

B/S = .40

We can substitute the value of equity and solve for the value of debt, doing so, we find:

B/$1,022,210.53 = .40
B = $408,884.21

So, the value of the company is:

V = $1,022,210.53 + 408,884.21
V = $1,431,094.74

4. a. In order to determine the cost of the firm’s debt, we need to find the yield to maturity on its
current bonds. With semiannual coupon payments, the yield to maturity of the company’s
bonds is:

$1,080 = $32.50(PVIFAR%,30) + $1,000(PVIFR%,30)

R = .028497, or 2.8497%
 Since the coupon payments are semiannual, the YTM on the bonds is:

YTM = 2.8497% × 2
YTM = 5.70%

b. We can use the Capital Asset Pricing Model to find the return on unlevered equity. According
to the Capital Asset Pricing Model:

R0 = RF + βUnlevered(RM – RF)
R0 = .035 + .95(.11 – .035)
R0 = .1063, or 10.63%

Now we can find the cost of levered equity. According to Modigliani-Miller Proposition II with
corporate taxes:

RS = R0 + (B/S)(R0 – RB)(1 – TC)

RS = .1063 + (.40)(.1063 – .0570)(1 – .21)
RS = .1218, or 12.18%

c. In a world with corporate taxes, a firm’s weighted average cost of capital is equal to:

RWACC = [B/(B + S)](1 – TC)RB + [S/(B + S)]RS

The problem does not provide either the debt-value ratio or equity-value ratio. However, the
firm’s debt-equity ratio is:

B/S = .40

Solving for B:

B = .4S

Substituting this in the debt-value ratio, we get:

B/V = .4S/(.4S + S)
B/V = .4/1.4
B/V = .29

And the equity-value ratio is one minus the debt-value ratio, or:

S/V = 1 – .29
S/V = .71

So, the WACC for the company is:

RWACC = .29(1 – .21)(.0570) + .71(.1218)

RWACC = .0999, or 9.99%
5. a. The equity beta of a firm financed entirely by equity is equal to its unlevered beta. Since each
firm has an unlevered beta of 1.05, we can find the equity beta for each. Doing so, we find:

North Pole

βEquity = [1 + (1 – TC)(B/S)]βUnlevered
βEquity = [1 + (1 – .21)($2,400,000/$4,100,000](1.05)
βEquity = 1.54

South Pole

βEquity = [1 + (1 – TC)(B/S)]βUnlevered
βEquity = [1 + (1 – .21)($4,100,000/$2,400,000](1.05)
βEquity = 2.47

b. We can use the Capital Asset Pricing Model to find the required return on each firm’s equity.
Doing so, we find:

North Pole:

RS = RF + βEquity(RM – RF)
RS = .0320 + 1.54(.1090 – .0320)
RS = .1502, or 15.02%

South Pole:

RS = RF + βEquity(RM – RF)
RS = .0320 + 2.47(.1090 – .0320)
RS = .2220, or 22.20%

6. a. If flotation costs are not taken into account, the net present value of a loan equals:

NPVLoan = Gross Proceeds – Aftertax present value of interest and principal payments
NPVLoan = $4,600,000 – .063($4,600,000)(1 – .21)PVIFA6.3%,10 – $4,600,000/1.06310
NPVLoan = $441,621.98

b. The flotation costs of the loan will be:

Flotation costs = $4,600,000(.025)

Flotation costs = $115,000

So, the annual flotation expense will be:

Annual flotation expense = $115,000/10

Annual flotation expense = $11,500
 If flotation costs are taken into account, the net present value of a loan equals:

NPVLoan = Proceeds net of flotation costs – Aftertax present value of interest and principal
payments + Present value of the flotation cost tax shield
NPVLoan = ($4,600,000 – 115,000) – .063($4,600,000)(1 – .21)(PVIFA6.3%,10)
– $4,600,000/1.06310 + $11,500(.21)(PVIFA6.3%,10)
NPVLoan = $344,146.66

7. First we need to find the aftertax value of the revenues minus expenses. The aftertax value is:

Aftertax revenue = $3,800,000(1 – .23)

Aftertax revenue = $2,926,000

Next, we need to find the depreciation tax shield. The depreciation tax shield each year is:

Depreciation tax shield = Depreciation(TC)

Depreciation tax shield = ($11,400,000/6)(.23)
Depreciation tax shield = $437,000

Now we can find the NPV of the project, which is:

NPV = Initial cost + PV of depreciation tax shield + PV of aftertax revenue

To find the present value of the depreciation tax shield, we should discount at the risk-free rate, and
we need to discount the aftertax revenues at the cost of equity, so:

NPV = –$11,400,000 + $437,000(PVIFA3.5%,6) + $2,926,000(PVIFA11.9%,6)

NPV = $2,992,703.89

8. Whether the company issues stock or issues equity to finance the project is irrelevant. The
company’s optimal capital structure determines the WACC. In a world with corporate taxes, a firm’s
weighted average cost of capital equals:

RWACC = [B/(B + S)](1 – TC)RB + [S/(B + S)]RS

RWACC = .60(1 – .21)(.059) + .40(.1030)
RWACC = .0692, or 6.92%

Now we can use the weighted average cost of capital to discount NEC’s unlevered cash flows.
Doing so, we find the NPV of the project is:

NPV = –$53,000,000 + $4,100,000/.0692

NPV = $6,277,679.78

9. a. The company has a capital structure with three parts: long-term debt, short-term debt, and
equity. Since interest payments on both long-term and short-term debt are tax-deductible,
multiply the pretax costs by (1 – TC) to determine the aftertax costs to be used in the weighted
average cost of capital calculation. The WACC using the book value weights is:

RWACC = (XSTD)(RSTD)(1 – TC) + (XLTD)(RLTD)(1 – TC) + (XEquity)(REquity)

RWACC = ($12/$41)(.041)(1 – .21) + ($20/$41)(.072)(1 – .21) + ($9/$41)(.138)
RWACC = .0675, or 6.75%
b. Using the market value weights, the company’s WACC is:

RWACC = (XSTD)(RSTD)(1 – TC) + (XLTD)(RLTD)(1 – TC) + (XEquity)(REquity)

RWACC = ($12.5/$89.5)(.041)(1 – .21) + ($23/$89.5)(.072)(1 – .21) + ($54/$89.5)(.138)
RWACC = .1024, or 10.24%

c. Using the target debt-equity ratio, the target debt-value ratio for the company is:

B/S = .60
B = .6S

Substituting this in the debt-value ratio, we get:

B/V = .6S/(.6S + S)
B/V = .6/1.6
B/V = .375

And the equity-value ratio is one minus the debt-value ratio, or:

S/V = 1 – .375
S/V = .625

We can use the ratio of short-term debt to long-term debt in a similar manner to find the short-
term debt to total debt and long-term debt to total debt. Using the short-term debt to long-term
debt ratio, we get:

STD/LTD = .20
STD = .2LTD

Substituting this in the short-term debt to total debt ratio, we get:

STD/B = .2LTD/(.2LTD + LTD)

STD/B = .2/1.2
STD/B = .167

And the long-term debt to total debt ratio is one minus the short-term debt to total debt ratio, or:

LTD/B = 1 – .167
LTD/B = .833

Now we can find the short-term debt to value ratio and long-term debt to value ratio by
multiplying the respective ratio by the debt-value ratio. So:

STD/V = (STD/B)(B/V)
STD/V = .167(.375)
STD/V = .063
 And the long-term debt to value ratio is:

LTD/V = (LTD/B)(B/V)
LTD/V = .833(.375)
LTD/V = .313

So, using the target capital structure weights, the company’s WACC is:

RWACC = (XSTD)(RSTD)(1 – TC) + (XLTD)(RLTD)(1 – TC) + (XEquity)(REquity)

RWACC = (.063)(.041)(1 – .21) + (.313)(.072)(1 – .21) + (.625)(.138)
RWACC = .1060, or 10.60%

d. The differences in the WACCs are due to the different weighting schemes. The company’s
WACC will most closely resemble the WACC calculated using target weights since future
projects will be financed at the target ratio. Therefore, the WACC computed with target
weights should be used for project evaluation.