AMERICAN UNIVERSITY IN BULGARIA

BUS 330: CORPORATE FINANCE I

FALL 2012, AUBG

MIDTERM EXAM 2
Name: ___________________________________ ID _________

Version 1 Solution Guide

INSTRUCTIONS:
1. You have 75 minutes to complete the exam.
2. The exam is worth a total of 100 points.
3. You may use a calculator and scratch paper sheets. You must hand in the sheets with
your exam (put your name on it).
4. Allocate your time wisely. Use the number of points assigned to each problem as
your guide.
5. In order to get full credit on the problems, you must show ALL your work!
6. You can get partial credits if you show your calculations or provide arguments to
support your answer.
7. No credits will be warded if you fail to state your assumptions or conclusions
explicitly.
Part A: Multiple choice questions (2 points each, 12 points in total):
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1. Which of the following statements is CORRECT?

a. When calculating the cost of preferred stock, a company needs to adjust for taxes,
because preferred stock dividends are deductible by the paying corporation.
b. All else equal, an increase in a companys stock price will increase its marginal
cost of retained earnings, rs.
c. All else equal, an increase in a companys stock price will increase its marginal
cost of new common equity, re.
d. Since the money is readily available, the after-tax cost of retained earnings is
usually much lower than the after-tax cost of debt.
e. If a companys tax rate increases but the YTM on its outstanding bonds remains
the same, the after-tax cost of its debt will fall.
Answer: E
2. Which of the following is NOT a capital component when calculating the weighted
average cost of capital (WACC) for use in capital budgeting?
a. Long-term debt.
b. Accounts payable.
c. Retained earnings.
d. Common stock.
e. Preferred stock.
Answer: B
3. The relative risk of a proposed project is best accounted for by one of the following
procedures?
a. Adjusting the discount rate upward if the project is estimated to have aboveaverage risk.
b. Adjusting the discount rate downward if the project is judged to have aboveaverage risk.
c. Reducing the NPV by 10% to 20% for risky projects.
d. Picking a risk factor equal to the average discount rate.
e. Ignoring risk because project risk cannot be measured accurately.
Answer: A
4. Which of the following should be considered when a company estimates the cash
flows used to analyze a proposed project?
a. The new project is expected to reduce sales of one of the companys existing
products by 5%.
b. Since the firms director of capital budgeting spent some of her time last year
to evaluate the new project, a portion of her salary for that year should be
charged to the projects initial cost.
c. The company has spent and expensed $1 million on R&D associated with the
new project.
d. The company spent and expensed $10 million on a marketing study before its
current analysis regarding whether to accept or reject the project.
e. The firm would borrow all the money used to finance the new project, and the
interest on this debt would be $1.5 million per year.
Answer: A
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5. Myron Gordon and John Lintner believe that the required return on equity increases
as the dividend payout ratio is decreased. Their argument is based on the assumption
that:
a. Investors are indifferent between dividends and capital gains.
b. Investors require that the dividend yield and capital gains yield equal a
constant.
c. Capital gains are taxed at a higher rate than dividends.
d. Investors view dividends as being less risky than potential future capital gains.
e. Investors value a dollar of expected capital gains more highly than a dollar of
expected dividends because of the lower tax rate on capital gains.
Answer: D
6. Which of the following statements is NOT correct?
a. Stock repurchases can be used by a firm as part of a plan to change its capital
structure.
b. After a 3-for-1 stock split, a company s price per share should fall, but the
number of shares outstanding will rise.
c. Investors can interpret a stock repurchase program as a signal that the firm s
managers believe the stock is undervalued.
d. Companies can repurchase shares to distribute large inflows of cash, say from
the sale of a division, to stockholders without paying cash dividends.
e. Stockholders pay no income tax on dividends if the dividends are used to
purchase stock through a dividend reinvestment plan.
Answer: E

Problem 1 (5 points)
A companys 6% coupon rate, semiannual payment, $1,000 par value bond that matures
in 30 years, sells at a price $515.16. The companys federal-plus-state tax rate is 40%.
What is the firms after-tax component cost of debt for purposes of calculating the
WACC? (Hint: Base your answer on the nominal rate.)
Solution:
Enter these values: N = 60, PV = -515.16, PMT = 30 and FV = 1000, to get I =
6% periodic rate.
Then, the nominal rate is 6%*(2) = 12%, and
The after-tax component cost of debt is 12%*(0.6) = 7.2%.
Problem 2 (8 points)
The market value balance sheet for Inbox Manufacturing is shown below. Inbox has
declared a 25 percent stock dividend (i.e., 25 new/100 shares). The stock goes ex
dividend tomorrow (the chronology for a stock dividend is similar to that for a cash
dividend). There are 15,000 shares of stock outstanding. What will the ex-dividend price
be? (Note: find first the number of new shares outstanding)
Market Value Balance Sheet
Cash
190,000
Debt
160,000
Fixed assets
330,000
Equity
360,000
Total
520,000
Total
520,000
a. (5 points) What will the ex-dividend price be? (Note: find first the number of
new shares outstanding)
b. (3 points) Outline three major similarities between stock dividends and stock
splits.
Solution:
a. The stock price is the total market value of equity divided by the shares
outstanding, so:
P0 = $360,000 equity/15,000 shares = $24 per share
The shares outstanding will increase by 25 percent because of the declared stock
dividend, so:
New shares outstanding = 15,000(1.25) = 18,750 (or 3,750 new shares)
The new stock price is the market value of equity divided by the new shares
outstanding, so:
PX = $360,000 equity /18,750 shares = $19.20
b.

Three major similarities between stock dividends and stock splits are:
Large stock dividend (i.e. 100%) is the same as 2-for-1 stock split
They both are not a true dividend because it is not paid in cash
They both are used to adjust the price to the proper trading range
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Problem 3 (10 points)

Suppose the Tysseland Company has this book value balance sheet:
Current assets
Fixed assets

Total assets

Balance sheet [000]

$30,000 Current liabilities
$50,000 Long-term debt
Common equity
Common stock (1 million shares)
Retained earnings
$80,000 Total liabilities and common equity

$10,000
$40,000
$1,000
$39,000
$80,000

The current liabilities consist of notes payable to banks, and the interest rate on this debt
is 8%, the same as the rate on new bank loans. These bank loans are not use for seasonal
financing but instead are part of the companys permanent capital structure. The longterm debt consists of 40,000 bonds, each with a par value of $1,000, an annual coupon
rate of 6%, and a 20-year maturity. The going rate of interest on new long-term debt, Rd,
is 10%, and this is the present yield to maturity on the bond. The common stock sells at a
price of $65 per share and the cost of equity capital is 14%. Calculate the firms market
value capital structure and its weighted average cost of capital, if the federal-plus-state
tax rate is 40%.
Solution:
a. (7 points) The book and market value of the current liabilities are both
$10,000,000.
The bonds market value is:
V = $60(PVIFA10%,20) + $1,000(PVIF10%,20) = $60([1/0.10]-[1/(0.1(1+0.10)20)]) +
$1,000((1+0.10)20)
= $60(8.5136) + $1,000(0.1486) = $510.82 + $148.60
V = $659.42.
Alternatively, using a financial calculator, input N = 20, I/YR = 10, PMT = 60,
and FV = 1000 to arrive at PV = $659.46.
The total market value of the long-term debt is 40,000($659.46) = $26,378,400.
The total market value of the equity is $65,000,000 (there are 1 million shares of
stock outstanding, and the stock sells for $65 per share.)
The market value capital structure is thus:
Short-term debt
Long-term debt
Common equity

10,000,000
26,378,400
65,000,000
101,378,400

9.86%
26.02%
64.12%
100.00%

b. (3 points) The weighted average cost of capital is:

WACC = (wd, ST)(rd)(1 - T) + (wd, LT)(rd)(1 - T) + (ws)(rs)
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WACC = 9.86%(0.08)(1-0.40) + 26.02%(0.10)(1-0.40) + 64.12%(0.14) =

11.011%

Problem 4 (20 points)

Consider the following cash flows of two mutually exclusive projects for Tokyo Rubber
Company. Assume the discount rate for Tokyo Company is 10 percent.
Year
0
1
2
3

Dry Project
-$1,000,000
600,000
400,000
1,000,000

Solvent Project
-$500,000
300,000
500,000
100,000

a. (3 points) Based on the NPV and IRR rules, which project should be taken?
b. (7 points) Based on discounted payback period, which project should be
taken?
c. (10 points) Based on this analysis, is incremental IRR analysis necessary? If
yes, please, conduct the analysis (Hint: subtract the cash flows of smaller
project from the cash flows of the larger project to find IRR.)
Solution:
a. Based on the NPV rule, which project should be taken?
The NPV of each project is:
NPV(Dry) = $1,000,000 + $600,000 / 1.10 + $400,000 / 1.10^2 + $1,000,000 /
1.10^3. So, NPV(Dry) = $627,347.86
NPV(Solvent) = $500,000 + $300,000 / 1.10 + $500,000 / 1.10^2 + $100,000 /
1.10^3. So, NPV(Solvent) = $261,081.89
The NPV rule implies accepting the Dry project because it has the highest NPV.
The IRR of the two projects is:
0 = $1,000,000 + $600,000 / (1 + IRR) + $400,000 / (1 + IRR)^2 + $1,000,000 /
(1 + IRR)^3. So, IRR(Dry) = 39.79%
0 = $500,000 + $300,000 / (1 + IRR) + $500,000 / (1 + IRR)^2 + $100,000 / (1 +
IRR)^3. So, IRR(Solvent) = 40.99%
The IRR rile implies accepting the Solvent project because it has the highest IRR.
Remember the IRR does not necessarily rank projects correctly.
b. Based on discounted payback period, which project should be taken?
The payback period is the time that it takes for the cumulative undiscounted cash
inflows to equal the initial investment.
Dry project:
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Cumulative cash flows Year 1 = $600,000/1.10 = $545,454.55

Cumulative cash flows Year 2 = $545,454.55 + 400,000/1.10^2 = $876,033.06
Payback period = 2 + (1,000,000 876,033.06)/(1,000,000/1.10^3) =
PBP = 2 + (123,966.94)/751,314.80 = 2.165
Solvent project:
Cumulative cash flows Year 1 = $300,000/1.10 = $272,727.27
Cumulative cash flows Year 2 = $272,727.27 + 500,000/1.10^2 = $685,950.41
Payback period = 1 + ($500,000 - 272,727.27)/$500,000/1.10^2
PBP = 1 + 227,272.73/413,223.14 = 1,550
Since the Solvent project has a shorter payback period than the Dry project the
company should choose the Solvent project.
c. Based on this analysis, is incremental IRR analysis necessary? If yes,
please, conduct the analysis and find IRR.
Incremental IRR analysis is necessary. The Solvent project has a higher IRR, but
is relatively smaller in terms of investment and NPV. In calculating the
incremental cash flows, we subtract the cash flows of the project with the smaller
initial investment from the cash flows of the project with the large initial
investment, so the incremental cash flows are:
Dry project
Solvent project
Dry - Solvent

Year 0
-$1,000,000
-500,000
-$500,000

Year 1
$600,000
300,000
$300,000

Year 2
$400,000
500,000
-$100,000

Year 3
$1,000,000
100,000
$900,000

Setting the present value of these incremental cash flows equal to zero, we find
the incremental IRR is:
0 = $500,000 + $300,000 / (1 + IRR) $100,000 / (1 + IRR)^2 + $900,000 / (1 +
IRR)^3. So, IRR = 38.90%
Non-conventional CFs, so MIRR = 29.419% (check)

Problem 5 (20 points)

Using the information from the Balance sheet of Nantucket Nectars, and the additional
market information, answer the four questions below:
Balance sheet as of December 31, 2001 [in $000]
Assets
Liabilities and net worth
Current Assets
$20,000 Current Liabilities
Fixed Assets
Long-term debt (bonds,
Net Plan, Property and
110,000 $1000 par, 8% coupon, due
Equipment
2009)
Goodwill & other
60,000
Total Fixed Assets
170,000
Total liabilities
Preferred Stock, 10%
dividend, par $100
Common stock, par $2.50
Paid-in surplus
Retained earnings
Total shareholders equity
Total Assets:
$190,000 Total liabilities and net
worth:

$20,000
50,000
70,000
15,000
20,000
10,000
75,000
120,000
$190,000

Market information:
1) Bonds: Po = $902 (at the end of 2001). Flotation costs are estimated at 1% of the
market price.
2) Preferred stock: Po = $85 (at the end of 2001). Flotation costs are estimated at 4% of
the market price.
3) Common stock: Div0 = $2.00 and g = 10% (based on historical earnings and dividends
growth). Flotation costs would be 9% based on Po = $20 per share (at the end of 2001).
4) The corporate marginal tax rate is 30%.
Find:
a. (5 points) What are the market value weights of different sources of
financing?
b. (10 points) What is the cost of each source of financing?
c. (5 points) What is the weighted average cost of capital for Nantucket Nectars?
Solution:
a. Determining the market weights
Capital Source
Debt
Preferred
Equity
Common
Retained
Total equity

Market value*
$45,100,000
12,750,000

160,000,000
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Market value
Weight, %
20.70
5.85

73.45

Total

$217,850,000

100.00

Here:
Market value of debt = Number of bonds outstanding (50,000) current price
per bond ($902)
Market value of preferred stock = Number of shares of preferred stock
(150,000) current market price per share ($85)
Market value of common stock = Number of shares of common stock
(8,000,000) current market price per share ($20)
b. Determining the component cost of capital
1) Calculating the component cost of debt
Net P = current market price (1 Flotation cost) = $902 (1 - 0.01) = $892.98
8

$902(1 0.01) $80

t 1

1
1
$1000
i
(1 YTM )
(1 YTM ) 8

Solve for YTM = 10.0% (Use the financial calculator)

k d YTM (1 T ) 0.10 (1 0.30) 0.07 or 7.0%

2) Calculating the component cost of preferred stock

kp

DIV
$10

0.1225 , or 12.25%
P0 (1 F) $85 (1 0.04)

Div = 10% @ $100 = $10

3) Calculating the component cost of retained earnings
k re

DIV0 (1 g )
$2.00(1 0.10)
g
0.10 0.21 , or 21%
P0
$20

4) Calculating the component cost of common stock

k cs

DIV0 (1 g )
$2.00(1 0.10)
g
0.10 0.2209 , or 22.09%
P0 (1 F)
$20(1 0.09)

c. Determining the weighted average cost of capital

WACC = 0.2070(7.00%) + 0.0585(12.25%) + 0.7345(22.09%) = 18.391%

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Note: we do not use cost of retained earnings to find WACC as they have no
market weight to be determined.

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Problem 6 (25 points)

The Madison Manufacturing currently uses an injection-molding machine that was
purchased 2 years ago. This machine is being depreciated on a straight-line basis, and it
has 6 years of remaining life. Its current book value is $2,100, and it can be sold for 2,500
at this time. Thus, the annual depreciation expense is $2,100/6 = $350 per year. If the old
machine is not replaced, it can be sold for $550 at the end of its useful life. Madison is
offered a replacement machine that has a cost of $8,000, an estimated useful life of 6
years, and an estimated salvage value of $800. This machine falls into the MACRS 5year class, so the applicable depreciation rates are 20%, 32%, 19.20%, 11.52%, 11.52%,
and 5.76%. The replacement machine would permit an output expansion, so sales would
rise by $1,000 per year; even so, the new machines much greater efficiency would
reduce operating expenses by $1,500 per year. The new machine would require that
inventories be increased by $2,000, but accounts payable would simultaneously increase
by $500. Madisons marginal federal-plus-state tax rate is 40%, and its WACC is 15%.
Should the company replace the old machine with the new one?
Solution:
a. (5 points) Determine the net cash flow at year 0.
First determine the net cash flow at t = 0:
Purchase price
Sale of old machine
Tax on sale of old machine
Change in net working capital
Total investment

($8,000)
2,500
(160)
(1,500)
($7,160)

Note:
1. The market value of the old machine is $2,500 $2,100 = $400 above the book
value. Thus, there is a $400 recapture of depreciation, and Madison would have to
pay 0.40($400) = $160 in taxes.
2. The change in net working capital is a $2,000 increase in current assets minus a
$500 increase in current liabilities, which totals to $1,500.
b. (8 points) Determine after-tax incremental cash flows. Find the annual
depreciation expenses and the tax shield they create, that is,
T*(Depreciation).
Sales increase
Cost decrease
Increase in pre-tax revenues

$1,000
1,500
$2,500

After-tax revenue increase:

$2,500*(1 T) = $2,500*(0.60) = $1,500.
Depreciable basis = $8,000. Depreciation expense in each year equals depreciable
basis times the MACRS percentage allowances of 20%, 32%, 19.20%, 11.52%,
11.52%, and 5.76% in Years 1- 6, respectively.
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Depreciation tax savings = T*(Depreciation) = 0.4*(Depreciation).

Rounded numbers
Depreciation:
Year
New
Old
350
Change
Depreciation tax savings
44

1
6
$1,600
$461
350
$1,250
$111
$ 500

$2,560

$1,536

$922

$922

350

350

350

350

$2,210

$1,186

$572

$572

$ 884

$ 474

$229

$229

c. (10 points) Determine annual net cash flows. Find the terminal value of the
project (Hint: include NWC recovery and opportunity cost of old machine in
year 6)
Year 6 - net working capital investment of $1,500, and it would also receive $800
from the sale of the replacement machine.
0.40*($800) = $320 are the taxes on the new machine sale.
$500*(0.4) = $200 would be due because the old machine would be fully
depreciated in Year 6.
$500 $200 = $300 is the opportunity cost of the old machine.
Finally, place all the cash flows on a time line:
Rounded numbers

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15%
0
|
Net investment
(7,160)
After-tax revenue increase
1,500
Depreciation tax savings
Working capital recovery
1,500
Salvage value of new machine
800
Tax on salvage value of
new machine
(320)
Opportunity cost of
old machine
(330)
Project net cash flows
(7,160)
3,194

1,500

1,500

1,500

1,500

1,500

500

884

474

229

229

2,000

2,384

1,974

1,729

1,729

d. (2 points) Determine net present value and internal rate of rate. Should it
replace the old machine?
The net present value of this incremental cash flow stream, when discounted at
15%, is $908.748. The internal rate of rate is 19.467%. Thus, the replacement
should be made.

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Bonus questions (4 point in total):

1. (2 points) What is the German Stock Exchange index? The best answer is D.
a. SOFIX
b. Dow Jones
c. Nikkei
d. DAX
2. (2 points) What is the meaning of the acronym EBRD? The best answer is A.
a. European Bank for Reconstruction and Development
b. European Bank for Research and Development
c. European Bureau for Research and Development
d. European Board for Risk Development

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