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1) You're trying to figure out why the chairman of the Board of Directors fired you as CEO of a small corporation. You never missed an interest payment and the firm had a cash ratio of 2, the highest of any firm in their peer group. Because of this financial safety net, the firm's debt was considered very safe by industry standards. Why were you fired? Be specific.

2) Acme Widgets Inc. has steady earnings (EBIT), and is an average firm in most ways in the widget industry. The one exception is it has the highest debt-equity ratio of any firm in its industry. It has regularly sold most of its bonds over the last 40 years to Ajax Holdings, a large institutional investor (like a pension fund or an insurance company). Given the lessons of Modigliani-Miller Proposition #1, explain Acme's unique capital structure?

3) You work for Campbell's Soup. Your boss has asked you to calculate the NPV of a new line of chewing gum which will have some of the firm's popular flavors (e.g. Chicken Noodle Gum). You estimate the annual revenues for this project will be $500,000, cost of goods sold will be $200,000, new equipment will cost $800,000 and will be depreciated completely over the project's life (four years, straight line). The project will also need $100,000 in working capital (immediately), which will be recouped in the final year. The building adjacent to your existing factory will be rented for this project at an annual cost of $50,000. You accumulated $10,000 in overtime pay figuring all of this stuff out. The firm's current cost of capital is 10% and their D/E = 2. A potentially relevant publicly traded chewing gum company's financial information is:

ßstock = 1.5 ßdebt = 0.5 rf = 4%

E(rmkt) = 12% Tax Rate = 50% D/E = 2.0

What is this project's NPV?

4) A pizza shop owner is asking for a loan from the bank where you work as a loan officer. She tells you that she's been in business for five years and this is the best year she's ever had. She says that half of her business comes from deliveries. She indicates that she's been frugal to a fault and muses that she decided not to change the store's original logo because she would have to repaint the old delivery vans. She shows you several accounting ratios from this year's financial statements to support her loan application and she focuses on her TIE of 2 and her Debt/Total Assets of 0.5. Based on what she has told you, what two pieces of additional information would you like before you proceed? Note: This information should pertain to the two ratios she focused on (individually) and your reasons for wanting this information should be related to her description of her business.

5) ABC Inc. is a nonprofit and thus pays no corporate taxes. XYZ Inc. is a for-profit firm whose current corporate tax rate is 40%. They are in the same business. In setting up operations, ABC chose to use fewer fixed assets (plant and equipment). As a result of that, they have higher expenditures on working capital (in a sense, substituting inventories for machines). Why did XYZ choose more fixed assets and lower working capital expenditures?

Both of these companies are considering getting a new copier. Which of them is more likely to lease it? Why?

6) The stock of BFD Inc. is selling for $5/share. Its assets have a book value of $12 and it has liabilities of $5 (both per share). What is BFD's market to book ratio? Show how you could break up this company and make a profit? What important assumption underlies this potential profit?

7) Your boss at Stanley Tools is disappointed. The firm has decided to branch out into some new industries and he wanted the firm to enter the potato chip industry. Unfortunately, the careful analysis that you provided him ended up showing a negative NPV. He asks you to consider the following changes in order to make the project work:

a. Accelerated Depreciation (you used straight line)
b. Leasing the manufacturing equipment
c. Eliminating Accounts Receivable and Inventory to save working capital costs
d. Switching to the Stanley's current (lower) WACC

Of the four, which one is least likely to increase this project's NPV? Explain.

Of the four, which one should you reject as an inappropriate use of good finance principles?

Of the four, which one would be best using good business and finance principles? Explain.

8) In Slobovia, an obscure European country, dividends and interest are given the same tax treatment: they are both deductible at the corporate level and both taxed as income at the investor's level. All else the same, where would you expect more corporate bankruptcies, in Slobovia or in the US? Explain.

9) Your firm has had steady earnings for many years but it has resisted paying dividends. It typically uses its earnings to finance the replacement of its worn out assets, thus saving the cost of borrowing for that purpose. Your firm's. stock price has not risen much in recent years. A Drucker-educated consultant tells the CEO to start paying a modest dividend out of earning. "The borrowing costs you will incur by occasionally having to raise money with debt will be outweighed by a subtle benefit." What subtle benefit is the consultant referring to?

10) United Cut and Scab is a large, profitable consumer products company. After being taken over in an LBO, they cease their common practice of merging with small, R&D-oriented biotech firms. Why?

11) Over the past year, the dollar has depreciated by about 10% against the Euro. A year ago you took out a home equity loan in the US at an interest rate of 8% and you invested the money in a German mutual fund that paid a 5% Euro return. What net return did you earn on all of these transactions over the year?

See attached file for full problem description.

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Solution Summary

Answers questions on Capital Structure, Modigliani-Miller Proposition, NPV, Working Capital, Accelerated Depreciation, corporate bankruptcies, LBO, currencies.

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Business Finance Applications

(See attached file for full problem description)

7.3 The Best Manufacturing Company is considering a new investment. Financial projections for the investment are tabulated below. Cash flows are in $ thousands and the corporate tax rate is 34 percent. Assume all sales revenue is received in cash, all operating costs and income taxes are paid in cash, and all cash flows occur at the end of the year.

1. Compute the incremental net income of the investment for each year.
2. Compute the incremental cash flows of the investment for each year.
3. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?
Year 0 Year 1 Year 2 Year 3 Year 4
Investment $10,000 ? ? ? ?
Sales revenue ? $7,000 $7,000 $7,000 $7,000
Operating costs ? 2,000 2,000 2,000 2,000
Depreciation ? 2,500 2,500 2,500 2,500
Net working capital (end of year) 200 250 300 200

7.12 A firm is considering an investment of $28 million (purchase price) in new equipment to replace old equipment with a book value of $12 million and a market value of $20 million. If the firm replaces the old equipment with the new equipment, it expects to save $17.5 million in operating costs the first year. The amount of these savings will grow at a rate of 12 percent per year for each of the following three years. The old equipment has a remaining life of four years. It is being depreciated by the straight-line method. 33.3 percent of the original book value of the new equipment will be depreciated in the first year, 39.9 percent will be depreciated in the second year, 14.8 percent will be depreciated in the third year, and 12.0 percent will be depreciated in the final year. The salvage value of both the old equipment and the new equipment at the end of four years is 0. In addition, replacement of the old equipment with the new equipment requires an immediate increase in net working capital of $5 million, which will not be recovered until the end of the four-year investment. Assume that the purchase and sale of equipment occurs today and all other cash flows occur at the end of their respective years. If the firm's cost of capital is 14 percent and is subject to a 40 percent tax rate, find:
1. The net investment.
2. The after-tax incremental cash flow at the end of each year.
3. The internal rate of return on the investment.
4. The net present value of the investment.

8.13 ? The Cornchopper Company is considering the purchase of a new harvester. Cornchopper has hired you to determine the break-even purchase price (in terms of present value) of the harvester. This break-even purchase price is the price at which the project's NPV is zero. Base your analysis on the following facts: The new harvester is not expected to affect revenues, but pretax operating expenses will be reduced by $10,000 per year for 10 years. and has been depreciated by the straight-line method.
? The old harvester can be sold for $20,000 today.
? The new harvester will be depreciated by the straight-line method over its 10-year life.
? The firm's required rate of return is 15 percent.
? The initial investment, the proceeds from selling the old harvester, and any resulting tax effects occur immediately.
? The corporate tax rate is 34 percent when they are realized.
? All other cash flows occur at year-end.
? The market value of each harvester at the end of its economic

12.3 The correlation between the returns on Ceramics Craftsman, Inc., and the returns on the S&P 500 is 0.675. The variance of the returns on Ceramics Craftsman, Inc., is 0.004225, and the variance of the returns on the S&P 500 is 0.001467. What is the beta of Ceramics Craftsman stock?

12.8 The following table lists possible rates of return on Compton Technology's stock and debt and on the market portfolio. The probability of each state is also listed.
State Probability Return on Stock (%) Return on Debt (%) Return on the Market (%)
1 0.1 3% 8% 5%
2 0.3 8 8 10
3 0.4 20 10 15
4 0.2 15 10 20
1. What is the beta of Compton Technology debt?
2. What is the beta of Compton Technology stock?
3. If the debt-to-equity ratio of Compton Technology is 0.5, what is the asset beta of Compton Technology? Assume no taxes.

29.1 The Lager Brewing Corporation has acquired the Philadelphia Pretzel Company in a vertical merger. Lager Brewing has issued $300,000 in new long-term debt to pay for its purchase. ($300,000 is the purchase price.) Construct the balance sheet for the new corporation if the merger is treated as a purchase for accounting purposes. The balance sheets shown here represent the assets of both firms at their true market values. Assume these market values are also the book values.
Balance Sheet
(in $ thousands)
Current assets $ 400 Current liabilities $ 200
Other assets 100 Long-term debt 100
Net fixed assets 500 Equity 700
Total $1,000 Total $1,000
Balance Sheet
(in $ thousands)
Current assets $ 80 Current liabilities $ 80
Other assets 40 Equity 120
Net fixed assets 80
Total $200 Total $200

29.4 Indicate whether you think the following claims regarding takeovers are true or false. In each case provide a brief explanation for your answer.
1. By merging competitors, takeovers have created monopolies that will raise product prices, reduce production, and harm consumers.
2. Managers act in their own interests at times and, in reality, may not be answerable to shareholders. Takeovers may reflect runaway management.
3. In an efficient market, takeovers would not occur because market price would reflect the true value of corporations. Thus, bidding firms would not be justified in paying premiums above market prices for target firms.
4. Traders and institutional investors, having extremely short time horizons, are influenced by their perceptions of what other market traders will be thinking of stock prospects and do not value takeovers based on fundamental factors. Thus, they will sell shares in target firms despite the true value of the firms.
5. Mergers are a way of avoiding taxes because they allow the acquiring firm to write up the value of the assets of the acquired firm.
6. Acquisitions analysis frequently focuses on the total value of the firms involved. An acquisition, however, will usually affect relative values of stocks and bonds, as well as their total value.

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