公司理财精要 第四版 (斯蒂芬罗斯 伦道夫.韦斯特菲尔德 张建平 著) 人民邮电出版社 课后答案 142页

'课后答案网，用心为你服务！大学答案---中学答案---考研答案---考试答案最全最多的课后习题参考答案，尽在课后答案网（www.khdaw.com）！Khdaw团队一直秉承用心为大家服务的宗旨，以关注学生的学习生活为出发点，旨在为广大学生朋友的自主学习提供一个分享和交流的平台。爱校园（www.aixiaoyuan.com）课后答案网（www.khdaw.com）淘答案（www.taodaan.com） AnswerstoConceptsReviewandCriticalThinkingQuestions1.Capitalbudgeting(decidingonwhethertoexpandamanufacturingplant),capitalstructure(decidingwhethertoissuenewequityandusetheproceedstoretireoutstandingdebt),andworkingcapitalmanagement(modifyingthefirm’screditcollectionpolicywithitscustomers).2.Disadvantages:unlimitedliability,limitedlife,difficultyintransferringownership,hardtoraisecapitalfunds.Someadvantages:simpler,lessregulation,theownersarealsothemanagers,sometimespersonaltaxratesarebetterthancorporatetaxrates.3.Theprimarydisadvantageofthecorporateformisthedoubletaxationtoshareholdersofdistributedearningsanddividends.Someadvantagesinclude:limitedliability,easeoftransferability,abilitytoraisecapital,andunlimitedlife.4.Thetreasurer’sofficeandthecontroller’sofficearethetwoprimaryorganizationalgroupsthatreportdirectlytothechieffinancialofficer.Thecontroller’sofficehandlescostandfinancialaccounting,taxmanagement,andmanagementinformationsystems.Thetreasurer’sofficeisresponsibleforcashandcreditmanagement,capitalbudgeting,andfinancialplanning.Therefore,thestudyofcorporatefinanceisconcentratedwithinthefunctionsofthetreasurer’soffice.5.Tomaximizethecurrentmarketvalue(shareprice)oftheequityofthefirm(whetherit’spubliclytradedornot).6.Inthecorporateformofownership,theshareholdersaretheownersofthefirm.Theshareholderselectthedirectorsofthecorporation,whointurnappointthefirm’smanagement.Thisseparationofownershipfromcontrolinthecorporateformoforganizationiswhatcausesagencyproblemstoexist.Managementmayactinitsownorsomeoneelse’sbestinterests,ratherthanthoseoftheshareholders.Ifsucheventsoccur,theymaycontradictthegoalofmaximizingthesharepriceoftheequityofthefirm.7.Aprimarymarkettransaction.8.InauctionmarketsliketheNYSE,brokersandagentsmeetataphysicallocation(theexchange)tobuyandselltheirassets.DealermarketslikeNasdaqrepresentdealersoperatingindispersedlocaleswhobuyandsellassetsthemselves,usuallycommunicatingwithotherdealerselectronicallyorliterallyoverthecounter.9.Sincesuchorganizationsfrequentlypursuesocialorpoliticalmissions,manydifferentgoalsareconceivable.Onegoalthatisoftencitedisrevenueminimization;i.e.,providingtheirgoodsandservicestosocietyatthelowestpossiblecost.Anotherapproachmightbetoobservethatevenanot-for-profitbusinesshasequity.Thus,anappropriategoalwouldbetomaximizethevalueoftheequity. CHAPTER18B-210.Anargumentcanbemadeeitherway.Attheoneextreme,wecouldarguethatinamarketeconomy,allofthesethingsarepriced.Thisimpliesanoptimallevelofethicaland/orillegalbehaviorandtheframeworkofstockvaluationexplicitlyincludesthese.Attheotherextreme,wecouldarguethatthesearenon-economicphenomenaandarebesthandledthroughthepoliticalprocess.Thefollowingisaclassic(andhighlyrelevant)thoughtquestionthatillustratesthisdebate:“Afirmhasestimatedthatthecostofimprovingthesafetyofoneofitsproductsis$30million.However,thefirmbelievesthatimprovingthesafetyoftheproductwillonlysave$20millioninproductliabilityclaims.Whatshouldthefirmdo?”11.Thegoalwillbethesame,butthebestcourseofactiontowardthatgoalmayrequireadjustmentsduedifferentsocial,political,andeconomicclimates.12.Thegoalofmanagementshouldbetomaximizethesharepriceforthecurrentshareholders.Ifmanagementbelievesthatitcanimprovetheprofitabilityofthefirmsothatthesharepricewillexceed$35,thentheyshouldfighttheofferfromtheoutsidecompany.Ifmanagementbelievesthatthisbidderorotherunidentifiedbidderswillactuallypaymorethan$35persharetoacquirethecompany,thentheyshouldstillfighttheoffer.However,ifthecurrentmanagementcannotincreasethevalueofthefirmbeyondthebidprice,andnootherhigherbidscomein,thenmanagementisnotactingintheinterestsoftheshareholdersbyfightingtheoffer.Sincecurrentmanagersoftenlosetheirjobswhenthecorporationisacquired,poorlymonitoredmanagershaveanincentivetofightcorporatetakeoversinsituationssuchasthis.13.Wewouldexpectagencyproblemstobelesssevereinothercountries,primarilyduetotherelativelysmallpercentageofindividualownership.Fewerindividualownersshouldreducethenumberofdiverseopinionsconcerningcorporategoals.Thehighpercentageofinstitutionalownershipmightleadtoahigherdegreeofagreementbetweenownersandmanagersondecisionsconcerningriskyprojects.Inaddition,institutionsmaybebetterabletoimplementeffectivemonitoringmechanismsonmanagersthancanindividualowners,givenaninstitutions’deeperresourcesandexperienceswiththeirownmanagement.TheincreaseininstitutionalownershipofstockintheUnitedStatesandthegrowingactivismoftheselargeshareholdergroupsmayleadtoareductioninagencyproblemsforU.S.corporationsandamoreefficientmarketforcorporatecontrol.14.Howmuchistoomuch?Whoisworthmore,MichaelEisnerorTigerWoods?Thesimplestansweristhatthereisamarketforexecutivesjustasthereisforalltypesoflabor.Executivecompensationisthepricethatclearsthemarket.Thesameistrueforathletesandperformers.Havingsaidthat,oneaspectofexecutivecompensationdeservescomment.Aprimaryreasonexecutivecompensationhasgrownsodramaticallyisthatcompanieshaveincreasinglymovedtostock-basedcompensation.Suchmovementisobviouslyconsistentwiththeattempttobetteralignstockholderandmanagementinterests.Inrecentyears,stockpriceshavesoared,somanagementhascleanedup.Itissometimesarguedthatmuchofthisrewardissimplyduetorisingstockpricesingeneral,notmanagerialperformance.Perhapsinthefuture,executivecompensationwillbedesignedtorewardonlydifferentialperformance,i.e.,stockpriceincreasesinexcessofgeneralmarketincreases. CHAPTER2FINANCIALSTATEMENTS,TAXES,ANDCASHFLOWAnswerstoConceptsReviewandCriticalThinkingQuestions1.Liquiditymeasureshowquicklyandeasilyanassetcanbeconvertedtocashwithoutsignificantlossinvalue.It’sdesirableforfirmstohavehighliquiditysothattheycanmoresafelymeetshort-termcreditordemands.However,sinceliquidityalsohasanopportunitycostassociatedwithit—namelythathigherreturnscangenerallybefoundbyinvestingthecashintoproductiveassets—lowliquiditylevelsarealsodesirabletothefirm.It’suptothefirm’sfinancialmanagementstafftofindareasonablecompromisebetweentheseopposingneeds.2.Therecognitionandmatchingprinciplesinfinancialaccountingcallforrevenues,andthecostsassociatedwithproducingthoserevenues,tobe“booked”whentherevenueprocessisessentiallycomplete,notnecessarilywhenthecashiscollectedorbillsarepaid.Notethatthiswayisnotnecessarilycorrect;it’sthewayaccountantshavechosentodoit.3.Historicalcostscanbeobjectivelyandpreciselymeasuredwhereasmarketvaluescanbedifficulttoestimate,anddifferentanalystswouldcomeupwithdifferentnumbers.Thus,thereisatradeoffbetweenrelevance(marketvalues)andobjectivity(bookvalues).4.Depreciationisanon-cashdeductionthatreflectsadjustmentsmadeinassetbookvaluesinaccordancewiththematchingprincipleinfinancialaccounting.Interestexpenseisacashoutlay,butit’safinancingcost,notanoperatingcost.5.Marketvaluescanneverbenegative.Imagineashareofstocksellingfor–$20.Thiswouldmeanthatifyouplacedanorderfor100shares,youwouldgetthestockalongwithacheckfor$2,000.Howmanysharesdoyouwanttobuy?Moregenerally,becauseofcorporateandindividualbankruptcylaws,networthforapersonoracorporationcannotbenegative,implyingthatliabilitiescannotexceedassetsinmarketvalue.6.Forasuccessfulcompanythatisrapidlyexpanding,capitaloutlayswouldtypicallybelarge,possiblyleadingtonegativecashflowfromassets.Ingeneral,whatmattersiswhetherthemoneyisspentwisely,notwhethercashflowfromassetsispositiveornegative.7.It’sprobablynotagoodsignforanestablishedcompany,butitwouldbefairlyordinaryforastart-up,soitdepends.8.Forexample,ifacompanyweretobecomemoreefficientininventorymanagement,theamountofinventoryneededwoulddecline.Thesamemightbetrueifitbecomesbetteratcollectingitsreceivables.Ingeneral,anythingthatleadstoadeclineinendingNWCrelativetobeginningNWCwouldhavethiseffect.Negativenetcapitalspendingwouldmeanmorelong-livedassetswereliquidatedthanpurchased. CHAPTER2B-29.Ifacompanyraisesmoremoneyfromsellingstockthanitpaysindividendsinaparticularperiod,itscashflowtostockholderswillbenegative.Ifacompanyborrowsmorethanitpaysininterest,itscashflowtocreditorswillbenegative.10.Theadjustmentsdiscussedwerepurelyaccountingchanges;theyhadnocashflowormarketvalueconsequencesunlessthenewaccountinginformationcausedstockholderstorevaluetheoilfields.SolutionstoQuestionsandProblemsBasic1.BalanceSheetCA$2,800CL$1,600OE=$8,800–6,800=$2,000NFA6,000LTD5,200NWC=$2,800–1,600=$1,200TA$8,800OE2,000TL+OE$8,8002.IncomeStatementSales$425,000Costs210,000Depreciation63,000EBIT$152,000Interest38,000Taxableincome$114,000Taxes39,900Netincome$74,1003.Netincome=Divs+Add.toret.earnings;Add.toret.earnings=$74,100–35,000=$39,1004.EPS=NI/shares=$74,100/30,000=$2.47pershareDPS=Divs/shares=$35,000/30,000=$1.167pershare5.NWC=CA–CL;CA=$600K+750K=$1.35MBookvalueCA=$1.35MMarketvalueCA=$1.25MBookvalueNFA=$2.10MMarketvalueNFA=$4MBookvalueassets=$1.35+2.10=$3.45MMarketvalueassets=$1.25+4=$5.25M6.Taxes=0.15($50K)+0.25($25K)+0.34($25K)+0.39($310K–100K)=$104,1507.Averagetaxrate=$104,150/$310,000=33.60%;Marginaltaxrate=39% CHAPTER2B-38.IncomeStatementSales$9,620OCF=EBIT+D–TCosts4,840=$3,480+1,300–794.50=$3,985.50Depreciation1,300EBIT$3,480Interest1,210Taxableincome$2,270Taxes(35%)794.50Netincome$1,475.509.Netcapitalspending=NFAend–NFAbeg+Depreciation=$3.1M–2.8M+510K=$810K10.ChangeinNWC=NWCend–NWCbeg=(CAend–CLend)–(CAbeg–CLbeg)=($860–415)–(800–280)=$445–520=–$7511.Cashflowtocreditors=Interestpaid–Netnewborrowing=$420K–(LTDend–LTDbeg)=$420K–(2.3M–1.9M)=$420K–400K=$20K12.Cashflowtostockholders=Dividendspaid–Netnewequity=$120K–[(Commonend+APISend)–(Commonbeg+APISbeg)]=$120K–[(230K+4.5M)–(200K+4.2M)]=$120K–[4.73M–4.4M]=–$210K13.Cashflowfromassets=Cashflowtocreditors+Cashflowtostockholders=$20K–210K=–$190KCashflowfromassets=–$190K=OCF–ChangeinNWC–Netcapitalspending=OCF–(–$135K)–(760K)=–$190K;Operatingcashflow=–$190+135K+760K=$705KIntermediate14.IncomeStatementSales$114,000a.OCF=EBIT+Depreciation–TaxesCosts61,200=$39,900+9,600–10,710=$38,790OtherExpenses3,300b.CFC=Interest–NetnewLTDDepreciation9,600=$8,400–(–3,600)=$12,000EBIT$39,900c.CFS=Dividends–NetnewequityInterest8,400=$3,840–1,700=$2,140Taxableincome$31,500d.CFA=CFC+CFS=$12K+2,140=$14,140Taxes10,710$14,140=OCF–Netcap.sp.–ChangeinNWCNetincome$20,790Netcap.sp.=Inc.inNFA+DepreciationDividends$3,840=$11,400+9,600=$21,000Add.toRE16,950ChangeinNWC=OCF–Netcap.sp.–CFA=$38,790–21,000–14,140=$3,650 CHAPTER2B-415.Netincome=Dividends+Additiontoret.earnings=$900+2,100=$3,000Taxableincome=NI/(1–Taxrate)=$3,000/0.65=$4,615EBIT=Taxableincome+Interest=$4,615+1,430=$6,045Sales–Costs–Depreciation=EBIT=$30,000–19,000–Depreciation=$6,045Depreciation=$30,000–19,000–6,045=$4,95516.BalanceSheetCash$204,000Accountspayable$605,000Accountsreceivable226,000Notespayable193,000Inventory473,000Currentliabilities$798,000Currentassets$903,000Long-termdebt908,000Totalliabilities$1,706,000Tangiblenetfixedassets4,400,000Intangiblenetfixedassets798,000Commonstock??Totalassets$6,101,000Accumulatedret.earnings3,905,000Totalliab.&owners’equity$6,101,000??=$6,101,000–3,905,000–1,706,000=$490,00017.Owners’equity=Max[(TA–TL),0];ifTA=$4,500,OE=$700;ifTA=$3,400,OE=$018.a.TaxesGrowth=0.15($50K)+0.25($25K)+0.34($7K)=$16,130TaxesIncome=0.15($50K)+0.25($25K)+0.34($25K)+0.39($235K)+0.34($7.865M)=$2.788Mb.Eachfirmhasamarginaltaxrateof34%onthenext$10,000oftaxableincome,despitetheirdifferentaveragetaxrates,sobothfirmswillpayanadditional$3,400intaxes.19.IncomeStatementa.Sales$2,400,000b.OCF=EBIT+D–TCostofgoodssold1,440,000=$120,000+480,000–0=$600,000Otherexpenses360,000c.NetincomewasnegativebecauseoftheDepreciation480,000taxdeductibilityofdepreciationandint-EBIT$120,000erestexpense.However,theactualcashInterest180,000flowfromoperationswaspositiveTaxableincome($60,000)becausedepreciationisanon-cashTaxes(35%)0expenseandinterestisafinancing,notNetincome($60,000)anoperating,expense.20.Afirmcanstillpayoutdividendsifnetincomeisnegative;itjusthastobesurethereissufficientcashflowtomakethedividendpayments.ChangeinNWC=Netcap.sp.=Netnewequity=0.(Assumed)Cashflowfromassets=OCF–ChangeinNWC–Netcap.sp.=$600K–0–0=$600KCashflowtostockholders=Dividends–Netnewequity=$480K–0=$480KCashflowtocreditors=Cashflowfromassets–Cashflowtostockholders=$600K–480K=$120KCashflowtocreditors=Interest–NetnewLTD;NetnewLTD=Interest–Cashflowtocreditors=$180K–120K=$60K CHAPTER2B-521.a.IncomeStatementSales$10,980b.OCF=EBIT+Dep.–TaxesCostofgoodssold8,100=$1,440+1,440–441=$2,439Depreciation1,440c.ChangeinNWC=NWCend–NWCbegEBIT$1,440=(CAend–CLend)–(CAbeg–CLbeg)Interest180=($2,790–1,620)–(1,800–1,350)Taxableincome$1,260=$1,170–450=$720Taxes(35%)441Netcap.sp.=NFAend–NFAbeg+Dep.Netincome$819=$7,560–7,200+1,440=$1,800CFA=OCF–ChangeinNWC–Netcap.sp.=$2,439–720–1,800=–$81Thecashflowfromassetscanbepositiveornegative,sinceitrepresentswhetherthefirmraisedfundsordistributedfundsonanetbasis.Inthisproblem,eventhoughnetincomeandOCFarepositive,thefirminvestedheavilyinbothfixedassetsandnetworkingcapital;ithadtoraiseanet$81infundsfromitsstockholdersandcreditorstomaketheseinvestments.d.Cashflowtocreditors=Interest–NetnewLTD=$180–0=$180Cashflowtostockholders=Cashflowfromassets–Cashflowtocreditors=–$81–180=–$261=Dividends–Netnewequity;Netnewequity=$270+261=$531Thefirmhadpositiveearningsinanaccountingsense(NI>0)andhadpositivecashflowfromoperations.Thefirminvested$720innewnetworkingcapitaland$1,800innewfixedassets.Thefirmhadtoraise$81fromitsstakeholderstosupportthisnewinvestment.Itaccomplishedthisbyraising$531intheformofnewequity.Afterpayingout$270ofthisintheformofdividendstoshareholdersand$180intheformofinteresttocreditors,$81waslefttojustmeetthefirm’scashflowneedsforinvestment.22.a.Totalassets2002=$1,425+6,600=$8,025;Totalliabilities2002=$615+3,600=$4,215Owners’equity2002=$8,025–4,215=$3,810Totalassets2003=$1,509+6,900=$8,409;Totalliabilities2003=$903+4,200=$5,103Owners’equity2003=$8,409–5,103=$3,306b.NWC2002=CA02–CL02=$1,425–615=$810NWC2003=CA03–CL03=$1,509–903=$606ChangeinNWC2003=NWC03–NWC02=$606–810=–$204c.Netcap.sp.=NFA03–NFA02+D00=$6,900–6,600+1,800=$2,100Netcap.sp.=Fixedassetsbought–Fixedassetssold$2,100=$3,000–Fixedassetssold;Fixedassetssold=$3,000–2,100=$900OCF00=EBIT+Dep.–Taxes=$8,820+1,800–2,973.60=$7,646.40Cashflowfromassets=OCF–Inc.inNWC–Inc.incap.sp.=$7,646.40–(–204)–2,100=$5,750.40d.Netnewborrowing=LTD03–LTD02=$4,200–3,600=$600Cashflowtocreditors=Interest–NetnewLTD=$324–600=–$276Netnewborrowing=$600=Debtissued–Debtretired;Debtretired=$900–600=$300 CHAPTER3WORKINGWITHFINANCIALSTATEMENTSAnswerstoConceptsReviewandCriticalThinkingQuestions1.a.Ifinventoryispurchasedwithcash,thenthereisnochangeinthecurrentratio.Ifinventoryispurchasedoncredit,thenthereisadecreaseinthecurrentratioifitwasinitiallygreaterthan1.0.b.Reducingaccountspayablewithcashincreasesthecurrentratioifitwasinitiallygreaterthan1.0.c.Reducingshort-termdebtwithcashincreasesthecurrentratioifitwasinitiallygreaterthan1.0.d.Aslong-termdebtapproachesmaturity,theprincipalrepaymentandtheremaininginterestexpensebecomecurrentliabilities.Thus,ifdebtispaidoffwithcash,thecurrentratioincreasesifitwasinitiallygreaterthan1.0.Ifthedebthasnotyetbecomeacurrentliability,thenpayingitoffwillreducethecurrentratiosincecurrentliabilitiesarenotaffected.e.Reductionofaccountsreceivablesandanincreaseincashleavesthecurrentratiounchanged.f.Inventorysoldatcostreducesinventoryandraisescash,sothecurrentratioisunchanged.g.Inventorysoldforaprofitraisescashinexcessoftheinventoryrecordedatcost,sothecurrentratioincreases.2.Thefirmhasincreasedinventoryrelativetoothercurrentassets;therefore,assumingcurrentliabilitylevelsremainmostlyunchanged,liquidityhaspotentiallydecreased.3.Acurrentratioof0.50meansthatthefirmhastwiceasmuchincurrentliabilitiesasitdoesincurrentassets;thefirmpotentiallyhaspoorliquidity.Ifpressedbyitsshort-termcreditorsandsuppliersforimmediatepayment,thefirmmighthaveadifficulttimemeetingitsobligations.Acurrentratioof1.50meansthefirmhas50%morecurrentassetsthanitdoescurrentliabilities.Thisprobablyrepresentsanimprovementinliquidity;short-termobligationscangenerallybemetcom-pletelywithasafetyfactorbuiltin.Acurrentratioof15.0,however,mightbeexcessive.Anyexcessfundssittingincurrentassetsgenerallyearnlittleornoreturn.Theseexcessfundsmightbeputtobetterusebyinvestinginproductivelong-termassetsordistributingthefundstoshareholders.4.a.Quickratioprovidesameasureoftheshort-termliquidityofthefirm,afterremovingtheeffectsofinventory,generallytheleastliquidofthefirm’scurrentassets.b.Cashratiorepresentstheabilityofthefirmtocompletelypayoffitscurrentliabilitiesbalancewithitsmostliquidasset(cash).c.Thecapitalintensityratiotellsusthedollaramountinvestmentinassetsneededtogenerateonedollarinsales.d.Totalassetturnovermeasureshowmuchinsalesisgeneratedbyeachdollaroffirmassets.e.Equitymultiplierrepresentsthedegreeofleverageforanequityinvestorofthefirm;itmeasuresthedollarworthoffirmassetseachequitydollarhasaclaimto.f.Long-termdebtratiomeasuresthepercentageoftotalfirmcapitalizationfundedbylong-termdebt.g.Timesinterestearnedratioprovidesarelativemeasureofhowwellthefirm’soperatingearningscancovercurrentinterestobligations.h.Profitmarginistheaccountingmeasureofbottom-lineprofitperdollarofsales.i.Returnonassetsisameasureofbottom-lineprofitperdollaroftotalassets.j.Returnonequityisameasureofbottom-lineprofitperdollarofequity.k.Price-earningsratioreflectshowmuchvaluepersharethemarketplacesonadollarofaccountingearningsforafirm. CHAPTER3B-25.Commonsizefinancialstatementsexpressallbalancesheetaccountsasapercentageoftotalassetsandallincomestatementaccountsasapercentageoftotalsales.Usingthesepercentagevaluesratherthannominaldollarvaluesfacilitatescomparisonsbetweenfirmsofdifferentsizeorbusinesstype.6.Peergroupanalysisinvolvescomparingthefinancialratiosandoperatingperformanceofaparticularfirmtoasetofpeergroupfirmsinthesameindustryorlineofbusiness.Comparingafirmtoitspeersallowsthefinancialmanagertoevaluatewhethersomeaspectsofthefirm’soperations,finances,orinvestmentactivitiesareoutoflinewiththenorm,therebyprovidingsomeguidanceonappropriateactionstotaketoadjusttheseratiosifappropriate.Anaspirantgroupwouldbeasetoffirmswhoseperformancethecompanyinquestionwouldliketoemulate.Thefinancialmanageroftenusesthefinancialratiosofaspirantgroupsasthetargetratiosforhisorherfirm;somemanagersareevaluatedbyhowwelltheymatchtheperformanceofanidentifiedaspirantgroup.7.Returnonequityisprobablythemostimportantaccountingratiothatmeasuresthebottom-lineperformanceofthefirmwithrespecttotheequityshareholders.TheDuPontidentityemphasizestheroleofafirm’sprofitability,assetutilizationefficiency,andfinancialleverageinachievingaROEfigure.Forexample,afirmwithROEof20%wouldseemtobedoingwell,butthisfiguremaybemisleadingifitwereamarginallyprofitable(lowprofitmargin)andhighlylevered(highequitymultiplier).Ifthefirm’smarginsweretoerodeslightly,theROEwouldbeheavilyimpacted.8.Thebook-to-billratioisintendedtomeasurewhetherdemandisgrowingorfalling.Itiscloselyfollowedbecauseitisabarometerfortheentirehigh-techindustrywherelevelsofrevenuesandearningshavebeenrelativelyvolatile.9.Ifacompanyisgrowingbyopeningnewstores,thenpresumablytotalrevenueswouldberising.Comparingtotalsalesattwodifferentpointsintimemightmisleading.Same-storesalescontrolforthisbyonlylookingatrevenuesofstoresopenwithinaspecificperiod.10.a.ForanelectricutilitysuchasConEd,expressingcostsonaperkilowatthourbasiswouldbeawaycomparingcostswithotherutilitiesofdifferentsizes.b.ForaretailersuchasSears,expressingsalesonapersquarefootbasiswouldbeusefulincomparingrevenueproductionagainstotherretailers.c.ForanairlinesuchasDelta,expressingcostsonaperpassengermilebasisallowsforcomparisonswithotherairlinesbyexamininghowmuchitcoststoflyonepassengeronemile.d.Foranon-lineservicesuchasAOL,usingapercallbasisforcostswouldallowforcomparisonswithsmallerservices.Apersubscriberbasiswouldalsomakesense.e.ForahospitalsuchasHolyCross,revenuesandcostsexpressedonaperbedbasiswouldbeuseful.f.ForacollegetextbookpublishersuchasMcGraw-Hill/Irwin,theleadingpublisheroffinancetextbooksforthecollegemarket,theobviousstandardizationwouldbeperbooksold.SolutionstoQuestionsandProblemsBasic1.NWC=$900=CA–CL;CA=$900+4,320=$5,220Currentratio=CA/CL=$5,220/$4,320=1.21timesQuickratio=(CA–Inventory)/CL=($5,220–1,900)/$4,320=0.77times CHAPTER3B-32.Profitmargin=Netincome/Sales;Netincome=($41M)(0.12)=$4.92millionROA=Netincome/TA=$4.92M/$32M=15.38%ROE=Netincome/TE=Netincome/(TA–TD)=$4.92M/($32M–11M)=23.43%3.Receivablesturnover=Sales/Receivables=$2,131,516/$308,165=6.92timesDays’salesinreceivables=365days/Receivablesturnover=365/6.92=52.77daysTheaveragecollectionperiodforanoutstandingaccountsreceivablebalancewas52.77days.4.Inventoryturnover=COGS/Inventory=$1,843,127/$921,386=2.00timesDays’salesininventory=365days/Inventoryturnover=365/2.00=182.46daysOnaverage,aunitofinventorysatontheshelf182.46daysbeforeitwassold.5.Totaldebtratio=0.45=TD/TA=TD/(TD+TE);0.55(TD)=0.45(TE)Debt-equityratio=TD/TE=0.45/0.55=0.82Equitymultiplier=1+D/E=1.826.NI=Additiontoretainedearnings+Dividends=$300K+220K=$520KEPS=NI/Shares=$520K/300K=$1.73pershareDPS=Dividends/Shares=$220K/300K=$0.73pershareBVPS=TE/Shares=$5M/300K=$16.67pershareMarket-to-bookratio=Shareprice/BVPS=$25/$16.67=1.50timesP/Eratio=Shareprice/EPS=$25/$1.73=14.42times7.ROE=(PM)(TAT)(EM)=(.11)(1.05)(1.60)=18.48%8.ROE=.1720=(.12)(1.35)(EM);EM=1.062;D/E=EM–1=0.0629.Payablesturnover=COGS/Payables=$18,364/$3,105=5.91timesDays’salesinpayables=365days/Payablesturnover=365/5.91=61.71daysThecompanyleftitsbillstosuppliersoutstandingfor61.71daysonaverage.Alargevalueforthisratiocouldimplythateither(1)thecompanyishavingliquidityproblems,makingitdifficulttopayoffitsshort-termobligations,or(2)thatthecompanyhassuccessfullynegotiatedlenientcredittermsfromitssuppliers.10.EM=1+D/E=1.80ROE=(ROA)(EM)=.084(1.80)=15.12%ROE=NI/TE;NI=(.1512)($430,000)=$65,016 CHAPTER3B-411.b=1–.30=.70;internalg=[.19(.70)]/[1–.19(.70)]=15.34%12.b=1–.40=.60;sustainableg=[.17(.60)]/[1–.17(.60)]=11.36%13.ROE=(PM)(TAT)(EM)=(.102)(1/.70)(1+.50)=21.86%b=1–($6,000/$30,000)=.80;sustainableg=[.2186(.80)]/[1–.2186(.80)]=21.19%14.ROE=(PM)(TAT)(EM)=(.065)(1.90)(2.05)=25.32%b=1–.30=.70;sustainableg=[.2532(.70)]/[1–.2532(.70)]=21.54%15.2002#152003#15AssetsCurrentassetsCash$16,1502.30%$19,1252.57%Accountsreceivable48,7346.93%52,8167.09%Inventory100,38714.28%137,80618.50%Total$165,27123.51%$209,74728.15%FixedassetsNetplantandequipment537,69176.49%535,22771.85%Totalassets$702,962100%$744,974100%LiabilitiesandOwners’EquityCurrentliabilitiesAccountspayable$161,71023.00%$137,83018.50%Notespayable74,39110.58%96,31812.93%Total$236,10133.59%$234,14831.43%Long-termdebt150,00021.34%125,00016.78%Owners’equityCommonstockandpaid-insurplus$150,00021.34%$150,00020.13%Accumulatedretainedearnings166,86123.74%235,82631.66%Total$316,86145.08%$385,82651.79%Totalliabilitiesandowners’equity$702,962100%$744,974100%16.a.CR02=$165,271/$236,101=0.70;CR03=$209,747/$234,148=0.90b.QR02=($165,271–100,387)/$236,101=0.27QR03=($209,747–137,806)/$234,108=0.31c.Cashratio02=$16,150/$236,101=0.07;Cashratio03=$19,125/$234,148=0.08d.D/E02=($236,101+150,000)/$316,861=1.22EM02=1+D/E99=2.22D/E03=($234,148+125,000)/$385,826=0.93EM03=1+D/E00=1.93e.TDR02=($236,101+150,000)/$702,962=0.55TDR03=($234,148+125,000)/$744,974=0.4817.ROE=($157,320/$1,986,382)($1,986,382/$744,974)($744,974/$385,826)=40.77% CHAPTER3B-518.ROA=ProfitmarginTotalassetturnover;Totalassetturnover=.11/.09=1.22ROE=ROAEquitymultiplierEquitymultiplier=.24/.11=2.1819.PM=NI/sales;NI=(.13)($22,000,000)=$2,860,000ROA=NI/TA=$2,860,000/$22,500,000=12.71%20.ROA=NI/TA=$11,071/$68,000=.1628b=1–.40=.60internalg=[(.1628)(.60)]/[1–(.1628)(.60)]=10.83%21.ROE=NI/E=$11,071/$23,000=.4814b=1–.40=.60sustainableg=[(.4814)(.60)]/[1–(.4814)(.60)]=40.61%22.TAT=Sales/TA=$15M/$8M=1.875timesSales=TATAT=$8M2.25=$18M23.Debtratio=(TA–E)/TA=.70=$140,000/TA;TA=$200,000Equity=$200,000–140,000=$60,000ROE=NI/Equity=$14,000/60,000=.233324.EPS=NI/Shares=$6,100,000/3,400,000=$1.79PE=Price/EPS=$70/$1.79=39.02Bookvaluepershare=Bookvalueofequity/Shares=$31M/3.4M=$9.12pershareMarket-to-book=Marketvaluepershare/Bookvaluepershare=$70/$9.12=7.6825.TAT=Sales/TA=2.9=Sales/$8M;Sales=$23.2MROA=NI/TA=.11=NI/$8M;NI=$880,000PM=NI/Sales=$880,000/$23.2M=3.79%Intermediate26.ROE=0.12=(PM)(TAT)(EM)=(PM)(S/TA)(1+D/E)PM=[(0.12)($800)]/[(1+1)($3,680)]=.013PM=.013=NI/S;NI=.013($3,680)=$48.0027.CR=1.20=CA/CL;CA=1.20($750)=$900.00PM=.09=NI/sales;NI=.09($3,920)=$352.80ROE=.185=NI/TE;TE=$352.80/.185=$1,907.03Long-termdebtratio=0.65=LTD/(LTD+TE)1+TE/LTD=1.538;LTD=$1,907.03/.538=$3,541.62TD=CL+LTD=$750+$3,541.62=$4,291.62TA=TD+TE=$4,291.62+$1,907.03=$6,198.65NFA=TA–CA=$6,198.65–900.00=$5,298.65 CHAPTER3B-628.Child:profit=$0.50/$25=2%;store:profitmargin=NI/S=$4.5/$450M=1%Theadvertisementisreferringtothestore’sprofitmargin,butamoreappropriateearningsmeasureforthefirm’sownersisthereturnonequity.ROE=NI/TE=NI/(TA–TD)=$4.5M/($105.0M–67.5M)=12.00%29.Days’salesinreceivables=21.50days=365days/ReceivablesturnoverReceivablesturnover=Sales/Days’salesinreceivablesSales=($138,600)(365)/21.50=$2,352,976.74PM=NI/S=$141,200/$2,352,976.74=6.00%TAT=S/TA=$2,352,976.74/$960,000=2.45timesEM=1+D/E=2.15ROE=(PM)(TAT)(EM)=(.0600)(2.45)(2.15)=31.62%30.Netincome=(1–t)EBT;EBT=$6,820/0.66=$10,333.33EBIT=EBT+Interestpaid=$10,333.33+1,931=$12,264.33Cashcoverageratio=(EBIT+Depreciationexpense)/InterestCashcoverageratio=($12,264.33+1,380)/$1,931=7.07times31.Sales–COGS–Dep.=EBIT=$380K–93K–47K=$240KDPS=Dividends/Shares;Dividends=$1.70(20,000)=$34KNetincome=Dividends+Additionstoretainedearnings=$34,000+61,420=$95,420EBT=NI/(1–t)=$95,420/0.66=$144,575.76EBIT–EBT=Interestpaid=$240,000–$144,575.76=$95,424.24Timesinterestearnedratio=EBIT/interest=$240,000/$95,242.24=2.52times32.Totaldebtratio=TD/TA=.40=$300K/TA;TA=$300K/.40=$750KTA=TD+E=$750K=$300K+E;E=$450KROE=NI/E=.15=NI/$450K;NI=(.15)($450K)=$67,500ROA=NI/TA=$67,500/$750K=9.00%33.PM=NI/S=–£10,386/£161,583=–6.43%Aslongasbothnetincomeandsalesaremeasuredinthesamecurrency,thereisnoproblem;infact,exceptforsomemarketvalueratioslikeEPSandBVPS,noneofthefinancialratiosdiscussedinthetextaremeasuredintermsofcurrency.Thisisonereasonwhyfinancialratioanalysisiswidelyusedininternationalfinancetocomparethebusinessoperationsoffirmsand/ordivisionsacrossnationaleconomicborders.NI=–0.0643($362,814)=–$23,320.4434.Short-termsolvencyratios:CR02=$10,210/$3,014=3.39timesCR03=$12,700/$3,050=4.16timesQR02=($10,210–6,218)/$3,014=1.32timesQR03=($12,700–6,462)/$3,050=2.05timesCashratio02=$1,180/$3,014=0.39timesCashratio03=$2,122/$3,050=0.70times CHAPTER3B-7Assetutilizationratios:TAT=$26,800/$36,516=0.73timesInventoryturnover=$8,400/$6,462=1.30timesReceivablesturnover=$26,800/$4,116=6.51timesLong-termsolvencyratios:Totaldebtratio02=($3,014+9,815)/$33,582=0.38Totaldebtratio03=($3,050+10,518)/$36,516=0.37D/E02=($3,014+9,815)/$20,753=0.62D/E03=($3,050+10,518)/$22,984=0.59EM02=1+D/E02=1.62;EM03=1+D/E03=1.59TIEratio=$17,000/$1,250=13.60timesCashcoverageratio=($17,000+1,400)/$1,250=14.72timesProfitabilityratios:PM=$10,395/$26,800=38.79%ROA=$10,395/$36,516=28.47%ROE=$10,395/$22,948=45.30%35.ROE=(NI/Sales)(Sales/TA)(TA/E)=($10,395/$26,800)($26,800/$36,516)($36,516/$22,948)=0.453036.EPS=$10,395/10,000shares=$1.0395pershareP/Eratio=$24/$1.0395=23.09timesDPS=$8,200/10,000shares=$0.82pershareBVPS=$22,948/10,000shares=$2.2948pershareMarket-to-bookratio=$24.00/$2.2948=10.46times37.Thecurrentratioappearstoberelativelyhighwhencomparedtothemedian,howeveritisbelowtheupperquartile,meaningthatatleast25percentoffirmsintheindustryhaveahighercurrentratio.Overall,itdoesnotappearthatthecurrentratioisoutoflinewiththeindustry.Thetotalassetturnoverislowwhencomparedtotheindustry.Infact,thetotalassetturnoverisinthelowerquartile.Thismeansthatthecompanydoesnotuseassetsasefficientlyoverallorthatthecompanyhasnewerassetsthantheindustry.Thiswouldmeanthattheassetshavenotbeendepreciated,whichwouldmeanahigherbookvalueandalowertotalassetturnover.Thedebt-equityratioisinlinewiththeindustry,betweenthemeanandtheupperquartile.Theprofitmarginisapproximatelythreetimesaslargeastheindustrymedianandovertwiceaslargeastheupperquartile,whichisexceptional.Thecompanymaybebetteratcontrollingcosts,orhasabetterproductwhichenablesthemtochargeapremiumprice.38.b=1–.40=.60;sustainableg=.08=[ROE(.60)]/[1–ROE(.60)];ROE=12.35%ROE=.1235=PM(1/1.50)(1+.55);PM=(.1235)(1.50)/1.55=11.95%39.b=1–.30=.70;sustainableg=.09=[ROE(.70)]/[1–ROE(.70)];ROE=11.80%ROE=.1180=(.07)(1/.8)EM;EM=(.1180)(.8)/.07=1.35;D/E=.3540.b=1–.70=.30;internalg=.06=[ROA(.30)]/[1–ROA(.30)];ROA=.1887ROA=.1887=(PM)(TAT);TAT=.1887/.11=1.715 CHAPTER3B-841.TDR=0.60=TD/TA;1/0.60=TA/TD=1+TE/TD;D/E=1/[(1/0.60)–1]=1.5ROE=(PM)(TAT)(EM)=(.085)(1.50)(1+1.5)=.31875ROA=(PM)(TAT)=.085(1.50)=12.75%;b=1–.40=.60;sustainableg=[.31875(.60)]/[1–.31875(.60)]=23.65%42.b=1–($2,100/$7,000)=.30;ROE=NI/TE=$7,000/$24,000=29.17%sustainableg=[.70(.2917)]/[1–.70(.2917)]=25.65%newTA=1.2565($75,000)=$94,240.84newTD=[D/(D+E)](TA)=(51/75)($94,240.84)=$64,083.77additionalborrowing=$64,083.77–$51,000=$13,083.77ROA=NI/TA=$7,000/$75,000=.0933;internalg=[.0933(.70)]/[1–.0933(.70)]=6.99%43.ROE=(PM)(TAT)(EM)=(.08)(0.95)(1+0.3)=9.88%sustainableg=.13=[.0988(b)]/[1–.0988(b)];b=1.16;payoutratio=1–b=–.16Thisisanegativedividendpayoutratioof116%,whichisimpossible;thegrowthrateisnotconsistentwiththeotherconstraints.Thelowestpossiblepayoutrateis0,whichcorrespondstob=1,ortotalearningsretention.maxsustainableg=.0988/(1–.0988)=10.96% CHAPTER4INTRODUCTIONTOVALUATION:THETIMEVALUEOFMONEYAnswerstoConceptsReviewandCriticalThinkingQuestions1.Thefourpartsarethepresentvalue(PV),thefuturevalue(FV),thediscountrate(r),andthelifeoftheinvestment(t).2.Compoundingreferstothegrowthofadollaramountthroughtimeviareinvestmentofinterestearned.Itisalsotheprocessofdeterminingthefuturevalueofaninvestment.Discountingistheprocessofdeterminingthevaluetodayofanamounttobereceivedinthefuture.3.Futurevaluesgrow(assumingapositiverateofreturn);presentvaluesshrink.4.Thefuturevaluerises(assumingapositiverateofreturn);thepresentvaluefalls.5.Itwouldappeartobebothdeceptiveandunethicaltorunsuchanadwithoutadisclaimerorexplanation.6.It’sareflectionofthetimevalueofmoney.GMACgetstousethe$500immediately.IfGMACusesitwisely,itwillbeworthmorethan$10,000inthirtyyears.7.Oddlyenough,itactuallymakesitmoredesirablesinceGMAConlyhastherighttopaythefull$10,000beforeitisdue.Thisisanexampleofa“call”feature.Suchfeaturesarediscussedinalaterchapter.8.Thekeyconsiderationswouldbe:(1)Istherateofreturnimplicitintheofferattractiverelativetoother,similarriskinvestments?and(2)Howriskyistheinvestment;i.e.,howcertainarewethatwewillactuallygetthe$10,000?Thus,ouranswerdoesdependonwhoismakingthepromisetorepay.9.TheTreasurysecuritywouldhaveasomewhathigherpricebecausetheTreasuryisthestrongestofallborrowers,thereforehasalowerrateofreturn.10.Thepricewouldbehigherbecause,astimepasses,thepriceofthesecuritywilltendtorisetoward$10,000.Thisriseisjustareflectionofthetimevalueofmoney.Astimepasses,thetimeuntilreceiptofthe$10,000growsshorter,andthepresentvaluerises.In2006,thepricewillprobablybehigherforthesamereason.Wecannotbesure,however,becauseinterestratescouldbemuchhigher,orGMAC’sfinancialpositioncoulddeteriorate.Eithereventwouldtendtodepressthesecurity’sprice.SolutionstoQuestionsandProblemsBasic1.$5,000(1.06)10=$8,954.24;$3,954.24–300(10)=$954.2432.FV=$2,250(1.18)=$3,696.8210FV=$9,310(1.06)=$16,672.7917FV=$81,550(1.12)=$559,925.63 CHAPTER4B-222FV=$210,384(1.07)=$932,085.6443.PV=$15,451/(1.04)=$13,207.589PV=$51,557/(1.12)=$18,591.9714PV=$886,073/(1.22)=$54,756.02PV=$550,164/(1.20)18=$20,664.7341/44.FV=$307=$221(1+r);r=($307/$221)–1=8.56%81/8FV=$761=$425(1+r);r=($761/$425)–1=7.55%161/16FV=$136,771=$25,000(1+r);r=($136,771/$25,000)–1=11.21%251/25FV=$255,810=$40,200(1+r);r=($255,810/$40,200)–1=7.68%t5.FV=$1,105=$250(1.04);t=ln($1,105/$250)/ln1.04=37.89yrstFV=$3,860=$1,941(1.09);t=ln($3,860/$1,941)/ln1.09=7.98yrstFV=$387,120=$21,320(1.23);t=ln($387,120/$21,320)/ln1.23=14.00yrstFV=$198,212=$32,500(1.34);t=ln($198,212/$32,500)/ln1.34=6.18yrs181/186.FV=$300,000=$40,000(1+r);r=($300,000/$40,000)–1=11.84%7.FV=$2=$1(1.09)t;t=ln2/ln1.09=8.04yrstFV=$4=$1(1.09);t=ln4/ln1.09=16.09yrs151/158.FV=$40,000=$10,000(1+r);r=($40,000/$10,000)–1=9.68%t9.FV=$120,000=$26,000(1.035);t=ln($120,000/$26,000)/ln1.035=44.46yrs2010.PV=$950M/(1.08)=$203,820,7978011.PV=$2M/(1.12)=$230.9910312.FV=$50(1.0425)=$3,637.511061/10613.FV=$900,000=$150(1+r);r=($900,000/$150)=8.55%39FV=$900,000(1.0855)=$22,096,171.203614.PV=$750/(1.1386)=$7.01615.FV=$2.2M/(1+r)=$3.52M;r=–7.53%Intermediate3016.a.FV=$10,000/(1+r)=$500;r=10.50%20b.FV=$6,340.81/(1+r)=$500;r=13.54%10c.FV=$10,000/(1+r)=$6,340.81;r=4.66% CHAPTER4B-31017.PV=$120,000/(1.115)=$40,404.764518.FV=$2,000(1.12)=$327,975.2135FV=$2,000(1.12)=$105,599.24Betterstartearly!619.FV=$28,000(1.07)=$42,020.45t20.FV=$120,000=$40,000(1.08);t=ln($120,000/$40,000)/ln1.08=14.27yrsFromnow,you’llwait2+14.27=16.27yrs12021.RotenBank:FV=$8,000(1.01)=$26,403.1010BrookBank:FV=$8,000(1.12)=$24,846.79622.FV=$4=$1(1+r);r=25.99%t23.FV=$2,500=$1,100(1.003);t=274.07months9624.PV=$50,000/(1.0065)=$26,844.004025.PV=$1M/(1.12)=$10,746.8040PV=$1M/(1.06)=$97,222.19CalculatorSolutions1.Enter106%$5,000I/YPVPMTFVNSolvefor$8,954.24$3,954.24–10($300)=$954.242.Enter318%$2,250I/YPVPMTFVNSolvefor$3,696.82Enter106%$9,310I/YPVPMTFVNSolvefor$16,672.79Enter1712%$81,550I/YPVPMTFVNSolvefor$559,925.63Enter227%$210,384I/YPVPMTFVNSolvefor$932,085.64 CHAPTER4B-43.Enter44%$15,451I/YPVPMTFVNSolvefor–$13,207.58Enter912%$51,557I/YPVPMTFVNSolvefor–$18,591.97Enter1422%$886,073I/YPVPMTFVNSolvefor–$54,756.02Enter1820%$550,164I/YPVPMTFVNSolvefor–$20,664.734.Enter4$221$307I/YPVPMTFVNSolvefor8.56%Enter8$425$761I/YPVPMTFVNSolvefor7.55%Enter16$25,000$136,771I/YPVPMTFVNSolvefor11.21%Enter25$40,200$255,810I/YPVPMTFVNSolvefor7.68%5.Enter4%$250$1,105I/YPVPMTFVNSolvefor37.89Enter9%$1,941$3,860I/YPVPMTFVN CHAPTER4B-5Solvefor7.98Enter23%$21,320$387,120I/YPVPMTFVNSolvefor14.00Enter34%$32,500$198,212I/YPVPMTFVNSolvefor6.186.Enter18$40,000$300,000I/YPVPMTFVNSolvefor11.84%7.Enter9%$1$2I/YPVPMTFVNSolvefor8.04Enter9%$1$4I/YPVPMTFVNSolvefor16.098.Enter15$10,000$40,000I/YPVPMTFVNSolvefor9.68%9.Enter3.5%$26,000$120,000I/YPVPMTFVNSolvefor44.4610.Enter208%$950,000,000I/YPVPMTFVNSolvefor–$203,820,79711.Enter8012%$2,000,000I/YPVPMTFVNSolvefor–$230.9912. CHAPTER4B-6Enter1034.25%$50I/YPVPMTFVNSolvefor$3,637.5113.Enter106$150$900,000I/YPVPMTFVNSolvefor8.55%Enter398.55%$900,000I/YPVPMTFVNSolvefor$22,096,171.2014.Enter3613.86%$750I/YPVPMTFVNSolvefor–$7.0115.Enter6$3,520,000$2,200,000I/YPVPMTFVNSolvefor–7.53%16.a.Enter30$500$10,000I/YPVPMTFVNSolvefor10.50%b.Enter20$500$6,340.81I/YPVPMTFVNSolvefor13.54%c.Enter10$6,340.81$10,000I/YPVPMTFVNSolvefor4.66%17.Enter1011.5%$120,000I/YPVPMTFVNSolvefor–$40,404.7618.Enter4512%$2,000I/YPVPMTFVN CHAPTER4B-7Solvefor$327,975.21Enter3512%$2,000I/YPVPMTFVNSolvefor$105,599.2419.Enter67%$28,000I/YPVPMTFVNSolvefor$42,020.4520.Enter8%$40,000$120,000I/YPVPMTFVNSolvefor14.27Youmustwait2+14.27=16.27years.21.Enter1201%$8,000I/YPVPMTFVNSolvefor$26,403.10Enter1012%$8,000I/YPVPMTFVNSolvefor$24,846.7922.Enter6$1$4I/YPVPMTFVNSolvefor25.99%23.Enter.3%$1,100$2,500I/YPVPMTFVNSolvefor274.0724.Enter96.65%$50,000I/YPVPMTFVNSolvefor–$26,844.0025.Enter4012%$1,000,000I/YPVPMTFVNSolvefor–$10,746.80 CHAPTER4B-8Enter406%$1,000,000I/YPVPMTFVNSolvefor–$97,222.19 CHAPTER5DISCOUNTEDCASHFLOWVALUATIONAnswerstoConceptsReviewandCriticalThinkingQuestions1.Thefourpiecesarethepresentvalue(PV),theperiodiccashflow(C),thediscountrate(r),andthenumberofpayments,orthelifeoftheannuity,t.2.Assumingpositivecashflowsandapositiveinterestrate,boththepresentandthefuturevaluewillrise.3.Assumingpositivecashflowsandapositiveinterestrate,thepresentvaluewillfall,andthefuturevaluewillrise.4.It’sdeceptive,butverycommon.Thedeceptionisparticularlyirritatinggiventhatsuchlotteriesareusuallygovernmentsponsored!5.Ifthetotalmoneyisfixed,youwantasmuchaspossibleassoonaspossible.Theteam(or,moreaccurately,theteamowner)wantsjusttheopposite.6.Thebetterdealistheonewithequalinstalments.7.Yes,theyshould.APRsgenerallydon’tprovidetherelevantrate.Theonlyadvantageisthattheyareeasiertocompute,but,withmoderncomputingequipment,thatadvantageisnotveryimportant.8.Afreshmandoes.Thereasonisthatthefreshmangetstousethemoneyformuchlongerbeforeintereststartstoaccrue.9.Thesubsidyisthepresentvalue(onthedaytheloanismade)oftheinterestthatwouldhaveaccruedupuntilthetimeitactuallybeginstoaccrue.10.Theproblemisthatthesubsidymakesiteasiertorepaytheloan,notobtainit.However,abilitytorepaytheloandependsonfutureemployment,notcurrentneed.Forexample,considerastudentwhoiscurrentlyneedy,butispreparingforacareerinahigh-payingarea(suchascorporatefinance!).Shouldthisstudentreceivethesubsidy?Howaboutastudentwhoiscurrentlynotneedy,butispreparingforarelativelylow-payingjob(suchasbecomingacollegeprofessor)?SolutionstoQuestionsandProblemsBasic2341.PV@10%=$700/1.10+$300/1.10+$1,200/1.10+$1,600/1.10=$2,878.70234PV@18%=$700/1.18+$300/1.18+$1,200/1.18+$1,600/1.18=$2,364.29234PV@24%=$700/1.24+$300/1.24+$1,200/1.24+$1,600/1.24=$2,065.77 CHAPTER5B-2102.X@5%:PVA=$4,000{[1–(1/1.05)]/.05}=$30,886.944Y@5%:PVA=$8,000{[1–(1/1.05)]/.05}=$28,367.6010X@15%:PVA=$4,000{[1–(1/1.15)]/.15}=$20,075.074Y@15%:PVA=$8,000{[1–(1/1.15)]/.15}=$22,839.83323.FV@8%=$500(1.08)+$900(1.08)+$1,100(1.08)+$1,300=$4,167.6232FV@11%=$500(1.11)+$900(1.11)+$1,100(1.11)+$1,300=$4,313.7132FV@24%=$500(1.24)+$900(1.24)+$1,100(1.24)+$1,300=$5,001.15154.PVA@15yrs:PVA=$6,000{[1–(1/1.08)]/.08}=$51,356.8740PVA@40yrs:PVA=$6,000{[1–(1/1.08)]/.08}=$71,547.6875PVA@75yrs:PVA=$6,000{[1–(1/1.08)]/.08}=$74,766.50PVA@forever:PVA=$6,000/.08=$75,000125.PVA=$10,000=$C{[1–(1/1.095)]/.095};C=$10,000/6.9838=$1,431.8886.PVA=$50,000{[1–(1/1.0875)]/.0875}=$279,331.08;canaffordthesystem.207.FV@20yrs=$2,000[(1.075–1)/.075]=$86,609.3640FV@40yrs=$2,000[(1.075–1)/.075]=$454,513.0478.FVA=$50,000=$C[(1.0375–1)/.0375];C=$50,000/7.8386=$6,378.6879.PVA=$20,000=$C{[1–(1/1.11)]/.11};C=$20,000/4.71219=$4,244.3110.PV=$10,000/.09=$111,111.1111.PV=$120,000=$10,000/r;r=$10,000/$120,000=8.33%412.EAR=[1+(.07/4)]–1=7.19%12EAR=[1+(.09/12)]–1=9.38%365EAR=[1+(.12/365)]–1=12.75%2EAR=[1+(.16/2)]–1=16.64%21/213.EAR=.09=[1+(APR/2)]–1;APR=2[(1.09)–1]=8.81%121/12EAR=.19=[1+(APR/12)]–1;APR=12[(1.19)–1]=17.52%521/52EAR=.08=[1+(APR/52)]–1;APR=52[(1.08)–1]=7.70%3651/365EAR=.15=[1+(APR/365)]–1;APR=365[(1.15)–1]=13.98%1214.FirstNational:EAR=[1+(.126/12)]–1=13.35%2FirstUnited:EAR=[1+(.128/2)]–1=13.21%3651/36515.EAR=.16=[1+(APR/365)]–1;APR=365[(1.16)–1]=14.85%Theborrowerisactuallypayingannualizedinterestof16%peryear,notthe14.85%reportedontheloancontract.2416.FV=$1,420[1+(.10/2)]=$4,579.64 CHAPTER5B-35(365)17.FVin5years=$5,000[1+(.026/365)]=$5,694.1210(365)FVin10years=$5,000[1+(.026/365)]=$6,484.5920(365)FVin20years=$5,000[1+(.026/365)]=$8,409.986(365)18.PV=$60,000/[1+(.08/365)]=$37,128.961219.APR=12(20%)=240%;EAR=[1+(.20)]–1=791.61%6020.PVA=$52,350=$C[1–{1/[1+(.086/12)]}/(.086/12)];C=$52,350/48.6269=$1,076.57EAR=[1+(.086/12)]12–1=8.95%tt21.PVA=$11,652=$400{[1–(1/1.014)]/.014};1/1.014=1–[($11,652)(.014)/($400)]t1.014=1/(0.59218)=1.68868;t=ln1.68868/ln1.014=37.69months22.$3(1+r)=$4;r=$4/$3–1=33.33%perweek52APR=(52)33.33%=1,733.33%;EAR=[1+(.3333)]–1=313,916,515.69%23.PV=$130,000=$2,000/r;r=$2,000/$130,000=1.54%permonth12Nominalreturn=12(1.54%)=18.46%peryear;Effectivereturn=[1.0154]–1=20.11%peryear36024.FVA=$200[{[1+(.11/12)]–1}/(.11/12)]=$560,903.951225.EAR=[1+(.11/12)]–1=11.57%30FVA=$2,400[(1.1157–1)/.1157]=$533,184.021626.PVA=$1,500{[1–(1/1.005)]/.005}=$23,009.8923427.PV=$600/1.10+$800/1.10+$400/1.10+$900/1.10=$2,121.8523428.PV=$1,500/1.1165+$3,200/1.1165+$6,800/1.1165+$8,100/1.1165=$14,008.84Intermediate101/1029.(.07)(10)=(1+r)–1;r=1.7–1=5.45%30.PVA=$68,000/[1+(.095/12)]=$67,465.9060PVA=$67,465.90=$C{[{1–{1/[1+(.095/12)]}]/(.095/12)};C=$1,416.916631.FV=$5,000[1+(.018/12)][1+(.21/12)]=$5,598.64Interest=$5,598.64–5,000.00=$598.6432.First:$72,000(.05)=$3,600peryear($100,000–72,000)/$3,600=7.78yearstSecond:$100,000=$72,000[1+(.05/12)];t=79.01months=6.58years1233.FV=$1(1.0112)=$1.1424FV=$1(1.0112)=$1.31 CHAPTER5B-4t34.FV=$720=$500(1+.0075);t=48.80months2435.PVA1=$6,100{[1–(1/1.0058)]/.0058}=$136,244.1124PVA2=$30,000+$4,500{[1–(1/1.0058)]/.0058}=$130,507.952036.PVA=$15,000[1–(1/1.11)/.11]=$119,449.92661/637.G:$40,000=[$70,000/(1+r)]=0;(1+r)=$70,000/$40,000;r=(7/4)–1=9.78%12111/12H:$40,000=[$120,000/(1+r)]=0;(1+r)=$120,000/$40,000;r=(3)–1=9.59%38.PVAfallsasrincreases,andPVArisesasrdecreasesFVArisesasrincreases,andFVAfallsasrdecreases10PVA@10%=$4,000{[1–(1/1.10)]/.10}=$24,578.2710PVA@5%=$4,000{[1–(1/1.05)]/.05}=$30,886.9410PVA@15%=$4,000{[1–(1/1.15)]/.15}=$20,075.07t39.FVA=$40,000=$120[{[1+(.12/12)]–1}/(.12/12)];t1.01=1+[($40,000)(.12/12)/$120];t=ln4.33/ln1.01=147.37payments6040.PVA=$50,000=$1,300[{1–[1/(1+r)]}/r];solvingonafinancialcalculator,orbytrialanderror,givesr=1.59%;APR=12(1.59%)=19.11%234541.PV=$2,900,000/1.12+$3,770,000/1.12+$4,640,000/1.12+$5,510,000/1.12+$6,380,000/1.12+678910$7,250,000/1.12+$8,120,000/1.12+$8,990,000/1.12+$9,860,000/1.12+$10,730,000/1.12=$34,006,704.09234542.PV=$3,000,000/1.12+$3,900,000/1.12+$4,800,000/1.12+$5,700,000/1.12+$6,600,000/1.12+67$7,500,000/1.12+$8,400,000/1.12=$24,171,109.85ThePVofShaq’scontractrevealsthatRobinsondidachievehisgoalofbeingpaidmorethananyotherrookieinNBAhistory.Thedifferentcontractlengthsareanimportantfactorwhencomparingthepresentvalueofthecontracts.Abettermethodofcomparisonwouldbetoexpressthecostofhiringeachplayeronanannualbasis.Thistypeofproblemwillbeinvestigatedinalaterchapter.36043.PVA=0.80($1,450,000)=$9,800[{1–[1/(1+r)]}/r];solvingonafinancialcalculator,orbytrialanderror,givesr=0.7962%permonth12APR=12(0.7962%)=9.55%;EAR=(1.007962)–1=9.98%344.PV=$10,000/1.12=$71,178.02;thefirmwillmakeaprofitprofit=$71,178.02–67,000.00=$4,178.0231/3$67,000=$100,000/(1+r);r=(100/67)–1=14.28%45.$12,000=$10,800(1+r);r=11.11%Becauseofthediscount,youonlygettheuseof$10,800,andtheinterestyoupayonthatamountis11.11%,not10%.446.a.PVA=$750{[1–(1/1.10)]/.10}=$2,377.403b.PVA=$750+$750{[1–(1/1.10)]/.10}=$2,615.14 CHAPTER5B-5nd47.PV@0%=$10million;choosethe2payout10ndPV@10%=$10M/1.1=$3,855,432.89million;choosethe2payout10stPV@20%=$10M/1.2=$1,615,055.83million;choosethe1payout48.Semiannualrate=0.15/2=.07510PVA=$5,000{[1–(1/1.075)]/.075}=$34,320.408PV@t=5;$34,320.40/1.075=$19,243.5312PV@t=3;$34,320.40/1.075=$14,409.5618PV@t=0;$34,320.40/1.075=$9,336.841649.PVA=$920{[1–(1/1.10)]/.10}=$7,197.81@year44PV=$7,197.81/1.10=$4,916.204850.PVA1=$1,500[{1–1/[1+(.13/12)]}/(.13/12)]=$55,912.7872PVA2=$1,500[{1–1/[1+(.09/12)]}/(.09/12)]=$83,215.2748PV=$55,912.78+{$83,215.27/[1+(.13/12)]}=$105,524.5212051.A:FVA=$1,500[{[1+(.09/12)]–1}/(.09/12)]=$290,271.4210B:FV=$290,271.42=PV(1+.07);PV=$147,559.2752.PV@t=13:$510/.0775=$6,580.654PV@t=9:$6,580.65/1.0775=$4,882.021253.PVA=$20,000=$1,916.67{(1–[1/(1+r)])/r};solvingonafinancialcalculator,orbytrialanderror,givesr=2.219%permonth12APR=12(2.219%)=26.62%;EAR=(1.02219)–1=30.12%3254.FV@5years=$30,000(1.102)+$45,000(1.102)+$75,000=$169,796.38FV@10years=$169,796.38(1.102)5=$275,953.81BeginningTotalInterestPrincipalEnding55.YearBalancePaymentPaidPaymentBalance1$60,000.00$24,552.78$6,600.00$17,952.78$42,047.22242,047.2224,552.784,625.1919,927.5922,119.63322,119.6324,552.782,433.1622,119.630.00Inthethirdyear,$2,433.16ofinterestispaid.Totalinterestoverlifeoftheloan=$6,600+4,625.19+2,433.16=$13,658.35BeginningTotalInterestPrincipalEnding56.YearBalancePaymentPaidPaymentBalance1$60,000.00$26,600.00$6,600.00$20,000.00$40,000.00240,000.0024,400.004,400.0020,000.0020,000.00320,000.0022,200.002,200.0020,000.000Inthethirdyear,$2,200.00interestispaid.Totalinterestoverlifeoftheloan=$6,600+4,400+2,200=$13,200 CHAPTER5B-6CalculatorSolutions1.CFo$0CFo$0CFo$0C01$700C01$700C01$700F011F011F011C02$300C02$300C02$300F021F021F021C03$1,200C03$1,200C03$1,200F031F031F031C04$1,600C04$1,600C04$1,600F041F041F041I=10I=18I=24NPVCPTNPVCPTNPVCPT$2,878.70$2,364.29$2,065.772.Enter105%$4,000I/YPVPMTFVNSolvefor$30,886.94Enter45%$8,000I/YPVPMTFVNSolvefor$28,367.60Enter1015%$4,000I/YPVPMTFVNSolvefor$20,075.07Enter415%$8,000I/YPVPMTFVNSolvefor$22,839.833.Enter38%$500I/YPVPMTFVNSolvefor$629.86Enter28%$900I/YPVPMTFVNSolvefor$1,049.76 CHAPTER5B-7Enter18%$1,100I/YPVPMTFVNSolvefor$1,188.00FV=$629.86+1,049.76+1,188.00+1,300.00=$4,167.62Enter311%$500I/YPVPMTFVNSolvefor$683.82Enter211%$900I/YPVPMTFVNSolvefor$1,108.89Enter111%$1,100I/YPVPMTFVNSolvefor$1,221.00FV=$683.82+1,108.89+1,221.00+1,300=$4,313.71Enter324%$500I/YPVPMTFVNSolvefor$953.31Enter224%$900I/YPVPMTFVNSolvefor$1,383.84Enter124%$1,100I/YPVPMTFVNSolvefor$1,364.00FV=$953.31+1,383.84+1,364.00+1,300.00=$5,001.154.Enter158%–$6,000I/YPVPMTFVNSolvefor$51,356.87Enter408%–$6,000I/YPVPMTFVNSolvefor$71,547.68 CHAPTER5B-8Enter758%–$6,000I/YPVPMTFVNSolvefor$74,766.505.Enter129.5%–$10,000I/YPVPMTFVNSolvefor$1,431.886.Enter88.75%–$50,000I/YPVPMTFVNSolvefor$297,331.087.Enter207.5%–$2,000I/YPVPMTFVNSolvefor$86,608.36Enter407.5%–$2,000I/YPVPMTFVNSolvefor$454,513.048.Enter73.75%$50,000I/YPVPMTFVNSolvefor–$6,378.689.Enter711%$20,000I/YPVPMTFVNSolvefor–$4,244.3112.Enter7%4NOMEFFC/YSolvefor7.19%Enter9%12NOMEFFC/YSolvefor9.38% CHAPTER5B-9Enter12%365NOMEFFC/YSolvefor12.75%Enter16%2NOMEFFC/YSolvefor16.64%13.Enter9%2NOMEFFC/YSolvefor8.81%Enter19%12NOMEFFC/YSolvefor17.52%Enter8%52NOMEFFC/YSolvefor7.70%Enter15%365NOMEFFC/YSolvefor13.98%14.Enter12.6%12NOMEFFC/YSolvefor13.35%Enter12.8%2NOMEFFC/YSolvefor13.21%15.Enter16%365NOMEFFC/YSolvefor14.85% CHAPTER5B-1016.Enter245%–$1,420I/YPVPMTFVNSolvefor$4,579.6417.Enter53652.6%/365–$5,000I/YPVPMTFVNSolvefor$5,694.12Enter103652.6%/365–$5,000I/YPVPMTFVNSolvefor$6,484.59Enter203652.6%/12–$5,000I/YPVPMTFVNSolvefor$8,409.9818.Enter63658%/365$60,000I/YPVPMTFVNSolvefor–$37,128.9619.APR=12(20%)=240%Enter240%12NOMEFFC/YSolvefor796.61%20.Enter608.6%/12–$52,350I/YPVPMTFVNSolvefor$1,076.57Enter8.6%12NOMEFFC/YSolvefor8.95%21.Enter1.4%–$11,652$400I/YPVPMTFVNSolvefor37.69 CHAPTER5B-1122.Enter1–$3$4I/YPVPMTFVNSolvefor33.33%APR=52(33.33%)=1,733.33333%Enter1,733.3333%52NOMEFFC/YSolvefor313,916,515%24.Enter301211%/12–$200I/YPVPMTFVNSolvefor$560,903.9525.Enter11%12NOMEFFC/YSolvefor11.5718836%Enter3011.5718836%–$20012I/YPVPMTFVNSolvefor$533,184.0226.Enter44.50%$1,500I/YPVPMTFVNSolvefor$23,009.8927.CFo$0C01$600F011C02$800F021C03$400F031C04$900F041I=10NPVCPT$2,121.85 CHAPTER5B-1228.CFo$0C01$1,500F011C02$3,200F021C03$6,800F031C04$8,100F041I=11.65NPVCPT$14,008.8429.FirstSimple:$100(.07)=$7;10yearinvestment=$100+10($7)=$170Enter10–$100$170I/YPVPMTFVNSolvefor5.45%ndnd30.2BGN2SETEnter609.5%/12–$68,000I/YPVPMTFVNSolvefor$1,416.9131.Enter61.80%/12–$5,000I/YPVPMTFVNSolvefor$5,045.17Enter621%/12–$5,045.17I/YPVPMTFVNSolvefor$5,598.64Interest=$5,598.64–5,000.00=$598.6432.First:$72,000(.05)=$3,600peryear($100,000–72,000)/$3,600=7.78yearsSecond:Enter5%/12–$72,000$100,000I/YPVPMTFVNSolvefor79.00579.002/12=6.58years CHAPTER5B-1333.Enter121.12%–$1I/YPVPMTFVNSolvefor$1.14Enter241.12%–$1I/YPVPMTFVNSolvefor$1.3134.Enter0.75%–$500$720I/YPVPMTFVNSolvefor48.8035.Enter247%/12–$6,100I/YPVPMTFVNSolvefor$136,244.11Enter247%/12–$4,500I/YPVPMTFVNSolvefor$100,507.95$100,507.95+30,000=$130,507.9536.Enter2011%–$15,000I/YPVPMTFVNSolvefor$119,449.9237.Enter6–$40,000$70,000I/YPVPMTFVNSolvefor9.78%Enter12–$40,000$120,000I/YPVPMTFVNSolvefor9.59%38.Enter1010%–$4,000I/YPVPMTFVNSolvefor$24,578.27 CHAPTER5B-14Enter105%–$4,000I/YPVPMTFVNSolvefor$30,886.94Enter1015%–$4,000I/YPVPMTFVNSolvefor$20,075.0739.Enter12%/12–$120$40,000I/YPVPMTFVNSolvefor147.3740.Enter60–$50,000$1,300I/YPVPMTFVNSolvefor1.59%APR=1.59%(12)=19.11%442.1.CFo$0CFo$0C01$2,900,000C01$3,000,000F011F011C02$3,770,000C02$3,900,000F021F021C03$4,640,000C03$4,800,000F031F031C04$5,510,000C04$5,700,000F041F041C05$6,380,000C05$6,600,000F051F051C06$7,250,000C06$7,500,000F061F061C07$8,120,000C07$8,400,000F071F071C08$8,990,000C08F081F08C09$9,860,000C09F091F09C010$10,730,000C010I=12%I=12%NPVCPTNPVCPT$34,006,704.09$24,171,109.85 CHAPTER5B-1543.Enter3012.80($1,450,000–$9,800)I/YPVPMTFVNSolvefor0.796%APR=0.796%(12)=9.55%Enter9.55%12NOMEFFC/YSolvefor9.98%44.Enter312%$100,000I/YPVPMTFVNSolvefor–$71,178.02profit=$71,178.02–67,000=$4,178.02Enter3–$67,000$100,000I/YPVPMTFVNSolvefor14.28%45.Enter1–$10,800$12,000I/YPVPMTFVNSolvefor11.11%46.Enter410%–$750I/YPVPMTFVNSolvefor$2,377.40ndnd2BGN2SETEnter410%–$750I/YPVPMTFVNSolvefor$2,615.1447.Enter1010%–$10,000,000I/YPVPMTFVNSolvefor$3,855,432.89Enter1020%–$10,000,000I/YPVPMTFVNSolvefor$1,615,055.83 CHAPTER5B-1648.Valueatt=9Enter1015%/2–$5,000I/YPVPMTFVNSolvefor$34,320.40Valueatt=5Enter3215%/2–$33,950.04I/YPVPMTFVNSolvefor$19,243.53Valueatt=3Enter6215%/2–$34,320.40I/YPVPMTFVNSolvefor$14,409.56ValuetodayEnter9215%/2–$34,320.40I/YPVPMTFVNSolvefor$9,336.8449.Valueatt=4Enter1610%$920I/YPVPMTFVNSolvefor$7,197.81ValuetodayEnter410%–$7,197.81I/YPVPMTFVNSolvefor$4,916.2050.Valueatt=4Enter6129%/12–$1,500I/YPVPMTFVNSolvefor$83,215.27ValuetodayEnter41213%/13$1,500$83,215.27I/YPVPMTFVNSolvefor–$105,524.52 CHAPTER5B-1751.FVofAEnter10129%/12–$1,500I/YPVPMTFVNSolvefor$290,271.42ValuetoinvestinBEnter107%$290,271.42I/YPVPMTFVNSolvefor–$147,559.2753.Enter12–$20,000$1,916.67I/YPVPMTFVNSolvefor2.2185%APR=2.2185%(12)=26.62%Enter26.62%12NOMEFFC/YSolvefor30.12%54.Enter310.2%–$30,000I/YPVPMTFVNSolvefor$40,148.20Enter210.2%–$45,000I/YPVPMTFVNSolvefor$54,648.18Valueatt=5:$40,148.20+54,648.18+75,000=$169,796.38Valueatt=10:Enter510.2%–$169,796.38I/YPVPMTFVNSolvefor$275,953.81 CHAPTER6INTERESTRATESANDBONDVALUATIONAnswerstoConceptsReviewandCriticalThinkingQuestions1.No.Asinterestratesfluctuate,thevalueofaTreasurysecuritywillfluctuate.Long-termTreasurysecuritieshavesubstantialinterestraterisk.2.Allelsethesame,theTreasurysecuritywillhavelowercouponsbecauseofitslowerdefaultrisk,soitwillhavegreaterinterestraterisk.3.No.Ifthebidwerehigherthantheask,theimplicationwouldbethatadealerwaswillingtosellabondandimmediatelybuyitbackatahigherprice.Howmanysuchtransactionswouldyouliketodo?4.Pricesandyieldsmoveinoppositedirections.Sincethebidpricemustbelower,thebidyieldmustbehigher.5.Therearetwobenefits.First,thecompanycantakeadvantageofinterestratedeclinesbycallinginanissueandreplacingitwithalowercouponissue.Second,acompanymightwishtoeliminateacovenantforsomereason.Callingtheissuedoesthis.Thecosttothecompanyisahighercoupon.Aputprovisionisdesirablefromaninvestor’sstandpoint,soithelpsthecompanybyreducingthecouponrateonthebond.Thecosttothecompanyisthatitmayhavetobuybackthebondatanunattractiveprice.6.Bondissuerslookatoutstandingbondsofsimilarmaturityandrisk.Theyieldsonsuchbondsareusedtoestablishthecouponratenecessaryforaparticularissuetoinitiallysellforparvalue.Bondissuersalsosimplyaskpotentialpurchaserswhatcouponratewouldbenecessarytoattractthem.Thecouponrateisfixedandsimplydetermineswhatthebond’scouponpaymentswillbe.Therequiredreturniswhatinvestorsactuallydemandontheissue,anditwillfluctuatethroughtime.Thecouponrateandrequiredreturnareequalonlyifthebondsellsforexactlypar.7.Yes.Someinvestorshaveobligationsthataredenominatedindollars;i.e.,theyarenominal.Theirprimaryconcernisthataninvestmentprovidetheneedednominaldollaramounts.Pensionfunds,forexample,oftenmustplanforpensionpaymentsmanyyearsinthefuture.Ifthosepaymentsarefixedindollarterms,thenitisthenominalreturnonaninvestmentthatisimportant.8.Companiespaytohavetheirbondsratedsimplybecauseunratedbondscanbedifficulttosell;manylargeinvestorsareprohibitedfrominvestinginunratedissues.9.Treasurybondshavenocreditrisk,soaratingisnotnecessary.Junkbondsoftenarenotratedbecausetherewouldnopointinanissuerpayingaratingagencytoassignitsbondsalowrating(it’slikepayingsomeonetokickyou!). CHAPTER6B-210.Thetermstructureisbasedonpurediscountbonds.Theyieldcurveisbasedoncoupon-bearingissues.11.Bondratingshaveasubjectivefactortothem.Splitratingsreflectadifferenceofopinionamongcreditagencies.12.Asageneralconstitutionalprinciple,thefederalgovernmentcannottaxthestateswithouttheirconsentifdoingsowouldinterferewithstategovernmentfunctions.Atonetime,thisprinciplewasthoughttoprovideforthetax-exemptstatusofmunicipalinterestpayments.However,moderncourtrulingsmakeitclearthatCongresscanrevokethemunicipalexemption,sotheonlybasisnowappearstobehistoricalprecedent.Thefactthatthestatesandthefederalgovernmentdonottaxeachother’ssecuritiesisreferredtoas“reciprocalimmunity.”13.Lackoftransparencymeansthatabuyerorsellercan’tseerecenttransactions,soitismuchhardertodeterminewhatthebestbidandaskpricesareatanypointintime.14.Onemeasureofliquidityisthebid-askspread.Liquidinstrumentshaverelativelysmallspreads.LookingatFigure6.4,thebellwetherbondhasaspreadofonetick;itisoneofthemostliquidofallinvestments.Generally,liquiditydeclinesafterabondisissued.Someolderbonds,includingsomeofthecallableissues,havespreadsaswideassixticks.15.Companieschargethatbondratingagenciesarepressuringthemtopayforbondratings.Whenacompanypaysforarating,ithastheopportunitytomakeitscaseforaparticularrating.Withanunsolicitedrating,thecompanyhasnoinput.16.A100-yearbondlookslikeashareofpreferredstock.Inparticular,itisaloanwithalifethatalmostcertainlyexceedsthelifeofthelender,assumingthatthelenderisanindividual.Withajunkbond,thecreditriskcanbesohighthattheborrowerisalmostcertaintodefault,meaningthatthecreditorsareverylikelytoendupaspartownersofthebusiness.Inbothcases,the“equityindisguise”hasasignificanttaxadvantage.SolutionstoQuestionsandProblemsBasic1.Theyieldtomaturityistherequiredrateofreturnonabondexpressedasanominalannualinterestrate.Fornoncallablebonds,theyieldtomaturityandrequiredrateofreturnareinterchangeableterms.UnlikeYTMandrequiredreturn,thecouponrateisnotareturnusedastheinterestrateinbondcashflowvaluation,butisafixedpercentageofparoverthelifeofthebondusedtosetthecouponpaymentamount.Fortheexamplegiven,thecouponrateonthebondisstill10percent,andtheYTMis8percent.2.Priceandyieldmoveinoppositedirections;ifinterestratesrise,thepriceofthebondwillfall.Thisisbecausethefixedcouponpaymentsdeterminedbythefixedcouponratearenotasvaluablewheninterestratesrise—hence,thepriceofthebonddecreases.3.P=$90(PVIFA8%,12)+$1000(PVIF8%,12)=$1,075.364.$902.25=$70(PVIFAR%,8)+$1000(PVIFR%,8);R=YTM=8.75% CHAPTER6B-35.$905=$C(PVIFA8.5%,13)+$1000(PVIF8.5%,13);C=$72.648;couponrate=7.26%6.P=$37.50(PVIFA4.3%,20)+$1000(PVIF4.3%,20)=$927.207.$840=$42.00(PVIFAR%,26)+$1000(PVIFR%,26);R=5.534%;YTM=25.354=10.71%8.$1,090=$C(PVIFA4.25%,21)+$1000(PVIF4.25%,21);C=$49.06;couponrate=24.906=9.81%9.Approximate=.05–.014=.036;Exactr=[(1+.05)/(1+0.014)]–1;r=3.55%10.(1+.035)(1+.05)–1=8.675%11.(1+.14)=(1+i)–(1+.10);i=3.64%12.(1+r)(1+.04)–1=0.14;r=9.62%13.Thisisanote.Couponrate=3.50%.Bidprice=96:08=96.25%$1,000=$962.50Previousday’saskedprice=today’saskedprice–change=9609/32–08/32=9601/32or96:01=96.03125%$1,000=$960.312514.Thisisapremiumbondbecauseitsellsformorethan100%offacevalue.Currentyield=$61.25/$1,032.1875=5.93%;YTM=5.88%Bid-Askspread=103:08–103:07=1/32Intermediate15.X:P0=$90(PVIFA7%,13)+$1000(PVIF7%,13)=$1,167.15P1=$90(PVIFA7%,12)+$1000(PVIF7%,12)=$1,158.85P3=$90(PVIFA7%,10)+$1000(PVIF7%,10)=$1,140.47P8=$90(PVIFA7%,5)+$1000(PVIF7%,5)=$1,082.00P12=$90(PVIFA7%,1)+$1000(PVIF7%,1)=$1,018.69;P13=$1,000Y:P0=$50(PVIFA7%,13)+$1000(PVIF7%,13)=$832.85P1=$50(PVIFA7%,12)+$1000(PVIF7%,12)=$841.15P3=$50(PVIFA7%,10)+$1000(PVIF7%,10)=$859.53P8=$50(PVIFA7%,5)+$1000(PVIF7%,5)=$918.00P12=$50(PVIFA7%,1)+$1000(PVIF7%,1)=$981.31;P12=$1,000Allelseheldequal,thepremiumoverparvalueforapremiumbonddeclinesasmaturityappro-aches,andthediscountfromparvalueforadiscountbonddeclinesasmaturityapproaches.Inbothcases,thelargestpercentagepricechangesoccurattheshortestmaturitylengths.16.Ifbothbondssellatpar,theinitialYTMonbothbondsisthecouponrate,8percent.IftheYTMsuddenlyrisesto10percent:PBill=$40(PVIFA5%,6)+$1000(PVIF5%,6)=$949.24PTed=$40(PVIFA5%,40)+$1000(PVIF5%,40)=$828.41PBill%=($949.24–1000)/$1000=–5.08%PTed%=($828.41–1000)/$1000=–17.16% CHAPTER6B-4IftheYTMsuddenlyfallsto6percent:PBill=$40(PVIFA3%,6)+$1000(PVIF3%,6)=$1,054.17PTed=$40(PVIFA3%,40)+$1000(PVIF3%,40)=$1,231.15PBill%=($1,054.17–1000)/$1000=+5.42%PTed%=($1,231.15–1000)/$1000=+23.11%Allelsethesame,thelongerthematurityofabond,thegreaterisitspricesensitivitytochangesininterestrates.17.Initially,ataYTMof9percent,thepricesofthetwobondsare:PJ=$20(PVIFA4.5%,16)+$1000(PVIF4.5%,16)=$719.15PK=$70(PVIFA4.5%,16)+$1000(PVIF4.5%,16)=$1,280.85IftheYTMrisesfrom9percentto11percent:PJ=$20(PVIFA5.5%,16)+$1000(PVIF5.5%,16)=$633.82PK=$60(PVIFA5.5%,16)+$1000(PVIF5.5%,16)=$1,156.93PJ%=($633.82–719.15)/$719.15=–11.86%PK%=($1,156.93–1,280.85)/$1,280.85=–9.67%IftheYTMdeclinesfrom9percentto7percent:PJ=$20(PVIFA3.5%,16)+$1000(PVIF3.5%,16)=$818.59PK=$70(PVIFA3.5%,16)+$1000(PVIF3.5%,16)=$1,423.29PJ%=($818.59–719.15)/$719.15=+13.83%PK%=($1,423.29–1,280.85)/$1,280.85=+11.12%Allelsethesame,thelowerthecouponrateonabond,thegreaterisitspricesensitivitytochangesininterestrates.18.$1,050=$45(PVIFAR%,24)+$1000(PVIFR%,24);R=4.166%,YTM=24.166=8.33%2Currentyield=$90/$1,050=8.57%;effectiveannualyield=(1.04166)–1=8.51%19.Thecompanyshouldsetthecouponrateonitsnewbondsequaltotherequiredreturn;therequiredreturncanbeobservedinthemarketbyfindingtheYTMonoutstandingbondsofthecompany.P=$1,094=$50(PVIFAR%,40)+$1000(PVIFR%,40);R=4.4899%;YTM=24.4899=8.98%20.Currentyield=.074=$84.50/P0;P0=$84.50/.074=$1,141.89=114.19%ofparBondcloseddown.50,soyesterday’sclose=114.69.21.a.Thebondpriceisthepresentvaluetermwhenvaluingthecashflowsfromabond;YTMistheinterestrateusedindiscountingthefuturecashflows(couponpaymentsandprincipal)backtotheirpresentvalues.b.Ifthecouponrateishigherthantherequiredreturnonabond,thebondwillsellatapremium,sinceitprovidesperiodicincomeintheformofcouponpaymentsinexcessofthatrequiredbyinvestorsonothersimilarbonds.Ifthecouponrateislowerthantherequiredreturnonabond,thebondwillsellatadiscount,sinceitprovidesinsufficientcouponpaymentscomparedtothatrequiredbyinvestorsonothersimilarbonds.Forpremiumbonds,thecouponrateexceedstheYTM;fordiscountbonds,theYTMexceedsthecouponrate,andforbondssellingatpar,theYTMisequaltothecouponrate. CHAPTER6B-5c.Currentyieldisdefinedastheannualcouponpaymentdividedbythecurrentbondprice.Forpremiumbonds,thecurrentyieldexceedstheYTM,fordiscountbondsthecurrentyieldislessthantheYTM,andforbondssellingatparvalue,thecurrentyieldisequaltotheYTM.Inallcases,thecurrentyieldplustheexpectedone-periodcapitalgainsyieldofthebondmustbeequaltotherequiredreturn.3022.a.P0=$1,000/1.09=$75.3729b.P1=$1,000/1.09=$82.15;year1interestdeduction=$82.15–75.37=$6.78P29=$1,000/1.09=$917.43;year30interestdeduction=$1,000–917.43=$82.57c.Totalinterest=$1,000–75.37=$924.63Annualinterestdeduction=$924.63/30=$30.82d.Thecompanywillpreferstraight-linemethodswhenallowedbecausethevaluableinterestdeductionsoccurearlierinthelifeofthebond.23.a.Thecouponbondshavea9%couponwhichmatchesthe9%requiredreturn,sotheywillsellatpar;#ofbonds=$15M/$1,000=15,000.20Forthezeroes,P0=$1,000/1.08=$214.55;$15M/$214.55=69,914bondswillbeissued.b.Couponbonds:repayment=15,000($1,080)=$16.2MZeroes:repayment=69,914($1,000)=$69,914,000c.Couponbonds:(15,000)($80)(1–.35)=$780,000cashoutflow19Zeroes:P1=$1,000/1.08=$231.71year1interestdeduction=$231.71–214.55=$17.16(69,914)($17.16)(.35)=$419,903.48cashinflowDuringthelifeofthebond,thezerogeneratescashinflowstothefirmintheformoftheinteresttaxshieldofdebt.24.Thematurityisindeterminate;abondsellingatparcanhaveanylengthofmaturity.25.$1,274.69=$49.375(PVIFAR%,32)+$1000(PVIFR%,32);R=3.497%,YTM=23.497=6.99%26.P0=$26.25(PVIFA3.55%,54)+$1000(PVIF3.55%,54)=$779.05Bidprice=$779.05–2(.0625)(10)=$778.4227.$1,099.38=$C(PVIFA3.31%,6)+$1000(PVIF3.31%,6);C=$51.63couponrate=10.33%28.$590=$30(PVIFAR%,70)+$1000(PVIFR%,70);R=5.19%,YTM=25.19=10.38%29.P0=$57.50(PVIFA5.04%,6)+$1000(PVIF5.04%,6)=$1,035.99Currentyield=$115/$1,035.99=11.10%30.$906.30=$C(PVIFA5.37%,12)+$1000(PVIF5.37%,12);C=$42.91;couponrate=8.58% CHAPTER6B-6CalculatorSolutions3.Enter128%$90$1,000I/YPVPMTFVNSolvefor–$1,075.364.Enter8–$902.25$70$1,000I/YPVPMTFVNSolvefor8.75%5.Enter138.5%–$905$1,000I/YPVPMTFVNSolvefor$72.65Coupon=7.26%6.Enter1028.6%/2$75/2$1,000I/YPVPMTFVNSolvefor–$927.207.Enter132–$840$84/2$1,000I/YPVPMTFVNSolvefor5.35%YTM=5.35%2=10.71%8.Enter10.528.5%/2–$1,090$1,000I/YPVPMTFVNSolvefor$49.06Annualcoupon=$49.062=$98.12;Couponrate=9.81%15.BondXEnter137%$90$1,000I/YPVPMTFVNSolvefor–$1,167.15Enter127%$90$1,000I/YPVPMTFVNSolvefor–$1,158.85 CHAPTER6B-7Enter107%$90$1,000I/YPVPMTFVNSolvefor–$1,140.47Enter57%$90$1,000I/YPVPMTFVNSolvefor–$1,082.00Enter17%$90$1,000I/YPVPMTFVNSolvefor–$1,018.69BondYEnter137%$50$1,000I/YPVPMTFVNSolvefor–$832.85Enter127%$50$1,000I/YPVPMTFVNSolvefor–$841.15Enter107%$50$1,000I/YPVPMTFVNSolvefor–$859.53Enter57%$50$1,000I/YPVPMTFVNSolvefor–$918.00Enter17%$50$1,000I/YPVPMTFVNSolvefor–$981.3116.Ifbothbondssellatpar,theinitialYTMonbothbondsisthecouponrate,8percent.IftheYTMsuddenlyrisesto10percent:PBillEnter65%$40$1,000I/YPVPMTFVNSolvefor–$949.24 CHAPTER6B-8PTedEnter405%$40$1,000I/YPVPMTFVNSolvefor–$828.41PBill%=($949.24–1000)/$1000=–5.08%PTed%=($828.41–1000)/$1000=–17.16%IftheYTMsuddenlyfallsto6percent:PBillEnter63%$40$1,000I/YPVPMTFVNSolvefor–$1,054.17PTedEnter403%$40$1,000I/YPVPMTFVNSolvefor–$1,231.15PBill%=($1,054.17–1000)/$1000=+5.42%PTed%=($1,231.15–1000)/$1000=+23.11%Allelsethesame,thelongerthematurityofabond,thegreaterisitspricesensitivitytochangesininterestrates.17.Initially,ataYTMof9percent,thepricesofthetwobondsare:PJEnter164.5%$20$1,000I/YPVPMTFVNSolvefor–$719.15PKEnter164.5%$70$1,000I/YPVPMTFVNSolvefor–$1,280.85IftheYTMrisesfrom9percentto11percent:PJEnter165.5%$20$1,000I/YPVPMTFVNSolvefor–$633.82PKEnter165.5%$70$1,000I/YPVPMTFVNSolvefor–$1,156.93 CHAPTER6B-9PJ%=($633.82–719.15)/$719.15=–11.86%PK%=($1,156.93–1,280.85)/$1,280.85=–9.67%IftheYTMdeclinesfrom9percentto7percent:PJEnter163.5%$20$1,000I/YPVPMTFVNSolvefor–$818.59PKEnter163.5%$70$1,000I/YPVPMTFVNSolvefor–$1,423.29PJ%=($818.59–719.15)/$719.15=+13.83%PK%=($1,423.29–1,280.85)/$1,280.85=+11.12%Allelsethesame,thelowerthecouponrateonabond,thegreaterisitspricesensitivitytochangesininterestrates.18.Enter122–$1,050$90/2$1,000I/YPVPMTFVNSolvefor4.166YTM=24.166=8.33%2Currentyield=$90/$1,050=8.57%;effectiveannualyield=(1.04166)–1=8.51%19.Thecompanyshouldsetthecouponrateonitsnewbondsequaltotherequiredreturn;therequiredreturncanbeobservedinthemarketbyfindingtheYTMonoutstandingbondsofthecompany.Enter202–$1,094$100/2$1,000I/YPVPMTFVNSolvefor4.4899%YTM=24.4899=8.98%22.a.Enter309%$1,000I/YPVPMTFVNSolvefor–$75.37b.Enter299%$1,000I/YPVPMTFVNSolvefor–$82.15year1interestdeduction=$82.15–75.37=$6.78 CHAPTER6B-10Enter19%$1,000I/YPVPMTFVNSolvefor–$917.43year30interestdeduction=$1,000–917.43=$82.57c.Totalinterest=$1,000–75.37=$924.63Annualinterestdeduction=$924.63/30=$30.82d.Thecompanywillpreferstraight-linemethodswhenallowedbecausethevaluableinterestdeductionsoccurearlierinthelifeofthebond.23.a.Thecouponbondshavea9%couponwhichmatchesthe9%requiredreturn,sotheywillsellatpar;#ofbonds=$15M/$1,000=15,000.Forthezeroes,P0=Enter208%$1,000I/YPVPMTFVNSolvefor–$214.55$15M/$214.55=69,914bondswillbeissued.b.Couponbonds:repayment=15,000($1,080)=$16.2MZeroes:repayment=69,914($1,000)=$69,914,000c.Couponbonds:(15,000)($80)(1–.35)=$780,000cashoutflow19Zeroes:P1=$1,000/1.08=$231.71Enter198%$1,000I/YPVPMTFVNSolvefor–$231.71year1interestdeduction=$231.71–214.55=$17.16(69,914)($17.16)(.35)=$419,903.48cashinflowDuringthelifeofthebond,thezerogeneratescashinflowstothefirmintheformoftheinteresttaxshieldofdebt.25.Enter162–$1,274.69$98.75/2$1,000I/YPVPMTFVNSolvefor3.497%YTM=23.497=6.99%26.Enter2727.10%/2$52.50/2$1,000I/YPVPMTFVNSolvefor–$779.05Bidprice=$779.05–2(.0625)(10)=$778.42 CHAPTER6B-1127.Enter326.62%/2–$1,099.38$1,000I/YPVPMTFVNSolvefor$51.63couponrate=10.33%28.Enter352–$590$60/2$1,000I/YPVPMTFVNSolvefor5.19%YTM=25.19=10.38%29.Enter3210.08%/2$115/2$1,000I/YPVPMTFVNSolvefor–$1,035.99Currentyield=$115/$1,035.99=11.10%30.Enter6210.74%/2–$906.30$1,000I/YPVPMTFVNSolvefor$42.90couponrate=8.58% CHAPTER7EQUITYMARKETSANDSTOCKVALUATIONAnswerstoConceptsReviewandCriticalThinkingQuestions1.Thevalueofanyinvestmentdependsonitscashflows;i.e.,whatinvestorswillactuallyreceive.Thecashflowsfromashareofstockarethedividends.2.Investorsbelievethecompanywilleventuallystartpayingdividends(orbesoldtoanothercompany).3.Ingeneral,companiesthatneedthecashwilloftenforgodividendssincedividendsareacashexpense.Young,growingcompanieswithprofitableinvestmentopportunitiesareoneexample;anotherexampleisacompanyinfinancialdistress.Thisquestionisexaminedindepthinalaterchapter.4.Thegeneralmethodforvaluingashareofstockistofindthepresentvalueofallexpectedfuturedividends.Thedividendgrowthmodelpresentedinthetextisonlyvalid(i)ifdividendsareexpectedtooccurforever,thatis,thestockprovidesdividendsinperpetuity,and(ii)ifaconstantgrowthrateofdividendsoccursforever.Aviolationofthefirstassumptionmightbeacompanythatisexpectedtoceaseoperationsanddissolveitselfsomefinitenumberofyearsfromnow.Thestockofsuchacompanywouldbevaluedbythemethodsofthischapterbyapplyingthegeneralmethodofvaluation.Aviolationofthesecondassumptionmightbeastart-upfirmthatisn’tcurrentlypayinganydividends,butisexpectedtoeventuallystartmakingdividendpaymentssomenumberofyearsfromnow.Thisstockwouldalsobevaluedbythegeneraldividendvaluationmethodofthischapter.5.Thecommonstockprobablyhasahigherpricebecausethedividendcangrowwhereasitisfixedonthepreferred.However,thepreferredislessriskybecauseofthedividendandliquidationpreference,soitispossiblethepreferredcouldbeworthmore,dependingonthecircumstances.6.Thetwocomponentsarethedividendyieldandthecapitalgainsyield.Formostcompanies,thecapitalgainsyieldislarger.Thisiseasytoseeforcompaniesthatpaynodividends.Forcompaniesthatdopaydividends,thedividendyieldsarerarelyoverfivepercentandareoftenmuchless.7.Yes.Ifthedividendgrowsatasteadyrate,sodoesthestockprice.Inotherwords,thedividendgrowthrateandthecapitalgainsyieldarethesame.8.Inacorporateelection,youcanbuyvotes(bybuyingshares),somoneycanbeusedtoinfluenceorevendeterminetheoutcome.Manywouldarguethesameistrueinpoliticalelections,but,inprincipleatleast,noonehasmorethanonevote.9.Itwouldn’tseemtobe.Investorswhodon’tlikethevotingfeaturesofaparticularclassofstockareundernoobligationtobuyit. CHAPTER7B-210.Investorsbuysuchstockbecausetheywantit,recognizingthattheshareshavenovotingpower.Presumably,investorspayalittlelessforsuchsharesthantheywouldotherwise.11.Presumably,thecurrentstockvaluereflectstherisk,timing,andmagnitudeofallfuturecashflows,bothshort-termandlong-term.Ifthisiscorrect,thenthestatementisfalse.SolutionstoQuestionsandProblemsBasic1.P0=D0(1+g)/(R–g)=$2.00(1.05)/(.12–.05)=$30.0044P3=D3(1+g)/(R–g)=D0(1+g)/(R–g)=$2.00(1.05)/(.12–.05)=$34.731616P15=D15(1+g)/(R–g)=D0(1+g)/(R–g)=$2.00(1.05)/(.12–.05)=$62.372.R=D1/P0+g=$2.00/$45.00+.07=11.44%3.Dividendyield=D1/P0=4.44%;Capitalgainsyield=7%4.P0=D1/(R–g)=$5.00/(.12–.05)=$71.435.R=Dividendyield+Capitalgainsyield=.054+.06=11.40%6.Dividendyield=1/2(.15)=.075=CapitalgainsyieldD1=.075($60)=$4.50;D0(1+g)=D1,D0=$4.50/1.075=$4.197.P0=$10.00(PVIFA11%,7)=$47.128.R=D/P0=$6.00/$80.86=7.42%9.Straightvoting:200,000shares/2=100,000+1=100,001;100,001$65=$6,500,065Cumulativevoting:1/(4+1)=.20;200,000.20=40,000;40,001$65=$2,600,06510.g=R–(D1/P0)=.13–($4.20/$80)=7.75%191911.P19=D20/R=$20/.08=$250.00;P0=P19/(1+R)=$250.00/(1.08)=$57.9312.15%return:P0=$4.00/(.15–.05)=$40.0010%return:P0=$4.00/(.10–.05)=$80.00Allelseheldconstant,ahigherrequiredreturnmeansthatthestockwillsellforalowerprice.Intermediate613.P6=D7/(R–g)=$9.00/(.15–.05)=$90.00;P0=$90.00/(1.15)=$38.9123414.P0=$15/(1.12)+$18/(1.12)+$21/(1.12)+$24/(1.12)=$57.94 CHAPTER7B-315.P4=D4(1+g)/(R–g)=$3.00(1.05)/(.13–.05)=$39.38234P0=$10.00/(1.13)+$15.00/(1.13)+$7.00/(1.13)+$42.38/(1.13)=$51.443316.P3=D3(1+g)/(R–g)=D0(1+g1)(1+g2)/(R–g)=$2.50(1.25)(1.06)/(.14–.06)=$64.7022333P0=$2.50(1.25)/(1.14)+$2.50(1.25)/(1.14)+$2.50(1.25)/(1.14)+$64.70/(1.14)=$52.7117.P0=D0(1+g)/(R–g)=$10.00(0.90)/(.13+.10)=$39.1318.P0=$72=D0(1+g)/(R–g);D0=$72(.14–.06)/(1+.06)=$5.4319.Dividendyield=.04=$2.00/P0;P0=$2.00/.04=$50.00Stockcloseddown$0.25,soyesterday’sclosingprice=$50+0.25=$50.25P/E=16;EPS=$50/16=$3.125=NI/shares;NI=$3.125(1,000,000)=$3.125M20.W:P0=D0(1+g)/(R–g)=$3.75(1.10)/(.20–.10)=$41.25Dividendyield=D1/P0=3.75(1.10)/41.25=10%;Capitalgainsyield=.20–.10=10%X:P0=D0(1+g)/(R–g)=$3.75/(.20–0)=$18.75Dividendyield=D1/P0=3.75/18.75=20%;Capitalgainsyield=.20–.20=0%Y:P0=D0(1+g)/(R–g)=$3.75(0.95)/(.20+.05)=$14.25Dividendyield=D1/P0=3.75(0.95)/14.25=25%;Capitalgainsyield=.20–.25=–5%22Z:P0=D2(1+g)/(R–g)=D0(1+g1)(1+g2)/(R–g)=$3.75(1.2)(1.12)/(.20–.12)=$75.60222P0=$3.75(1.2)/(1.2)+$3.75(1.2)/(1.2)+$75.60/(1.2)=$60.00Dividendyield=D1/P0=3.75(1.2)/60=7.5%;Capitalgainsyield=.20–.075=12.5%Inallcases,therequiredreturnis20%,butthisreturnisdistributeddifferentlybetweencurrentincomeandcapitalgains.Highgrowthstockshaveanappreciablecapitalgainscomponentbutarelativelysmallcurrentincomeyield;conversely,mature,negative-growthstocksprovideahighcurrentincomebutalsopricedepreciationovertime.21.R=$1.82/$23.91=7.61%HighestR=$1.82/$23.12=7.87%LowestR=$1.82/$25.90=7.03%22.R=(D1/P0)+g=[$0.21(1.06)/$23.14]+.06=6.96%Therequiredreturndependsonthecompanyandtheindustry.Wewilldiscusshistoricalreturnsinalaterchapter,butthisrequiredreturnseemslow.ThemostbasicwaytoreconciletheanswersisthatthemarketmaybeexpectingsupernormalgrowthforDisney.23.R=(D1/P0)+g=[$1.10(1.02)/$33.14]+.02=5.39%Therequiredreturndependsonthecompanyandtheindustry.SinceDukeEnergyisaregulatedutilitycompany,thereislittleroomforgrowth.Thisisthereasonfortherelativelyhighdividendyield.Sincethecompanyhaslittlereasontokeepretainedearningsfornewprojects,amajorityofnetincomeispaidtoshareholdersintheformofdividends.Thismaychangeinthenearfuturewiththede-regulationoftheelectricityindustry.Infact,thede-regulationisprobablyalreadyaffectingtheexpectedgrowthrateforDukeEnergy. CHAPTER7B-424.R=(D1/P0)+g=[$0.50(0.988)/$20.97]–.012=1.16%ForJCPenney,samestoresaleshadfalleninrecentyears,whileatthesametimeindustrysamestoresaleshadincreased.Additionally,JCPenneypreviouslyownedtheirowncreditsubsidiarythathadlostmoneyinrecentyears.Althoughthisnumberiscorrectwhenthequotesweregathered,therequiredreturnisobviouslytoolowsinceitislowerthanTreasurybills.25.Dividendyield=Dividend/Price;Price=$0.80/.031=$25.81Yesterday’sprice=$25.81+0.13=$25.94R=(D1/P0)+g=[$0.80(1.06)/$25.81]+.06=9.29% CHAPTER8NETPRESENTVALUEANDOTHERINVESTMENTCRITERIAAnswerstoConceptsReviewandCriticalThinkingQuestions1.Apaybackperiodlessthantheproject’slifemeansthattheNPVispositiveforazerodiscountrate,butnothingmoredefinitivecanbesaid.Fordiscountratesgreaterthanzero,thepaybackperiodwillstillbelessthantheproject’slife,buttheNPVmaybepositive,zero,ornegative,dependingonwhetherthediscountrateislessthan,equalto,orgreaterthantheIRR.2.IfaprojecthasapositiveNPVforacertaindiscountrate,thenitwillalsohaveapositiveNPVforazerodiscountrate;thusthepaybackperiodmustbelessthantheprojectlife.IfNPVispositive,thenthepresentvalueoffuturecashinflowsisgreaterthantheinitialinvestmentcost;thusPImustbegreaterthan1.IfNPVispositiveforacertaindiscountrateR,thenitwillbezeroforsomelargerdiscountrateR*;thustheIRRmustbegreaterthantherequiredreturn.3.a.Paybackperiodissimplythebreak-evenpointofaseriesofcashflows.Toactuallycomputethepaybackperiod,itisassumedthatanycashflowoccurringduringagivenperiodisrealizedcontinuouslythroughouttheperiod,andnotatasinglepointintime.Thepaybackisthenthepointintimefortheseriesofcashflowswhentheinitialcashoutlaysarefullyrecovered.Givensomepredeterminedcutoffforthepaybackperiod,thedecisionruleistoacceptprojectsthatpaybackbeforethiscutoff,andrejectprojectsthattakelongertopayback.b.Theworstproblemassociatedwithpaybackperiodisthatitignoresthetimevalueofmoney.Inaddition,theselectionofahurdlepointforpaybackperiodisanarbitraryexercisethatlacksanysteadfastruleormethod.Thepaybackperiodisbiasedtowardsshort-termprojects;itfullyignoresanycashflowsthatoccurafterthecutoffpoint.c.Despiteitsshortcomings,paybackisoftenusedbecause(1)theanalysisisstraightforwardandsimpleand(2)accountingnumbersandestimatesarereadilyavailable.Materialityconsider-ationsoftenwarrantapaybackanalysisassufficient;maintenanceprojectsareanotherexamplewherethedetailedanalysisofothermethodsisoftennotneeded.Sincepaybackisbiasedtowardsliquidity,itmaybeausefulandappropriateanalysismethodforshort-termprojectswherecashmanagementismostimportant.4.a.Theaverageaccountingreturnisinterpretedasanaveragemeasureoftheaccountingperfor-manceofaprojectovertime,computedassomeaverageprofitmeasureduetotheprojectdividedbysomeaveragebalancesheetvaluefortheproject.ThistextcomputesAARasaveragenetincomewithrespecttoaverage(total)bookvalue.GivensomepredeterminedcutoffforAAR,thedecisionruleistoacceptprojectswithanAARinexcessofthetargetmeasure,andrejectallotherprojects.b.AARisnotameasureofcashflowsandmarketvalue,butameasureoffinancialstatementaccountsthatoftenbearlittlesemblancetotherelevantvalueofaproject.Inaddition,theselectionofacutoffisarbitrary,andthetimevalueofmoneyisignored.Forafinancialmanager,boththerelianceonaccountingnumbersratherthanrelevantmarketdataandtheexclusionoftimevalueofmoneyconsiderationsaretroubling.Despitetheseproblems,AARcontinuestobeusedinpracticebecause(1)theaccountinginformationisusuallyavailable,(2)analystsoftenuseaccountingratiostoanalyzefirmperformance,and(3)managerialcompensationisoftentiedtotheattainmentofcertaintargetaccountingratiogoals. CHAPTER8B-25.a.NPVissimplythesumofthepresentvaluesofaproject’scashflows.NPVspecificallymeasures,afterconsideringthetimevalueofmoney,thenetincreaseordecreaseinfirmwealthduetotheproject.ThedecisionruleistoacceptprojectsthathaveapositiveNPV,andrejectprojectswithanegativeNPV.b.NPVissuperiortotheothermethodsofanalysispresentedinthetextbecauseithasnoseriousflaws.Themethodunambiguouslyranksmutuallyexclusiveprojects,andcandifferentiatebetweenprojectsofdifferentscaleandtimehorizon.TheonlydrawbacktoNPVisthatitreliesoncashflowanddiscountratevaluesthatareoftenestimatesandnotcertain,butthisisaproblemsharedbytheotherperformancecriteriaaswell.AprojectwithNPV=$2,500impliesthatthetotalshareholderwealthofthefirmwillincreaseby$2,500iftheprojectisaccepted.6.a.TheIRRisthediscountratethatcausestheNPVofaseriesofcashflowstobeequaltozero.IRRcanthusbeinterpretedasafinancialbreak-evenrateofreturn;attheIRRdiscountrate,thenetvalueoftheprojectiszero.TheIRRdecisionruleistoacceptprojectswithIRRsgreaterthanthediscountrate,andtorejectprojectswithIRRslessthanthediscountrate.b.IRRistheinterestratethatcausesNPVforaseriesofcashflowstobezero.NPVispreferredinallsituationstoIRR;IRRcanleadtoambiguousresultsiftherearenon-conventionalcashflows,andalsoambiguouslyrankssomemutuallyexclusiveprojects.However,forstand-aloneprojectswithconventionalcashflows,IRRandNPVareinterchangeabletechniques.c.IRRisfrequentlyusedbecauseitiseasierformanyfinancialmanagersandanalyststorateperformanceinrelativeterms,suchas“12%”,thaninabsoluteterms,suchas“$46,000.”IRRmaybeapreferredmethodtoNPVinsituationswhereanappropriatediscountrateisunknownoruncertain;inthissituation,IRRwouldprovidemoreinformationabouttheprojectthanwouldNPV.7.a.Theprofitabilityindexisthepresentvalueofcashinflowsrelativetotheprojectcost.Assuch,itisabenefit/costratio,providingameasureoftherelativeprofitabilityofaproject.TheprofitabilityindexdecisionruleistoacceptprojectswithaPIgreaterthanone,andtorejectprojectswithaPIlessthanone.b.PI=(NPV+cost)/cost=1+(NPV/cost).IfafirmhasabasketofpositiveNPVprojectsandissubjecttocapitalrationing,PImayprovideagoodrankingmeasureoftheprojects,indicatingthe“bangforthebuck”ofeachparticularproject.8.PB=I/C;–I+C/R=NPV,0=–I+C/IRRsoIRR=C/I;thusIRR=1/PBForlong-livedprojectswithrelativelyconstantcashflows,thesoonertheprojectpaysback,thegreateristheIRR.9.Thereareanumberofreasons.Twoofthemostimportanthavetodowithtransportationcostsandexchangerates.ManufacturingintheU.S.placesthefinishedproductmuchclosertothepointofsale,resultinginsignificantsavingsintransportationcosts.Italsoreducesinventoriesbecausegoodsspendlesstimeintransit.Higherlaborcoststendtooffsetthesesavingstosomedegree,atleastcomparedtootherpossiblemanufacturinglocations.OfgreatimportanceisthefactthatmanufacturingintheU.S.meansthatamuchhigherproportionofthecostsarepaidindollars.Sincesalesareindollars,theneteffectistoimmunizeprofitstoalargeextentagainstfluctuationsinexchangerates.Thisissueisdiscussedingreaterdetailinthechapteroninternationalfinance. CHAPTER8B-310.Thesinglebiggestdifficulty,byfar,iscomingupwithreliablecashflowestimates.Determininganappropriatediscountrateisalsonotasimpletask.Theseissuesarediscussedingreaterdepthinthenextseveralchapters.Thepaybackapproachisprobablythesimplest,followedbytheAAR,buteventheserequirerevenueandcostprojections.Thediscountedcashflowmeasures(NPV,IRR,andprofitabilityindex)arereallyonlyslightlymoredifficultinpractice.11.Yes,theyare.Suchentitiesgenerallyneedtoallocateavailablecapitalefficiently,justasfor-profitsdo.However,itisfrequentlythecasethatthe“revenues”fromnot-for-profitventuresarenottangible.Forexample,charitablegivinghasrealopportunitycosts,butthebenefitsaregenerallyhardtomeasure.Totheextentthatbenefitsaremeasurable,thequestionofanappropriaterequiredreturnremains.Paybackrulesarecommonlyusedinsuchcases.Finally,realisticcost/benefitanalysisalongthelinesindicatedshoulddefinitelybeusedbytheU.S.governmentandwouldgoalongwaytowardbalancingthebudget!SolutionstoQuestionsandProblemsBasic1.Payback=3+($100/$600)=3.17years2.Payback=4($700)+($600/$700)=4.86years=5($700)+($250/$700)=5.36years=8($700)=$5,600;projectneverpaysbackifcostis$5,8003.A:Payback=2+($3,000/$18,000)=2.17yearsB:Payback=3+($25,000/$250,000)=3.10yearsUsingthepaybackcriterionandacutoffof3years,acceptprojectAandrejectprojectB.4.Averagenetincome=($1,210,000+$1,720,000+$1,465,000+$1,313,000)/4=$1,427,000Averagebookvalue=($13M+0)/2=$6.5MAAR=Averagenetincome/Averagebookvalue=21.95%5.0=–$90,000+$35,000/(1+IRR)+$43,000/(1+IRR)2+$40,000/(1+IRR)3IRR=14.51%0soaccepttheproject.23NPV=–$90,000+$35,000/1.23+$43,000/1.23+$40,000/1.23=–$11,627.12NPV<0sorejecttheproject.7.NPV=–$4,900+$1,000(PVIFA8%,8)=$846.64;accepttheprojectifR=8%NPV=–$4,900+$1,000(PVIFA24%,8)=–$1,478.78;rejecttheprojectifR=24%0=–$4,900+$1,000(PVIFAIRR,8);IRR=12.39%;indifferentabouttheprojectifR=12.39%238.0=–$2,200+$640/(1+IRR)+$800/(1+IRR)+$1,900/(1+IRR);IRR=19.72% CHAPTER8B-49.@0%:NPV=–$2,200+$640+$800+$1,900=$1,140.0023@10%:NPV=–$2,200+$640/1.1+$800/1.1+$1,900/1.1=$470.4723@20%:NPV=–$2,200+$640/1.2+$800/1.2+$1,900/1.2=–$11.5723@30%:NPV=–$2,200+$640/1.3+$800/1.3+$1,900/1.3=–$369.5023410.a.A:$20,000=$10,000/(1+IRR)+$7,000/(1+IRR)+$5,000/(1+IRR)+$3,000/(1+IRR)IRR=11.93%234B:$20,000=$4,000/(1+IRR)+$4,500/(1+IRR)+$9,000/(1+IRR)+$9,500/(1+IRR)IRR=11.19%IRRA>IRRB,soIRRdecisionruleimpliesacceptprojectA.Thismaynotbeacorrectdecisionhowever,becausetheIRRcriterionhasarankingproblemformutuallyexclusiveprojects.ToseeiftheIRRdecisionruleiscorrectornot,weneedtoevaluatetheprojectNPVs.234b.A:NPV=–$20,000+$10,000/1.11+$7,000/1.11+$5,000/1.11+$3,000/1.11=$322.52234B:NPV=–$20,000+$4,000/1.11+$4,500/1.11+$9,000/1.11+$9,500/1.11=$94.57NPVA0soaccepttheproject.22b.$28M=$53M/(1+IRR)–$8M/(1+IRR)…$28M(1+IRR)–$53M(1+IRR)+$8M=0IRR=72.75%,–83.46%WhentherearemultipleIRRs,theIRRdecisionruleisambiguous;inthiscase,ifthecorrectIRRis72.75%,thenwewouldaccepttheproject,butifthecorrectIRRis–83.46%,wewouldrejecttheproject.2313.PI=[$6,500/1.10+$4,000/1.10+$2,500/1.10]/$10,000=1.10923=[$6,500/1.15+$4,000/1.15+$2,500/1.15]/$10,000=1.03223=[$6,500/1.22+$4,000/1.22+$2,500/1.22]/$10,000=0.939 CHAPTER8B-514.a.PII=$13,000(PVIFA9%,3)/$30,000=1.097;PIII=$2,600(PVIFA9%,3)/$4,500=1.463TheprofitabilityindexdecisionruleimpliesacceptprojectII,sincePIII>PIIb.NPVI=–$30,000+$13,000(PVIFA9%,3)=$2,906.83NPVII=–$4,500+$2,600(PVIFA9%,3)=$2,081.37NPVdecisionruleimpliesacceptI,sinceNPVI>NPVIIc.Usingtheprofitabilityindextocomparemutuallyexclusiveprojectscanbeambiguouswhenthemagnitudeofthecashflowsforthetwoprojectsareofdifferentscale.Inthisproblem,projectIislargerthanprojectIIandproducesalargerNPV,yettheprofitabilityindexcriterionimpliesthatprojectIIismoreacceptable.15.a.PBA=3+($133K/$425K)=3.31years;PBB=1+($8K/$10.5K)=1.76yearsPaybackcriterionimpliesacceptprojectB,becauseitpaysbacksoonerthanprojectA.234b.A:NPV=–$210K+$15K/1.15+$30K/1.15+$32K/1.15+$425K/1.15=$89,763.44234B:NPV=–$20K+$12K/1.15+$10.5K/1.15+$9.5K/1.15+$8.2K/1.15=$9,309.07NPVcriterionimpliesacceptprojectA,becauseprojectAhasahigherNPVthanprojectB.234c.A:$210K=$15K/(1+IRR)+$30K/(1+IRR)+$32K/(1+IRR)+$425K/(1+IRR)IRR=26.90%234B:$20K=$12K/(1+IRR)+$10.5K/(1+IRR)+$9.5K/(1+IRR)+$8.2K/(1+IRR)IRR=38.30%IRRdecisionruleimpliesacceptprojectB,becauseIRRforBisgreaterthanIRRforA.234d.A:PI=[$15K/1.15+$30K/1.15+$32K/1.15+$425K/1.15]/$210K=1.427234B:PI=[$12K/1.15+$10.5K/1.15+$9.5K/1.15+$8.2K/1.15]/$20K=1.465ProfitabilityindexcriterionimpliesacceptprojectB,becauseitsPIisgreaterthanprojectA’s.e.Inthisinstance,theNPVcriterionimpliesthatyoushouldacceptprojectA,whilepaybackperiod,PIandIRRimplythatyoushouldacceptprojectB.ThefinaldecisionshouldbebasedontheNPVsinceitdoesnothavetherankingproblemassociatedwiththeothercapitalbudgetingtechniques.Therefore,youshouldacceptprojectA.23416.a.M:$35K=$10K/(1+IRR)+$21K/(1+IRR)+$15K/(1+IRR)+$14K/(1+IRR)IRR=24.78%234N:$420K=$180K/(1+IRR)+$200K/(1+IRR)+$170K/(1+IRR)+$110K//(1+IRR)IRR=22.71%234b.M:NPV=–$35K+$10K/1.15+$21K/1.15+$15K/1.15+$10K/1.15=$7,441.96234N:NPV=–$420K+$180K/1.15+$200K/1.15+$170K/1.15+$110K/1.15=$62,421.09c.AcceptprojectNsincetheNPVishigher.IRRcannotbeusedtorankmutuallyexclusiveprojects.17.a.Y:PI=$14,000(PVIFA12%,4)/$35,000=1.215Z:PI=$27,000(PFIFA12%,4)/$70,000=1.172TheprofitabilityindeximpliesacceptprojectY.b.Y:NPV=–$35,000+$14,000(PVIFA12%,4)=$7,522.89Z:NPV=–$70,000+$27,000(PFIFA12%,4)=$12,008.43TheNPVforprojectZislarger,thereforeacceptZsincetheprofitabilityindexcannotbeusedtorankmutuallyexclusiveprojects.. CHAPTER8B-623418.Crossoverrate:0=$7,000/(1+R)+$1,000/(1+R)–$3,000/(1+R)–$9,000/(1+R);R=16.75%AtalowerinterestrateprojectJismorevaluablebecauseofthehighertotalcashflows.Atahigherinterestrate,projectIbecomesmorevaluablesincethedifferentialcashflowsreceivedinthefirsttwoyearsarelargerthanthecashflowsforprojectJ.234519.a.K:PI=[$20K/1.13+$19K/1.13+$18K/1.13+$17K/1.13+$16K/1.13]/$40K=1.6042345S:PI=[$130K/1.13+$120K/1.13+$118K/1.13+$115K/1.13+$110K/1.13]/$380K=1.1082345b.K:NPV=–$40K+$20K/1.13+$19K/1.13+$18K/1.13+$17K/1.13+$16K/1.13=$24,164.38234S:NPV=–$380K+$130K/1.13+$120K/1.13+$118K/1.13+$115K/1.13+5$110K/1.13=$41,037.02c.YoushouldacceptprojectSsincetheNPVishigher.Theprofitabilityindexhasarankingproblemwithmutuallyexclusiveinvestmentprojects.20.Ifthepaybackperiodisexactlyequaltotheproject’slifethentheIRRmustbeequaltozerosincetheprojectpaysbackexactlytheinitialinvestment.Iftheprojectneverpaysbackitsinitialinvestment,thentheIRRoftheprojectmustbe<0%.21.NPV@R=0%=–$418,570+$142,180+$172,148+$118,473+$97,123=$111,354NPV@R==–$418,57023NPV=0=–$418,570+$142,180/(1+IRR)+$172,148/(1+IRR)+$118,473/(1+IRR)4+$97,123/(1+IRR);IRR=10.98%;NPV=022.a.F:Payback=2+$20,000/$30,000=2.67yearsG:Payback=1+$55,000/$60,000=1.92yearsH:Payback=3+$10,000/$160,000=3.06years2345b.F:NPV=–$100K+$50K/1.12+$30K/1.12+$30K/1.12+$20K/1.12+$20K/1.12=$13,970.982345G:NPV=–$150K+$95K/1.12+$60K/1.12+$35K/1.12+$35K/1.12+$20K/1.12=$41,157.042345H:NPV=–$200K+$60K/1.12+$70K/1.12+$60K/1.12+$160K/1.12+$40K/1.12=$76,461.78c.EventhoughprojectHdoesnotmeetthepaybackperiodofthreeyears,itdoesprovidethelargestincreaseinshareholderwealth,therefore,chooseprojectH.Paybackperiodgenerallyshouldbeignoredinthissituation.23423.a.M:$25K=$11K/(1+IRR)+$7K/(1+IRR)+$15K/(1+IRR)+$25K/(1+IRR)IRR=36.31%234N:$60K=$40K/(1+IRR)+$25K/(1+IRR)+$20K/(1+IRR)+$15K/(1+IRR)IRR=29.90%234b.M:NPV=–$25K+$11K/1.12+$7K/1.12+$15K/1.12+$25K/1.12=$16,966.44234N:NPV=–$60K+$40K/1.12+$25K/1.12+$20K/1.12+$15K/1.12=$19,412.51c.AcceptprojectNsincetheNPVishigher.IRRcannotbeusedtorankmutuallyexclusiveprojects. CHAPTER8B-7Intermediate234224.$12K=–$1K/(1+R)–$7K/(1+R)–$6K/(1+R)–$5K/(1+R)–$5K/(1+R);R=25.14%2345R:NPV=–$30K+$18K/1.2514+$12K/1.2514+$12K/1.2514+$6K/1.2514+$6K/1.2514=$2,573.972345S:NPV=–$42K+$19K/1.2514+$19K/1.2514+$18K/1.2514+$11K/1.2514+$11K/1.2514=$2,573.9723425.a.C:IRR:$100K=–$30K/(1+IRR)–$40K/(1+IRR)–$35K/(1+IRR)–$30K/(1+IRR)IRR=13.26%234D:IRR:$150K=–$65K/(1+IRR)–$60K/(1+IRR)–$50K/(1+IRR)–$30K/(1+IRR)IRR=15.71%AccordingtotheIRRdecisionruleyoushouldacceptDsincetheIRRishigherthanC.Infact,thisisonetimewheretheIRRdecisionruleisvalidonmutuallyexclusiveprojects.Sincetheprojectshaveconventionalcashflows,weknowthatprojectCmustberejectedsincetheIRRisbelowtherequiredreturn,thereforeweareleftwithonlyprojectD.Ofcourse,theseIRRsimplythatprojectCwillhaveanegativeNPVandprojectDwillhaveapositiveNPV.234b.C:NPV=–$100K+$30K/1.14+$40K/1.14+$35K/1.14+$30K/1.14=–$1,519.10234D:NPV=–$150K+$65K/1.14+$60K/1.14+$50K/1.14+$30K/1.14=$4,696.58AcceptprojectDsinceNPVD>NPVC.226.IRR:–$45,000=–$20,000/(1+IRR)–$38,000/(1+IRR);IRR=16.76%22@12%:NPV=$45,000–$20,000/1.12–$38,000/1.12=–$3,150.51@0%:NPV=$45,000–$20,000–$38,000=–$13,000.0022@25%:NPV=$45,000–$20,000/1.25–$38,000/1.25=+$4,680.00Thecashflowsfortheprojectareunconventional.Sincetheinitialcashflowispositiveandtheremainingcashflowsarenegative,thedecisionruleforIRRininvalidinthiscase.TheNPVprofileisupwardsloping,indicatingthattheprojectismorevaluablewhentheinterestrateincreases.23427.–$252=$1,431/(1+IRR)–$3,035/(1+IRR)+$2,850/(1+IRR)–$1,000/(1+IRR)IRR=25%,33.33%,42.86%,66.67%TaketheprojectwhenNPV>0,forrequiredreturnsbetween25%and33.33%orbetween42.86%and66.67%.28.SincetheNPVindexhasthecostsubtractedinthenumerator,NPVindex=PI–1.29.a.Tohaveapaybackequaltotheproject’slife,givenCisaconstantcashflowforNyears,C=I/N.b.TohaveapositiveNPV,II/(PVIFAR%,N).c.Benefits=C(PVIFAR%,N)=2costs=2IC=2I/(PVIFAR%,N) CHAPTER8B-8CalculatorSolutions5.CFo–$90,000C01$35,000F011C02$43,000F021C03$40,000F031IRRCPT14.51%6.CFo–$90,000CFo–$90,000C01$35,000C01$35,000F011F011C02$43,000C02$43,000F021F021C03$40,000C03$40,000F031F031I=9%I=23%NPVCPTNPVCPT$9,189.67–$11,627.127.CFo–$4,900CFo–$4,900CFo–$4,900C01$1,000C01$1,000C01$1,000F018F018F018I=8%I=24%IRRCPTNPVCPTNPVCPT12.39%$846.64–$1,478.788.CFo–$2,200C01$640F011C02$800F021C03$1,900F031IRRCPT19.72% CHAPTER8B-99.CFo–$2,200CFo–$2,200C01$640C01$640F011F011C02$800C02$800F021F021C03$1,900C03$1,900F031F031I=0%I=10%NPVCPTNPVCPT$1,140.00$470.47CFo–$2,200CFo–$2,200C01$640C01$640F011F011C02$800C02$800F021F021C03$1,900C03$1,900F031F031I=20%I=30%NPVCPTNPVCPT–$11.57–$369.5010.CF(A)Cfo–$20,000CFo–$20,000C01$10,000C01$10,000F011F011C02$7,000C02$7,000F021F021C03$5,000C03$5,000F031F031C04$3,000C04$3,000F041F041CPTIRRI=1111.93%NPVCPT$322.52 CHAPTER8B-10CF(B)CFo–$20,000CFo–$20,000C01$4,000C01$4,000F011F011C02$4,500C02$4,500F021F021C03$9,000C03$9,000F031F031C04$9,500C04$9,500F041F041CPTIRRI=1111.19%NPVCPT$94.57Crossoverrate:CFo$0C01–$6,000F011C02–$2,500F021C03$4,000F031C04$6,500F041CPTIRR9.52%11.CF(X)CFo–$5,000CFo–$5,000C01$2,700C01$2,700F011F011C02$1,700C02$1,700F021F021C03$1,800C03$1,800F031F031I=0I=25NPVCPTNPVCPT$1,200–$830.40 CHAPTER8B-11CF(Y)Cfo–$5,000CFo–$5,000C01$1,700C01$1,700F011F011C02$2,100C02$2,100F021F021C03$2,600C03$2,600F031F031I=0I=25NPVCPTNPVCPT$1,400–$964.80Crossoverrate:CFo$0C01–$1,000F011C02$400F021C03$800F031CPTIRR11.65%12.Cfo–$28,000,000CFo–$28,000,000C01$53,000,000C01$53,000,000F011F011C02–$8,000,000C02–$8,000,000F021F021I=12IRRCPTNPVCPT72.75%$12,943,877.55NOTE:ThisistheonlyIRRtheBAIIPluswillcalculate.ThesecondIRRof–83.46%mustbecalculatedusinganotherprogram,byhand,ortrialanderror.13.CFo$0CFo$0CFo$0C01$6,500C01$6,500C01$6,500F011F011F011C02$4,000C02$4,000C02$4,000F021F021F021C03$2,500C03$2,500C03$2,500F031F031F031I=10I=15I=22NPVCPTNPVCPTNPVCPT$11,093.16$10,320.54$9,392.09 CHAPTER8B-12@10%:PI=$11,093.16/$10,000=1.109@15%:PI=$10,320.54/$10,000=1.032@22%:PI=$9,392.09/$10,000=0.93914.CF(I)Cfo–$30,000CFo$0C01$13,000C01$13,000F013F013I=9I=9NPVCPTNPVCPT$2,906.83$32,906.83PI=$32,906.83/$30,000=1.097CF(II)Cfo–$4,500CFo$0C01$2,600C01$2,600F013F013I=9I=9NPVCPTNPVCPT$2,081.37$4,581.37PI=$6,581.37/$4,500=1.463c.Usingtheprofitabilityindextocomparemutuallyexclusiveprojectscanbeambiguouswhenthemagnitudeofthecashflowsforthetwoprojectsareofdifferentscale.Inthisproblem,projectIislargerthanprojectIIandproducesalargerNPV,yettheprofitabilityindexcriterionimpliesthatprojectIIismoreacceptable.15.CF(A)CFo–$210,000CFo–$210,000CFo$0C01$15,000C01$15,000C01$15,000F011F011F011C02$30,000C02$30,000C02$30,000F021F021F021C03$32,000C03$32,000C03$32,000F031F031F031C04$425,000C04$425,000C04$425,000F041F041F041I=15IRRCPTI=15NPVCPT26.90%NPVCPT$89,763.44$299,763.44PI=$299,763.44/$210,000=1.427 CHAPTER8B-13CF(B)CFo–$20,000CFo–$20,000CFo0C01$12,000C01$12,000C01$12,000F011F011F011C02$10,500C02$10,500C02$10,500F021F021F021C03$9,500C03$9,500C03$9,500F031F031F031C04$8,200C04$8,200C04$8,200F041F041F041I=15IRRCPTI=15NPVCPT38.30%NPVCPT$9,309.07$29,309.07PI=$29,309.07/$20,000=1.465e.Inthisinstance,theNPVcriterionimpliesthatyoushouldacceptprojectA,whilepaybackperiod,PIandIRRimplythatyoushouldacceptprojectB.ThefinaldecisionshouldbebasedontheNPVsinceitdoesnothavetherankingproblemassociatedwiththeothercapitalbudgetingtechniques.Therefore,youshouldacceptprojectA.16.ProjectMCFo–$35,000CFo–$35,000C01$10,000C01$10,000F011F011C02$21,000C02$21,000F021F021C03$15,000C03$15,000F031F031C04$14,000C04$14,000F041F041CPTIRRI=1524.78%NPVCPT$7,441.96ProjectNCFo–$420,000CFo–$35,000C01$180,000C01$10,000F011F011C02$200,000C02$21,000F021F021C03$170,000C03$15,000F031F031C04$110,000C04$14,000F041F041CPTIRRI=1522.71%NPVCPT$64,421.09 CHAPTER8B-14c.AcceptprojectNsincetheNPVishigher.IRRcannotbeusedtorankmutuallyexclusiveprojects.17.ProjectYCfo$0CFo–$35,000C01$14,000C01$14,000F014F014I=12I=12NPVCPTNPVCPT$42,522.89$7,522.89PI=$42,522.89/$35,000=1.215ProjectZCfo$0CFo–$70,000C01$27,000C01$27,000F014F014I=12I=12NPVCPTNPVCPT$82,008.43$12,008.43PI=$82,008.43/$70,000=1.172TheNPVforprojectZislarger,thereforeacceptZsincetheprofitabilityindexcannotbeusedtorankmutuallyexclusiveprojects..18.CFo$0C01$7,000F011C02$1,000F021C03–$3,000F031C04–$9,000F041CPTIRR16.75%AtalowerinterestrateprojectJismorevaluablebecauseofthehighertotalcashflows.Atahigherinterestrate,projectIbecomesmorevaluablesincethedifferentialcashflowsreceivedinthefirsttwoyearsarelargerthanthecashflowsforprojectJ. CHAPTER8B-1519.ProjectKCFo$0CFo–$40,000C01$20,000C01$20,000F011F011C02$19,000C02$19,000F021F021C03$18,000C03$18,000F031F031C04$17,000C04$17,000F041F041C05$16,000C05$16,000F051F051I=13I=13NPVCPTNPVCPT$64,164.38$24,164.38PI=$64,164.38/$40,000=1.604ProjectSCfo$0CFo–$380,000C01$130,000C01$130,000F011F011C02$120,000C02$120,000F021F021C03$118,000C03$118,000F031F031C04$115,000C04$115,000F041F041C05$110,000C05$110,000F05F05I=13I=13NPVCPTNPVCPT$421,037.02$41,037.02PI=$421,037.02/$380,000=1.108c.YoushouldacceptprojectSsincetheNPVishigher.Theprofitabilityindexhasarankingproblemwithmutuallyexclusiveinvestmentprojects. CHAPTER8B-1621.Cfo–$418,570CFo–$418,570C01$142,180C01$142,180F011F011C02$172,148C02$172,148F021F021C03$118,473C03$118,473F031F031C04$97,123C04$97,123F041F041I=0IRRCPTNPVCPT10.98%$111,354NPV@R==–$418,57022.a.F:Payback=2+$20,000/$30,000=2.67yearsG:Payback=1+$55,000/$60,000=1.92yearsH:Payback=3+$10,000/$160,000=3.06yearsProjectFProjectGProjectHCFo–$100,000CFo–$150,000CFo–$200,000C01$50,000C01$95,000C01$60,000F011F011F011C02$30,000C02$60,000C02$70,000F022F021F021C03$20,000C0335,000C03$60,000F032F032F031C04C04$20,000C04$160,000F04F041F041C05C05C05$40,000F05F05F051I=12I=12I=12NPVCPTNPVCPTNPVCPT$13,970.98$41,157.04$76,461.78c.EventhoughprojectHdoesnotmeetthepaybackperiodofthreeyears,itdoesprovidethelargestincreaseinshareholderwealth,therefore,chooseprojectH.Paybackperiodgenerallyshouldbeignoredinthissituation. CHAPTER8B-1723.ProjectXCfo–$25,000CFo–$25,000C01$11,000C01$11,000F011F011C02$7,000C02$7,000F021F021C03$15,000C03$15,000F031F031C04$25,000C04$25,000F041F041IRRCPTI=1236.31%NPVCPT$16,966.44ProjectYCfo–$60,000CFo–$60,000C01$40,000C01$40,000F011F011C02$25,000C02$25,000F021F021C03$20,000C03$20,000F031F031C04$15,000C04$15,000F041F041IRRCPTI=1229.90%NPVCPT$19,412.51c.AcceptprojectNsincetheNPVishigher.IRRcannotbeusedtorankmutuallyexclusiveprojects.24.Crossoverrate:CFo$12,000C01–$1,000F011C02–$7,000F021C03–$6,000F031C04–$5,000F042IRRCPT25.13607% CHAPTER8B-18ProjectRProjectSCFo–$30,000CFo–$42,000C01$18,000C01$19,000F011F012C02$12,000C02$18,000F022F021C03$6,000C03$11,000F032F032I=25.13607%I=25.13607%NPVCPTNPVCPT$2,573.97$2,573.9725.ProjectCCFo–$100,000CFo–$100,000C01$30,000C01$30,000F011F011C02$40,000C02$40,000F021F021C03$35,000C03$35,000F031F031C04$30,000C04$30,000F041F041IRRCPTI=1413.26%NPVCPT–$1,519.10ProjectDCfo–$150,000CFo–$150,000C01$65,000C01$65,000F011F011C02$60,000C02$60,000F021F021C03$50,000C03$50,000F031F031C04$30,000C04$30,000F041F041IRRCPTI=1415.71%NPVCPT$4,696.58AccordingtotheIRRdecisionruleyoushouldacceptDsincetheIRRishigherthanC.Infact,thisisonetimewheretheIRRdecisionruleisvalidonmutuallyexclusiveprojects.Sincetheprojectshaveconventionalcashflows,weknowthatprojectCmustberejectedsincetheIRRisbelowtherequiredreturn,thereforeweareleftwithonlyprojectD.Ofcourse,theseIRRsimplythatprojectCwillhaveanegativeNPVandprojectDwillhaveapositiveNPV. CHAPTER8B-1926.CFo$45,000C01–$20,000F011C02–$38,000F021IRRCPT16.76%CFo$45,000CFo$45,000CFo$45,000C01–$20,000C01–$20,000C01–$20,000F011F011F011C02–$38,000C02–$38,000C02–$38,000F021F021F021I=0I=12I=25NPVCPTNPVCPTNPVCPT–$13,000–$3,150.51$4,680.00Thecashflowsfortheprojectareunconventional.Sincetheinitialcashflowispositiveandtheremainingcashflowsarenegative,thedecisionruleforIRRininvalidinthiscase.TheNPVprofileisupwardsloping,indicatingthattheprojectismorevaluablewhentheinterestrateincreases.27.CFo–$252C01$1,431F011C02–$3,035F021C03$2,850F031C04–$1,000F041IRRCPTERROR7TheBAIIPluswillnotsolvethisproblemduetothenumberofiterationsnecessarytosolvetheequation.Byhand,anotherprogram,ortrialanderror,youcanfindIRR=25%,33.33%,42.86%,66.67%.TaketheprojectwhenNPV>0,forrequiredreturnsbetween25%and33.33%orbetween42.86%and66.67%. CHAPTER9MAKINGCAPITALINVESTMENTDECISIONSAnswerstoConceptsReviewandCriticalThinkingQuestions1.Inthiscontext,anopportunitycostreferstothevalueofanassetorotherinputthatwillbeusedinaproject.Therelevantcostiswhattheassetorinputisactuallyworthtoday,not,forexample,whatitcosttoacquire.2.Fortaxpurposes,afirmwouldchooseMACRSbecauseitprovidesforlargerdepreciationdeductionsearlier.Theselargerdeductionsreducetaxes,buthavenoothercashconsequences.NoticethatthechoicebetweenMACRSandstraight-lineispurelyatimevalueissue;thetotaldepreciationisthesame,onlythetimingdiffers.3.It’sprobablyonlyamildover-simplification.Currentliabilitieswillallbepaidpresumably.Thecashportionofcurrentassetswillberetrieved.Somereceivableswon’tbecollected,andsomeinventorywillnotbesold,ofcourse.Counterbalancingtheselossesisthefactthatinventorysoldabovecost(andnotreplacedattheendoftheproject’slife)actstoincreaseworkingcapital.Theseeffectstendtooffset.4.Management’sdiscretiontosetthefirm’scapitalstructureisapplicableatthefirmlevel.Sinceanyoneparticularprojectcouldbefinancedentirelywithequity,anotherprojectcouldbefinancedwithdebt,andthefirm’soverallcapitalstructureremainunchanged,financingcostsarenotrelevantintheanalysisofaproject’sincrementalcashflowsaccordingtothestand-aloneprinciple.5.Depreciationisanon-cashexpense,butitistax-deductibleontheincomestatement.Thusdeprecia-tioncausestaxespaid,anactualcashoutflow,tobereducedbyanamountequaltothedepreciationtaxshieldtCD.Areductionintaxesthatwouldotherwisebepaidisthesamethingasacashinflow,sotheeffectsofthedepreciationtaxshieldmustbeaddedintogetthetotalincrementalaftertaxcashflows.6.Therearetwoparticularlyimportantconsiderations.Thefirstiserosion.Willtheessentializedbooksimplydisplacecopiesoftheexistingbookthatwouldhaveotherwisebeensold?Thisisofspecialconcerngiventhelowerprice.Thesecondconsiderationiscompetition.Willotherpublishersstepinandproducesuchaproduct?Ifso,thenanyerosionismuchlessrelevant.Aparticularconcerntobookpublishers(andproducersofavarietyofotherproducttypes)isthatthepublisheronlymakesmoneyfromthesaleofnewbooks.Thus,itisimportanttoexaminewhetherthenewbookwoulddisplacesalesofusedbooks(goodfromthepublisher’sperspective)ornewbooks(notgood).Theconcernarisesanytimethereisanactivemarketforusedproduct.7.Thismarketwasheatinguprapidly,andanumberofothermanufacturerswereplanningcompetingproducts. CHAPTER9B-28.Onecompanymaybeabletoproduceatlowerincrementalcostormarketbetter.Forexample,GMmayhavebeenabletoretoolexistingproductionmorecheaply,andGMalsohasalargerdealernetwork.Also,ofcourse,oneofthetwomayhavemadeamistake!9.GMwouldrecognizethattheoutsizedprofitswoulddwindleasmoreproductscometomarketandcompetitionbecomesmoreintense.10.Withasensitivityanalysis,onevariableisexaminedoverabroadrangeofvalues.Withascenarioanalysis,allvariablesareexaminedforalimitedrangeofvalues.11.Itistruethatifaveragerevenueislessthanaveragecost,thefirmislosingmoney.Thismuchofthestatementisthereforecorrect.Atthemargin,however,acceptingaprojectwithamarginalrevenueinexcessofitsmarginalcostclearlyactstoincreaseoperatingcashflow.12.Theimplicationisthattheywillfacehardcapitalrationing.13.Forecastingriskistheriskthatapoordecisionismadebecauseoferrorsinprojectedcashflows.Thedangerisgreatestwithanewprojectbecausethecashflowsareprobablyhardertopredict.14.Theoptiontoabandonreflectsourabilitytoreallocateassetsifwefindourinitialestimatesweretoooptimistic.Theoptiontoexpandreflectsourabilitytoincreasecashflowsfromaprojectifwefindourinitialestimatesweretoopessimistic.Sincetheoptiontoexpandcanincreasecashflowsandtheoptiontoabandonreduceslosses,failingtoconsiderthesetwooptionswillgenerallyleadustounderestimateaproject’sNPV.SolutionstoQuestionsandProblemsBasic1.The$6millionacquisitioncostofthelandsixyearsagoisasunkcost.The$6.8millioncurrentappraisalofthelandisanopportunitycostifthelandisusedratherthansoldoff,thereforeitrepresentspartoftheproject’sinitialinvestment.The$10millioncashoutlayand$500,000gradingexpensesaretheinitialfixedassetinvestmentsneededtogettheprojectgoing.Therefore,theproperyearzerocashflowtouseinevaluatingthisprojectis$6,800,000+10,000,000+500,000=$17.3million.2.Salesduesolelytothenewproductlineare12,000($15,000)=$180million.Increasedsalesofthemotorhomelineoccurbecauseofthenewproductlineintroduction;thus2,000($50,000)=$100millioninnewsalesisrelevant.Erosionofluxurymotorcoachsalesisalsoduetothenewmid-sizecampers;thus1,000($90,000)=$90millionlossinsalesisrelevant.Thenetsalesfiguretouseinevaluatingthenewlineisthus$180million+100million–90million=$190million. CHAPTER9B-33.Sales$800,000Variablecosts480,000Fixedcosts190,000Depreciation95,000EBIT$35,000Taxes@35%12,250Netincome$22,7504.Sales$612,800OCF=EBIT+D–TVariablecosts321,680=$186,120+105,000–65,142=$225,978Depreciation105,000Depreciationtaxshield=tcDEBIT$186,120=.35($105,000)=$36,750Taxes@35%65,142Netincome$120,9785.BeginningBeginningDepreciationDepreciationEndingYearBookValue%AllowanceBookValue1$861,000.0014.29$123,036.90$737,963.102737,963.1024.49210,858.90527,104.203527,104.2017.49150,588.90376,515.304376,515.3012.49107,538.90268,976.405268,976.408.9376,887.30192,089.106192,089.108.9376,887.30115,201.807115,201.808.9376,887.3038,314.50838,314.504.4538,314.500.006.BV5=$520,000–520,000(5/8)=$195,000Theassetissoldatalosstobookvalue,sothedepreciationtaxshieldofthelossisrecaptured.Aftertaxsalvagevalue=$125,000+($195,000–125,000)(0.35)=$149,5007.BV4=$6.4M–6.4M(0.2000+0.3200+0.1920+0.1152)=$1,105,920Theassetissoldatagaintobookvalue,sothisgainistaxable.Aftertaxsalvagevalue=$1,500,000+($1,105,920–1,500,000)(0.34)=$1,366,012.808.A/Rfellby$6,720,andinventoryincreasedby$4,484,sonetcurrentassetsfellby$2,236NWC=(CA–CL)=–$2,236–7,720=–$9,956Netcashflow=S–C–NWC=$116,400–45,400–(–9,956)=$80,956 CHAPTER9B-49.Sales$1,920,000Costs985,000Depreciation600,000EBIT335,000Taxes117,250Netincome$217,750OCF=EBIT+D–T=$335,000+600,000–117,250=$817,75010.NPV=–$1.8M+817,750(PVIFA15%,3)=$67,107.3411.YearCashFlow0–$2,050,000=–$1.8M–250,0001817,7502817,75031,262,750=$817,750+250K+300K(1–0.35)3NPV=–$2.05M+817,750(PVIFA15%,2)+($1,262,750/1.15)=$109,702.0612.D1=$1.8M(0.3333)=$599,940D2=$1.8M(0.4444)=$799,920D3=$1.8M(0.1482)=$266,760BV3=$1.8M–(599,940+799,920+266,760)=$133,380Theassetissoldatagaintobookvalue,sothisgainistaxable.Aftertaxsalvagevalue=$300,000+(133,380–300,000)(0.35)=$241,683OCFt=(S–C)(1–tc)+tcDt,so:YearCashFlow0–$2,050,000=–$1.8M–250,0001817,729=($1.92M–985K)(0.65)+0.35($599,940)2887,722=($1.92M–985K)(0.65)+0.35($799,920)31,192,799=($1.92M–985K)(0.65)+0.35($266,760)+250,000+241,68323NPV=–$2.05M+($817,729/1.15)+($887,722/1.15)+($1,192,799/1.15)=$116,598.7713.Annualdepreciationcharge=$460,000/5=$92,000Aftertaxsalvagevalue=$40,000(1–0.34)=$26,400OCF=$118,000(1–0.34)+0.34($92,000)=$109,1605NPV=–$460,000–27,000+109,160(PVIFA10%,5)+[($26,400+27,000)/1.10]=–$14,812.6314.Annualdepreciationcharge=$700,000/5=$140,000Aftertaxsalvagevalue=$160,000(1–0.35)=$104,000OCF=$300,000(1–0.35)+0.35($140,000)=$244,0005NPV=0=–$700,000+70,000+$244,000(PVIFAIRR%,5)+[($104,000–70,000)/(1+IRR)]IRR=27.82% CHAPTER9B-515.$250Kcostsavingscase:OCF=$250,000(1–0.35)+0.35($140,000)=$211,5005NPV=–$700,000+70,000+$211,500(PVIFA20%,5)+[($104,000–70,000)/(1.20)]=$16,178.31$200Kcostsavingscase:OCF=$200,000(1–0.35)+0.35($140,000)=$179,0005NPV=–$700,000+70,000+$179,000(PVIFA20%,5)+[($104,000–70,000)/(1.20)]=–$81,016.5916.BaseCaseBestCaseWorstCaseUnitsales80,00092,00068,000Price/unit$1,380$1,587$1,173Variablecost/unit$140$119$161Fixedcosts$7,000,000$5,950,000$8,050,00017.AnestimatefortheimpactofchangesinpriceontheprofitabilityoftheprojectcanbefoundfromthesensitivityofNPVwithrespecttoprice;NPV/P.ThismeasurecanbecalculatedbyfindingtheNPVatanytwodifferentpricelevelsandformingtheratioofthechangesintheseparameters.Wheneverasensitivityanalysisisperformed,allothervariablesareheldconstantattheirbase-casevalues.18.a.D=$1,260,000/6=$210,000peryearOCFbase=[(P–v)Q–FC](1–tc)+tcD=[($35–19)(105K)–950K](0.65)+0.35($210K)=$548,000NPVbase=–$1,260,000+$548,000(PVIFA15%,6)=$813,896.52SayQ=100,000:OCFnew=[($35–19)(100K)–950K](0.65)+0.35($210K)=$496,000NPVbase=–$1,260,000+$496,000(PVIFA15%,6)=$617,103.42NPV/S=($813,896.52–617,103.42)/(105,000–100,000)=+$39.359Ifsalesweretodropby500unitsthen,NPVwoulddropby$39.359(500)=$19,679b.Sayv=$17:OCFnew=[($35–18)(105K)–950K](0.65)+0.35($210K)=$616,5250OCF/v=($548,000–616,250)/($19–18)=–$68,250Ifvariablecostsfellby$1then,OCFwouldriseby$68,25019.OCFbest={[($35)(1.1)–(19)(0.9)](105K)(1.1)–950K(0.9)}(0.65)+0.35($210K)=$1,124,355NPVbest=–$1,260,000+$1,124,355(PVIFA15%,6)=$2,995,102.04OCFworst={[($35)(0.9)–(19)(1.1)](105K)(0.9)–950K(1.1)}(0.65)+0.35($210K)=$45,355NPVworst=–$1,260,000+$45,355(PVIFA15%,6)=–$1,088,354.7920.Themarketingstudyisasunkcostandshouldbeignored.Sales$380,000OCF=EBIT+D–T=$99,000+60,000–39,600Variablecosts76,000=$119,400Costs145,000PaybackPeriod=$240,000/$119,400=2.01yearsDepreciation60,000NPV=–$240K+$119,400(PVIFA13%,4)=$115,151.88EBIT99,000IRR=$240K=$119,400(PVIFAR%,4)=34.59%Taxes39,600Netincome$59,400 CHAPTER9B-6Intermediate21.D1=$500,000(0.2000)=$100,000;D2=$500,000(0.3200)=$160,000D3=$500,000(0.1920)=$96,000;D4=$500,000(0.1152)=$57,600BV4=$500,000–($100,000+160,000+96,000+57,600)=$86,400Theassetissoldatagaintobookvalue,sothisgainistaxable.After-taxsalvagevalue=$80,000+($86,400–80,000)(0.34)=$82,176OCF1=$200,000(1–0.34)+0.34($100,000)=$166,000OCF2=$200,000(1–0.34)+0.34($160,000)=$186,400OCF3=$200,000(1–0.34)+0.34($96,000)=$164,640OCF4=$200,000(1–0.34)+0.34($57,600)=$151,5842NPV=–$500,000–18,000+($166,000–3,000)/1.15+($186,400–3,000)/1.1534+($164,640–3,000)/1.15+($151,584+27,000+82,176)/1.15=$17,787.1822.OCF@110,000units=[($28–16)(110,000)–$170,000](0.66)+0.34($390,000/3)=$803,200OCF@111,000units=[($28–16)(111,000)–$170,000](0.66)+0.34($390,000/3)=$811,120Sensitivity=OCF/Q=($803,200–811,120)/(110,000–111,000)=+$7.92OCFwillincreaseby$7.92foreveryadditionalunitsold.23.a.BaseCaseLowerBoundUpperBoundUnitsales150135165Variablecost/unit$13,500$12,150$14,850Fixedcosts$160,000$144,000$176,000OCFbase=[($18,000–13,500)(150)–$160,000](0.65)+0.35($820K/4)=$406,500NPVbase=–$820,000+406,500(PVIFA15%,4)=$340,548.70OCFworst=[($18,000–14,850)(135)–$176,000](0.65)+0.35($820K/4)=$233,762.50NPVworst=–$820,000+233,762.50(PVIFA15%,4)=–$152,613.12OCFbest=[($18,000–12,150)(165)–$144,000](0.65)+0.35($820K/4)=$605,562.50NPVbest=–$820,000+605,562.50(PVIFA15%,4)=$908,867.83b.SayFCare$150K:OCF=[($18,000–13,500)(150)–$150,000](0.65)+0.35($820K/4)=$413,000NPV=–$820,000+$413,000(PVIFA15%,4)=$359,106.06NPV/FC=($340,548.70–359,106.06)/($160,000–$150,000)=–$1.856ForeverydollarFCincrease,NPVfallsby$1.86.24.Themarketingstudyandtheresearchanddevelopmentarebothsunkcostsandshouldbeignored.SalesNewclubs$70046,000=$32,200,000Exp.clubs$1,100(–12,000)=–13,200,000Cheapclubs$30020,000=6,000,000$25,000,000 CHAPTER9B-7Var.costsNewclubs$34046,000=$15,640,000Exp.clubs$550(–12,000)=–6,600,000Cheapclubs$10020,000=2,000,000$11,040,000Sales$25,000,000Variablecosts11,040,000Costs8,000,000Depreciation2,300,000EBIT3,660,000Taxes1,464,000Netincome$2,196,000OCF=EBIT+D–Taxes=$3,660,000+2,300,000–1,464,000=$4,496,000Paybackperiod=3+$3.512M/$4.496M=3.78years7NPV=–$16.1M–$0.9M+$4.496M(PVIFA14%,7)+$0.9/1.14=$2,639,892.157IRR=–$16.1M–$0.9M+$4.496M(PVIFAIRR%,7)+$0.9/IRR=18.85%25.BaseCaseLowerBoundUpperBoundUnitsales(new)46,00041,40050,600Price(new)$700$630$770VC(new)$340$306$374Fixedcosts$8,000,000$7,200,000$8,800,000Saleslost(expensive)12,00010,80013,200Salesgained(cheap)20,00018,00022,000BestcaseSalesNewclubs$77050,600=$38,962,000Exp.clubs$1,100(–10,800)=–11,880,000Cheapclubs$30022,000=6,600,000$33,682,000Var.costsNewclubs$30650,600=$15,483,600Exp.clubs$550(–10,800)=–5,940,000Cheapclubs$10022,000=2,200,000$11,743,600 CHAPTER9B-8Sales$33,682,000Variablecosts11,743,600Costs7,200,000Depreciation2,300,000EBIT12,438,400Taxes4,975,360Netincome$7,463,040OCF=EBIT+D–Taxes=$12,438,400+2,300,000–4,975,360=$9,763,0407NPV=–$16.1M–$0.9M+$9,763,040(PVIFA14%,7)+$0.9/1.14=$25,226,565.27WorstcaseSalesNewclubs$63041,400=$26,082,000Exp.clubs$1,100(–13,200)=–14,520,000Cheapclubs$30018,000=5,400,000$16,962,000Var.costsNewclubs$37441,400=$15,483,600Exp.clubs$550(–13,200)=–7,260,000Cheapclubs$10018,000=1,800,000$10,023,600Sales$16,962,000Variablecosts10,023,600Costs8,800,000Depreciation2,300,000EBIT–4,161,600Taxes1,664,640*assumesataxcreditNetincome–$2,496,960OCF=EBIT+D–Taxes=–$4,161,600+2,300,000+1,664,640=–$196,9607NPV=–$16.1M–$0.9M+(–$196,960)(PVIFA14%,7)+$0.9/1.14=–$17,484,950.93 CHAPTER10SOMELESSONSFROMCAPITALMARKETHISTORYAnswerstoConceptsReviewandCriticalThinkingQuestions1.Theyallwishtheyhad!Sincetheydidn’t,itmusthavebeenthecasethatthestellarperformancewasnotforeseeable,atleastnotbymost.2.Asinthepreviousquestion,it’seasytoseeafterthefactthattheinvestmentwasterrible,butitprobablywasn’tsoeasyaheadoftime.3.No,stocksareriskier.Someinvestorsarehighlyriskaverse,andtheextrapossiblereturndoesn’tattractthemrelativetotheextrarisk.4.Onaverage,theonlyreturnthatisearnedistherequiredreturn—investorsbuyassetswithreturnsinexcessoftherequiredreturn(positiveNPV),biddingupthepriceandthuscausingthereturntofalltotherequiredreturn(zeroNPV);investorssellassetswithreturnslessthantherequiredreturn(negativeNPV),drivingthepricelowerandthusthecausingthereturntorisetotherequiredreturn(zeroNPV).5.Themarketisnotweakformefficient.6.Yes,historicalinformationisalsopublicinformation;weakformefficiencyisasubsetofsemi-strongformefficiency.7.Ignoringtradingcosts,onaverage,suchinvestorsmerelyearnwhatthemarketoffers;thetradesallhavezeroNPV.Iftradingcostsexist,thentheseinvestorslosebytheamountofthecosts.8.Unlikegambling,thestockmarketisapositivesumgame;everybodycanwin.Also,speculatorsprovideliquiditytomarketsandthushelptopromoteefficiency.9.TheEMHonlysays,withintheboundsofincreasinglystrongassumptionsabouttheinformationprocessingofinvestors,thatassetsarefairlypriced.Animplicationofthisisthat,onaverage,thetypicalmarketparticipantcannotearnexcessiveprofitsfromaparticulartradingstrategy.However,thatdoesnotmeanthatafewparticularinvestorscannotoutperformthemarketoveraparticularinvestmenthorizon.Certaininvestorswhodowellforaperiodoftimegetalotofattentionfromthefinancialpress,butthescoresofinvestorswhodonotdowelloverthesameperiodoftimegenerallygetconsiderablylessattention.10.a.Ifthemarketisnotweakformefficient,thenthisinformationcouldbeactedonandaprofitearnedfromfollowingthepricetrend.Under(2),(3),and(4),thisinformationisfullyimpoundedinthecurrentpriceandnoabnormalprofitopportunityexists. CHAPTER10B-2b.Under(2),ifthemarketisnotsemi-strongformefficient,thenthisinformationcouldbeusedtobuythestock“cheap”beforetherestofthemarketdiscoversthefinancialstatementanomaly.Since(2)isstrongerthan(1),bothimplythataprofitopportunityexists;under(3)and(4),thisinformationisfullyimpoundedinthecurrentpriceandnoprofitopportunityexists.c.Under(3),ifthemarketisnotstrongformefficient,thenthisinformationcouldbeusedasaprofitabletradingstrategy,bynotingthebuyingactivityoftheinsidersasasignalthatthestockisunderpricedorthatgoodnewsisimminent.Since(1)and(2)areweakerthan(3),allthreeimplythataprofitopportunityexists.Under(4),thisinformationdoesnotsignalanyprofitopportunityfortraders;anypertinentinformationthemanager-insidersmayhaveisfullyreflectedinthecurrentshareprice.SolutionstoQuestionsandProblemsBasic1.R=[$1.25+($86–75)]/$75=16.33%2.Dividendyield=$1.25/$75=1.67%;Capitalgainsyield=($86–75)/$75=14.67%3.R=[$1.25+($62–75)]/$75=–15.67%Dividendyield=$1.25/$75=1.67%;Capitalgainsyield=($62–75)/$75=–17.33%4.$100+1,092–1,140=$52;R=[$100+($1,092–1,140)]/$1,140=4.56%r=(1.0456/1.03)–1=1.52%5.a.12.70%b.r=(1.1270)/(1.031)–1=9.31%6.rG=1.057/1.031–1=2.52%;rC=1.061/1.031–1=2.91%7.X:averagereturn=.09+.10–.12+.06+.15=.056or5.60%22222variance=1/4[(.09–.056)+(.10–.056)+(–.12–.056)+(.06–.056)+(.15–.056)]=0.010731/2standarddeviation=(0.01073)=0.1036=10.36%Y:averagereturn=.32–.06–.14+.46+.27=.1700or17.00%22222variance=1/4[(.32–.17)+(–.06–.17)+(–.14–.17)+(.46–.17)+(.27–.17)]=0.066401/2standarddeviation=(0.06640)=0.2577=25.77% CHAPTER10B-38.YearLargeco.stockreturnT-billreturnRiskPremium1973–14.69%7.17%–21.86%1974–26.478.06–34.53197537.235.8831.35197623.935.0718.861977–7.165.44–12.6019786.577.51–0.94197918.6110.558.0638.0249.68–11.66a.Largecompanystocks:averagereturn=38.02/7=5.43%T-bills:averagereturn=49.68/7=7.10%b.Largecompanystocks:2222variance=1/6[(.1469–.0543)+(–.26.47–.0543)+(.3723–.0543)+(.2393–.0543)+222(–.0716–.0543)+(.0657–.0543)+(.1861–.0543)]=0.0518241/2standarddeviation=(0.051824)=0.2276=22.76%T-bills:2222variance=1/6[(.0717–.0710)+(.0806–.0710)+(.0588–.0710)+(.0507–.0710)+222(.0544–.0710)+(.0751–.0710)+(.1055–.0710)]=0.0003561/2standarddeviation=(0.000356)=0.0189=1.89%c.Averageobservedriskpremium=–11.66/7=–1.67%222variance=1/6[(–.2186–(–0.167))+(–.3453–(–0.167))+(.3135–(–0.167))+222(.1886–(–0.167))+(–.1260–(–0.167))+(–.0094–(–0.167))+2(.0806–(–0.167))]=0.0535651/2standarddeviation=(0.053565)=0.2314=23.14%d.Beforethefact,formostassetstheriskpremiumwillbepositive;investorsdemandcompen-sationoverandabovetherisk-freereturntoinvesttheirmoneyintheriskyasset.Afterthefact,theobservedriskpremiumcanbenegativeiftheasset’snominalreturnisunexpectedlylow,therisk-freereturnisunexpectedlyhigh,orifsomecombinationofthesetwoeventsoccurs.9.a.Averagereturn=(.14+.21+.02+.24+–.18)/5=.086=8.60%22222b.Variance=1/4[(.14–.086)+(.21–.086)+(.02–.086)+(.24–.086)+(–.18–.086)]=0.029281/2Standarddeviation=(0.02928)=0.1711=17.11%10.a.r=(1.086/1.031)–1=5.33%b.RPR–Rf=.086–.035=5.10%11.Rf=(1.035/1.031)–1=0.388%;RP=R–Rf=5.33–0.388=4.95%12.T-billrateswerehighestintheearlyeighties.ThiswasduringaperiodofhighinflationandisconsistentwiththeFishereffect.1413.P1=$1,000/1.12=$263.33;R=($263.33–315.24)/$315.24=–16.47%14.R=[$6.00+($88.30–91.20)]/$91.20=3.40% CHAPTER10B-41515.P0=$90(PVIFA6.5%,15)+$1,000/1.065=$1,235.0714P1=$90(PVIFA8%,14)+$1,000/1.08=$1,082.44R=[$90+($1,082.44–1,235.07)]/$1,235.07=–5.07%16.Averagereturn=(.10–.08+.11+.19+.15)/5=.0940=9.40%22222Variance=1/4[(.10–.094)+(–.08–.094)+(.11–.094)+(.19–.094)+(.15–.094)]=0.010731/2Standarddeviation=(0.01073)=0.1036=10.36%17.Threemonthreturn:($24.34–21.76)/$21.76=11.86%;APR=11.86%4=47.43%4EAR=(1+.11.86)–1=56.55%18.T-billsInflationRealReturn19260.0442(0.0112)0.056019270.0416(0.0226)0.065719280.0499(0.0116)0.062219290.05990.00580.053819300.0357(0.0640)0.106519310.0270(0.0932)0.132619320.0269(0.1027)0.1444Average=(.0560+.0657+.0622+.0538+.1065+.1326+.1444)/7=.0887or8.87%19.Averagereturn=(–.18+.02+.25+.12+.14)/5=.0700=7.00%22222Variance=1/4[(–.18–.07)+(.02–.07)+(.25–.07)+(.12–.07)+(.14–.07)]=0.026201/2Standarddeviation=(0.02620)=0.1619=16.19%20.R=[$3.08+($126.72–121.18)]/$121.18=7.11%21.Averagereturn=(.14–.12+.11+.24+.16+.17)/6=.1167=11.67%22222Variance=1/5[(.14–.1167)+(–.12–.1167)+(.11–.1167)+(.24–.1167)+(.16–.1167)+2(.17+.1167)]=0.015311/2Standarddeviation=(0.01531)=0.1237=12.37%22.68%level:R±1=6.1±1(8.6)=–2.50%to14.70%95%level:R±2=6.1±2(8.6)=–11.10%to23.30%23.68%level:R±1=12.70±1(20.20)=–7.50%to32.90%95%level:R±2=12.70±2(20.20)=–27.70%to53.10% CHAPTER10B-5Intermediate24.YearT-billreturnInflationRealreturn19730.07170.0871–0.014219740.08060.1234–0.038119750.05880.0694–0.010219760.05070.04860.002019770.05440.0670–0.011819780.07510.0902–0.013919790.10550.1329–0.024219800.12310.1252–0.00190.61990.7438–0.1122a.T-bills:averagereturn=0.6199/8=7.75%Inflation:averagerate=0.7438/8=9.30%b.T-bills:2222variance=1/7[(.0717–.0775)+(.0806–.0775)+(.0588–.0775)+(.0507–.0775)+2222(.0544–.0775)+(.0751–.0775)+(.1055–.0775)+(.1231.0775)]=0.0006451/2standarddeviation=(0.000645)=0.0254=2.54%Inflation:2222variance=1/7[(.0871–.0930)+(.1234–.0930)+(.0697–.0930)+(.0486–.0930)+2222(.0670–.0930)+(.0902–.0930)+(.1329–.0930)+(.1252.0930)]=0.0009691/2standarddeviation=(0.000971)=0.0312=3.12%c.Averageobservedrealreturn=–.1122/8=–1.40%222variance=1/7{[–.0142–(–.0140)]+[–.0381–(–.0140)]+[–.0102–(–.0140)]+222[.0020–(–.0140)]+[–.0118–(–.0140)]+[–.0139–(–.0140)]+22[–.0242–(–.0140)]+[–.0019(–.0140)]}=0.0001581/2standarddeviation=(0.000158)=0.0126=1.26%d.ThestatementthatT-billshavenoriskreferstothefactthatthereisonlyanextremelysmallchanceofthegovernmentdefaulting,sothereislittledefaultrisk.SinceT-billsareshortterm,thereisalsoverylimitedinterestraterisk.However,asthisexampleshows,thereisinflationrisk,i.e.thepurchasingpoweroftheinvestmentcanactuallydeclineovertimeeveniftheinvestorisearningapositivereturn.625.P1=$90(PVIFA8%,6)+$1,000/1.08=$1,046.23R=[$90+($1,046.23–1,028.50)]/$1,028.50=.1047r=(1.1047/1.048)–1=5.41%26.Pr(R<–3.7orR>15.1)1/3,butweareonlyinterestedinonetailhere;Pr(R<–3.7)1/695%level:R±2=5.7±2(9.4)=–13.1%to24.5%99%level:R±3=5.7±3(9.4)=–22.5%to33.9% CHAPTER10B-627.=17.3%;=33.2%.Doublingyourmoneyisa100%return,soifthereturndistributionisnormal,z=(100–17.3)/33.2=2.49standarddeviationsabovethemean;thiscorrespondstoaprobabilityof1%,oronceevery100years.Triplingyourmoneywouldbez=(200–17.3)/33.2=5.50standarddeviationsabovethemean;thiscorrespondstoaprobabilityof(much)lessthan0.5%,oronceevery200years.(Theactualanswerislessthan0.0000019%oraboutonceevery1millionyears).28.Itisimpossibletolosemorethan100percentofyourinvestment.Therefore,returndistributionsaretruncatedonthelowertailat–100percent. CHAPTER11RISKANDRETURNAnswerstoConceptsReviewandCriticalThinkingQuestions1.Someoftheriskinholdinganyassetisuniquetotheassetinquestion.Byinvestinginavarietyofassets,thisunsystematicportionofthetotalriskcanbeeliminatedatlittlecost.Ontheotherhand,therearesystematicrisksthataffectallinvestments.Thisportionofthetotalriskofanassetcannotbecostlesslyeliminated.Inotherwords,systematicriskcanbecontrolled,butonlybyacostlyreductioninexpectedreturns.2.Ifthemarketexpectedthegrowthrateinthecomingyeartobe2percent,thentherewouldbenochangeinsecuritypricesifthisexpectationhadbeenfullyanticipatedandpriced.However,ifthemarkethadbeenexpectingagrowthratedifferentthan2percentandtheexpectationwasincorpo-ratedintosecurityprices,thenthegovernment’sannouncementwouldmostlikelycausesecuritypricesingeneraltochange;priceswouldtypicallydropiftheanticipatedgrowthratehadbeenmorethan2percent,andpriceswouldtypicallyriseiftheanticipatedgrowthratehadbeenlessthan2percent.3.a.systematicb.unsystematicc.both;probablymostlysystematicd.unsystematice.unsystematicf.systematic4.a.achangeinsystematicriskhasoccurred;marketpricesingeneralwillmostlikelydecline.b.nochangeinunsystematicrisk;companypricewillmostlikelystayconstant.c.nochangeinsystematicrisk;marketpricesingeneralwillmostlikelystayconstant.d.achangeinunsystematicriskhasoccurred;companypricewillmostlikelydecline.e.nochangeinsystematicrisk;marketpricesingeneralwillmostlikelystayconstant.5.Notobothquestions.Theportfolioexpectedreturnisaweightedaverageoftheassetreturns,soitmustbelessthanthelargestassetreturnandgreaterthanthesmallestassetreturn.6.False.Thevarianceoftheindividualassetsisameasureofthetotalrisk.Thevarianceonawell-diversifiedportfolioisafunctionofsystematicriskonly.7.Yes,thestandarddeviationcanbelessthanthatofeveryassetintheportfolio.However,cannotbelessthanthesmallestbetabecausePisaweightedaverageoftheindividualassetbetas.8.Yes.Itispossible,intheory,toconstructazerobetaportfolioofriskyassetswhosereturnwouldbeequaltotherisk-freerate.Itisalsopossibletohaveanegativebeta;thereturnwouldbelessthantherisk-freerate.Anegativebetaassetwouldcarryanegativeriskpremiumbecauseofitsvalueasadiversificationinstrument.9.Suchlayoffsgenerallyoccurinthecontextofcorporaterestructurings.Totheextentthatthemarketviewsarestructuringasvalue-creating,stockpriceswillrise.So,it’snotthelayoffspersethatarebeingcheeredonbutthecostsavingsassociatedwiththelayoffs.Nonetheless,WallStreetdoesencouragecorporationstotakesactionstocreatevalue,evenifsuchactionsinvolvelayoffs. CHAPTER11B-210.Earningscontaininformationaboutrecentsalesandcosts.Thisinformationisusefulforprojectingfuturegrowthratesandcashflows.Thus,unexpectedlylowearningsoftenleadmarketparticipantstoreduceestimatesoffuturegrowthratesandcashflows;lowerpricesaretheresult.Thereverseisoftentrueforunexpectedlyhighearnings.SolutionstoQuestionsandProblemsBasic1.totalvalue=80($42)+40($68)=$6,080weightA=80($42)/$6,080=.5526;weightB=40($68)/$6,080=.44742.E[Rp]=($500/$2,100)(0.12)+($1,600/$2,100)(0.18)=.16573.E[Rp]=.60(.10)+.25(.14)+.15(.16)=.11904.E[Rp]=.1480=.16wx+.11(1–wx);wx=0.7600investmentinX=0.7600($10,000)=$7,600;investmentinY=(1–0.7600)($10,000)=$2,4005.E[R]=.30(–.02)+.70(.24)=16.20%6.E[R]=.30(–.09)+.60(.10)+.10(.30)=6.30%7.E[RA]=.25(.06)+.45(.07)+.30(.11)=7.95%E[RB]=.25(–.20)+.45(.13)+.30(.33)=10.75%2222A=.25(.06–.0795)+.45(.07–.0795)+.30(.11–.0795)=.0004151/2=[.000415]=.0204=2.04%2222B=.25(–.2–.1075)+.45(.13–.1075)+.30(.33–.1075)=.0387191/2=[.038719]=.2557=19.68%8.E[Rp]=.35(.08)+.50(.17)+.15(.22)=14.60%9.a.boom:E[Rp]=(.12+.15+.33)/3=.2000;bust:E[Rp]=(.10+.03.06)/3=.02333E[Rp]=.40(.2000)+.60(.02333)=.0940b.boom:E[Rp]=.15(.12)+.15(.15)+.7(.33)=.2715bust:E[Rp]=.15(.10)+.15(.03)+.7(.06)=–.0225E[Rp]=.40(.2715)+.60(.0225)=.0951222p=.40(.2715–.0951)+.60(.0225–.0951)=.02074 CHAPTER11B-310.a.boom:E[Rp]=.40(.30)+.20(.45)+.40(.33)=.3420good:E[Rp]=.40(.12)+.20(.10)+.40(.15)=.1280poor:E[Rp]=.40(.01)+.20(–.15)+.40(–.05)=–.0460bust:E[Rp]=.40(–.20)+.20(–.30)+.40(–.09)=–.1760E[Rp]=.30(.3420)+.40(.1280)+.20(–.0460)+.10(–.1760)=.066522222b.p=.20(.3420–.0665)+.40(.1280–.0665)+.20(–.0460–.0665)+.10(–.1760–.0665)21/2p=.031429;p=[.031429]=.177311.p=.2(.7)+.2(.9)+.1(1.3)+.5(1.9)=1.4012.p=1.0=1/3(0)+1/3(1.2)+1/3(X);X=1.8013.E[Ri]=.05+(.10–.05)(0.9)=.09514.E[Ri]=.15=.04+.08i;i=1.37515.E[Ri]=.16=.05+(E[RM]–.05)(1.2);E[RM]=.141716.E[Ri]=.164=Rf+(.14–Rf)(1.3);Rf=.060017.a.E[Rp]=(.14+.05)/2=.0950b.p=0.7=wS(1.2)+(1–wS)(0);wS=0.7/1.2=.5833;wRf=1–.5833=.4167c.E[Rp]=.11=.14ws+.05(1–ws);wS=.6667;p=.6667(1.2)+.3333(0)=0.800d.p=2.4=wS(1.2)+(1–wS)(0);wS=2.4/1.2=2;wRf=1–2=–1Theportfolioisinvested200%inthestockand–100%intherisk-freeasset.Thisrepresentsborrowingattherisk-freeratetobuymoreofthestock.18.ßp=wW(1.2)+(1–wW)(0)=1.2wWE[RW]=.12=.04+MRP(1.20);MRP=.08/1.2=.0667E[Rp]=.04+.0667p;slopeofline=MRP=.0667;E[Rp]=.04+.0667p=.04+.0667(1.2)wWwWE[Rp]ßpwWE[Rp]p0%.04000100%.12001.225.06000.3125.14001.550.08000.6150.16001.875.10000.919.E[Ri]=.04+.07iRisktorewardratio:Y:(.101–.04)/.9=.0678;Z:(.142–.04)/1.4=.0729.101E[RZ]=.04+.07(1.4)=.1380;ZplotsabovetheSMLandisundervalued.20.[.101–Rf]/0.90=[.142–Rf]/1.40;Rf=.0272 CHAPTER11B-421.Foraportfoliothatisequallyinvestedincommonstocksandlong-termbonds:return=(12.70%+6.10%)/2=9.40%ForaportfoliothatisequallyinvestedinsmallstocksandTreasurybills:return=(17.30%+3.90%)/2=10.60%22.E[Rp]=.14=.19wH+.11(1–wH);wH=0.3750investmentinH=0.3750($250,000)=$93,750investmentinL=(1–0.3750)($250,000)=$156,25023.E[R]=.2(–.04)+.8(.21)=16.00%24.E[R]=.2(–.10)+.5(.13)+.3(.38)=15.90%25.E[RP]=.20(.04)+.65(.08)+.20(.16)=8.40%E[RQ]=.20(–.20)+.65(.20)+.20(.60)=18.00%2222P=.20(.04–.0840)+.65(.08–.0840)+.20(.16–.0840)=.0012641/2P=[.001264]=.0356=3.56%2222Q=.20(–.20–.1800)+.65(.08–.1800)+.20(.60–.1800)=.05561/2Q=[.0556]=.2358=23.58%26.E[Rp]=.25(.09)+.35(.17)+.40(.23)=.174027.a.boom:E[Rp]=(.14+.18+.26)/3=.1933;bust:E[Rp]=(.08+.02.02)/3=.0267E[Rp]=.60(.1933)+.40(.0267)=.1267b.boom:E[Rp]=.25(.14)+.25(.18)+.50(.26)=.2100bust:E[Rp]=.25(.08)+.25(.02)+.50(.02)=.0150E[Rp]=.60(.2100)+.40(.0150)=.1320222p=.60(.2100–.1320)+.40(.0150–.1320)=.00912628.a.boom:E[Rp]=.40(.10)+.30(.35)+.30(.20)=.2050good:E[Rp]=.40(.07)+.30(.15)+.30(.11)=.1060poor:E[Rp]=.40(.03)+.30(–.05)+.30(.02)=.0030bust:E[Rp]=.40(.00)+.30(–.40)+.30(–.08)=–.1440E[Rp]=.15(.2050)+.50(.1060)+.25(.0030)+.10(–.1440)=.070102222b.p=.15(.2050–.0701)+.50(.1060–.0701)+.25(.0030–.0701)+2.25(–.1440–.0701)21/2p=.009084;p=[.009084]=.095329.E[R]=.30(.14)+.50(.18)+.20(.26)=18.40%30.ßp=1=wJ(1.4)+(1–wJ)(0.5);wJ=.5556,so55.56%ofyourmoneyinstockJand44.44%instockKE[R]=.5556(.19)+.4444(.10)=15.00% CHAPTER11B-531.Portfoliovalue=500($34)+300($22)+600($78)+800($53)=$112,800wW=500($34)/$112,800=.1507;wX=300($22)/$112,800=.0585wY=600($78)/$112,800=.4149;wZ=800($53)/$112,800=.3759E[R]=.1507(.12)+.0585(.16)+.4149(.14)+.3759(.15)=14.19%Intermediate32.E[Rp]=.1400=.50(.19)+wF(.13)+(1–.50–wF)(.06)solvingtheequationforwFyieldswF=.2142857thereforewRf=.2857143amountofstockFtobuy=.2142857($100,000)=$21,428.5733.a.boom:E[Rp]=.30(.04)+.30(.20)+.40(.60)=.3120normal:E[Rp]=.30(.08)+.30(.10)+.40(.20)=.1340bust:E[Rp]=.30(.12)+.30(–.13)+.40(–.40)=–.1630E[Rp]=.20(.3120)+.60(.1340)+.20(–.1630)=.11022p=.20(.3120–.1102)2+.60(.1340–.1102)2+.20(–.1630–.1120)2=.02341p=[.02341]1/2=.1530b.RPi=E[Ri]–Rf=.1102–.0425=.067734.(E[RA]–Rf)/A=(E[RB]–Rf)/ßBRPA/A=RPB/B;B/A=RPB/RPA35.a.boom:E[Rp]=.30(.38)+.30(.02)+.40(.60)=.3600normal:E[Rp]=.30(.14)+.30(.10)+.40(.05)=.0920bust:E[Rp]=.30(–.05)+.30(.15)+.40(–.50)=–.1700E[Rp]=.20(.3600)+.70(.0920)+.10(–.1700)=.11942222p=.20(.3600–.1194)+.70(.0920–.1194)+.10(–.1700–.1194)=.020481/2p=[.02048]=.1431b.RPi=E[Ri]–Rf=.1194–.0360=.083436.wA=$120,000/$500,000=.24;wB=$130,000/$500,000=.26;wC+wRf=1–wA–wB=.50p=1.0=.24(.9)+.26(1.2)+wC(1.6)+wRf(0);wC=.2950,invest.2950($500,000)=$147,500inC.wRf=1–.24–.26–.2950=.2050;invest.2050($500,000)=$102,500intherisk-freeasset.37.E[Rp]=.15=wX(.25)+wY(.18)+(1–wX–wY)(.06)p=.6=wX(1.6)+wY(1.4)+(1–wX–wY)(0)solvingthesetwoequationsintwounknownsgiveswX=0.72973wY=–0.40541wR=0.67568amountofstockYtosellshort=–0.40541($100,000)=–$40,541 CHAPTER11B-638.E[RI]=.20(.08)+.30(.47)+.20(.23)=.3440;.3440=.04+.12I,I=2.5322221/2I=.20(.08–.344)+.60(.47–.344)+.20(.23–.344)=.026064;=[.026064]=.1614E[RII]=.20(–.24)+.60(.16)+.20(.58)=.162;.162=.04+.12II,II=1.022=.20(–.25–.162)2+.60(.16–.162)2+.20(.58–.162)2=.068896;=[.068896]1/2=.2625IIAlthoughstockIIhasmoretotalriskthanI,ithasmuchlesssystematicrisk,sinceitsbetaismuchsmallerthanI’s.ThusIhasmoresystematicrisk,andIIhasmoreunsystematicandmoretotalrisk.Sinceunsystematicriskcanbediversifiedaway,Iisactuallythe“riskier”stockdespitethelackofvolatilityinitsreturns.StockIwillhaveahigherriskpremiumandagreaterexpectedreturn. CHAPTER12COSTOFCAPITALAnswerstoConceptsReviewandCriticalThinkingQuestions1.Itistheminimumrateofreturnthefirmmustearnoverallonitsexistingassets.Ifitearnsmorethanthis,valueiscreated.2.Bookvaluesfordebtarelikelytobemuchclosertotheirmarketvaluesthanarebookvaluesforequity.3.No.Thecostofcapitaldependsontheriskoftheproject,notthesourceofthemoney.4.Interestexpenseistax-deductible.Thereisnodifferencebetweenpretaxandaftertaxequitycosts.5.TheprimaryadvantageoftheDCFmodelisitssimplicity.Themethodisdisadvantagedinthat(1)themodelisapplicableonlytofirmsthatactuallypaydividends;manydonot;(2)evenifafirmdoespaydividends,theDCFmodelrequiresaconstantdividendgrowthrateforever;(3)theestimatedcostofequityfromthismethodisverysensitivetochangesing,whichisaveryuncertainparameter;and(4)themodeldoesnotexplicitlyconsiderrisk,althoughriskisimplicitlyconsideredtotheextentthatthemarkethasimpoundedtherelevantriskofthestockintoitsmarketprice.Whilethesharepriceandmostrecentdividendcanbeobservedinthemarket,thedividendgrowthratemustbeestimated.Twocommonmethodsofestimatinggaretouseanalysts’earningsandpayoutforecasts,ordeterminesomeappropriateaveragehistoricalgfromthefirm’savailabledata.6.TwoprimaryadvantagesoftheSMLapproacharethatthemodelexplicitlyincorporatestherelevantriskofthestock,andthemethodismorewidelyapplicablethanistheDCFmodel,sincetheSMLdoesn’tmakeanyassumptionsaboutthefirm’sdividends.TheprimarydisadvantagesoftheSMLmethodare(1)estimatingthreeparameters:therisk-freerate,theexpectedreturnonthemarket,andbeta,and(2)themethodessentiallyuseshistoricalinformationtoestimatetheseparameters.Therisk-freerateisusuallyestimatedtobetheyieldonveryshortmaturityT-billsandishenceobservable;themarketriskpremiumisusuallyestimatedfromhistoricalriskpremiumsandhenceisnotobservable.Thestockbeta,whichisunobservable,isusuallyestimatedeitherbydeterminingsomeaveragehistoricalbetafromthefirmandthemarket’sreturndata,orusingbetaestimatesprovidedbyanalystsandinvestmentfirms.7.Theappropriateaftertaxcostofdebttothecompanyistheinterestrateitwouldhavetopayifitweretoissuenewdebttoday.Hence,iftheYTMonoutstandingbondsofthecompanyisobserved,thecompanyhasanaccurateestimateofitscostofdebt.Ifthedebtisprivately-placed,thefirmcouldstillestimateitscostofdebtby(1)lookingatthecostofdebtforsimilarfirmsinsimilarriskclasses,(2)lookingattheaveragedebtcostforfirmswiththesamecreditrating(assumingthefirm’sprivatedebtisrated),or(3)consultinganalystsandinvestmentbankers.Evenifthedebtispubliclytraded,anadditionalcomplicationiswhenthefirmhasmorethanoneissueoutstanding;theseissuesrarelyhavethesameyieldbecausenotwoissuesareevercompletelyhomogeneous. CHAPTER12B-28.a.Thisonlyconsidersthedividendyieldcomponentoftherequiredreturnonequity.b.Thisisthecurrentyieldonly,notthepromisedyieldtomaturity.Inaddition,itisbasedonthebookvalueoftheliability,anditignorestaxes.c.Equityisinherentlymoreriskythandebt(except,perhaps,intheunusualcasewhereafirm’sassetshaveanegativebeta).Forthisreason,thecostofequityexceedsthecostofdebt.Iftaxesareconsideredinthiscase,itcanbeseenthatatreasonabletaxrates,thecostofequitydoesexceedthecostofdebt.9.RSuperior=.12+.75(.08)=18%Bothshouldproceed.Theappropriatediscountratedoesnotdependonwhichcompanyisinvesting;itdependsontheriskoftheproject.SinceSuperiorisinthebusiness,itisclosertoapureplay.Therefore,itscostofcapitalshouldbeused.Withan18%costofcapital,theprojecthasanNPVof$1millionregardlessofwhotakesit.10.Ifthedifferentoperatingdivisionswereinmuchdifferentriskclasses,thenseparatecostofcapitalfiguresshouldbeusedforthedifferentdivisions;theuseofasingle,overallcostofcapitalwouldbeinappropriate.Ifthesinglehurdleratewereused,riskierdivisionswouldtendtoreceivefundsforinvestmentprojects,sincetheirreturnwouldexceedthehurdleratedespitethefactthattheymayactuallyplotbelowtheSMLandhencebeunprofitableprojectsonarisk-adjustedbasis.Thetypicalproblemencounteredinestimatingthecostofcapitalforadivisionisthatitrarelyhasitsownsecuritiestradedonthemarket,soitisdifficulttoobservethemarket’svaluationoftheriskofthedivision.Twotypicalwaysaroundthisaretouseapureplayproxyforthedivision,ortousesubjectiveadjustmentsoftheoverallfirmhurdleratebasedontheperceivedriskofthedivision.SolutionstoQuestionsandProblemsBasic1.RE=[$1.90(1.06)/$38]+.06=11.30%2.RE=.05+1.27(.13–.05)=15.16%3.RE1=.055+1.20(.07)=.1390;RE2=[$2.20(1.05)/$36]+.04=.1142RE=(.1390+.1141)/2=12.66%4.g1=(1.20–1.10)/1.10=.0909;g2=(1.32–1.20)/1.20=.1000g3=(1.43–1.32)/1.32=.0833;g4=(1.56–1.43)/1.43=.0909g=(.0909+.1000+.0833+.0909)/4=.0913RE=[$1.56(1.0913)/$38.00]+.0913=13.61%5.Rp=$6.50/$90=7.22%6.P0=$1,060=$42.50(PVIFAR%,14)+$1,000(PVIFR%,14);R=3.693%pretaxcostofdebt=YTM=2x3.693=7.387%RD=.07387(1–.38)=4.580% CHAPTER12B-37.a.P0=$960=$30(PVIFAR%,44)+$1,000(PVIFR%,54);R=3.1698%pretaxcostofdebt=YTM=2x3.1698=6.340%b.RD=.063396(1–.35)=4.121%c.Theaftertaxrateismorerelevantbecausethatistheactualcosttothecompany.8.BVD=$30M+$80M=$110MMVD=0.96($30M)+0.56($80M)=$73.6MPZ=$560=$1,000(PVIFR%,10);R=5.97%;RZ=.0597(1–.35)=3.88%RD=0.0412($28.8M/$73.6M)+0.0388($44.8M/$73.6M)=3.97%9.a.WACC=.65(.15)+.10(.06)+.25(.075)(1–.35)=11.57%b.Sinceinterestistaxdeductibleanddividendsarenot,wemustlookattheafter-taxcostofdebt,whichis.075(1–.35)=4.88%.Hence,onanaftertaxbasis,debtischeaperthanthepreferredstock.10.WACC=.17(1/1.8)+.08(.8/1.8)(1–.35)=11.76%11.WACC=.1240=.15(E/V)+.08(D/V)(1–.35).1240(V/E)=.15+.08(.65)(D/E).1240(D/E+1)=.15+.0520(D/E);.0720(D/E)=.0026;D/E=.361112.a.BVE=9M($4)=$36MBVD=$80M+$50M=$130MV=$36M+130M=$166ME/V=$36/$166M=0.2169;D/V=$130M/$166M=0.7831b.MVE=9M($52)=$468MMVD=1.04($80M)+1.02($50M)=$134.2MV=$468M+134.2M=$602.2ME/V=$468M/$602.2=0.7772;D/V=$134.2M/$602.2M=0.2228c.Themarketvalueweightsaremorerelevantbecausetheyrepresentamorecurrentvaluationofdebtandequity.13.RE=[$3.10(1.07)/$52]+.07=.1338P1=$1,040=$40(PVIFAR%,20)+$1,000(PVIFR%,20);R=3.713%,YTM=7.426%P2=$1,020=$37.50(PVIFAR%,12)+$1,000(PVIFR%,12);R=3.543%,YTM=7.085%RD=(1–.35)[($83.2M/$134.2M)(.07426)+($51M/$134.2M)(.07085)]=.0474WACC=.7772(.1338)+.2228(.0474)=11.45%14.a.WACC=.1380=(1/1.6)(.18)+(.6/1.6)(1–.35)RD;RD=10.46%b.WACC=.1380=(1/1.6)RE+(.6/1.6)(.075);RE=17.58%15.MVD=6,000($1,000)(1.04)=$6.24M;MVE=90,000($75)=$6.75MMVP=8,000($60)=$0.48M;V=$6.24M+6.75M+0.48M=$13.47MRE=.05+1.20(.06)=12.20%P0=$1,040=$45(PVIFAR%,20)+$1,000(PVIFR%,20);R=4.200%,YTM=8.400%RD=(1–.35)(.08400)=5.461%RP=$4.75/$60=7.92%WACC=.0546($6.24M/$13.47M)+.1220($6.75M/$13.47M)+.0792($0.48M/$13.47M)=8.93% CHAPTER12B-416.a.MVD=150,000($1,000)(0.93)=$139.5M;MVE=8M($43)=$344MMVP=400,000($67)=$26.8M;V=$139.5M+344M+26.8M=$510.3MD/V=$139.5M/$510.3M=.2734;P/V=$26.8M/$510.3M=.0525E/V=$344M/$510.3M=.6741b.Forprojectsequallyasriskyasthefirmitself,theWACCshouldbeusedasthediscountrate.RE=.05+1.30(.09)=16.70%P0=$930=$35(PVIFAR%,30)+$1,000(PVIFR%,30);R=3.8999%,YTM=7.7998%RD=(1–.34)(.77998)=5.15%RP=$4/$67=5.97%WACC=.2734(.0515)+.0525(.0597)+.6741(.1670)=12.98%17.a.ProjectsYandZ.b.Usingthefirm’soverallcostofcapitalasahurdlerate,projectsX,YandZ.However,afterconsideringriskviatheSML:E[W]=.06+.40(.13–.06)=.0880<.09,soacceptW.E[X]=.06+.95(.13–.06)=.1265>.11,sorejectX.E[Y]=.06+1.06(.13–.06)=.1342<.15,soacceptY.E[Z]=.06+2.20(.13–.06)=.2140>.19,sorejectZ.c.ProjectWwouldbeincorrectlyrejected;projectZwouldbeincorrectlyaccepted.18.MVD=3,000($1,000)(0.945)=$2,835,000;MVE=130,000($40)=$5,200,000MVP=10,000($80)=$800,000;V=$2,835,000+800,000+5,200,000=$8,835,000D/V=$2,835,000/$8,835,000=.3209;P/V=$800,000/$8,835,000=.0905E/V=$5,200,000/$8,835,000=.5886RE1=.07+0.90(.13–.07)=.1240;RE2=($3/$40)+.05=.1250RE=(.1240+.1250)/2=.1245P0=$945=$30(PVIFAR%,40)+$1,000(PVIFR%,40);R=3.248%,YTM=6.495%RD=(1–.35)(.06495)=4.222%RP=$6/$80=7.50%WACC=.3209(.0422)+.0905(.0750)+.5886(.1245)=9.36%19.MVD=2,000($1,000)(.93)=$1,860,000;MVE=80,000($45)=$3,600,000MVP=7,000($93)=$651,000;V=$1,860,000+3,600,000+651,000=$6,111,000D/V=$1,860,000/$6,111,000=.3044;E/V=$3,600,000/$6,111,000=.5891P/V=$651,000/$6,111,000=.1065RE1=.04+1.20(.12–.04)=.1360;RE2=($3.25/$45)+.07=.1422RE=(.1360+.1422)/2=.1391P0=$930=$35(PVIFAR%,40)+$1,000(PVIFR%,40);R=3.8456%,YTM=7.691%RD=(1–.35)(.07691)=4.999%RP=$6/$93=6.452%WACC=.3044(.04999)+.1065(.06452)+.5891(.1391)=10.40%20.WACC=.25(.04999)+.05(.06452)+.70(.1391)=11.31% CHAPTER12B-521.MVD=8,000($1,000)(1.04)=$8,320,000;MVE=200,000($75)=$15,000,000V=$7,440,000+15,000,000=$23,320,000D/V=$8,320,000/$23,320,000=.3568;E/V=$15,000,000/$23,320,000=.6432RE1=.06+1.10(.13–.06)=.1370;RE2=($3.40/$75)+.07=.1153RE=(.1370+.1153)/2=.1262P0=$1,040=$45(PVIFAR%,50)+$1,000(PVIFR%,50);R=4.3040%,YTM=8.608%RD=(1–.35)(.08608)=5.595%WACC=.3568(.05595)+.6432(.1262)=10.11%2722.P0=$1,000/(1.076)=$138.38;MVD=70,000$138.38=$9,686,496V=$9,686,496+20,000,000=$29,686,496D/V=$9,686,496/$29,686,496=.326323.g1=($1.93–1.80)/$1.80=.0722;g2=($2.02–1.93)/$1.93=.0466g3=($2.09–2.02)/$2.02=.0347;g3=($2.21–2.09)/$2.09=.0574g=(.0722+.0466+.0347+.0574)/4=.0527RE=[$2.21(1.0527)/$51]+.0527=9.83%24.MVD=50,000($1,000)(.94)=$47,000,000;MVE=3,000,000($28)=$84,000,000V=$47,000,000+84,000,000=$131,000,000D/V=$47,000,000/$131,000,000=.3588;E/V=$84,000,000/$131,000,000=.6412RE=.0625+1.1(.075)=.1450P0=$940=$40(PVIFAR%,36)+$1,000(PVIFR%,36);R=4.332%,YTM=8.664%RD=(1–.35)(.08644)=5.632%WACC=.3588(.05632)+.6412(.1450)=11.32%25.WACC=(.50/1.50)(.0675)+(1/1.50)(.145)=.1192;projectdiscountrate=.1192+.03=.1492Intermediate26.WACC=(.7/1.7)(.07)+(1/1.7)(.16)=12.29%;projectdiscountrate=12.29%+2%=14.49%NPV=–cost+PVcashflows;PV=[$6M/(.1449–.04)]=$58,285,714.29Theprojectshouldonlybeundertakenifitscostislessthan$58,285,714.29.27.WACC=.45(.078)+.55(.135)=10.935%;projectdiscountrate=10.935%+2%=12.935%Maximuminitialcost=$215,000(PVIFA12.935%,6)=$861,031.19 CHAPTER12B-628.MV1=0.98($10M)=$9,800,000;MV2=1.09($45M)=$49,050,000MV3=0.94($35M)=$32,900,000;MV4=1.15($45M)=$51,750,000MVD=$9,800,000+49,050,000+32,900,000+51,750,000=$143,500,000w1=$9,800,000/$143,500,000=.0683;w2=$49,050,000/$143,500,000=.3418w3=$32,900,000/$143,500,000=.2293;w4=$51,750,000/$143,500,000=.3606P1=$980=$25(PVIFAR%,10)+$1,000(PVIFR%,10);R=2.731%,YTM=5.463%P2=$1,090=$37.50(PVIFAR%,16)+$1,000(PVIFR%,16);R=3.032%,YTM=6.064%P3=$940=$32(PVIFAR%,31)+$1,000(PVIFR%,31);R=3.521%,YTM=7.042%P4=$1,150=$48.75(PVIFAR%,50)+$1,000(PVIFR%,50);R=4.157%,YTM=8.316%Aftertaxcost:D1=.05463(1–.34)=.0361D2=.06064(1–.34)=.0400D3=.07042(1–.34)=.0465D4=.08316(1–.34)=.0549Company’saftertaxcostofdebt=.0361(.0683)+.0400(.3418)+.0465(.2293)+.0549(.3606)=.046629.a.RE=[(0.80)(1.05)/$53]+.05=6.58%b.RE=.06+1.2(.13–.06)=14.40%c.WhenusingthedividendgrowthmodelortheCAPM,youmustrememberthatbothareestimatesforthecostofequity.Additionally,andperhapsmoreimportantly,eachmethodofestimatingthecostofequitydependsupondifferentassumptions.30.The$6millioncostoftheland3yearsagoisasunkcostandirrelevant;the$4.25Mappraisedvalueofthelandisanopportunitycostandisrelevant.Therelevantmarketvaluecapitalizationweightsare:MVD=10,000($1,000)(0.94)=$9.4M;MVE=250,000($65)=$16.25MMVP=10,000($81)=$810,000;V=$9.4M+16.25M+.81M=$26.46MRE=.0565+1.3(.08)=16.05%P0=$940=$40(PVIFAR%,30)+$1,000(PVIFR%,30);R=4.362%,YTM=8.725%RD=(1–.34)(.08725)=5.758%RP=$7/$81=8.642%a.CF0=–$4.25M–7.2M–750,000=–$12.2Mb.WACC=.02+[(9.4/26.46)(.05758)+(.81/26.46)(.08642)+(16.25/26.46)(.1605)]=.1417c.BV5=$2,700,000;after-taxsalvagevalue=$2M+.34($2.7M–2M)=$2,238,000d.OCF=[(P–v)Q–FC](1–tC)+tCD=[($10,000–9,100)(10,000)–$900,000](1–.34)+.34($7.2M/8)=$5,652,000e.YearCashFlow0–$12,200,000IRR=39.34%1$5,652,000NPV=$8,666,653.952$5,652,000discountrate=WACC=14.17%3$5,652,0004$5,652,0005$8,640,000 CHAPTER13LEVERAGEANDCAPITALSTRUCTUREAnswerstoConceptsReviewandCriticalThinkingQuestions1.Businessriskistheequityriskarisingfromthenatureofthefirm’soperatingactivity,andisdirectlyrelatedtothesystematicriskofthefirm’sassets.Financialriskistheequityriskthatisdueentirelytothefirm’schosencapitalstructure.Asfinancialleverage,ortheuseofdebtfinancing,increases,sodoesfinancialriskandhencetheoverallriskoftheequity.Thus,FirmBcouldhaveahighercostofequityifitusesgreaterleverage.2.No,itdoesn’tfollow.Whileitistruethattheequityanddebtcostsarerising,thekeythingtorememberisthatthecostofdebtisstilllessthanthecostofequity.Sinceweareusingmoreandmoredebt,theWACCdoesnotnecessarilyrise.3.Becausemanyrelevantfactorssuchasbankruptcycosts,taxasymmetries,andagencycostscannoteasilybeidentifiedorquantified,it’spracticallyimpossibletodeterminetheprecisedebt/equityratiothatmaximizesthevalueofthefirm.However,ifthefirm’scostofnewdebtsuddenlybecomesmuchmoreexpensive,it’sprobablytruethatthefirmistoohighlyleveraged.4.Themorecapitalintensiveindustries,suchasairlines,cabletelevision,andelectricutilities,tendtousegreaterfinancialleverage.Also,industrieswithlesspredictablefutureearnings,suchcomputersordrugs,tendtouseless.Suchindustriesalsohaveahigherconcentrationofgrowthandstartupfirms.Overall,thegeneraltendencyisforfirmswithidentifiable,tangibleassetsandrelativelymorepredictablefutureearningstousemoredebtfinancing.Thesearetypicallythefirmswiththegreatestneedforexternalfinancingandthegreatestlikelihoodofbenefitingfromtheinteresttaxshelter.5.It’scalledleverage(or“gearing”intheUK)becauseitmagnifiesgainsorlosses.6.Homemadeleveragereferstotheuseofborrowingonthepersonallevelasopposedtothecorporatelevel.7.Oneansweristhattherighttofileforbankruptcyisavaluableasset,andthefinancialmanageractsinshareholders’bestinterestbymanagingthisassetinwaysthatmaximizeitsvalue.Totheextentthatabankruptcyfilingprevents“aracetothecourthousesteps,”itwouldseemtobeareasonablealternativetocomplicatedandexpensivelitigation.8.Asinthepreviousquestion,itcouldbearguedthatusingbankruptcylawsasaswordmaysimplybethebestuseoftheasset.Creditorsareawareatthetimealoanismadeofthepossibilityofbankruptcy,andtheinterestchargedincorporatesthispossibility. CHAPTER13B-29.OnesideisthatContinentalwasgoingtogobankruptbecauseitscostsmadeituncompetitive.ThebankruptcyfilingenabledContinentaltorestructureandkeepflying.TheothersideisthatContinentalabusedthebankruptcycode.Ratherthanrenegotiatelaboragreements,Continentalsimplyabrogatedthemtothedetrimentofitsemployees.Itisimportantthingtokeepinmindthatthebankruptcycodeisacreationoflaw,noteconomics.Astrongargumentcanalwaysbemadethatmakingthebestuseofthebankruptcycodeisnodifferentfrom,forexample,minimizingtaxesbymakingbestuseofthetaxcode.Indeed,astrongcasecanbemadethatitisthefinancialmanager’sdutytodoso.AsthecaseofContinentalillustrates,thecodecanbechangedifsociallyundesirableoutcomesareaproblem.10.Aswithanymanagementdecision,thegoalistomaximizethevalueofshareholderequity.Toaccomplishthiswithrespecttothecapitalstructuredecision,managementattemptstochoosethecapitalstructurewiththelowestcostofcapital.SolutionstoQuestionsandProblemsBasic1.a.EBIT$7,000$10,000$12,000Interest000NI$7,000$10,000$12,000EPS$1.75$2.50$3.00EPS%–30–––+20b.MV$80,000/4,000shares=$20pershare;$40,000/$20=2,000sharesboughtbackEBIT$7,000$10,000$12,000Interest2,0002,0002,000NI$5,000$8,000$10,000EPS$2.50$4.00$5.00EPS%–37.5–––+25.02.a.EBIT$7,000$10,000$12,000Interest000EBT7,00010,00012,000Taxes2,4503,5004,200NI$4,550$6,500$7,800EPS$1.14$1.63$1.95EPS%–30–––+20b.MV$80,000/4,000shares=$20pershare;$40,000/$20=2,000sharesboughtbackEBIT$7,000$10,000$12,000Interest2,0002,0002,000EBT5,0008,00010,000Taxes1,7502,8003,500NI$3,250$5,200$6,500EPS$1.63$2.60$3.25EPS%–37.5–––+25.0 CHAPTER13B-33.a.market-to-bookratio=1.0,soTE=MV=$80,000;ROE=NI/$80,000ROE.0875.125.15ROE%–30–––+20b.now,TE=$80,000–40,000=$40,000;ROE=NI/$40,000ROE.125.20.25ROE%–37.5–––+25c.NodebtROE.05688.08125.0975ROE%–30–––+20WithdebtROE.08125.13.1625ROE%–37.5–––+25.04.a.PlanI:NI=$1.5M:EPS=$1.5M/600Kshares=$2.50PlanII:NI=$1.5M–.10($10M)=$500K;EPS=$500K/300Kshares=$1.67PlanIhasthehigherEPSwhenEBITis$600,000.b.PlanI:NI=$11M;EPS=$11M/600Kshares=$18.33PlanII:NI=$11M–.10($5M)=$10M;EPS=$10M/300Kshares=$33.33PlanIIhasthehigherEPSwhenEBITis$2,500,000.c.EBIT/600K=[EBIT–.10($10M)]/300K;EBIT=$2,000,0005.P=$10M/300Ksharesboughtwithdebt=$33.33pershareV1=$33.33(600Kshares)=$20M;V2=$33.33(300Kshares)+$10Mdebt=$20M6.a.IIIall-equityEBIT$12,000$12,000$12,000Interest3,0001,5000NI$9,000$10,500$12,000EPS$9.00$5.25$4.00Theall-equityplanhasthelowestEPS;PlanIhasthehighestEPS.b.PlanIvs.all-equity:EBIT/3,000=[EBIT–.10($30,000)]/1,000;EBIT=$4,500PlanIIvs.all-equity:EBIT/3,000=[EBIT–.10($15,000)]/2,000;EBIT=$4,500Thebreak-evenlevelsofEBITarethesamebecauseofM&MPropositionI.c.[EBIT–.10($30,000)]/1,000=[EBIT–.10($15,000)]/2,000;EBIT=$4,500Thisbreak-evenlevelofEBITisthesameasinpart(b)againbecauseofM&MPropositionI.d.IIIall-equityEBIT$12,000$12,000$12,000Interest3,0001,5000EBT9,00010,50012,000Taxes3,4203,9904,560NI$5,580$6,510$7,440EPS$5.58$3.26$2.48Theall-equityplanstillhasthelowestEPS;PlanIstillhasthehighestEPS.PlanIvs.all-equity:EBIT(.62)/3,000=[EBIT–.10($30,000)](.62)/1,000;EBIT=$4,500PlanIIvs.all-equity:EBIT(.62)/3,000=[EBIT–.10($15,000)](.62)/2,000;EBIT=$4,500[EBIT–.10($30,000)](.62)/1,000=[EBIT–.10($15,000)](.62)/2,000;EBIT=$4,500Thebreak-evenlevelsofEBITdonotchangebecausetheadditionoftaxesreducestheincomeofallthreeplansbythesamepercentage;therefore,theydonotchangerelativetooneanother. CHAPTER13B-47.I:P=$15,000/1,000sharesboughtwithdebt=$15pershare;II:P=$15,000/1,000shares=$15Thisshowsthatwhentherearenocorporatetaxes,thestockholderdoesnotcareaboutthecapitalstructuredecisionofthefirm.ThisisM&MPropositionIwithouttaxes.8.a.EPS=$6,000/800shares=$7.50;Rico’scashflow=$7.50(100shares)=$750b.V=$80(800)=$64,000;D=0.30($64,000)=$19,200$19,200/$80=240sharesarebought;NI=$6,000–.09($19,200)=$4,272EPS=$4,272/560shares=$7.63;Rico"scashflow=$7.63(100shares)=$763c.Sell30sharesofstockandlendtheproceedsat9%:interestcashflow=30($80)(.09)=$216cashflowfromsharesheld=$7.63(70shares)=$534;totalcashflow=$750.d.Thecapitalstructureisirrelevantbecauseshareholderscancreatetheirownleverageorunleverthestocktocreatethepayofftheydesire,regardlessofthecapitalstructurethefirmactuallychooses.9.a.EPS=$38,000/1,000shares=$38.00;Rebecca’scashflow=$38.00(100shares)=$3,800b.V=$120(1,000)=$120,000;D=0.40($120,000)=$48,000$48,000/$120=400sharesarebought;NI=$38,000–.08($48,000)=$34,160EPS=$34,160/700shares=$56.93;Rebecca"scashflow=$56.93(100shares)=$5,693c.Sell40sharesofstockandlendtheproceedsat8%:interestcashflow=40($120)(.08)=$384cashflowfromsharesheld=$56.93(60shares)=$3,416;totalcashflow=$3,800.d.Thecapitalstructureisirrelevantbecauseshareholderscancreatetheirownleverageorunleverthestocktocreatethepayofftheydesire,regardlessofthecapitalstructurethefirmactuallychooses.10.D/E=1implies50%debt;VL=VU+TCD=$60M+.40($30M)=$72MD/E=2implies67%debt;VL=VU+TCD=$60M+.40($40M)=$76M11.Withnodebtthevalueisunchangedat$60M.D/E=1implies50%debt;VL=VU+TCD=$60M+.30($30M)=$69MD/E=2implies67%debt;VL=VU+TCD=$60M+.30($40M)=$72MDebtwillincreasethevalueofthefirmmorewhenthecorporatetaxrateishigher.12.a.WACC=.14=(1/2.5)RE+(1.5/2.5)(.09);RE=.2150b..14=(1/2)RE+(1/2)(.09);RE=.1900.14=(1/1.5)RE+(.5/1.5)(.09);RE=.1650.14=(1)RE+(0)(.09);RE=WACC=.140013.a.all-equityfinanced:WACC=RE=.13b.RE=RA+(RA–RD)(D/E)=.13+(.13–.08)(.25/.75)=.1467c.RE=RA+(RA–RD)(D/E)=.13+(.13–.08)(.50/.50)=.1800d.WACCB=(E/V)RE+(D/V)RD=.75(.1467)+.25(.08)=.1300WACCC=(E/V)RE+(D/V)RD=.50(.18)+.50(.08)=.130014.V=VU+TCD=$325,000+.35($75,000)=$351,250 CHAPTER13B-515.Interesttaxshield=$32M(.38)=$12.16M.Theinteresttaxshieldrepresentsthetaxsavingsincurrentincomeduetothedeductibilityofafirm’squalifieddebtexpenses.Intermediate16.NodebtVU=VL;valueofthefirmis$160MWithdebt:V=VU+TCD=$160M+.40($50M)=$180M17.E=VL–DNodebt:E=$160M–50M=$110M,D/E=$50M/$110M=.45Withdebt:E=$180M–50M=$130M,D/E=$50M/$130M=.3818.Initially,RE=WACC=RA=.14Afterissuingdebt:RE=.14+(.14–.08)(1)=.20WACC=.20(.5)+.08(.5)=.1419.nodebt:V=VU=$21,000(.62)/.18=$72,333.3350%debt:V=$72,333.33+.38(V/2);V=$89,300.41100%debt:V=$72,333.33+.38V;V=$116,666.67 CHAPTER14DIVIDENDSANDDIVIDENDPOLICYAnswerstoConceptsReviewandCriticalThinkingQuestions1.Dividendpolicydealswiththetimingofdividendpayments,nottheamountsultimatelypaid.Dividendpolicyisirrelevantwhenthetimingofdividendpaymentsdoesn’taffectthepresentvalueofallfuturedividends.2.Astockrepurchasereducesequitywhileleavingdebtunchanged.Thedebtratiorises.Afirmcould,ifdesired,useexcesscashtoreducedebtinstead.Thisisacapitalstructuredecision.3.Thechiefdrawbacktoastrictdividendpolicyisthevariabilityindividendpayments.Thisisaproblembecauseinvestorstendtowantasomewhatpredictablecashflow.Also,ifthereisinforma-tioncontenttodividendannouncements,thenthefirmmaybeinadvertentlytellingthemarketthatitisexpectingadownturninearningsprospectswhenitcutsadividend,wheninrealityitsprospectsareverygood.Inacompromisepolicy,thefirmmaintainsarelativelyconstantdividend.Itincreasesdividendsonlywhenitexpectsearningstoremainatasufficientlyhighleveltopaythelargerdividends,anditlowersthedividendonlyifitabsolutelyhasto.4.Friday,December29istheex-dividendday.RemembernottocountJanuary1becauseitisaholiday,andtheexchangesareclosed.AnyonewhobuysthestockbeforeDecember29isentitledtothedividend,assumingtheydonotsellitagainbeforeDecember29.5.No,becausethemoneycouldbebetterinvestedinstocksthatpaydividendsincashthatwillbenefitthefundholdersdirectly.6.Thechangeinpriceisduetothechangeindividends,nottothechangeindividendpolicy.Dividendpolicycanstillbeirrelevantwithoutacontradiction.7.Thestockpricedroppedbecauseofanexpecteddropinfuturedividends.Sincethestockpriceisthepresentvalueofallfuturedividendpayments,iftheexpectedfuturedividendpaymentsdecrease,thenthestockpricewilldecline.8.Theplanwillprobablyhavelittleeffectonshareholderwealth.Theshareholderscanreinvestontheirown,andtheshareholdersmustpaythetaxesonthedividendseitherway.However,theshareholderswhotaketheoptionmaybenefitattheexpenseoftheoneswhodon’t(becauseofthediscount).Alsoasaresultoftheplan,thefirmwillbeabletoraiseequitybypayinga10%flotationcost(thediscount),whichmaybeasmallerdiscountthanthemarketflotationcostsofanewissue.9.Ifthesefirmsjustwentpublic,theyprobablydidsobecausetheyweregrowingandneededtheadditionalcapital.Growthfirmstypicallypayverysmallcashdividends,iftheypayadividendatall.Thisisbecausetheyhavenumerousprojects,andthereforereinvesttheearningsinthefirminsteadofpayingcashdividends. CHAPTER14B-210.Itwouldnotbeirrationaltofindlow-dividend,high-growthstocks.Thetrustshouldbeindifferentbetweenreceivingdividendsorcapitalgainssinceitdoesnotpaytaxesoneitherone(ignoringpossiblerestrictionsoninvasionofprincipal,etc.).Itwouldbeirrational,however,toholdmunicipalbonds.Sincethetrustdoesnotpaytaxesontheinterestincomeitreceives,itdoesnotneedthetaxbreakassociatedwiththemunicipalbonds.Therefore,itshouldprefertoholdhigheryielding,taxablebonds.SolutionstoQuestionsandProblemsBasic1.newstockprice=$105.00–1.50=$103.50;stockvalue=200$103.50=$20,7002.newstockprice=$105.00–1.50=$103.50;stockvalue=200$103.50=$20,700dividend=200$1.50=$300;totalwealth=$20,700+300=$21,0003.after-taxdividend=$4.00(1–.34)=$2.64;ex-dividendprice=$90–2.64=$87.364.a.newsharesoutstanding=16,000(1.10)=17,600;newsharesissued=1,600capitalsurplusonnewshares=1,600($29)=$46,400Commonstock($1parvalue)$17,600Capitalsurplus166,400Retainedearnings394,000$578,000b.newsharesoutstanding=16,000(1.25)=20,000;newsharesissued=4,000Commonstock($1parvalue)$20,000Capitalsurplus236,000Retainedearnings322,000$578,0005.a.newsharesoutstanding=16,000(4)=64,000.Theequityaccountsareunchangedexcepttheparvalueofthestockisnow$0.25pershare.b.newsharesoutstanding=16,000(1/5)=3,200.Theequityaccountsareunchangedexcepttheparvalueofthestockisnow$5.00pershare.6.a.$90(3/5)=$54.00b.$90(1/1.15)=$78.26c.$90(1/1.425)=$63.16d.$90(7/4)=$157.50e.a:400,000(5/3)=666,667;b:400,000(1.15)=460,000;c:400,000(1.425)=570,000;d:400,000(4/7)=228,5717.P0=$300,000equity/15,000shares=$20;PX=$20–1.25=$18.75$1.25(15,000shares)=$18,750;theequityandcashaccountswillbothdeclineby$18,750.8.Repurchasingtheshareswillreduceshareholders’equityby$3,000.sharesbought=$3,000/$20=150;newsharesoutstanding=14,850.Afterrepurchase,shareprice=$297,000equity/14,850shares=$20.Therepurchaseiseffectivelythesameasthecashdividendbecauseyoueitherholdashareworth$20,orashareworth$18.75and$1.25incash.Thereforeyouparticipateintherepurchaseaccordingtothedividendpayoutpercentage;youareunaffected. CHAPTER14B-39.P0=$150,000equity/5,000shares=$30;newsharesoutstanding=5,000(1.20)=6,000PX=$150,000/6,000shares=$25.0010.newsharesoutstanding=450,000(1.08)=486,000capitalsurplusfornewshares=36,000($9)=$324,000Commonstock($1parvalue)$486,000Capitalsurplus1,874,000Retainedearnings2,640,000$5,000,00011.Theequityaccountsareunchangedexceptthenewparvalueofthestockis$0.20pershare.Dividendsthisyear=$0.50(450,000shares)(5/1split)=$1,125,000Lastyear’sdividends=$1,125,000/1.10=$1,022,727Dividendspersharelastyear=$1,022,727/450,000shares=$2.2712.equityportionofcapitaloutlays=$1,800–620=$1,180;D/E=.60impliescapitalstructureis.6/1.6debtand1/1.6equity.Therefore,newborrowings=$708;totalcapitaloutlays=$1,88813.a.payoutratio=DPS/EPS=$1.50/$8=.1875b.equityportionofcapitaloutlays=7Mshares($8–1.50)=$45.5MD/Eratio=$13M/$45.5M=0.285714.a.maximumcapitaloutlayswithnoequityfinancing=$1,600,000+2($1,600,000)=$4,800,000.b.Ifplannedcapitalspendingis$6,000,000>$4,800,000,thennodividendwillbepaidandnewequitywillbeissued.c.No,theydonotmaintainaconstantdividendpayoutbecause,withthestrictresidualpolicy,thedividendwilldependontheinvestmentopportunitiesandearnings.Asthesetwothingsvary,thedividendpayoutwillalsovary.15.a.maximuminvestmentwithnoequityfinancing=$20M+1.4($30M)=$48M;debt=$28Mb.D/E=1.4impliescapitalstructureis1.4/2.4debtand1/2.4equity.equityportionofinvestmentfunds=1/2.4($40M)=$16,666,667Residual=$20M–16,666,667=$3,333,333Mdividendpershare=$3,333,333/8Mshares=$0.417c.borrowing=$40M–16.7M=$23.3M;additiontoretainedearnings=$16,666,667d.dividendpershare=$20M/8Mshares=$2.50;nonewborrowingwilltakeplaceIntermediate216.P0=$2.00/1.15+$50/1.15=$39.552$39.55=D/1.15+D/1.15;D=$24.32558P1=$50/1.15=$43.48Youwant1,000($24.33)=$24,325.58inoneyear,butyou’llonlyget1,000($2.00)=$2,000.Thussell($24,325.58–2,000)/$43.48=513.49sharesattime1.time2cashflow=$50(1,000–513.49)=$24,325.5817.youonlywant$400inyear1,sobuy($2,000–400)/$43.48=36.80sharesattime1.year2:(1,000+36.80)($50)=$51,8402PV=$400/1.15+($51,840)/1.15=$39,546.312PV=1,000($2.00)/1.15+1,000($50)/1.15=$39,546.31 CHAPTER14B-418.a.cashdividend:DPS=$9,600/600shares=$16.00;PX=$50–16.00=$34.00pershare.wealthofashareholder=ashareworth$34plus$16cash=$50.repurchase:$9,600/$50=192shareswillberepurchased.Ifyouchoosetoletyoursharesberepurchased,youhave$50incash;ifyoukeepyourshares,they’restillworth$50.b.dividends:EPS=$2.50;P/E=$34/$2.50=13.60repurchase:EPS=$2.50(600)/(600192)=$3.6765;P/E=$50/$3.6765=13.60c.Asharerepurchasewouldseemtobethepreferredcourseofaction.Onlythoseshareholderswhowishtosellwilldoso,givingtheshareholderataxtimingoptionthatheorshedoesn’tgetwithadividendpayment. CHAPTER15RAISINGCAPITALAnswerstoConceptsReviewandCriticalThinkingQuestions1.Acompany’sinternallygeneratedcashflowprovidesasourceofequityfinancing.Foraprofitablecompany,outsideequitymayneverbeneeded.Debtissuesarelargerbecauselargecompanieshavethegreatestaccesstopublicdebtmarkets(smallcompaniestendtoborrowmorefromprivatelenders).Equityissuersarefrequentlysmallcompaniesgoingpublic;suchissuesareoftenquitesmall.2.Fromthepreviousquestion,economiesofscalearepartoftheanswer.Beyondthis,debtissuesaresimplyeasierandlessriskytosellfromaninvestmentbank’sperspective.Thetwomainreasonsarethatverylargeamountsofdebtsecuritiescanbesoldtoarelativelysmallnumberofbuyers,particularlylargeinstitutionalbuyerssuchaspensionfundsandinsurancecompanies,anddebtsecuritiesaremucheasiertoprice.3.Theyareriskierandhardertomarketfromaninvestmentbank’sperspective.4.Yieldsoncomparablebondscanusuallybereadilyobserved,sopricingabondissueaccuratelyismuchlessdifficult.5.Itisclearthatthestockwassoldtoocheaply,soNetscapehadreasontobeunhappy.6.No,but,infairness,pricingthestockinsuchasituationisextremelydifficult.7.It’sanimportantfactor.Only5millionoftheshareswereunderpriced.Theother38millionwere,ineffect,pricedcorrectly.8.Hecouldhavedoneworsesincehisaccesstotheoversubscribedand,presumably,underpricedissueswasrestrictedwhilethebulkofhisfundswereallocatedinstocksfromtheundersubscribedand,quitepossibly,overpricedissues.9.a.ThepricewillprobablygoupbecauseIPOsaregenerallyunderpriced.Thisisespeciallytrueforsmallerissuessuchasthisone.b.Itisprobablysafetoassumethattheyarehavingtroublemovingtheissue,anditislikelythattheissueisnotsubstantiallyunderpriced. CHAPTER15B-2SolutionstoQuestionsandProblemsBasic1.Ifyoureceive1,000sharesofeach,theprofitis1,000($6)–1,000($3)=$3,000.Expectedprofit=500($6)–1,000($3)=$0.Thisisanexampleofthewinner’scurse.2.X(1–.07)=$60M;X=$64,516,129.03requiredtotalproceedsfromsale.numberofsharesoffered=$64,516,129.03/$75=860,2153.X(1–.08)=$60M+600K;X=$65,151,290.32requiredtotalproceedsfromsale.numberofsharesoffered=$65,151,290.32/$75=868,8174.netamountraised=(3.4Mshares)($31)–650,000=$104.75Mtotaldirectcosts=$450,000+($33–31)(3.4Mshares)=$7.25Mtotalindirectcosts=$200,000+($41–33)(3.4Mshares)=$27.4Mtotalcosts=$7.25M+27.4M=$34.65Mflotationcostpercentage=$34.65M/$104.75M=33.08%5.X(1–.06)=$35M;X=$37,234,042.55requiredtotalproceedsfromsale.numberofsharesoffered=$37,234,042.55/$42=886,5256.X(1–.06)=$35M+$400K;X=$37,659,574.47requiredtotalproceedsfromsale.numberofsharesoffered=$37,659,574.47/$42=896,6577.netamountraised=(3.5Mshares)($15.00)–550,000=$51.925Mtotaldirectcosts=$400,000+($16.50–15)(3.5Mshares)=$5.65Mtotalindirectcosts=$175,000+($23–16.50)(3.5Mshares)=$22.925Mtotalcosts=$5.65M+22.925M=$28.575Mflotationcostpercentage=$28.575M/$51.925M=55.03% CHAPTER16SHORT-TERMFINANCIALPLANNINGAnswerstoConceptsReviewandCriticalThinkingQuestions1.Thesearefirmswithrelativelylonginventoryperiodsand/orrelativelylongreceivablesperiods.Thus,suchfirmstendtokeepinventoryonhand,andtheyallowcustomerstopurchaseoncreditandtakearelativelylongtimetopay.2.Thesearefirmsthathavearelativelylongtimebetweenthetimepurchasedinventoryispaidforandthetimethatinventoryissoldandpaymentreceived.Thus,thesearefirmsthathaverelativelyshortpayablesperiodsand/orrelativelylongreceivablecycles.3.a.Use:Thecashbalancedeclinedby$200topaythedividend.b.Source:Thecashbalanceincreasedby$500assumingthegoodsboughtonpayablescreditweresoldforcash.c.Use:Thecashbalancedeclinedby$900topayforthefixedassets.d.Use:Thecashbalancedeclinedby$625topayforthehigherlevelofinventory.e.Use:Thecashbalancedeclinedby$1,200topayfortheredemptionofdebt.4.Carryingcostswilldecreasebecausetheyarenotholdinggoodsininventory.Shortagecostswillprobablyincreasedependingonhowclosethesuppliersareandhowwelltheycanestimateneed.Theoperatingcyclewilldecreasebecausetheinventoryperiodisdecreased.5.Sincethecashcycleequalstheoperatingcycleminustheaccountspayableperiod,itisnotpossibleforthecashcycletobelongerthantheoperatingcycleiftheaccountspayableispositive.Moreover,itisunlikelythattheaccountspayableperiodwouldeverbenegativesincethatimpliesthefirmpaysitsbillsbeforetheyareincurred.6.Itlengtheneditspayablesperiod,therebyshorteningitscashcycle.7.Theirreceivablesperiodincreased,therebyincreasingtheiroperatingandcashcycles.8.Itissometimesarguedthatlargefirms“takeadvantageof”smallerfirmsbythreateningtotaketheirbusinesselsewhere.However,consideringamovetoanothersuppliertogetbettertermsisthenatureofcompetitivefreeenterprise.9.Theywouldliketo!Thepayablesperiodisasubjectofmuchnegotiation,anditisoneaspectofthepriceafirmpaysitssuppliers.Afirmwillgenerallynegotiatethebestpossiblecombinationofpayablesperiodandprice.Typically,suppliersprovidestrongfinancialincentivesforrapidpayment.Thisissueisdiscussedindetailinalaterchapteroncreditpolicy.10.Ameritechwillneedlessfinancingbecauseitisessentiallyborrowingmorefromitssuppliers.Amongotherthings,Ameritechwilllikelyneedlessshort-termborrowingfromothersources,soitwillsaveoninterestexpense. CHAPTER16B-2SolutionstoQuestionsandProblemsBasic1.a.Nb.Nc.Nd.De.Df.Ig.Nh.Di.Ij.Dk.Dl.Nm.Dn.Do.D2.Cash=$21,000+5,000–8,000–8,500=$9,500Currentassets=$8,500+4,000+9,500=$22,0003.a.Ib.Ic.Dd.Ne.Df.N4.firstletteriscashcycle,a.D;Db.I;Nc.D;Dsecondisoperatingcycle.d.D;De.D;Nf.I;I5.a.45-daycollectionperiodimpliesallreceivablesoutstandingfrompreviousquarterarecollectedinthecurrentquarter,and(90-45)/90=1/2ofcurrentsalesarecollected.Q1Q2Q3Q4Beginningreceivables$500$300$360$450Sales600720900800Cashcollections(800)(660)(810)(850)Endingreceivables$300$360$450$400b.60-daycollectionperiodimpliesallreceivablesoutstandingfrompreviousquarterarecollectedinthecurrentquarter,and(90-60)/90=1/3ofcurrentsalesarecollected.Q1Q2Q3Q4Beginningreceivables$500$400$480$600Sales600720900800Cashcollections(700)(640)(780)(867)Endingreceivables$400$480$600$533c.30-daycollectionperiodimpliesallreceivablesoutstandingfrompreviousquarterarecollectedinthecurrentquarter,and(90-30)/90=2/3ofcurrentsalesarecollected.Q1Q2Q3Q4Beginningreceivables$500$200$240$300Sales600720900800Cashcollections(900)(680)(840)(833)Endingreceivables$200$240$300$267 CHAPTER16B-36.Inventoryturnover=$52,143/{[$9,146+11,416]/2}=5.07178timesInventoryperiod=365days/5.07178=71.967daysReceivablesturnover=$70,126/{[$4,819+5,627]/2}=13.42638timesReceivablesperiod=365days/13.42638=27.185daysOperatingcycle=71.967+27.185=99.15daysPayablesturnover=$52,143/{[$8,126+8,526]/2}=6.26267timesPayablesperiod=365days/6.26267=58.282daysCashcycle=99.15–58.28=40.87daysThefirmisreceivingcashonaverage40.87daysafteritpaysitsbills.365/487.EAR=(1+2/98)–1=16.61%8.a.ThepayablesperiodiszerosinceTobypaysimmediately.Paymentineachperiod=0.30timesnextperiodsales.Q1Q2Q3Q4Paymentofaccounts$222.00$258.00$291.00$276.00b.Sincethepayablesperiodis90days,paymentineachperiod=0.3timescurrentperiodsales.Q1Q2Q3Q4Paymentofaccounts$240.00$222.00$258.00$291.00c.Sincethepayablesperiodis60days,paymentineachperiod=2/3oflastquarter’sorders,and1/3ofthisquarter’sorders,or2/3(.30)timescurrentsales+1/3(.30)nextperiodsales.Q1Q2Q3Q4Paymentofaccounts$234.00$234.00$269.00$286.009.Sincethepayablesperiodis60days,payablesineachperiod=2/3oflastquarter’sorders,and1/3ofthisquarter’sorders,or2/3(.75)timescurrentsales+1/3(.75)nextperiodsales.Q1Q2Q3Q4Paymentofaccounts$580.00$600.00$700.00$700.00Wages,taxes,otherexpenses240.00216.00288.00264.00Long-termfinancingexpenses40.0040.0040.0040.00(interestanddividends)Total$860.00$856.00$1,028.00$1,004.0010.a.Novembersales=($50,000–28,000)/0.15=$146,667b.Decembersales=$28,000/0.35=$80,000c.Januarycollections=.15($146,667)+.20($80,000)+.65($120,000)=$116,000.00Februarycollections=.15($80,000)+.20($120,000)+.65($160,000)=$140,000.00Marchcollections=.15($120,000)+.20($160,000)+.65($180,000)=$167,000.00 CHAPTER16B-411.Salescollections=.35timescurrentmonthsales+.60timespreviousmonthsales.AprilMayJuneBeginningcashbalances$230,000$255,000$289,000CashreceiptsCashcollectionsfrom322,000347,000351,000creditsalesTotalcashavailable$552,000$602,000$640,000CashdisbursementsPurchases160,000160,000190,000Wages,taxes,andexpenses79,00075,00086,000Interest8,0008,0008,000Equipmentpurchases50,00070,000175,000Totalcashdisbursements$297,000$313,000$459,000Endingcashbalance$255,000$289,000$181,00012.a.45-daycollectionperiodimpliesallreceivablesoutstandingfrompreviousquarterarecollectedinthecurrentquarter,and(90-45)/90=1/2ofcurrentsalesarecollected.Q1Q2Q3Q4Beginningreceivables$1,800$1,800$1,650$1,200Sales3,6003,3002,4005,600Cashcollections(3,600)(3,450)(2,850)(4,000)Endingreceivables$1,800$1,650$1,200$2,800b.60-daycollectionperiodimpliesallreceivablesoutstandingfrompreviousquarterarecollectedinthecurrentquarter,and(90-60)/90=1/3ofcurrentsalesarecollected.Q1Q2Q3Q4Beginningreceivables$1,800$2,400$2,200$1,600Sales3,6003,3002,4005,600Cashcollections(3,000)(3,500)(3,000)(3,467)Endingreceivables$2,400$2,200$1,600$3,733c.30-daycollectionperiodimpliesallreceivablesoutstandingfrompreviousquarterarecollectedinthecurrentquarter,and(90-30)/90=2/3ofcurrentsalesarecollected.Q1Q2Q3Q4Beginningreceivables$1,800$1,200$1,100$800Sales3,6003,3002,4005,600Cashcollections(4,200)(3,400)(2,700)(4,533)Endingreceivables$1,200$1,100$800$1,867 CHAPTER16B-513.Inventoryturnover=$108,915/{[$21,430+23,865]/2}=4.80914timesInventoryperiod=365days/4.80914=75.897daysReceivablesturnover=$243,612/{[$15,362+17,120]/2}=14.9998timesReceivablesperiod=365days/14.9998=24.334daysOperatingcycle=75.897+24.334=100.23daysPayablesturnover=$108,915/{[$20,146+21,803]/2}=5.1595timesPayablesperiod=365days/5.1595=70.74daysCashcycle=100.23–70.74=29.49daysThefirmisreceivingcashonaverage25.29daysafteritpaysitsbills.365/6814.EAR=(1+4/96)–1=24.50%15.a.ThepayablesperiodiszerosinceVanMorrisonpaysimmediately.Paymentineachperiod=0.50timesnextperiodsales.Q1Q2Q3Q4Paymentofaccounts$250$280$400$240b.Sincethepayablesperiodis90days,paymentineachperiod=0.5timescurrentperiodsales.Q1Q2Q3Q4Paymentofaccounts$200$250$280$400c.Sincethepayablesperiodis60days,paymentineachperiod=2/3oflastquarter’sorders,and1/3ofthisquarter’sorders,or2/3(.50)timescurrentsales+1/3(.50)nextperiodsales.Q1Q2Q3Q4Paymentofaccounts$216.67$260.00$320.00$346.6716.Sincethepayablesperiodis60days,payablesineachperiod=2/3oflastquarter’sorders,and1/3ofthisquarter’sorders,or2/3(.60)timescurrentsales+1/3(.60)nextperiodsales.Q1Q2Q3Q4Paymentofaccounts$320.00$272.00$384.00$472.00Wages,taxes,otherexpenses150.00100.00140.00200.00Long-termfinancingexpenses10.0010.0010.0010.00(interestanddividends)Total$480.00$382.00$534.00$682.00Intermediate17.a.Borrow$50Mforonemonth,pay$212,500ininterest,butyouonlygettheuseof$48M.12EAR=[1+($212,500/$48M)]–1=5.44%b.toendupwith$10M,mustborrow$10M/.96=$10,416,666.676totalinterestpaid=$10,416,666.67(1.00425)–$10,416,666.67=$268,463.31 CHAPTER16B-6418.a.EAR=1.0075–1=3.03%4opportunitycost=.06($60M)(1.0075)–.06($60M)=$109,221.094b.interestcost=$40M(1.0152)–$40M=$2,488,013.624interestoncompensatingbalance=(.06)($20M)(1.0075)–(.06)($20M)=$36,407.03totalinterest=$2,488,013.62+36,407.03=$2,524,420.65EAR=$2,524,420.65/$40M=6.31%4c.interestcost=$60M(1.0152)–$60M=$3,732,020.44EAR=$3,732,020.44/$60M=6.22% CHAPTER17WORKINGCAPITALMANAGEMENTAnswerstoConceptsReviewandCriticalThinkingQuestions1.Yes.Onceafirmhasmorecashthanitneedsforoperationsandplannedexpenditures,theexcesscashhasanopportunitycost.Itcouldbeinvested(byshareholders)inpotentiallymoreprofitableways.Question9discussesanotherreason.2.Ifithastoomuchcashitcansimplypayadividend,or,morelikelyinthecurrentfinancialenvironment,buybackstock.Itcanalsoreducedebt.Ifithasinsufficientcash,thenitmusteitherborrow,sellstock,orimproveprofitability.3.Probablynot.Creditorswouldprobablywantsubstantiallymore.4.Automanufacturersoftenarguethatduetothecyclicalnatureoftheirbusiness,cashreservesareagoodwaytodealwithfutureeconomicdownturns.Thisisdebatable,butitistruethatautomanufacturers’operatingcashflowsareverysensitivetothebusinesscycle,andenormouslosseshaveoccurredduringrecentdownturns.5.Suchinstrumentsgobyavarietyofnames,butthekeyfeatureisthatthedividendadjusts,keepingthepricerelativelystable.Thispricestability,alongwiththedividendtaxexemption,makesso-calledadjustableratepreferredstockveryattractiverelativetointerest-bearinginstruments.6.Netdisbursementfloatismoredesirablebecausethebankthinksthefirmhasmoremoneythanitactuallydoes,andthefirmisthereforereceivinginterestonfundsithasalreadyspent.7.Thefirmhasanetdisbursementfloatof$500,000.Ifthisisanongoingsituation,thefirmmaybetemptedtowritechecksformorethanitactuallyhasinitsaccount.8.a.AbouttheonlydisadvantagetoholdingT-billsarethegenerallyloweryieldscomparedtoalternativemoneymarketinvestments.b.Someordinarypreferredstockissuesposebothcreditandpricerisksthatarenotconsistentwithmostshort-termcashmanagementplans.c.TheprimarydisadvantageofNCDsisthenormallylargetransactionssizes,whichmaynotbefeasiblefortheshort-terminvestmentplansofmanysmallertomedium-sizedcorporations.d.Theprimarydisadvantagesofthecommercialpapermarketarethehigherdefaultriskcharac-teristicsofthesecurity,andthelackofanactivesecondarymarketwhichmayexcessivelyrestricttheflexibilityofcorporationstomeettheirliquidityadjustmentneeds.9.Theconcernisthatexcesscashonhandcanleadtopoorlythought-outinvestments.Thethoughtisthatkeepingcashlevelsrelativelylowforcesmanagementtopaycarefulattentiontocashflowandcapitalspending. CHAPTER17B-210.Apotentialadvantageisthatthequickerpaymentoftenmeansabetterprice.Thedisadvantageisthatdoingsoincreasesthefirm’scashcycle.11.Thisisreallyacapitalstructuredecision.Ifthefirmhasanoptimalcapitalstructure,payingoffdebtmovesittoanunder-leveragedposition.However,acombinationofdebtreductionandstockbuy-backscouldbestructuredtoleavecapitalstructureunchanged.12.Itisunethicalbecauseyouhaveessentiallytrickedthegrocerystoreintomakingyouaninterest-freeloan,andthegrocerystoreisharmedbecauseitcouldhaveearnedinterestonthemoneyinsteadofloaningittoyou.13.a.Asightdraftisacommercialdraftthatispayableimmediately.b.Atimedraftisacommercialdraftthatdoesnotrequireimmediatepayment.c.Abanker’sacceptanceiswhenabankguaranteesthefuturepaymentofacommercialdraft.d.ApromissorynoteisanIOUthatthecustomersigns.e.Atradeacceptanceiswhenthebuyeracceptsthecommercialdraftandpromisestopayitinthefuture.14.Tradecreditisusuallygrantedonopenaccount.Theinvoiceisthecreditinstrument.15.Creditcosts:costofdebt,probabilityofdefault,andthecashdiscountNo-creditcosts:lostsalesThesumofthesearethecarryingcosts.16.1.Character:determinesifacustomeriswillingtopayhisorherdebts.2.Capacity:determinesifacustomerisabletopaydebtsoutofoperatingcashflow.3.Capital:determinesthecustomer’sfinancialreservesincaseproblemsoccurwithopera-tingcashflow.4.Collateral:assetsthatcanbeliquidatedtopayofftheloanincaseofdefault.5.Conditions:customer’sabilitytoweatheraneconomicdownturnandwhethersuchadown-turnislikely.17.1.Perishabilityandcollateralvalue2.Consumerdemand3.Cost,profitability,andstandardization4.Creditrisk5.Thesizeoftheaccount6.Competition7.CustomertypeIfthecreditperiodexceedsacustomer’soperatingcycle,thenthefirmisfinancingthereceivablesandotheraspectsofthecustomer’sbusinessthatgobeyondthepurchaseofthesellingfirm’smerchandise.18.a.B:Aislikelytosellforcashonly,unlesstheproductreallyworks.Ifitdoes,thentheymightgrantlongercreditperiodstoenticebuyers.b.A:Landlordshavesignificantlygreatercollateral,andthatcollateralisnotmobile.c.A:SinceA’scustomersturnoverinventorylessfrequently,theyhavealongerinventoryperiodandthuswillmostlikelyhavealongercreditperiodaswell. CHAPTER17B-3d.B:SinceA’smerchandiseisperishableandB’sisnot,Bwillprobablyhavealongercreditperiod.e.A:Rugsarefairlystandardizedandtheyaretransportable,whilecarpetsarecustomfitandarenotparticularlytransportable.19.Thethreemaincategoriesofinventoryare:rawmaterial(initialinputstothefirm’sproductionprocess),work-in-progress(partiallycompletedproducts),andfinishedgoods(productsreadyforsale).Fromthefirm’sperspective,thedemandforfinishedgoodsisindependentfromthedemandfortheothertypesofinventory.Thedemandforrawmaterialandwork-in-progressisderivedfrom,ordependenton,thefirm’sneedsfortheseinventorytypesinordertoachievethedesiredlevelsoffinishedgoods.20.JITsystemsreduceinventoryamounts.Assumingnoadverseeffectsonsales,inventoryturnoverwillincrease.Sinceassetswilldecrease,totalassetturnoverwillalsoincrease.RecallingtheDuPontequation,anincreaseintotalassetturnover,allelsebeingequal,hasapositiveeffectonROE.21.Carryingcostsshouldbeequaltoordercosts.Sincethecarryingcostsarelowrelativetotheordercosts,thefirmshouldincreasetheinventorylevel.SolutionstoQuestionsandProblemsBasic1.Disbursementfloat;Availablebalance=$200,000;Bookbalance=$82,0002.Collectionfloat;Availablebalance=$60,000;Bookbalance=$170,0003.Disbursementfloat=$4,000;Collectionfloat=–$16,000;Netfloat=–$12,0004.a.60daysuntilaccountoverdue;remittance:800($60)=$48,000b.1%discount;15daydiscountperiod;remittance:.99($48,000)=$47,520c.implicitinterest:$48,000–47,520=$480;60–15=45dayscredit5.Averagedailyfloat=6($80,000)/30=$16,000(assuminga30-daymonth)6.a.Disbursementfloat=5($43,000)=$215,000Collectionfloat=2($57,000)=–$114,000Netfloat=$215,000–114,000=$101,000b.Collectionfloat=1($57,000)=–$57,000Netfloat=$215,000–57,000=$158,0007.a.50daysuntilaccountoverdue;remittance:600($50)=$30,000b.3%discount;10daydiscountperiod;remittance:.97($30,000)=$29,100c.implicitinterest:$30,000–29,100=$900;50–10=40dayscredit8.Receivablesturnover=365/43=8.48837timesAveragereceivables=$60million/8.48837=$7,068,493 CHAPTER17B-49.a.ACP=.7(10days)+.3(30days)=16daysb.Totalannualsales=1,800(12)($2,000)=$43,200,000Receivablesturnover=365/16=22.8125timesAveragereceivables=$43.2million/22.8125=$1,893,698.6310.Totalannualsales=52($46,000)=$2,392,000Receivablesturnover=365/35=10.42857timesAveragereceivables=$2.392million/10.42857=$229,369.86Asanalternatesolution:Averageaccountsreceivable=5weeks’sales=5($46,000)=$230,000Thedifferenceisduetoa364day(52week)or365dayyear.11.nominalinterestrate=.01/.99=.0101for30–10=20days365/20EAR=(1.0101)–1=20.13%365/20a..02/.98=.0204;EAR=(1.0204)–1=44.59%365/35b.EAR=(1.0101)–1=11.05%365/10c.EAR=(1.0101)–1=44.32%12.Receivablesturnover=365/48=7.604167timesAnnualcreditsales=7.604167($73,000)=$555,10413.Carryingcosts=(2,300/2)($10)=$11,500Ordercosts=(52)($800)=$41,6001/2EOQ=[2(52)(2,300)($800)/$10]=4,374.47Thefirm’spolicyisnotoptimal,sincethecostsarenotequal.Thecompanyshouldincreasetheordersizeanddecreasethenumberoforders.14.Carryingcosts=(1,000/2)($38)=$19,000Restockingcosts=12($600)=$7,2001/2EOQ=[2(12)(1,000)($600)/$38]=615.59Numberofordersperyear=12(1,000)/616=19.49timesThefirm’spolicyisnotoptimal,sincethecostsarenotequal.Thecompanyshoulddecreasetheordersizeandincreasethenumberoforders.15.Carryingcosts=(4,300/2)($52)=$111,800Ordercosts=(52)($4,500)=$234,0001/2EOQ=[2(52)(4,300)($4,500)/$52]=6,220.93Thefirm’spolicyisnotoptimal,sincethecostsarenotequal.Thecompanyshouldincreasetheordersizeanddecreasethenumberoforders.16.Carryingcosts=(2,100/2)($6)=$6,300Restockingcosts=12($250)=$3,0001/2EOQ=[2(12)(2,100)($250)/$6]=1,449.14Numberofordersperyear=12(2,100)/1,449=17.39timesThefirm’spolicyisnotoptimal,sincethecostsarenotequal.Thecompanyshouldincreasetheordersizeanddecreasethenumberoforders. CHAPTER18INTERNATIONALASPECTSOFFINANCIALMANAGEMENTAnswerstoConceptsReviewandCriticalThinkingQuestions1.a.Thedollarissellingatapremium,becauseitismoreexpensiveintheforwardmarketthaninthespotmarket(SFr1.53versusSFr1.50).b.Thefrancisexpectedtodepreciaterelativetothedollar,becauseitwilltakemorefrancstobuyonedollarinthefuturethanitdoestoday.c.InflationinSwitzerlandishigherthanintheUnitedStates,asareinterestrates.2.Theexchangeratewillincrease,asitwilltakeprogressivelymoredeutschemarkstopurchaseadollarasthehigherinflationinRussiawilldevaluetherublemark.ThisistherelativePPPrelationship.3.a.TheAustraliandollarisexpectedtoweakenrelativetothedollar,becauseitwilltakemoreA$inthefuturetobuyonedollarthanitdoestoday.b.TheinflationrateinAustraliaishigher.c.NominalinterestratesinAustraliaarehigher;relativerealratesinthetwocountriesarethesame.4.AYankeebondismostaccuratelydescribedbyd.5.Either.Forexample,ifacountry’scurrencystrengthens,importsbecomecheaper(good),butitsexportsbecomemoreexpensiveforotherstobuy(bad).Thereverseistrueforacurrencydepreciation.6.Additionaladvantagesincludebeingclosertothefinalconsumerandtherebysavingontransportation,significantlylowerwages,andlessexposuretoexchangeraterisk.Disadvantagesincludepoliticalriskandcostsofsupervisingdistantoperations.7.Onekeythingtorememberisthatdividendpaymentsaremadeinthehomecurrency.Moregenerally,itmaybethattheownersofthemultinationalareprimarilydomesticwhoareultimatelyconcernedabouttheirwealthdenominatedintheirhomecurrencybecause,unlikeamultinational,theyarenotinternationallydiversified.8.a.False.IfpricesarerisingfasterinGreatBritain,itwilltakemorepoundstobuythesameamountofgoodsthatonedollarcanbuy;thepoundwilldepreciaterelativetothedollar.b.False.Theforwardmarketwouldalreadyreflecttheprojecteddeteriorationoftheeurorelativetothedollar.Onlyifyoufeelthattheremightbeadditional,unanticipatedweakeningoftheeurothatisn’treflectedinforwardratestodaywilltheforwardhedgeprotectyouagainstadditionaldeclines.c.True.Themarketwouldonlybecorrectonaverage,whileyouwouldbecorrectallthetime. CHAPTER18B-29.a.Americanexporters:theirsituationingeneralimprovesbecauseasaleoftheexportedgoodsforafixednumberofpesoswillbeworthmoredollars.Americanimporters:theirsituationingeneralworsensbecausethepurchaseoftheimportedgoodsforafixednumberofpesoswillcostmoreindollars.b.Americanexporters:theywouldgenerallybebetteroffiftheBritishgovernment’sintentionsresultinastrengthenedpound.Americanimporters:theywouldgenerallybeworseoffifthepoundstrengthens.c.Americanexporters:wouldgenerallybemuchworseoff,becauseanextremecaseoffiscalexpansionlikethisonewillmakeAmericangoodsprohibitivelyexpensivetobuy,orelseBraziliansales,iffixedincruzeiros,wouldbecomeworthanunacceptablylownumberofdollars.Americanimporters:wouldgenerallybemuchbetteroff,becauseBraziliangoodswillbecomemuchcheapertopurchaseindollars.SolutionstoQuestionsandProblemsBasic1.a.$100(Zloty4.2190/$1)=421.90zlotysb.$0.9945c.€5M($1.0055/€1)=$5,027,500d.Singaporedollare.Mexicanpesof.(SFr1.4816/$1)($0.9945/€1)=SFr1.47345/€1;thisisacrossrate.g.Mostvaluable:KuwaitDinar=$3.2637Leastvaluable:TurkishLira=$0.000001632.a.£100,since(£100)($1.5489/£1)=$154.89b.£100,since(£100)($1.5489/£1)=$154.89and(C$100)($1/C$1.5120)=$66.14c.(C$1.5120/$1)($1.5489/£1)=C$2.3419/£1;1/2.3419=£0.426997/FF13.a.F180=¥116.750(per$).Theyenissellingatapremiumbecauseitismoreexpensiveintheforwardmarketthaninthespotmarket($0.0084825versus$0.0085653).b.F90=$0.6596/C$.Thedollarissellingatadiscountbecauseitislessexpensiveintheforwardmarketthaninthespotmarket(C$1.5119versusC$1.5161).c.Thevalueofthedollarwillfallrelativetotheyen,sinceittakesmoredollarstobuyoneyeninthefuturethanitdoestoday.ThevalueofthedollarwillriserelativetotheCanadiandollar,becauseitwilltakefewerUSdollarstobuyCanadiandollarinthefuturethanitdoestoday. CHAPTER18B-34.a.TheU.S.dollar,since(Can$1)/(Can$1.20/$1)=$0.8333b.(Can$3.10)/(Can$1.20/$1)=$2.58.AmongthereasonsthatabsolutePPPdoesn’tholdaretariffsandotherbarrierstotrade,transactionscosts,taxes,anddifferentialtastes.c.TheU.S.dollarissellingatapremium,becauseitismoreexpensiveintheforwardmarketthaninthespotmarket(Can$1.23versusCan$1.20).d.TheCanadiandollarisexpectedtodepreciateinvaluerelativetothedollar,becauseittakesmoreCanadiandollarstobuyoneU.S.dollarinthefuturethanitdoestoday.e.InterestratesintheUnitedStatesareprobablylowerthantheyareinCanada.5.a.(¥110/$1)($1.65/£1)=¥181.5/£1b.Theyenisquotedtoolowrelativetothepound.Takeoutaloanfor$1andbuy¥110.Usethe¥110topurchasepoundsatthecross-rate—110/160=£0.6875.Usethepoundstobuybackdollarsandrepaytheloan—£0.6875(1.65)=$1.1344;arbitrageprofitis13.44¢perdollarused.6.Canada:RFC=(C$1.5211–C$1.5120)/C$1.5120+.05=5.60%Japan:RFC=(¥116.75–¥117.89)/¥117.89+.05=4.03%Switzerland:RFC=(SFr1.4767–SFr1.4816)/SFr1.4816+.05=4.67%37.US:$30M(1.0030)=$30,270,810.813GreatBritain:($30M)(£0.59/$1)(1.0045)/(£0.61/$1)=$29,409,880.14;investinU.S.31/38.RelativePPP:ruble31.02=(ruble29.15)(1+{hFC–hUS});(31.02/29.15)–1=.0209InflationinRussiaisexpectedtoexceedthatintheU.S.by2.09%overthisperiod.9.Nochangeinexchangerate:profit=30,000[$150–{(S$239.50)/(S$1.7555/$1)}]=$407,148.96Ifexchangeraterises:profit=30,000[$150–{(S$239.50)/1.1(S$1.7555/$1)}]=$779,226.33Ifexchangeratefalls:profit=30,000[$150–{(S$239.50)/0.9(S$1.7555/$1)}]=–$47,612.27Breakeven:$150=S$239.50/ST;ST=S$1.5967/$1=–9.05%decline1/210.a.IfIRPholds,thenF180=(DM1110.25)(1+{.09–.06})=won1126.78SincegivenF180=won1132.10,anarbitrageexists;theforwardpremiumistoohigh.Borrowwon1000todayat9%interest.Agreetoa180-dayforwardcontractatwon1132.10.Converttheloanproceedsintowon1000/won1110.25=$0.9007today.Investthesedollarsat6%,endingupwith$0.9547.Convertthedollarsbackintowonas$0.9547(won1132.10/$1)=won1080.86.Repaythewon1000loan,endingwithaprofitof1080.86–1045=won35.86.1/2b.F180=(DM1110.25)(1+{.09–.06})=won1126.7811.a.Theyenisexpectedtogetstronger,sinceitwilltakelessyentobuyonedollarinthefuturethanitdoestoday.4b.hUS–hJAP(¥106–¥108)/¥108=–.0185;(1–.0185)–1=–.0720TheapproximateinflationdifferentialbetweentheU.S.andJapanis–7.20%annually.112.RelativePPP:E[S1]=271{1+(.12–.04)}=HUF292.682E[S2]=271{1+(.12–.04)}=HUF316.095E[S5]=271{1+(.12–.04)}=HUF398.19 CHAPTER18B-413.(¥127.41/$)($/1.13546€)=¥112.210/€14.Buy$10,000(£/$1.4097)=£7,093.708inNewYork.Sellthe£7,098.708inLondonfor£7,098.708($1.4286/£)=$10,134.07.Yourprofitis$10,134.07–10,000=$134.07foreach$10,000transaction.15.krone17.40/$1.99=krone8.7437/$16.RelativePPP:¥122=(¥126)(1+{hFC–hUS});(122/126)–1=–.0317InflationintheU.S.isexpectedtoexceedthatintheJapanby3.17%overthisperiod.'