Tutorial 2

Chapter4
1
.

compounding periods : n4
(Assuming CF70 ,
r(0) => PVU ,
FVP

With positive CF s ir , length of time ↑

*
FV
↓ PV
=
↑ FV = V(( + r)m
( + r)nπ

2
. Interest rates :
Annuity : rT >
-
PVA +
,
FVA4 +PVA =
f [ -citrym]

.
3 Time value of
money :

The considerations would be rate of return implicit the offer attractive relative to other similar
key : (1) Is the in ,

risk investment :

(2) How
risky is the investment ,
e .

:
g
how certain are we that we will actually get $100 ,
000

=> Thus ,
our answer does depend on who is
making the promise to repay
.

% x9 12% x9
e 12
4. Continuous
Compounding FV = PV x = $1 , 900 x e = $5 594
,
. 89

5.
Calculating APR
2

semiannually
↑
: EAR = It -
1 : 8 9%
.
>
-
APR = 8 71 %
.

r"-1
Monthly : EAR = 1 +

12
= 18 8 % > APR
.
-
= 17 35 %
.

52

Weekly : EAR =
1 + 1 -
1 = 10 4 .
%> -
APR = 9 9%
.

52

Infinite : APR = In (1 + EAR) =

In / 1 + 13 6 % )
. = 12 75 %
.
 .
6
Calculating EAR
%"

&
10 3
First National Bank : 10 3 % .
compounded monthly >
-
EAR =
I +
.
-
1 =
10 .
80 %
12
First United Bank
>
-

2
10 5 %
First United Bank : 10 5 % .
compounded semiannually >
-
EAR =
1 +
.

-1 =
10 78 % .

O 12
123
I I
7. Interest rates I I I I

Cost of case = 12 < $10(1-10% ) = $108 $10 $10 $ 10

1st bottle today cash flows due

Assume he buys the wine consumes = The are
annity
I
I
10 1 98 %
CF rx52 = 102 77 %
=> PV =
(F + 1 -

=
10 + I = 108 = V = .
=> APR = 1 0277
. = .

p 11 + r(k) (1 + r) 12
+

~
(x PVIA(r , n) x (1+ r)
m

75
=> EAR 1
APR 1 1 + 1 98 % 1 %o
177 19
-

= + -

= . = .

Trade credit >

-

Term credit >

-

collecting
=> His analysis is correct : he can earn 177 %
buying wine
by the case.
credit policy policy
2/10 , n 140'

Periods
8
.
Calculating Number of
O I 2 3 P
I I

$500 $500'
. . . . .
I

$18. 450 $500 $500 $500

500
G
I 1
PV = 1 -
I 1 -
=
18 450
,
=> n = 47 6. months
n
(I + r)m 1 1%. 11 + 1 1
.
%)

9. Growing Perpetuities Mark Weinstein has been working on an advanced technology in laser eye
surgery. His technology will be available in the near term. He anticipates his first annual cash flow
from the technology to be $215,000, received two years from today. Subsequent annual cash flows
will grow at 3.8 percent in perpetuity. What is the present value of the technology if the discount rate
is 10 percent? 3 8% % 9= .
= 10

O ↓ 2 3 4 CF3 215 , 000 (1 + 3 8 % )

PV $3 599 516 13
.

I I I , ....
= I = , ,
.

r-
g 10 % -

3 8%
PVo $5 , 008 C C
.

n
W
PV2
PVz CF3 => PVo = =
2 974
, .
806 .
72
2) + 10 % 12

.
10 Growing annuity
Salaryo
C =
:

5 % of
$72 500 ,

salary
gs =

r
3 7%
.

= 9% n= 40yrs( = FV = ?

(1 3 7% )9
%

r-g-gh
+

Growing annuity PV CF 72 , 500 (1 + 3 7 % ) x5 %

90%
.

: x
= =
"

19 % 3 7 % (1 + 9 % 19
%
.

ro -

3 7%.
-

= $317 .
47
Chapter 5
1. Payback Period and Net Present Value
a, If a project with conventional cash flows has a payback period less than the project’s life, can
you definitively state the algebraic sign of the NPV? Why or why not?
Conventional cash flows and payback period less than the project's life.
This simply means that only when the discount rate is zero, the project will have a positive NPV.
In case discount rate is positive and which will be the case usually, we can't make any claim
withabsolute certainty, about the sign of the NPV. If discount rate is positive, and the payback
period is less than the project's life then:
NPV will be negative if discount rate > IRR
NPV will be zero if discount rate = IRR
NPV will be positive if discount rate < IRR

b, If you know that the discounted payback period is less than the project’s life, what can you
say about the NPV? Explain.
If a project has positive NPV then:
Then it will certainly have payback period less than the life of the project. This is because if
NPVis positive at some discount rate then NPV will certainly be positive at zero discount rate.
The Project will certainly have an IRR greater than the discount rate. This is because IRR is that
discount rate at which NPV is zero. NPV is inversely related to discount rate. If NPV is positive
at a given discount rate and cash flows are conventional, then we need to increase discount rate
further to make NPV zero. This implies IRR (the discount rate at which NPV is zero) is greater
than discount rate.

2
. .
a CFs from the 2

investment (investments
projects are identical
& > IRRA
=
> IRRB

b
.(IB = 2 CIA ,
C2B = <C2A ,
(BB = CC3A

=> IRRA =
IRRB bcs both the CFs as well as the initial investments are twice that of Project .
B

"200
1 , 100 900
3. a .
Project Alpha :
Plaipha : t

1 .
0852
t

1 .
0853
2 100
, =
1 3071
.

800 2 , 300 2 , 900

Project Beta :
P'Beta : t t
3 , 700 = 1 3409
.

↓. 085 1 .
0852 1 . 0853

b
. The co .
should accept project Beta based on the profitability index rule .

4
.
Calculating Incremental Cash Flows
B :
financially attractive NPVB>
more : NPVm >
-

NPVB-NPVM <0 >

-
NPV 70
CFM
ACFB-M
 ACFB-M
-

Io + 1 , 200

240

240

400

NPVB NPVM
NOVACESo
> (=>

2402 +
40 +
40 O

1 , 890 .
32 > Lo

Conclusion : The initial investment should be greater than $1 ,

890 32 for
.
which project Billion is more
financially
attractive than project Million
.
 Tutorial 3 investment

Chapter 6 change of CFs resulted from

1 Incremental Cash Flows Which of the following should be treated as an incremental cash flow when
computing the NPV of an investment?
a. A reduction in the sales of a company’s other products caused by the investment. Side effects:
erosion => Yes Relevant outflow
b. An expenditure on plant and equipment that has not yet been made and will be made only if the
project is accepted. Capital expenditure => Yes Relevant outflow
c. Costs of research and development undertaken in connection with the product during the past three
years. Sunk cost (cannot recoverable by our decision) => No Irrelevant outflow
d. Annual depreciation expense from the investment. Depreciation tax shield => Yes Relevant inflow
e. Dividend payments by the firm. Not the CF from the project/investment => No Irrelevant inflow
f. The resale value of plant and equipment at the end of the project’s life. Salvage value => Yes
Relevant inflow
g. Salary and medical costs for production personnel who will be employed only if the project is
accepted. => Yes Relevant outflow
2. Incremental Cash Flows Your company currently produces and sells steel shaft golf clubs. The board
of directors wants you to consider the introduction of a new line of titanium bubble woods with
graphite shafts. Which of the following costs are not relevant?
a. Land you already own that will be used for the project, but otherwise will be sold for $700,000, its
market value. Opportunity cost => Relevant outflow (ICF0)
b. A $300,000 drop in your sales of steel shaft clubs if the titanium woods with graphite shafts are
introduced. Side effects: erosion => Relevant outflow (annual CF)
c. $200,000spent on research and development last year on graphite shafts. Sunk cost (cannot
recoverable) => Irrelevant
 1 Calculating Project NPV Flatte Restaurant is considering the purchase of a $7,500 soufflé maker. The
soufflé maker has an economic life of five years and will be fully depreciated by the straight-line
method. The machine will produce 1,300 soufflés per year, with each costing $2.15 to make and priced
at $5.25. Assume that the discount rate is 14 percent and the tax rate is 34 percent. Should the
company make the purchase?
Investment: CFO $7 500 5 > Deprec 7 , 500/5 $1 500/yr r 14 %
yrs
= =
, n= = . = =
,

Sale = 1 , 300 x $5 25
.
= $6 825
,
Cost = 1 , 300 x $2 15
. = $2 ,
795 tc = 34 %

Top-down approach
OCF : (Sales-Cash costs) (1- t) +
Depres .
xt OCE = Sales-Cash cost-taxes

= 16 , 825 -

2 , 795)(1-34 % ) + 1 , 500 x 34 % The bottom-up approach

= $3 ,
169 8 .
OCF = N1 +
deprec .

O I 2 3 4 5
I I I ↓ -
I I
OCF = EBIT (1-t) + deprec .

7 , 500 3 , 169 8 .
3 , 169 8 .
3, 169 8
... .
-- . The tax shield
3 , 169 8 I
(Sales-Cash costs) (1- t) xt
=> NPV =
-

7 , 500 +
.

1 -

= $3 ,
382 18.
OCF = +
Depres .

14 % L I + 14 % )5
OCF = EBITDA (1 t) - +
Deprec .
* t

2. Calculating Project NPV The Best Manufacturing Company is considering a new investment. Financial
projections for the investment are tabulated here. The corporate tax rate is 34 percent. Assume all
sales revenue is received in cash, all operating costs and income taxes are paid in cash, and all cash
flows occur at the end of the year. All net working capital is recovered at the end of the project.

a. Compute the incremental net income of the investment for each year.
b. Compute the incremental cash flows of the investment for each year.
c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?
Year O Year 1 Year 2 Year 3 Year 4

Sales 12 , 900 14 , 000 15 200 11 , 200

=
,

-
EBITDA
cost 2 , 700 2, 800 2 , 900 2 100,

Depreciation 6 850
,
6 , 850 6 , 850 6 , 850

EBT 3 , 350 4 350

,
5 , 450 2 , 250
x 34 %

Tax 1, 139 1 , 479 1 , 853 765

a
. NI 2 . 211 , 871
2 3 , 597 1 , 485
 I III I
CFO = NI + Deprec 9 061
,
9.721 10 , 447 8 , 335 = EBITDA (1-t) + Dxt

Investment -

27 , 400

875

los 4
NWC

· Incremental ca 27 ,
7 23000s COO egg20 9,210 .
Or
9. 210

3. Project Evaluation Your firm is contemplating the purchase of a new $530,000 computer-based
order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be
worth $50,000 at the end of that time. You will save $186,000 before taxes per year in order
processing costs, and you will be able to reduce working capital by $85,000 (this is a one-time
reduction). If the tax rate is 35 percent,what is the IRR for this project?

530
-$330000n= 5 = Deprec= 000 =$106
Investment : (Fo =
,
,
,
000

salvage value = $50 , 000 EBITDA = $186 , 000

I 10 000/10000 /
-
Year4. Years

Investment -
530 000 ,

CFO 186 , 000 x 0 65 + 106 , 000

.

= EBITDA (1-t) + Deprecxt -s = 150 , 158 , 000 158 000

, 158 , 000

NWC 85 080 ,
-

85 000
,

50 , 000 x (1-0 35) =

.

Salvage value 32 500

,

Incremental CFs -

445 000 ,
158 000 ,
158 , 000 158 000 ,
158 , 000 105 , 500

105 , 500

158
000
0 =
-

445, 000 +
,
- => IRR = 20 68 %
-
.

IMM1 4 (1 + IRR)5

4. Calculating EAC (Equivalent Annual Cost) You are evaluating two different silicon wafer milling
machines. The Techron I costs $245,000, has a three-year life, and has pretax operating costs of
$39,000 per year. The Techron II costs $315,000, has a five-year life, and has pretax operating costs
of $48,000 per year. For both milling machines, use straight-line depreciation to zero over the
project’s life and assume a salvage value of $20,000. If your tax rate is 35 percent and your discount
rate is 9 percent, compute the EAC for both machines. Which do you prefer? Why?
Techron

Techron 1 : cost
I : cost =

=
$245

$315 , 000
,
000 n

n
=

=
3

5
Pretax

Pretax
operating
operating
cost

cost
=

=
$39

$48
,
000

,
000
3 r = 9%

salvage value = $20 , 000 >

-
after-tax salvage value = 20 , 000 x (1-35 % ) = $13 ,
000
 245 000
Techron Pretax operating cost (1 t) += 39 000 (1-35 % ) 35 %
,
* I OCF +
Depres x +
-

x
-

: = .
,

3
= $3 233 33 , .

3 , 233 33 I 13 000
NPV =
-
245 , 000 +
.

1 -

+
,

=
-

$226777 .
0953
9% (1 + 9 % )3 (1 + 9 % 13

= EAC
-
$226 , 777 0956 .

$89 589 37
= = , .

9 % [11 + % (3) 9

Techron I -48 000(1-35 % ) 315, 000

*
: OCF = ,
+ x 35 % = $
5

13,000 =
1
NPV =
-

315 , 000 + 1 -

+
9% 11 + 9 % 15 ,

99 , 426 96
$25
-

=> EAC 561 92

. -

= = ,
.

I
-% [1-x + 9% 75]
=> Conclusion : Prefer Techron II bas lower annual cost .

5. Capital Budgeting with Inflation Consider the following cash flows on two mutually exclusive
projects:

The cash flows of Project A are expressed in real terms, whereas those of Project B are expressed in
nominal terms. The appropriate nominal discount rate is 13 percent and the inflation rate is 4 percent.
Which project should you choose?

in = 13 % it = 4% Fisher equation : (1 + in) = (1 + iv) (1 + A) (1 + 13 % ) = (1 + ir) (1 + 4 % ) >

-
i = 8 65 %
.

Project A : expressed in real terms >

-

ir = 8 65 % .

, %13
18 , 000 16 , 000
$9 476
NPVA =
-

30 , 000 + + + = , .
78
18 65 % .
(1 + 8 65 % /2
.

Project B : expressed in nominal terms >

->
in = 13 %

21 , 000
30002 +25 1 000s
NPVB =
-
45 000
, + + =
$8 92.
. ,

I + 13 % y

=> Conclusion : NPVBLNPVA = Choose project B .

 6. Calculating NPV and IRR for a Replacement A firm is considering an investment in a new machine
with a price of $15.6 million to replace its existing machine. The current machine has a book value of
$5.4 million and a market value of $4.1 million. The new machine is expected to have a four-year life,
and the old machine has four years left in which it can be used. If the firm replaces the old machine
with the new machine, it expects to save $6.3 million in operating costs each year over the next four
years. Both machines will have no salvage value in four years. If the firm purchases the new machine,
it will also need an investment of $250,000 in net working capital. The required return on the
investment is 10 percent, and the tax rate is 39 percent. What are the NPV and IRR of the decision to
replace the old machine?

&
Old machine : BV = $5 4m .
MV = $4 . I m n = 4 => Deprec . = 5 4/4
.
= $1 .

35m/yr
New machine : Cost = $15 6 m .
n = 4 => Deprec . = $3 .
9mlyr => Save operating cost $6 .
3m/yr no salvage value

NWC = $250 ,
000 r = 10 % + = 39 %

*
Purchase new machine ↑

Year O <
Year 1 .
Year 2 Year 3. Year 4

Buy new machine 15 6 m

-

NWC -
0 25
.
M 0 25 m
.

EBITDA = 6 3m.
6. 3 m 6 3m
.
. 3m
6

Operating cost saved

OCF

EBITDA (1-t) Dxt . 364m 5. 364m . 364m . 364m

5
5

: + 5

1st
= 6 3 m /1-0 39)
.
.
+ 3 9m
.
x 0 .
39

5 364 0 25
NPV =- 15 85m
( 14 $1 324
. m
m
.

+ + =
-1
. .

10 % .
1 .
14

5 364m I 0 25 m
21/2
0 =
-
15 85m . +
.

1 -
t
.

= IRR = 13 78 %
.

4
IRR (1 + IRR) 4 (HIRR)

Keep old machine

*

I ↑ Yar1) )Years)mara
Year O years

MV
(Opportunity cost) 4. Im
-

Tax on lOSS
&ain
of disposal -
1 . 3 m x 0 39 : 0 507 . . m
OCF
= EBITDA (1 t -
+ Dxt 0 5265 m
.
0 5265 m
.

= 1 .
35 x 0 .
39

0 5265 I
NPV =
-

4 607
. +
.

1 -
I
-

$2 94 .
m

10 % 1 .
14

0 4 607 +
0 5265 1
1
IRR %
E
-
. -

= .
-
=
4
IRR CHIRR)

7. Calculate the difference in NPV between using different depreciation methods

Cach 2 : Incremental CF

if sell old s
buy new >
-

ACFrew-old >
-

NPVpcFnew-old

&
>
(Fo >
Sell old : 4 Im.

>
- Tax gain on loss of disposal : 1 3m .
x 0 39
.
Cro = (11 243m)
.

>
-
Buy new : (15 6m)
.

25m) old
TNWC : 10 .

Dep = 1 35m
.

CF1-4 (New-old) : DEBITDA(1 -tc) + A DepxTc Dep new = 3 9 .

m

= 6 3 .
x (1 -
0 .
39) + (3 9-1 35)
.
.
x 0 39
. : 4 8375
.

CF4 : 0 25
. m

8375 0 25
4. 1
$4 Should sell old
buy
NPVACF(new-old) 11 243 1 262 = new
.

= .
t -

+ = .
,

0 I . 1 14. 1 .
14

Chapter 7
1. Decision Trees Ang Electronics, Inc., has developed a new DVDR. If the DVDR is successful, the
present value of the payoff (when the product is brought to market) is $27 million. If the DVDR fails,
the present value of the payoff is $9 million. If the product goes directly to market, there is a 50
percent chance of success. Alternatively, Ang can delay the launch by one year and spend $1.3 million
to test market the DVDR. Test marketing would allow the firm to improve the product and increase
the probability of success to 80 percent. The appropriate discount rate is 11 percent. Should the firm
conduct test marketing?
*
Going directly to market
O 1
I I

+ 27m -

50 %

[ + 9m -
50%

PV of P(Success) failure P (failure)

NPV =
payoff successful x + PV of payoff x

= $27m x 50 % +
$9m x 50% = $18m

* Test
marketing first
1
O = 11 %
I I

- $1 3m (test) + $27m -80 %

It $ 9 m
.

28 %
Profsuccess x P(success) + Prof failure x P(failure)
NPV =
-

Cost of test market +

1+ P

$27m x 80 % + $9mx 20 %
=
-

1 3m
.
+
= $19 .
97m

It 11 %

=> Conclusion : The firm should conduct test marketing.

2. Decision Trees The manager for a growing firm is considering the launch of a new product. If the
product goes directly to market, there is a 50 percent chance of success. For $125,000 the manager
can conduct a focus group that will increase the product’s chance of success to 65 percent.
Alternatively, the manager has the option to pay a consulting firm $285,000 to research the market
and refine the product. The consulting firm successfully launches new products 80 percent of the
time. If the firm successfully launches the product, the payoff will be $1.8 million. If the product is a
failure, the NPV is zero. Which action will result in the highest expected payoff to the firm?
*
Going directly to market NPV =
Payoff x P(success) = $1 8m .
x 50% = $0 .
9m

Conduct Payoff P(success)

* a focus
group NPV
Costromsgr + x $0 125m +
$1 8m x 65 % $1 045m
- -

= = .
. = .

*
Pay a
consulting firm NPV =
-

Costconsult +
Payoff x P(success) =
-

$0 285 .
+ $1 8 .
x 80% = $1 .
155m

=> Conclusion : The

growing firm should
pay a
consulting firm .

50
% success
payoff- 1 8m .

=> expected payoff = 1 8m.

x 05 . = 0 9m
.

go directly 50%
>
failure
payoff = O

65 %
focus group >
success :
Payoff : 1 Om
. => expected payoff :
-

125 000 , x 18
.
x 0 65
.

Product (125, 000 35 % failure : O = 1 .

045m

consulting firm
80
% success :
payoff = 1 8m. => expected payoff = 1 .
155m

1285 , 000) 20
% facture O

3. Abandonment Value We are examining a new project. We expect to sell 7,000 units per year at $38
net cash flow a piece for the next 10 years. In other words, the annual operating cash flow is
projected to be $38 x 7,000 = $266,000. The relevant discount rate is 16 percent, and the initial
investment required is $1,040,000.
a. What is the base-case NPV?
b. After the first year, the project can be dismantled and sold for $820,000. If expected sales are
revised based on the first year’s performance, when would it make sense to abandon the investment?
In other words, at what level of expected sales would it make sense to abandon the project?
c. Explain how the $820,000 abandonment value can be viewed as the opportunity cost of keeping the
project in one year.
Annual OCF = $266 ,
000 n= 10 = 16 % CFO = -$1 , 040 ,
000

$266 , 000
a .
Base-case NPV =
-
$1 , 040 , 000 + 1 -
I
= $245 ,
638 .
51
16 % (1 + 16 % /10

b
. We would abandon the project if the CF from
selling equip >PV of future CF

Abandon project at sale quantity where CF PV of future (F(t1-g)

=> from
selling equip =

$38 x Q I
abandon
$820 ,
000 = 1 -
=> Q
= 4684 .
41 = 4685 units => Q 4685 >
-

16 % (1 + 16 % )9

=> At expected sales of 4685 units it would make sense to abandon the project.

$820 000 is the market value of the project. If the project is continued foregoes the
c . , in
1yr ,
co ·

that could been used for else.

$820 ,
000 have
something
 ① I gyrs 10
I I (

now

·
Abandonment value : 820 , 000 - > abandon
·
continue >
-

OCF2-10 = Q x 38 x PVIFA (10 %, 9)

4. Abandonment In the previous problem, suppose you think it is likely that expected sales will be
revised upward to 9,500 units if the first year is a success and revised downward to 3,800 units if the
first year is not a success.
If success and failure are equally likely, what is the value of the option to abandon?
1st yo is a success >
-
Q = 9 , 500

38 9 , 500 1
future
x
PV , of CF = 1 -
= $1 662 962 , , .
34
16 % 1 .
169

=> Loss from option to abandon = $820 ,

000 -

$1 662 962 34
, ,
.
:
-$842 ,
962 .
34 >
-
Not abandon continue project
,

* 1st is a failure > Q 3 , 800 ii

yr
- ~
= -

&

38 x3 , 800 I
PV) of future $665, 84
<Pr
(F = "
= .
94 ,
16 % 1 .
169 154

46% 820 , 000

= Gain from option to abandon = $820 ,

000 -
$665 ,
184 .
94 = $154 ,
815 .
06

value of option to abandon $154 815 06 0 5

=> Present =
, .
x .

= $66. 459 .
08
1 .
16

> expansion option : Q : 19 000 ,

50
% Q = 9 500 >
, QBE >
-
continue >
- PV I (OCF2-10) = 9 , 500 x 38 x PVA (16 %, 9) (1)

50
% Q = 3 , 800 < QBE >
- Abandon value = 820 , 000 value with abandonment
if continue
, => PV i < CF2-10) = 38 x 3 , 800 x PVA /16 %, 9) (2)
Iwbout abandonment)
(1) -

(2) >
-
value of abandonment
↓

# x 0 . 5

1 .
16
 5. Abandonment and Expansion In the previous problem, suppose the scale of the project can be
doubled in one year in the sense that twice as many units can be produced and sold. Naturally,
expansion would be desirable only if the project were a success. This implies that if the project is a
success, projected sales after expansion will be 19,000. Again assuming that success and failure are
equally likely, what is the NPV of the project? Note that abandonment is still an option if the project
is a failure. What is the value of the option to expand?
1st yu is a success >
-
& = 19 , 000 (expansion (
38 x19 , 000 1
PV , of future (F = 1 -
= $3 ,
325 , 924 .
68 = Gain from option to expand
16 % 1 .
169

$3 325 924 68 50 %
of option expand
x
=> Value to =
, , .

= $1 433 588 22
, , .

1 16.

1st yr is a failure >

-
Q = 3 , 800 labandon) >
-
Abandon project with MV = $820 ,
000
O 1
I I
. . .

1 , 040 000
,
+ 266 , 000

+ 3 , 325 , 924 68(50% )4

[
.

+ 820 000 (50 % ) ,

266 , 000 3 , 325 , 924 68x50 % + 820 000 50 %

of project
x
$976 354
+
NPV = - 1 , 040 , 000 +
. ,

= , .
60

1 16
.
Chapter 16
Tutorial 4
1. True/False
a. In a world with no taxes, no transaction costs, and no costs of financial distress, if a firm issues
equity to repurchase some of its debt, the price per share of the firm’s stock will rise because the
shares are less risky. Explain.
False. vin Leverages risk of E ~Re(required rate of return by SH)
>

MM proposition
taxes? "stock unchanged
absence of

b. The riskiness of a firm’s equity will rise if the firm increases its use of debt financing. True
c. If a firm increases its use of borrowing, the likelihood of default increases, thereby increasing the
risk of the firm’s debt. True
d. Given that the firm uses only debt and equity financing, and given that the risks of both are
increased by increased borrowing, so that increasing debt increases the overall risk of the firm and
therefore decreases the value of the firm. False

2. Why is the use of debt financing referred to as financial “leverage”?

Debt financing is referred to as financial "leverage" because it allows a company to amplify its returns
and potential profits. Just like a lever helps to lift heavy objects with less effort, debt financing
enables a company to increase its financial power and achieve higher returns on investment. By using
borrowed funds, a company can leverage its existing capital to finance projects or investments that
have the potential to generate greater returns than the cost of borrowing. However, it's important to
note that while leverage can magnify gains, it can also amplify losses, as the company is obligated to
repay the borrowed funds regardless of the outcome of the investment.
 1 EBIT and Leverage Music City, Inc., has no debt outstanding and a total market value of $295,000.
Earnings before interest and taxes, EBIT, are projected to be $23,000 if economic conditions are
normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a
recession, then EBIT will be 40 percent lower. The company is considering an $88,500 debt issue with
an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are
currently 5,000 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is
issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) if the company goes through with recapitalization. What do you observe?
Vu = $295 ,
000 D = $88 500
,

EBIT = $23 ,
000 -
normal Rd = 8%

$ 28 .
750 -

expansion No of share = 5 000 ,

shares

$13 ,
800 -

recession

a Recession Normal Expansion

EBIT 23 , 000 x 60 % = $13 ,
800 $ 23 ,
000 23 000,
x 1 25 =
. $28 ,
750

EPS 13 800 ,
5000 = $2 .
76 share , 000
23 5 000 ,
= $4 6/ share
.
28 750.
5 , 000 = $5 75 share
.

DEPS v 40 % 0% ↑ 25 %

b .

EBIT $13 ,
800 $23 000 ,
$ 28 750 ,

Interest $ 7 , 080 $ 7 , 080 $ 7 , 080

Earnings after int $6 ,

720 $ 15 920 ,
$ 21 , 670

EPS 6 720 3 500

, ,
= $1 .
92 share $4 55.
share $6 19 .
share

DEPS ~ 57 8 .
% 0% ~
36 04 % .

share price =
295,000 = $59/share = Share repurchase =
80500 =
1 , 500 shares => Intpmt = 88 500
,
x 8% = $7 .
08

share outstd = 5 , 000 -

1 500
,

= 3 500
,
shares

2 Break-Even EBIT Franklin Corporation is comparing two different capital structures, an all-equity plan
(Plan I) and a levered plan (Plan II). Under Plan I, the company would have 315,000 shares of stock
outstanding. Under Plan II, there would be 225,000 shares of stock outstanding and $4.14 million in
debt outstanding. The interest rate on the debt is 10 percent and there are no taxes.
a. If EBIT is $750,000, which plan will result in the higher EPS?
b. If EBIT is $1,750,000, which plan will result in the higher EPS?
c. What is the break-even EBIT?
750 000 750 , 000 4 14m 10 %
$2 38 share PlanI : EPS x
$1 493 share
-

a .
* PlanI : EPS =
,

= .
* =
.

= .

315 , 000
225 , 000

1 , 750 , 000 1 ,750 , 000 4 14 m 10%

b. Plan I EPS $5 56 share I
Plan EPS
x
$5 938 share
-

* : * :
.

= = .
= =
.

315 , 000 225 , 000

 EBIT EBIT -4 14m 10 % Break-even
.
C I
.
x
>
-
EBIT = $1 449 , ,
000
315 , 000 225 , 000

3 Homemade Leverage Star, Inc., a prominent consumer products firm, is debating whether to convert
its all-equity capital structure to one that is 35 percent debt. Currently there are 6,000 shares
outstanding and the price per share is $58. EBIT is expected to remain at $39,600 per year forever.
The interest rate on new debt is 7 percent, and there are no taxes.
a. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the
current capital structure, assuming the firm has a dividend payout rate of 100 percent?
b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that
she keeps all 100 of her shares.
c. Suppose the company does convert, but Ms. Brown prefers the current all-equity capital structure.
Show how she could unlever her shares of stock to recreate the original capital structure.
d. Using your answer to part (c), explain why the company’s choice of capital structure is irrelevant.
100 % E > 65 % E ,
35% D EBIT = $39 , 600
yo no taxes

6 , 000 shares outstanding ,

P = $58 Rd = 7%

.
a Current capital structure : 100 % E no int , no taxes >
-

EBIT = NI

Ms Brown's (F $39 , 600 x 100 = $660

.
=

6 , 000

.
b Proposed capital structure : 65 % E ,
35 % D
800
MV of firm 6 , 000 $58 $348 000 D $348 000 35 % $121 800 Share repurchase 121 sharee
,
= x = , => =
,
x =
, => = - 2 , 100

=> Share outstanding = 6 , 000 -

2 , 100 = 3 900
,
shares
EBIT -int 39 600 121 , 800 7%
x
$7 97 share Brown's
-

EPS = =
,
= . >
=
Ms. .
CF = EPSx 100 : $796 77 .

share ostd 3 , 900

.
c To unlever her shares of stock .
. Brown
Ms should sell 35 % of her shares / = 35 shares) lend the proceed at 7%

=> Int CF received

Dir received = 65
=

x
35

$7
x

.
$58

97
x

share
7%

=
= $142 I

$518 05 .
.

& => Total CF for Ms. Brown = 142 1

.
+ 518 05
.
= $660 .
15

.
d The co .
's choice of capital structure is irrelevant bis SH can create their own
leverage unlever stock , regardless
of the capital structure the firm
actually chooses.

4. Scarlett Corp. uses no debt. The weighted average cost of capital is 8.4 percent. If the current market
value of the equity is $43 million and there are no taxes, what is EBIT?
WACC = 8 4 %:
.
Ru E = $43m = Un D = 0 no taxes

EBIT (l- tc) EBIT

Vn =
x
I =
$43m => EBIT = $3 612m .

Ru 8 4%.
5. Calculating WACC Weston Industries has a debt–equity ratio of 1.5. Its WACC is 10.5 percent, and its
cost of debt is 6 percent. The corporate tax rate is 35 percent.
a. What is the company’s cost of equity capital?
b. What is the company’s unlevered cost of equity capital?
c. What would the cost of equity be if the debt–equity ratio were 2? What if it were 1.0? What if it
were zero?
DIE = 1 5 .
=> D = 1 . 5E Rd = 6%

WACC = 10 5 %
.
tc = 35 %
E D E 1 5E
WACC Re xRox (l tc) Re xRdx(l -tc)
.

a +
-

. = + =

E+ D E+ D E+ 1 5 E .
E + 1 .
5E

= 0 4 .
x Re + 0 6 .
x 6% x /1-35 % ) = 10 % => Re = 19 15 %
.

b
. Re = Ru +
P (l-tc)(Ru-Rd)

=> 19 15 %
. = Ru + 1 .
5 (1-35 % )(Ru-6 %) => Ru = 12 66 % .

/12 66 % -6 % )
.
c DIE = 2 => Re = Ru +
#(l-tc) (Ru-Rd) = 12 66 %
.
+ 2 x65% x
.
= 21 318 %
.

DIE = 10 => Re = 12 66 %
.
+ 10x65 % x (12 66 %
.
-
6% ) = 55 95 %
.

DIE = 0 => Re = Ru = 12 66 %
.

6. Firm Value Cavo Corporation expects an EBIT of $26,850 every year forever. The company currently
has no debt, and its cost of equity is 14 percent. The tax rate is 35 percent.
a. What is the current value of the company?
b. Suppose the company can borrow at 8 percent. What will the value of the company be if it takes on
debt equal to 50 percent of its unlevered value?
EBIT =
$26 ,
850 D = O Re = 14 % = Ru to = 35 %

EBIT (1-tc ( 26 850 x (1-35 % )

a
. Un = I
,

= $124 ,
660 7143 .

Ru 14 %

b
. Ro = 8% D = 50 % x Vu = $62 330 , .
357
> x debt
V = Vn +
# = 124 ,
660 7143 .
+ 35 % x62 330 357 , .
= $146 ,
476 3393 .

~
PV of interest tax shield
7 MM Proposition I with Taxes The Dart Company is financed entirely with equity. The company is
considering a loan of $2.6 million. The loan will be repaid in equal installments over the next two years,
and it has an interest rate of 8 percent. The company’s tax rate is 35 percent. According to MM
Proposition I with taxes, what would be the increase in the value of the company after the loan?
D = $2 6m .
n =
2yrs Ro = 8% to = 35 % C = 1 3m
.
,
Interest AV = PV (intxtc)
PMT
PV = 2 , 600 , 000 =

8%
1 -

,082 => PMT = $1 458

, ,
000
> Principal repret
Principal
year Loan balance Pmt = 1 3m
.
> Interest pmt Tax shield
8 2 , 600 ,
000

I 1 , 300 , 000 2 6m .
x 8% = $208 ,
000 $ 208 000 ,
x 35 % = $72 800 ,

2 O 1 3m .
x 8% = $104 ,
000 $ 104 ,
000 x 35 % = $36 ,
400

The increase in the value of the co .

after the loan = PV of interest tax shield
72 , 800 36 , 400
= + =
$98 614 54 , .

1 + 8% (1 + 8 % )2

8. MM Proposition I without Taxes Alpha Corporation and Beta Corporation are identical in every way
except their capital structures. Alpha Corporation, an all-equity firm, has 18,000 shares of stock
outstanding, currently worth $35 per share. Beta Corporation uses leverage in its capital structure. The
market value of Beta’s debt is $85,000, and its cost of debt is 9 percent. Each firm is expected to have
earnings before interest of $93,000 in perpetuity. Neither firm pays taxes. Assume that every investor
can borrow at 9 percent per year.
a. What is the value of Alpha Corporation?
b. What is the value of Beta Corporation?
c. What is the market value of Beta Corporation’s equity?
d. How much will it cost to purchase 20 percent of each firm’s equity?
e. Assuming each firm meets its earnings estimates, what will be the dollar return to each position in
part (d) over the next year?
f. Construct an investment strategy in which an investor purchases 20 percent of Alpha’s equity and
replicates both the cost and dollar return of purchasing 20 percent of Beta’s equity.
g. Is Alpha’s equity more or less risky than Beta’s equity? Explain.

Alpha Corp
Beta Corp
.:

:
100 % E

D = $85 000 ,
18 000
,
shares
Ro =
outstanding
9%
P = $35 share
& EBIT

no
=

taxes
$93 ,
000

a .
Valpha = 18 000,
x $35 = $630 ,
000

b
. MM Proposition I wout Taxes : VI = Un =>> V Beta =
Valpha = $630 , 000

.
c VBeta = D + E = 85 , 000 + E = 630 000 ,
=> E = $545 000 ,

.
d Alpha corp .: Cost to purchase 20 % E = 20 % x 630 , 000 = $126 ,
000

Beta corp
.: Cost to purchase 20 % E = 20 % x 545 , 000 = $109 000 ,

> invest in 2 corp .

 .
e EBIT = $93 ,
000
- > $ return for investor in d. =?

Alpha corp . : 100 % E =>

Earnings = EBIT = $93 ,
000

=> $ return for investor

owning 20 % E = 20 % x 93 000,
= $18 600
,

Beta corp . : Earnings = EBIT -

int = 93 000 ,
-

85 000
,
x 9% = $85 ,
350

=> $ return for investor

owning 20 % E = 20 % x 85 350
, = $17 ,
070

.
f

Alpha corp . : Cost to purchase 20 % E = $126 ,

000

Beta corp
.: Cost to purchase 20 % E = $109 000 ,

=> In order to purchase $126 ,

000 of Alpha's E using only $109 ,
000 of his own
money ,
the investor
must borrow $17 ,
000 /126 , 000 -

109 , 000

=> Investor receives the same amt of $ return from Alpha & int the amt borrowed.
corp. .

pays on

=> Net $ return = 18 , 600 -

17 000
, x 9% = $17 ,
070

Alpha's less risky than Beta's bcs Beta has to its debt holders b4 to
pay to paying
E is E SH.
g
.
Since SH are residual claimants they receive nothing if Beta does not do biz well.
,
may

9. Business and Financial Risk Assume a firm’s debt is risk-free, so that the cost of debt equals the
risk-free rate, Rf. Define 𝛽𝐴 as the firm’s asset beta—that is, the systematic risk of the firm’s assets.
Define 𝛽𝐸 to be the beta of the firm’s equity. Use the capital asset pricing model, CAPM, along with
MM Proposition II to show that 𝛽𝐸 = 𝛽𝐴 × (1 + 𝐷/𝐸), where 𝐷/𝐸 is the debt–equity ratio. Assume
the tax rate is zero.

Rd = Rf BA , BE BE = BA x (1 + PIE) tc = 0%

CAPM : Re = Rf + BE (Rm-Rf)
MM Proposition
E
I
,

Re
no taxes
D
: Re = WACC E WACC = Rf + BA (Rm -
Rf)
&
DRf
WACC =
+

E+ B E+

=> Rf + BA(Rm-Rf) =

Ep Re +
+

E
Rf + BA(Rm-Rf) = Ep (Rf +
BECRm-Rf)) +
E
D
+ D
Rf

L
E+D

(I-P D)Rf +
+ BA(Rm-Rf) = Ep [Rf +
BECRm-Rf))
E
BA(Rm-Rf) = x BE(Rm-Rf)
E+ D