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# Present Value

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Hopeful House, a nonprofit orgnanization serving the Big City community, is considering building a playground. It needs to rationally convince the Community Chest that its project is worthy of a special grant by calculating the present value of future benefits. The financial manager estimates future benefits of the playground at \$10,000 that will be realized at the end of a four year period. Further, he recommends using a discount rate of 9%. His executive director thinks that his discount rate is too high and she recommends using 8%. The Community Chest associate, however, insists both rates are too low and wants them to use 10%. Calculate the present value of the estimated benefit stream at all three discount rates. Explain the effect of higher and lower discount rates.

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Hopeful House, a nonprofit organization serving the Big City community, is considering building a playground. It needs to rationally convince the Community Chest that its project is worthy of a special grant by calculating the present value of future benefits. The financial manager estimates future benefits of the playground at ...

#### Solution Summary

Calculates the present value of the estimated benefit stream at three discount rates (8%, 9%, 10%).

\$2.19

## Finance Review Questions

Question 1. Otel Corporation entered into an agreement with its investment banker to sell 15 million shares of the company's stock with Otel netting \$270 million dollars from the offering.

The out-of-pocket expenses incurred by the investment banker were \$5,000,000.

a. What profit or loss would the investment banker incur if the issue sold to the public at an average price of \$25 per share?
b. What profit or loss would the investment banker incur if the issue were sold to the public at an average price of \$15 per share?
c. Is this an example of a negotiated deal or best efforts? Why? Who bears the greater risk, the investment banker or the company? Why?
d. If the investment banker agrees to handle the issue on a best efforts basis, earning 7.5 percent of the proceeds, calculate the investment banker's profit or loss if all 15 million shares are sold at an average price of \$15. How much will the company receive?
e. Who bears the greater risk in a best efforts deal, the investment banker or the company? Why?

Question 2. Differentiate between each of the following and provide a specific example to illustrate each answer.

a. A golden parachute and a poison pill.
b. A friendly merger and a hostile merger.
c. A vertical merger and a horizontal merger.
d. An acquiring company and a target company
e. Purchase accounting and pooling of interest accounting

Problem 3. Campbell Company's balance sheet and income statement are shown below (in millions of dollars). The company and its creditors have agreed upon a voluntary reorganization plan. In this plan, each share of the \$4 preferred will be exchanged for one share of \$1.50 preferred with a par value of \$50 plus one 10 percent subordinated income debenture with a par value of \$50. The \$6 preferred issue will be retired with cash.

Current Current
Current Assets 250.0 Current liabilities 275.0
Net fixed assets 195.0 Advance payments 15.00
\$4 preferred stock, \$100 par value (1,000,000) shares 100.0
\$6 preferred stock, no par, callable at 10 (800,000 shares) 8.0
Common stock, \$0.50 par value (20,000,000) shares 10.0
Retained earnings 37.0
Total assets 445.0 Total claims 445.0

a. Construct the pro forma balance sheet after reorganization takes place. Show the new preferred at its par value.
b. Construct the pro forma income statement after reorganization takes place. How does the recapitalization affect net income available to common stockholders?
Income Statement
Current
Net sales 600.0
Operating expense 550.0
Net operating income 50.0
Other income 10.0

EBT 60.0
Taxes 9.0 15%
Net income 51.0
Dividends on \$4 PS 4.0
Dividends on \$6 PS 4.8
Income to Common SHs 42.2
c. What are the required pre-tax earnings before and after the reorganization?
d. Calculate the debt ratio before and after the reorganization?
e. Would the common stockholders be in favor of the reorganization? Why or why not?

Problem 4. A Treasury bond futures contract settles at 105-8.

a. What is the present value of the futures contract?
b. If the contract settles at 105-8, are current market interest rates higher or lower than the standardized rate on a futures contract? Explain.
c. What is the implied annual interest rate on the futures contract?
d. Calculate the new value of the futures contract if interest rates increase by 1 percentage point annually.
e. Calculate your profit or loss if you sold a futures contract at 105-8 and purchased an offsetting contract when rates increased by 1 percentage point annually.

Question 5. Your portfolio is diversified . It has an expected return of 11.0% and a beta of 1.10. You want to add 300 shares of Tundra Corporation at \$40 a share to your portfolio. Tundra has an expected return of 13.0% and a beta of 1.50. The total value of the investor's current portfolio is \$45,000.

a. Calculate the expected return on the portfolio after the purchase of the Tundra stock?
b. Calculate the expected beta on the portfolio after you add the new stock?
c. Is your portfolio less risky or more risky than average? Explain.
d. Will your portfolio likely outperform or underperform the market in a period when stocks are rapidly falling in value?
e. Is beta always an accurate predictor of a portfolio's performance? Explain?

Question 6. Calhoun Resorts is interested in developing a new facility in Toronto. The company estimates that the hotel would require an initial investment of \$10 million. The company expects that the facility will produce positive cash flows of \$2,710,000 a year at the end of each of the next 5 years. The project's cost of capital is 11%.

a. Calculate the expected net present value of the project.
b. The company recognizes that the cash flows could be higher or lower than 2,710,000, depending on whether the host government imposes a facility tax. The company will know in one year whether the tax will be imposed. There is a 30 percent chance that the tax will the imposed, in which case the yearly cash flows will be only \$2.5 million. At the same time, there is a 70 percent chance that the tax will not be imposed, in which case the yearly cash flows will be \$3.2 million. The company is deciding whether to proceed with the facility today or to wait 1 year to find out whether the tax will be imposed. If it waits year, the initial investment will remain at \$10 million and positive cash flows will continue for 5 years. Assume that all cash flows are discounted at 11 percent. Using decision tree analysis, calculate the value of the real option to wait a year before deciding.
c. Discuss 2-3 factors other than the value of the real option that the company should consider in making its decision.

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