# advantage of MACRS v. straight-line depreciation

You are interested in a bond. It has a 15 year remaining term and a 7% coupon rate. The price is 100.

1.What is the bond's YTM?

2.What is the formula you used to arrive at the answer?

3.Beacon Products has a project with an NPV of $500,000.

a. Should the company accept the project?

b. Why/why not?

c. What is the impact of acceptance on the company (quantify your answer)?

4. If the real rate is 2%, the inflation premium is 3%, and the risk premium (i.e., Rm - Rf) is 9%: what is the required rate of return (3 decimal places .XXX or xx.x%) for a stock with a Beta of 1.2?

5. What is the formula you used to arrive at the answer?

6. What is the required rate of return (3 decimal places .XXX or xx.x%) for a stock with a Beta of 1.2?

7. AMI Corp. is considering the purchase of a new measuring instrument. It will cost $80,000 and will require another $20,000 to install and get ready for production. It is subject to 5-yr MACRS depreciation. Show the depreciation schedule (and annual amounts) for the new instrument.

8. Sun Hydraulics purchased a milling machine 3 years ago at an "all in" (i.e., fully installed) cost of $1.25 million. It is subject to 5-year MACRS. What is the current book value?

9. What is the formula you used to arrive at the answer?

10. What is the current book value?

11. Your family's business exclusively uses the payback measure when evaluating possible capital projects. No project will be undertaken with a payback of more than 2 years. Family members are pleased because the company has been consistently profitable. However, the company's market value has been declining relative to competitors. How would you advise family members?

12. What are the NPV (in whole numbers) and IRR (2 decimal places) of the following cash flow series (if k = 0.11)? What are the formulas you used to arrive at the answers?

YR 0 YR 1 YR 2 YR 3 YR 4 YR 5

(1500) 330 330 330 330 300

13. What is the advantage of MACRS v. straight-line depreciation?

14. The price of a bond is 100. Is the YTM less than, equal to, or greater than the coupon rate?

15. Use the following information, the Gordon DDM model, and a constant growth assumption to compute the firm's stock price. Note: you must compute the next dividend. NOTE: round growth rate to the nearest whole percent; round all dollar values (dividend & price) to the nearest penny.

Historic dividends Beta = 1.3

2004 $3.24 Rf = 0.04

2003 $3.15 Rm = 0.12

2002 $2.90

2001 $2.78

2000 $2.66

1999 $2.31

16. Growth rate is (include the formula):

17. k is equal to (include the formula):

18. Dividend for 2005 is (include the formula):

19. Stock price is (include the formula):

20.a. What is the price of a 7% coupon bond with 5 years remaining to maturity if the current market required return (e.g., yield) is 8%? What is the price of the same bond if the current market required return increases to 10%? (Round to the nearest penny)

20.b. Market return at 8%, price is:

20.c. Market return is 10%:

21. Using the following Income Statement, Balance Sheet, and associated data, compute the firm's WACC.

[Note: round all costs to 3 decimals ... e.g., xx.x% or 0.xxx]

(Note: use the gross approximation method for the cost of debt)

Revenues 350,000 beta = 1.50

EBIT 35,000 Rf = 0.048

Interest expense 10,000 Rm = 0.121

EBT 25,000

EAT 15,000 Tax rate = 0.40

Preferred dividends = 2,000

Current Assets 95,000 Current Liabilities 31,000

Net Fixed Assets 110,000 Long term Debt 74,000

Preferred Stock 14,000

Common at par 1,000

Paid in surplus 40,000

Retained earnings 45,000

Tot Equity 100,000

Total Assets 205,000 Tot Liab & Equity 205,000

22. The Cost of Debt is:

23. The Cost of Preferred Stock is:

24. Cost of Common Stock is:

25. WACC is:

26. AdFlex is considering replacing one of its machines with a newer model. The new machine has a purchase price of $315,000 and an installation cost of $25,000. It will have a 5-yr life, no salvage value, and will be depreciated using the 5-yr MACRS schedule.

The firm has been offered $260,000 for the old machine. Its original cost was $280,000; it was purchased 3 years ago; and it is being depreciated using the 5-yr MACRS schedule. The machine has a 5-yr remaining life and no salvage value.

The firm's WACC is 0.12 and the marginal ordinary & capital gains tax rates are 0.40. Any purchase will be funded with internal funds. The following table summarizes the operating cash flows of the old machine (provided to expedite processing) and the EBITD expected if the new machine is purchased.

Yr - 1 Yr - 2 Yr - 3 Yr - 4 Yr - 5

Current machine (OCF) 55,000 60,000 60,000 60,000 60,000

New machine (EBITD) 95,000 125,000 120,000 150,000 122,000

(NOTE: notice that the OCF of the current machine has already been computed and is available. It does not have to be recomputed.)

27. What is the formula you used to calculate the initial investment?

28. The initial investment is:

29. The OCF by year for the new machine is:

30. The incremental OCF by year are:

31. The NPV for this project is (round to the nearest dollar):

32. What should the company do and why?

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#### Solution Summary

The advantage of MACRS v. straight-line depreciation is emphasized.

Hedging with Financial Derivatives

11) A bank added a bond to its portfolio. The bond has a duration of 12.3 years and cost $1,109. Just after buying the bond, the bank discovered that market interest rates are expected to rise from 8% to 8.75%. What is the expected change in the bond value?

5) Suppose that the pension you are managing is expecting an inflow of funds of $100 million next year and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?

6) How would you use the options market to accomplish the same thing as in Problem 5? What the advantages and disadvantages of using an options contract rather than a futures contract?

11) If your company has a payment of 200 million euros due one year from now, how would you hedge the foreign exchange risk in this payment with 125,000 euros futures contracts?

13) Suppose that you company will be receiving 30 million euros six months from now and the euro is currently selling for 1 euro per dollar. If you want to hedge the foreign exchange risk in this payment, what kind of forward contract would you want to enter into?

23) A bank issues a $100,000 fixed-rate 30 year mortgage with a nominal annual rate of 4.5%. If the required rate drops to 4.0% immediately after the mortgage is issued, what is the impact on the value of the mortgage? Assume the bank hedged the position with a short position in two 10-year T-bond futures. The original price was 64 12/32 and expired at 67 16/32 on a $100,000 face value contract. What was the gain on the futures? What is the total impact on the bank?

24) A bank customer will be going to London in June to purchase 100,000 in new inventory. The current spot and futures exchange rates are as follows: The customer enters into a position in June futures to fully hedge her position. When June arrives, the actual exchange rate is $1.725 per pound. How much did she save?

4. Options Pricing Problem.

Answer the following question to be submitted to the Facilitator.

Calculate the call option value at the end of one period for a European call option with the following terms:

-The current price of the underlying asset = $80.

-The strike price = $75

-The one period, risk-free rate = 10%

-The price of the asset can go up or down 10% at the end of one period.

a. What is the fundamental or intrinsic value?

b. What is the time premium?

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Depreciation Methods

440) Wendy's boss wants to use straight-line depreciation for the new expansion project because he said it will give higher net income in earlier years and give him a larger bonus. The project will last 4 years and requires $1,700,000 of equipment. The company could use either straight line of the 3-year MACRS accelerated method. Under straight-line depreciation, the cost of the equipment would be depreciated evenly over its 4-year life (ignore the half-year convention for the straight-line method). The applicable MACRS depreciation rates are 33.33%, 44.45%, and 7.41%, as discussed in Appendix 13A. The company's WACC is 10%, and its tax rate is 40%.

a) What would the depreciation expense be each year under each method?

b) Which depreciation method would produce the higher NPV, and how much higher would it be?

c) Why might Wendy's boss prefer straight-line depreciation?

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