Principles of Managerial Finance 13th Edition

Chapter 19 International Managerial Finance ◼ Instructor’s Resources Overview In today’s global business environment, the financial manager must also be aware of the international aspects of finance. A variety of international finance topics are presented in this chapter, including taxes, accounting practices, risk, the international capital markets, and the effect on capital structure of operating in different countries. This chapter discusses limited techniques but provides a broad overview of the financial considerations of the multinational corporation (MNC). Chapter 19 highlights the fact that international differences in culture, currencies, and taxes impact the student’s personal life as well as his or her future professional activities.

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Suggested Answer to Opener in Review Question

What makes entering an international marketplace attractive for companies like GE, and what are some common risks associated with operating internationally?

At many companies, including GE, a majority of revenue comes from sales occurring outside the United States. By having locations in many areas, the firm may be more responsive to changes in the marketplace.

To be selected and developed, international markets must meet the same criteria as domestic markets, plus compensate for the additional hurdles faced by the firm. The area must provide solid and predictable demand for the company’s products. Areas of the world that are unstable are generally not attractive markets for most companies. If the product is to be produced locally and the manufacturing process is sophisticated, the international market also must provide a local workforce that is educated. Finally, the international market must be receptive to foreign capital and foreign business. Countries that protect their local markets and industries make poor choices for companies looking to enter a foreign market.

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Answers to Review Questions

1. One of the most important trading blocs was created by the North American Free Trade Agreement (NAFTA) which is the treaty that establishes free trade and open markets between Canada, Mexico, and the United States. Like NAFTA, the European Union (EU) is a trading bloc designed to eliminate tariff barriers and create a single marketplace. Twenty-seven countries, representing almost half of a billion people, are members of the EU. The EU has established a single currency for thirteen member countries called the euro. Mercocur is a trading bloc in Latin America. However, the largest one is ASEAN, which with China has a regional free market including over 1.8 billion people. Countries also participate in bilateral and regional trade agreements.

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An important component of free trade among countries, including those not part of one of the three trading blocs, is the General Agreement on Tariffs and Trade (GATT). GATT extends free trade to broad areas of activity—such as agriculture, financial services, and intellectual property—to any member country. GATT also established the World Trade Organization (WTO) to police and mediate disputes between member countries.

2. A joint venture is a partnership under which the participants have contractually agreed to contribute specified amounts of money and expertise in exchange for stated proportions of ownership and profit.

It is essential to use this type of arrangement in countries requiring that majority ownership of MNC joint venture projects be held by domestically-based investors.

Laws and restrictions regarding joint ventures have effects on MNC operations in four major areas: (1) majority foreign ownership reduces management control by the MNC, (2) disputes over distribution of income and reinvestment frequently occur, (3) ceilings cap profit remittances to parent company, and (4) there is political risk exposure.

3. From the point of view of a U.S.-based MNC, key tax factors that need to be considered are (1) the level of foreign taxes, (2) the definition of taxable income, and (3) the existence of tax agreements between the U.S. and the host country. Although the U.S. government taxes MNC income regardless of source, MNCs can typically reduce federal taxes by the taxes paid abroad.

4. The emergence and the subsequent growth of the Euromarket, which provides for borrowing and lending currencies outside the country of origin, have been attributed to the following factors: the desire by the Russians to maintain their dollars outside the U.S.; consistent U.S. balance of payments deficits, and the existence of certain regulations and controls on dollar deposits in the United States.

Though originally dominated by the U.S. dollar, the euro and Chinese yuan have become popular Euromarket currencies.

Certain cities around the world⎯including London, Singapore, Hong Kong, Bahrain, Luxembourg, and Nassau⎯have become known as major offshore centers of Euromarket business, where extensive Eurocurrency and Eurobond activities take place. Major participants in the Euromarket include the United States, Germany, Switzerland, Japan, France, Britain, and the OPEC nations. In recent years, developing nations have also become part of the Euromarket.

5. FASB No. 52 requires MNCs first to convert the financial statement accounts of foreign subsidiaries into functional currency (the currency of the economy where the entity primarily generates and spends cash and where its accounts are maintained) and then to translate the accounts into the parent firm’s currency, using the all-current-rate method. Under the temporal method, specific assets are translated at historical exchange rates, and the foreign-exchange translation gains or losses are reflected in the current year’s income. By comparison, under the all-current-rate method, gains or losses are charged to a separate component of stockholder’s equity.

6. The spot exchange rate is the rate of exchange between two currencies on any given day. The forward exchange rate is the rate of exchange between two currencies at some future date. Foreign exchange fluctuation affects individual accounts in the financial statements; this risk is called accounting exposure.

Economic exposure is the risk arising from the potential impact of exchange rate fluctuations on the firm’s value. Accounting exposure demonstrates paper translation losses, while economic exposure is the potential for real loss.

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7. If one country experiences a higher inflation rate than a country it trades with, the high inflation country will experience a decline (depreciation) in the value of its currency. This depreciation results from the fact that relatively high inflation causes the price of goods to increase. Foreign purchasers will decrease their demand for products from the country with high inflation due to the higher cost. This decrease in demand forces the value of the inflated currency to decline to bring the exchange-rateadjusted price back into line with pre-inflation prices.

8. Macro political risk means that uncertainty due to political change, all foreign firms in the country will be affected. Micro political risk is specific to the individual firm or industry that is targeted for nationalization. Techniques for dealing with political risk are outlined in Table 19.4 and include joint venture agreements, prior sale agreements, international guarantees, license restrictions, and local financing.

9. If cash flows are blocked by local authorities, the net present value (NPV) of a project and its level of return is “normal,” from the subsidiary’s point of view. From the parent’s perspective, however, NPV in terms of repatriated cash flows may actually be “zero.” The life of a project, of course, can prove to be quite important. For longer projects, even if the cash flows are blocked during the first few years, there can still be meaningful NPV from the parent’s point of view if later years’ cash flows are permitted to be freely repatriated back to the parent.

10. Several factors cause MNCs’ capital structure to differ from that of purely domestic firms. Because MNCs have access to international bond and equity markets, and therefore to a greater variety of financial instruments, certain capital components may have lower costs. The particular currency markets to which the MNC has access will also affect capital structure. The ability to diversify internationally also affects capital structure and may result in either higher leverage and/or higher agency costs. The differing political, legal, financial, and social aspects of each country can also impact capital structure considerations.

11. A foreign bond is an international bond sold primarily in the country of the currency in which it is issued. A Eurobond is sold primarily in countries other than the country of the currency in which the issue is denominated. Foreign bonds are generally sold by those resident underwriting institutions that normally handle bond issues. Eurobonds are usually handled by an international syndicate of financial institutions based in the United States or Western Europe. In the case of foreign bonds, interest rates are generally directly correlated with the domestic rates prevailing in the respective countries. For Eurobonds, several domestic and international (Euromarket) interest rates can influence the actual rates applicable to these bonds.

12. In terms of potential political risks and adverse actions by a host government, having more local debt (and thus more local investors or investments) in a foreign project can prove to be a valuable protective measure over the long run. This strategy will likely cause the local government to be less threatening in the event of governmental or regulatory changes, since the larger amount of local sources of financing are included in the subsidiary’s capital structure.

13. The Eurocurrency market provides short-term foreign currency financing to MNC subsidiaries.

Supply and demand are major factors influencing exchange rates in this market. In international markets, the nominal interest rate is the stated interest rate charged when only the MNC’s parent currency is involved. Effective interest rates are nominal rates adjusted for any forecast changes in the foreign currency relative to the parent MNC’s currency. Consideration of effective rates of interest is critical to any MNC investment and borrowing decisions.

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14. In dealing with “third parties,” when the subsidiary’s local currency is expected to appreciate in value, attempts must be made to increase accounts receivable and to decrease accounts payable. The net result would be to increase the subsidiary’s resources in the local currency when it is expected to appreciate relative to the parent MNC’s currency.

15. When it is expected that the subsidiary’s local currency will depreciate relative to the “home” currency of the parent, intra-MNC accounts payable must be paid as soon as possible while intra-MNC accounts receivable should not be collected for as long as possible. The net result would be to decrease the resources denominated in that local currency.

16. The motives of international business combinations are much the same as for domestic combinations: growth, diversification, synergy, fund-raising, increased managerial skills, tax considerations, and increased ownership liquidity. Additional considerations are entry into foreign markets, and a conducive legal, corporate, and tax environment.

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Suggested Answer to Global Focus Box: Take an Overseas Assignment to Take a Step Up the Corporate Ladder

If going abroad for a full-immersion assignment is not possible, what are some substitutes for a global assignment that may provide some—albeit limited—global experience?

International experience can begin as early as your college years if you seek out a study abroad program or international internship. Once in the workforce, even though you may not be initially assigned to an overseas job, there are several things you can do to gain some global experience. You may want to get involved in internationally focused business groups in your area. The Chicago Council on Foreign Relations and the World Council in Maine are just two examples of such groups.

Another way to develop global experience is to develop expertise in a particular area such as U.S. GAAP, valuation, or turnaround management. Those skills are often needed at a foreign business location where local skills are not developed in those subjects.

Finally, at most large companies, global audit, treasury, and international M&A staffs offer the best international exposure with shorter but more frequent trips overseas to a variety of locations.

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Suggested Answer to Focus on Ethics Box: Chiquita’s Slippery Situation

Chiquita saw their options in Columbia as (a) pay extortion to a terrorist organization or (b) put their employees’ safety at risk. Is it ethical to break the law in an effort to save lifes?

Most will probably agree that Chiquita’s initial decision to pay for protection was justified. However, Chiquita continued to operate in this environment for nearly eight years before selling their Colombian banana operations. Chiquita might have been better off exiting Colombia at an earlier date.

What, if anything, do you think Chiquita should do differently?

Chiquita should have sold their Colombian banana operations as soon as possible after receiving threats from the AUC.

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Answers to Warm-Up Exercises

E19-1.

Taxation of income of a foreign subsidiary

Answer: Subsidiary income before local taxes Foreign income tax at 40% Dividend available to be declared Foreign dividend withholding tax at 5% Santana’s receipt of dividends a.

Santana’s receipt of dividends U.S. tax liability at 34% Foreign taxes available to be used as a credit −23,650 U.S. taxes due (i.e., credit exceeds U.S.tax) Net funds available to Santana

$55,000 −22,000 $33,000 −1,650 $31,350 $31,350 $10,659 −23,650 0 $31,350

b. Foreign taxes cannot be applied against the U.S. tax liability Santana’s receipt of dividends $31,350 U.S. tax liability at 34% −10,659 Net funds available to Santana $20,691 E19-2.

Currency valuation

Answer: a. Dollar price for the Mexican peso = US$0.083333 b. Calculate the exchange rates 1 year from now Assume a basket of goods costs $100 in the United States and 1,200 pesos in Mexico. One year from now the expected cost of the same basket of goods will be: United States $100  1.03 = $103 Mexico 1,200 pesos  1.05 = 1,260 pesos Dollar price of the Mexican peso 1 year from now = $103  1,260 pesos = US$0.081746 Peso price of the U.S dollar 1 year from now = $1,260 peso  $103 = 12.233010 pesos Based on expected inflation rates, the dollar is expected to appreciate in value against the peso and the peso is expected to depreciate in value against the U.S. dollar over the next year.

E19-3.

Effective interest rate of a foreign currency loan

Answer: E = N + F + (N  F) = 0.02 + 0.10 + (0.02  0.10) = 0.1220 = 12.20% E19-4.

Effective interest rate of a foreign loan

Answer: F = Forecast percentage change of the yen = 9.09% E = N + F + (N  F) = 0.03 + 0.0909 + (0.03  0.0909) = 0.1236 = 12.36% E19-5.

Comparing effective interest rates of two loans Answer: EMP = N + F + (N  F) = 0.08 − 0.10 + (0.08  −0.10) = −0.0280 = −2.80% ECD = N + F + (N  F) = 0.03 + 0.03 + (0.03  0.03) = 0.0609 = 6.09%

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The loan in Mexican pesos has the lower effective annual interest rate.

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Chapter 19

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International Managerial Finance

Solutions to Problems

P19-1. Tax credits LG 1; Intermediate MNC’s receipt of dividends can be calculated as follows: Subsidiary income before local taxes Foreign income tax at 33% Dividend available to be declared Foreign dividend withholding tax at 9% MNC’s receipt of dividends a.

$250,000 82,500 $167,500 15,075 $152,425

If tax credits are allowed, then the so-called “grossing up” procedure will be applied:

Additional MNC income U.S. tax liability at 34% Total foreign taxes paid (credit) ($82,500 + $15,075) U.S. taxes due Net funds available to the MNC b. If no tax credits are permitted, then:

$250,000 $ 85,000 (97,575)

MNC’s receipt of dividends U.S. tax liability ($152,425  0.34) Net funds available to the MNC

(97,575) 0 $152,425 $152,425 51,825 $100,600

P19-2. Translation of financial statements LG 3; Intermediate Balance Sheet 12/31/12 U.S.$ Cash 48.00 Inventory 360.00 Plant and equipment (net) 192.00 Total 600.00 Debt 288.00 Paid-in capital 240.00 Retained earnings 72.00 Total 600.00**

12/31/13 U.S.$* 50.88 381.60 203.52 636.00 305.28 254.40 76.32 636.00**

Partial income statement

Sales Cost of goods sold Operating profits

12/31/12 U.S.$

12/31/13 U.S.$

36,000.00 35,700.00 300.00

38,160.00 37,842.00 318.00

*

At 6% appreciation, the new exchange rate becomes U.S.$ 1.272 /€/

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Differences in totals result from rounding.

P19-3. Personal finance problem: Exchange rates LG 3; Easy a.

Cost of tour (EUR) Current exchange rate Cost of tour in dollars Round trip airfare Incidental travel expenses Cost of meals in Italy (EUR) Cost of meals in Italy ($) Miscellaneous expenditures Total cost of trip in dollars

2,750 1.3411 $ 3,688 $ 1,490 $ 300 500 $ 671 $ 1,000 $ 7,149

b.

Amount of euros needed in Italy Cost of means in Italy (EUR) Miscellaneous expenditures Current exchange rate Miscellaneous expenditures (EUR) Amount of euros needed in Italy

500 $ 1,000 0.7456 746 1,246

P19-4. Personal finance: International investment diversification LG 4; Intermediate b.

(1) Global funds are the most diverse of the four categories. But don’t be fooled by their cosmopolitan-sounding name. They’re able to be invested in any region of the world, including the United States, so they don’t actually offer as much diversification as a good international fund. A prime example: Vanguard’s Global Equity Fund (VHGEX), which is 42% invested in the United States, 24% in Europe, 16% in the Pacific Rim, and the remaining 18% in emerging markets. Global funds tend to be the safest foreign-stock investments, but that’s because they typically lean on better-known U.S. stocks.

(2) International funds invest most of their assets outside the United States. Depending on the countries selected for investment, international funds can range from relatively safe to more risky. Vanguard’s International Growth Fund (VWIGX), for instance, has 53% invested in Europe, 24% in emerging markets, and 21% in the Pacific Rim, which leaves only 2 percent for North American companies. Fidelity Diversified International, by comparison, has at least one percent of its assets in 23 different countries, many of which are in Europe. One can even invest in mutual funds that provide extensive exposure to companies in communist countries, such as T. Rowe Price’s Emerging Markets Stock Fund which has a plurality of its portfolio in Chinese companies. Oakmark International Small Cap, on the other hand, has significant exposure to some of the most volatile regions in the world: Thailand, South Korea, Hong Kong, and Turkey. The best thing to do is to choose a fund with the best balance, or make sure the manager has done a good job of moving in and out of regions profitably.

(3) Emerging-market funds are the most volatile. They invest in undeveloped regions of the world, which have enormous growth potential, but also pose significant risks—political upheaval, corruption, and currency collapse, to name just a few.

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Don’t go near these funds with anything but money you are willing to lose.

(4) Country-specific funds are invested in one country or region of the world. That kind of concentration makes them particularly volatile. If you pick the right country—like the Turkey Investment Fund, with a 160% rise in 2009—the returns can be substantial.

But pick the wrong one, and watch out. For instance, the Japan Equity Fund rose only 9% in 2009. Only the most sophisticated investors should venture into this territory P19-5. Euromarket investment and fund raising LG 5; Challenge The effective rates of interest can be obtained by adjusting the nominal rates by the forecast percent revaluation in each case:

Effective rates Euromarket Domestic

US$

MP

¥

4.00% 3.75%

3.01% 2.72%

3.53% 3.68%

Following the assumption outlined in the problem, the best sources of investment and borrowing are the following: $80 million excess is to be invested in the US$ Euromarket. $60 million to be raised in the MP Euromarket.

P19-6. Ethics problem LG 1; Intermediate Yes, because the company may lose out in numerous contract bid opportunities. The management team must explain that it is “ethics first” when doing business, and that the objective is to maximize shareholder wealth subject to ethical constraints. Hopefully, over time, stockholders will get on board with this philosophy—although most will likely be supportive from the outset.

◼ Case Case studies are available on www.myfinancelab.com.

Assessing a Direct Investment in Chile by U.S. Computer Corporation In this case, students evaluate the feasibility of a proposed foreign investment⎯construction of a factory in Chile. They must consider many factors that make international transactions complex, including political and foreign exchange rate risks and raising funds in international markets. a.

Cost of capital—US$: Type of Capital Long-term debt Equity

Amount 6,000,000 4,000,000

Weight 60.00% 40.00 %

Cost 6.0% 12.0%

Weighted Cost 3.60% 4.80%

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Total

$10,000,000

100.00%

8.40%

WACC = 8.40%, or 8% to the nearest whole percent

b.

Present value (PV), 5 years: Operating cash flow = sales  0.20 = $20,000,000  0.20 = $4,000,000 N = 5, I = 8%, PMT = $4,000,000

Present value Calculation

Solve for PV = $15,970,840 If the dollar appreciates (gets stronger) against the Chilean peso, it takes more pesos to buy each dollar. For example, if the exchange rate changes to 800 pesos per dollar, sales of Ps 14 billion equals $17,500,000, compared to $20,000,000 at the current exchange rate. Peso cash flows are therefore worth less, and the present value would decrease. c.

d.

USCC faces foreign exchange risks because the value of the Chilean peso can fluctuate against the dollar, and it is not a currency that can be hedged. Any changes in exchange rates will result in a corresponding change in USCC’s dollar-denominated revenues, costs, and profits.

To minimize foreign exchange risk, USCC can purchase more components with pesos, sell more products priced in dollars, or both. It could purchase or produce more computer components in Chile rather than importing them from the United States. USCC could also export finished computers to market outside of Chile with sales denominated in dollars.

Local (peso) financing carries a much higher cost, 14% for long-term funds versus 6% in the Eurobond market. Also, if the peso depreciates against the dollar, the value of USCC’s investment will decrease, as will any repatriated amounts. The use of peso financing minimizes exchange rate risk.

An unstable political environment increases both political and exchange rate risks. The factory could be seized by the Chilean government if it decides to nationalize foreign assets. The value of the peso relative to the dollar would be likely to depreciate.

Joining into a bilateral trade pact would strengthen Chile’s economic ties with the United States. This should make the project more attractive.

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Spreadsheet Exercise

The answer to Chapter 19’s MNC economic exposure spreadsheet problem is located on the Instructor’s Resource Center at www.pearsonhighered.com/irc under the Instructor’s Manual.

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Group Exercise

Group exercises are available on www.myfinancelab.com.

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Chapter 19

International Managerial Finance

This final chapter broadens the view of the firm internationally. This is also the direction of this final assignment. Opportunities for expansion are now investigated beyond the fictitious firm’s domestic borders. This expansion will take the form of either an attempt to increase market share or locate a new supplier. This, in fact, is the first task of this assignment. The next decision is the nation chosen for the potential expansion.

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Exchange rate risk is the next part of the assignment. This begins by first retrieving recent exchange rate information for the national currency of choice. This recent information is then compared to the past 5 years to give students a sense of volatility in the exchange rate. Risk analysis is then enhanced by comparing the U.S. inflation rate to that of the chosen nation. The progenitor of the inflation comparison is the theory of purchasing power parity. Although not discussed in detail, students are asked to use recent inflation rates to form expectations of future exchange rate moves. Specifically, the nation with the higher inflation rate is expected to see its currency fall in value if this inflation differential persists. Inflation differences are then compared to the recent evolution of the exchange rate. The final task is to explain what advantages are to be gained by “going international.” Although the project asks groups to consider either a situation where the fictitious firm is looking abroad for a foreign supplier or foreign sales, both could be done. As in other group exercises, providing examples of firms going abroad brings realism to the classroom and makes unrealistic assumptions less likely.

◼ Integrative Case 8: Organic Solutions Integrative Case 8, Organic Solutions, asks students to evaluate a proposed acquisition by means of either a cash transaction or a stock swap. The effects on the short- and long-term earnings per share (EPS) should be calculated and other proposals to achieve the merger discussed. The students must also consider the qualitative implications of acquiring a non-U.S.-based company. a.

Price for cash acquisition of GTI: Year

Incremental Cash Flow

1 2 3 4 5 6–30

$18,750,000 18,750,000 20,500,000 21,750,000 24,000,000 25,000,000

Discount Rate

Present Value of GTI

16%

$139,243,245

[Note: F6 = 25]

The maximum price Organic Solutions (OS) should offer GTI for a cash acquisition is $139,243,245.

Net of the $8,400,000 liabilities, GTI’s owners would receive $130,843,245. b.

1. Straight bonds—Financing such a large portion of the acquisition with straight bonds will dramatically increase the financial risk of the firm. The management of OS must be very comfortable that the combined firm is able to generate adequate cash to service this debt. The coupon rate on these bonds could also be quite high. The potential benefit to the OS owners is the magnified return on equity that could result from the leverage.

2. Convertible bonds—Initially convertibles will provide much of the same concern as straight bonds since financial leverage will increase. There are two benefits to convertible bonds not available with straight bonds. First is that the coupon rate will be lower. Investors will value the conversion feature and will be willing to pay more, thus reducing the cost, for the convertible bond. The second advantage is that the leverage will decrease as conversion occurs, assuming the benefits of the acquisition ultimately proves favorable, and the value of the firm increases by the merger. The drawback is the potential dissolution of ownership that will occur if and when the bonds are converted.

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3. Bonds with stock purchase warrants attached—The benefits and disadvantages of this security mix are similar to those of a convertible bond. However, there is one major difference. The attached warrants may eventually be used to supply the firm with additional equity capital. This inflow of capital will lower the financial risk of the firm and generate additional funds. There will still be the dissolution of ownership potential. c.

1. Ratio of exchange: $30  $50 = 0.60 OS must exchange 0.60 shares of its stock for each share of GTI’s stock to acquire the firm in a stock swap.

2. The exchange of stock should increase OS’s EPS to $3.93, an increase from $3.50.

Calculations: New OS shares required: Total OS shares: EPS for OS: EPS for GTI:

4,620,000  0.60 = 2,772,000 10,000,000 + 2,772,000 = 12,772,000 $35,000,000 + $15,246,000 = $3.93 12,772,000 $3.93  0.60 = $2.36, a decrease from $3.30

The decrease in EPS for GTI can be explained by looking at the price/earnings (P/E) ratio for OS and the P/E ratio based on the price paid for GTI:

Price per share EPS—premerger P/E ratio EPS—postmerger

OS

GTI

$50 (market) $3.50 14.29 $3.93

$30 (price paid) $3.30 9.09 $2.36

When the P/E ratio paid is less than the P/E ratio of the acquiring company, there is an increase in the acquiring company’s EPS and a decrease in the target’s EPS. 3. Over the long run, the EPS of the merged firm would probably not increase. Usually the earnings attributable to the acquired company’s assets grow at a faster rate than those resulting from the acquiring company’s premerger assets. d.

OS could make a tender offer to GTI’s stockholders or the firm could propose a combination cash payment-stock swap acquisition.

e.

The fact that GTI is actually a foreign-based company would impact many areas of the foregoing analysis. Regulations that apply to international operations tend to complicate the preparation of financial statements for foreign-based subsidiaries. Certain factors influence the risk and return characteristics of a MNC, particularly economic and political risks. There are two forms of political risk: macro, which involves all foreign firms in a country, and micro, which involves only a specific industry, individual firm, or corporations from a particular country. International cash flows can be subject to a variety of factors, including local taxes in host countries, host-country regulations that may block the return of MNCs’ cash flow, the usual business and financial risks, currency and political actions of host governments, and local capital market conditions. Foreign exchange risks can also complicate international cash management.

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Monsanto Corporation Purchase of New Equipment Cost-Benefit Analysis Benefits with the new equipment Less: Benefits with the old equipment (1) Marginal (added) benefits of the New Equipment

$

Cost of new equipment Less: Proceeds from the sale of the old equipment (2) Marginal (added) costs of the New Equipment

$

Net benefit (1) - (2)

900,000 300,000 $600,000 (a.)

600,000 250,000 $

350,000 (b.) $250,000 (c.)

(d.) Monsanto Corporation should replace the old equipment with the new equipment because the marginal benefits of $600,000 are greater than the marginal costs of $350,000.

Monsanto Corporation Purchase of New Equipment Cost-Benefit Analysis Benefits with the new equipment Less: Benefits with the old equipment (1) Marginal (added) benefits of the New Equipment

900000 300000

Cost of new equipment Less: Proceeds from the sale of the old equipment (2) Marginal (added) costs of the New Equipment

600000 250000

Net benefit (1) - (2)

=B5-B6

(a.)

=B9-B10

(b.)

=C7-C11

(c.)

(d.) Monsanto Corporation should replace the old equipment with the new equipment because the marginal benefits of $600,000 are greater than the marginal costs of $350,000.

Hemingway Corporation Tax Analysis Corporate Tax Rate Schedule

Tax Calculation Range of taxable income $ 0 to $ 50,000 50,000 to 75,000 75,000 to 100,000 100,000 to 335,000 335,000 to 10,000,000 10,000,000 to 15,000,000 15,000,000 to 18,333,333 over 18,333,333

Base Tax $ 0 7,500 13,750 22,250 113,900 3,400,000 5,150,000 18,333,333

+ (Marginal tax rate x amount over base) + ( 15% x amount over $ 0) + ( 25% x amount over 50,000) + ( 34% x amount over 75,000) + ( 39% x amount over 100,000) + ( 34% x amount over 335,000) + ( 35% x amount over 1,000,0000) + ( 38% x amount over 15,000,000) + ( 35% x amount over 18,333,333)

(a.) Current tax liability is found using the corporate tax rate schedule: Before tax income: Tax liability (b.) Current average tax rate:

$200,000 $61,250 30.63%

(c.) Using the cash reserves, the new tax liability and average tax rate is found below using the corporate tax rate schedule: Before tax income: $350,000 Tax liability $119,000 Average tax rate: 34.00% (d.) With debt, the new tax liability and average tax rate is found below using the corporate tax rate schedule: Before tax income: Less: Interest expense: Taxable income: Tax liability Average tax rate:

$350,000 $70,000 $280,000 $92,450 33.02%

(e.) You should consider the after tax income from each possibility shown below, and you should recommend choice with the highest after tax income.

Current after tax income: Expansion with Cash Reserve after tax income: Expansion with debt after tax income:

$138,750 $231,000 $257,550

Hemingway Corporation Tax Analysis Corporate Tax Rate Schedule

Tax Calculation Range of taxable income $ 0 to $ 50,000 50000 to 75000 75000 to 100000 100000 to 335000 335000 to 10000000 10000000 to 15000000 15000000 to 18333333 over 18,333,333

Base Tax $ 0 7500 13750 22250 113900 3400000 5150000 18333333

+ + ( + ( + ( + ( + ( + ( + ( + (

(Marginal tax rate x amount over base) 0.15 x 0.25 x 0.34 x 0.39 x 0.34 x 0.35 x 0.38 x 0.35 x

(a.) Current tax liability is found using the corporate tax rate schedule: Before tax income: Tax liability

(b.) Current average tax rate:

200000 =((E18-IF(E18<=0,$A$7,IF(E18<=$C$8,$A$8,IF(E18<=$C$9,$A$9

=E19/E18

(c.) Using the cash reserves, the new tax liability and average tax rate is found below using the corporate tax rate schedule: Before tax income: 350000 Tax liability =((E26-IF(E26<=0,$A$7,IF(E26<=$C$8,$A$8,IF(E26<=$C$9,$A$9 Average tax rate: =E27/E26 (d.) With debt, the new tax liability and average tax rate is found below using the corporate tax rate schedule: Before tax income: Less: Interest expense: Taxable income: Tax liability Average tax rate:

350000 70000 =E32-E33 =((E34-IF(E34<=0,$A$7,IF(E34<=$C$8,$A$8,IF(E34<=$C$9,$A$9 =E35/E34

(e.) You should consider the after tax income from each possibility shown below, and you should recommend choice with th highest after tax income.

Current after tax income: Expansion with Cash Reserve after tax income: Expansion with debt after tax income:

Tax Calculation

rginal tax rate x amount over base) amount over $ 0) amount over 50,000) amount over 75,000) amount over 100,000) amount over 335,000) amount over 1,000,0000) amount over 15,000,000) amount over 18,333,333)

E18<=$C$8,$A$8,IF(E18<=$C$9,$A$9,IF(E18<=$C$10,$A$10,IF(E18<=$C$11,$A$11,IF(E18<=$C$12,$A$12,IF(E18<=$C$13,$A$13,$

using the corporate tax rate schedule:

E26<=$C$8,$A$8,IF(E26<=$C$9,$A$9,IF(E26<=$C$10,$A$10,IF(E26<=$C$11,$A$11,IF(E26<=$C$12,$A$12,IF(E26<=$C$13,$A$13,$

orate tax rate schedule:

E34<=$C$8,$A$8,IF(E34<=$C$9,$A$9,IF(E34<=$C$10,$A$10,IF(E34<=$C$11,$A$11,IF(E34<=$C$12,$A$12,IF(E34<=$C$13,$A$13,$

you should recommend choice with the

=E18-E19 =E26-E27 =E32-E35

F(E18<=$C$13,$A$13,$C$13))))))))*IF(E18<=0,$G$7,IF(E18<=$C$8,$G$8,IF(E18<=$C$9,$G$9,IF(E18<=$C$10,$G$10,IF(E18<=$C$1

F(E26<=$C$13,$A$13,$C$13))))))))*IF(E26<=0,$G$7,IF(E26<=$C$8,$G$8,IF(E26<=$C$9,$G$9,IF(E26<=$C$10,$G$10,IF(E26<=$C$1

F(E34<=$C$13,$A$13,$C$13))))))))*IF(E34<=0,$G$7,IF(E34<=$C$8,$G$8,IF(E34<=$C$9,$G$9,IF(E34<=$C$10,$G$10,IF(E34<=$C$1

,$G$9,IF(E18<=$C$10,$G$10,IF(E18<=$C$11,$G$11,IF(E18<=$C$12,$G$12,IF(E18<=$C$13,$G$13,$C$13))))))))+IF(E18<=0,$E$7,IF

,$G$9,IF(E26<=$C$10,$G$10,IF(E26<=$C$11,$G$11,IF(E26<=$C$12,$G$12,IF(E26<=$C$13,$G$13,$C$13))))))))+IF(E26<=0,$E$7,IF

,$G$9,IF(E34<=$C$10,$G$10,IF(E34<=$C$11,$G$11,IF(E34<=$C$12,$G$12,IF(E34<=$C$13,$G$13,$C$13))))))))+IF(E34<=0,$E$7,IF

$13,$G$13,$C$13))))))))+IF(E18<=0,$E$7,IF(E18<=$C$8,$E$8,IF(E18<=$C$9,$E$9,IF(E18<=$C$10,$E$10,IF(E18<=$C$11,$E$11,IF

$13,$G$13,$C$13))))))))+IF(E26<=0,$E$7,IF(E26<=$C$8,$E$8,IF(E26<=$C$9,$E$9,IF(E26<=$C$10,$E$10,IF(E26<=$C$11,$E$11,IF

$13,$G$13,$C$13))))))))+IF(E34<=0,$E$7,IF(E34<=$C$8,$E$8,IF(E34<=$C$9,$E$9,IF(E34<=$C$10,$E$10,IF(E34<=$C$11,$E$11,IF

18<=$C$10,$E$10,IF(E18<=$C$11,$E$11,IF(E18<=$C$12,$E$12,IF(E18<=$C$13,$E$13,$C$13)))))))

26<=$C$10,$E$10,IF(E26<=$C$11,$E$11,IF(E26<=$C$12,$E$12,IF(E26<=$C$13,$E$13,$C$13)))))))

34<=$C$10,$E$10,IF(E34<=$C$11,$E$11,IF(E34<=$C$12,$E$12,IF(E34<=$C$13,$E$13,$C$13)))))))

$C$13)))))))

$C$13)))))))

$C$13)))))))

Dayton, Inc. Annual Income Statement (Values in Millions) Common Size 2012 2011 2012 2011 Sales $ 178,909 $ 187,510 100.0% 100.0% Cost of Sales 109,701 111,631 61.3% 59.5% Gross Operating Profit $ 69,208 $ 75,879 38.7% 40.5% Selling, General & Admin. Expense 12,356 12,900 6.9% 6.9% Other Taxes 33,572 33,377 18.8% 17.8% EBITDA $ 23,280 $ 29,602 13.0% 15.8% Depreciation & Amortization 12,103 7,944 6.8% 4.2% EBIT $ 11,177 $ 21,658 6.2% 11.6% Other Income, Net 3,147 3,323 1.8% 1.8% Earnings Before Interest and Taxes $ 14,324 $ 24,981 8.0% 13.3% Interest Expense 398 293 0.2% 0.2% Earnings Before Taxes $ 17,719 $ 24,688 9.9% 13.2% Income Taxes 6,259 9,368 35.32% 37.95% Net Income Available to Common $ 11,460 $ 15,320 6.4% 8.2% Dividends per share EPS Computation of 2012 Cost of Sales: Beginning Inventory Purchases Goods Available Cost of Sales Ending Inventory

$ $

0.92 1.69

$

7,904 109,865 117,769 109,701 8,068

$ $

$ $

0.91 2.20

Dayton, Inc. Annual Balance Sheet (Values in Millions)

2012 Assets Current Assets Cash and Equivalents Receivables Inventories Other Current Assets Total Current Assets Non-Current Assets Property, Plant & Equipment, Gross Accum. Depreciation & Depletion Property, Plant & Equipment, Net Other Non-Current Assets Total Non-Current Assets Total Assets

$

2011

Common Size 2012 2011

7,229 $ 21,163 8,068 1,831 38,291 $

6,547 19,549 7,904 1,681 35,681

4.74% 13.86% 5.29% 1.20% 25.09%

4.57% 13.65% 5.52% 1.17% 24.92%

$

204,960 $ 110,020 94,940 $ 19,413 114,353 $

187,519 97,917 89,602 17,891 107,493

134.27% 72.08% 62.20% 12.72% 74.91%

130.97% 68.39% 62.58% 12.50% 75.08%

$

152,644

143,174

100.00%

100.00%

$

$ $

$

Liabilities & Shareholder's Equity Current Liabilities Accounts Payable Short Term Debt Other Current Liabilities Total Current Liabilities

13,792 $ 4,093 15,290 33,175 $

22,862 3,703 3,549 30,114

65.2% 19.3% 72.2% 156.8%

116.9% 18.9% 18.2% 154.0%

$ $

6,655 $ 16,484 21,733 44,872 $ 78,047 $

7,099 16,359 16,441 39,899 70,013

31.4% 77.9% 102.7% 212.0% 368.8%

36.3% 83.7% 84.1% 204.1% 358.1%

Retained Earnings Total Equity

$ $

74,597 74,597

$ $

73,161 73,161

352.5% 352.5%

374.2% 374.2%

Total Liabilities & Stock Equity

$

152,644

$

143,174

721.3%

732.4%

Total Common Shares Outstanding Treasury Shares

6.7 Bil 1.3 Bil

Non-Current liabilites Long Term Debt Deferred Income Taxes Other Non-Current Liabilities Total Non-Current Liabilities Total Liabilities

$

$

$

6.8 Bil 1.2 Bil Dayton, Inc. Operating Ratios

2012

2011

Analysis: Compare 2012 to 2011

Liquidity Current Ratio Quick Ratio

1.15 0.91

1.18 0.92

Worse than last year Worse than last year

Activity Inventory Turnover Average Days of Inventory A/R Turnover Average Collection Period Fixed Asset Turnover Total Asset Turnover

13.60 26.84 8.45 43.18 1.88 1.17

14.12 25.49 9.59 37.53 2.09 1.31

Worse than last year Worse than last year Worse than last year Worse than last year Worse than last year Worse than last year

Debt Debt-to-Asset Ratio Times Interest Earned

51.1% 2.29

48.9% 2.67

Better than last year Worse than last year

Profitability Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Assets Return on Equity

38.7% 6.2% 6.4% 7.5% 15.4%

40.5% 11.6% 8.2% 10.7% 20.9%

Worse than last year Worse than last year Worse than last year Worse than last year Worse than last year

6,700,000,000 6,800,000,000 $ 1.71 $ 1.23

Better than last year

Market Ratios outstanding stock Earnings Per Share

Price P/E ratio

$

90 52.62

NA NA

Dayton, Inc. Annual Income Statement (Values in Millions)

Sales Cost of Sales Gross Operating Profit Selling, General & Admin. Expense Other Taxes EBITDA Depreciation & Amortization EBIT Other Income, Net Earnings Before Interest and Taxes Interest Expense Earnings Before Taxes Income Taxes Net Income Available to Common

2012 178909 =B29 =B6-B7 12356 33572 =B8-B9-B10 12103 =B11-B12 3147 =B13+B14 398 17719 6259 =B17-B18

2011 187510 111631 =C6-C7 12900 33377 =C8-C9-C10 7944 =C11-C12 3323 =C13+C14 293 =C15-C16 9368 =C17-C18

Dividends per share EPS

0.92 1.69

0.91 2.2

Computation of 2012 Cost of Sales: Beginning Inventory Purchases Goods Available Cost of Sales Ending Inventory

7904 109865 =B26+B27 =B28-B30 8068

Dayton, Inc. Annual Balance Sheet (Values in Millions)

2012

2011

Assets Current Assets Cash and Equivalents Receivables Inventories Other Current Assets Total Current Assets

7229 21163 8068 1831 =SUM(B40:B43)

6547 19549 7904 1681 =SUM(C40:C43)

Non-Current Assets Property, Plant & Equipment, Gross Accum. Depreciation & Depletion Property, Plant & Equipment, Net Other Non-Current Assets Total Non-Current Assets

204960 110020 =B47-B48 19413 =B49+B50

187519 97917 =C47-C48 17891 =C49+C50

Total Assets

=B44+B51

=C44+C51

Liabilities & Shareholder's Equity Current Liabilities Accounts Payable Short Term Debt Other Current Liabilities Total Current Liabilities

13792 4093 15290 =SUM(B57:B59)

22862 3703 3549 =SUM(C57:C59)

Non-Current liabilites Long Term Debt Deferred Income Taxes Other Non-Current Liabilities Total Non-Current Liabilities Total Liabilities

6655 16484 =18965+2768 =SUM(B63:B65) =B60+B66

7099 16359 =13616+2825 =SUM(C63:C65) =C60+C66

Retained Earnings Total Equity

74597 =SUM(B69)

73161 =SUM(C69)

Total Liabilities & Stock Equity

=B67+B70

=C67+C70

Total Common Shares Outstanding Treasury Shares

6.7 Bil 1.3 Bil

6.8 Bil 1.2 Bil

2012

2011

Liquidity Current Ratio Quick Ratio

=B44/B60 =(B44-B42)/B60

=C44/C60 =(C44-C42)/C60

Activity Inventory Turnover Average Days of Inventory A/R Turnover Average Collection Period Fixed Asset Turnover Total Asset Turnover

=B7/B42 =365/B86 =B6/B41 =365/B88 =B6/B49 =B6/B53

=C7/C42 =360/C86 =C6/C41 =360/C88 =C6/C49 =C6/C53

Debt Debt-to-Asset Ratio Times Interest Earned

=B67/B53 =B15/B18

=C67/C53 =C15/C18

Profitability Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Assets Return on Equity

=B8/B6 =B13/B6 =B19/B6 =B19/B53 =B19/B70

=C8/C6 =C13/C6 =C19/C6 =C19/C53 =C19/C70

Market Ratios outstanding stock Earnings Per Share

6700000000 =11460000000/6700000000

6800000000 =8351000000/6800000000

Price P/E ratio

90 =B107/B106

NA NA

n, Inc. ent (Values in Millions) Common Size 2012 2011 =B6/$B$6 =C6/$C$6 =B7/$B$6 =C7/$C$6 =B8/$B$6 =C8/$C$6 =B9/$B$6 =C9/$C$6 =B10/$B$6 =C10/$C$6 =B11/$B$6 =C11/$C$6 =B12/$B$6 =C12/$C$6 =B13/$B$6 =C13/$C$6 =B14/$B$6 =C14/$C$6 =B15/$B$6 =C15/$C$6 =B16/$B$6 =C16/$C$6 =B17/$B$6 =C17/$C$6 0.35324 0.3795 =B19/$B$6 =C19/$C$6

n, Inc. t (Values in Millions)

2012

Common Size 2011

=B40/$B$53 =B41/$B$53 =B42/$B$53 =B43/$B$53 =B44/$B$53

=C40/$C$53 =C41/$C$53 =C42/$C$53 =C43/$C$53 =C44/$C$53

=B47/$B$53 =B48/$B$53 =B49/$B$53 =B50/$B$53 =B51/$B$53

=C47/$C$53 =C48/$C$53 =C49/$C$53 =C50/$C$53 =C51/$C$53

=B53/$B$53

=C53/$C$53

=B57/$B$41 =B58/$B$41 =B59/$B$41 =B60/$B$41

=C57/$C$41 =C58/$C$41 =C59/$C$41 =C60/$C$41

=B63/$B$41 =B64/$B$41 =B65/$B$41 =B66/$B$41 =B67/$B$41

=C63/$C$41 =C64/$C$41 =C65/$C$41 =C66/$C$41 =C67/$C$41

=B69/$B$41 =B70/$B$41

=C69/$C$41 =C70/$C$41

=B72/$B$41

=C72/$C$41

Dayton, Inc. Operating Ratios Analysis:Compare Firm 2012 to Firm 2011 =IF(B82>C82,"Better than last year","Worse than last year") =IF(B83>C83,"Better than last year","Worse than last year")

=IF(B86>C86,"Better than last year","Worse than last year") =IF(B87>C87,"Worse than last year","Better than last year") =IF(B88>C88,"Better than last year","Worse than last year") =IF(B89>C89,"Worse than last year","Better than last year") =IF(B90>C90,"Better than last year","Worse than last year") =IF(B91>C91,"Better than last year","Worse than last year")

=IF(B94>C94,"Better than last year","Worse than last year") =IF(B95>C95,"Better than last year","Worse than last year")

=IF(B98>C98,"Better than last year","Worse than last year") =IF(B99>C99,"Better than last year","Worse than last year") =IF(B100>C100,"Better than last year","Worse than last year") =IF(B101>C101,"Better than last year","Worse than last year") =IF(B102>C102,"Better than last year","Worse than last year")

=IF(B106>C106,"Better than last year","Worse than last year")

ACME Company Cash Budget July through December 2013

Sales Forcasts (000's) Cash Sales Less: Discount Collections of A/R Lagged one month Lagged two months Total Cash Receipts Purchases (% of Sales) Cash Purchases Payment of A/P Lagged one month Wages Lease payments Advertising Expense R&D Expenditures Prepaid Insurance Other expenses Taxes Total Cash Disbursement

May $300.00 $36.00 $1.08

June $290.00 $34.80 $1.04

July $425.00 $51.00 $1.53

August September $500.00 $600.00 $60.00 $72.00 $1.80 $2.16

October $625.00 $75.00 $2.25

______ $34.92

225.00 ______ $258.76

217.50 39.00 $305.97

318.75 37.70 $414.65

375.00 55.25 $500.09

450.00 65.00 $587.75

468.75 78.00 $622.41

487.50 81.25 $650.23

60% 0%

$174.00 $0.00

$255.00 $0.00

$300.00 $0.00

$360.00 $0.00

$375.00 $0.00

$390.00 $0.00

$420.00 $0.00

$0.00 $0.00

100% 6% 2% 3% 12%

$18.00 $6.00 $9.00

$174.00 $17.40 $5.80 $8.70

$255.00 $25.50 $8.50 $12.75

$300.00 $30.00 $10.00 $15.00 $60.00

$360.00 $36.00 $12.00 $18.00 $72.00

$375.00 $37.50 $12.50 $18.75 $75.00

$390.00 $39.00 $13.00 $19.50

$420.00 $42.00 $14.00 $21.00

______ $205.90

$15.00 ______ $316.75

$20.00 ______ $435.00

$25.00 $40.00 $563.00

$30.00 ______ $548.75

$35.00 ______ $496.50

$24.00 $40.00 $45.00 $606.00

$305.97 $316.75 ($10.78) $15.00 $4.22 $15.00 ($10.78)

$414.65 $435.00 ($20.35) $4.22 ($16.13) $15.00 ($31.13)

$500.09 $563.00 ($62.91) ($16.13) ($79.04) $15.00 ($94.04)

$587.75 $548.75 $39.00 ($79.04) ($40.04) $15.00 ($55.04)

$622.41 $496.50 $125.91 ($40.04) $85.87 $15.00

$650.23 $606.00 $44.23 $85.87 $130.10 $15.00

$70.87

$115.10

12.00% 3.00% 75% 13%

______ $33.00

Cash Budget: Total Cash Receipts Less: Total Cash Disbursements New Cash Flow Add: Beginning Balance Ending Balance Less: Minimum Cash Balance Required total financing (notes payable) Excess Cash balance (marketable securities)

November December $650.00 $700.00 $78.00 $84.00 $2.34 $2.52

ACME Company Cash Budget July through December 2013

Sales Forcasts (000's) Cash Sales Less: Discount Collections of A/R Lagged one month Lagged two months Total Cash Receipts Purchases (% of Sales) Cash Purchases Payment of A/P Lagged one month Wages Lease payments Advertising Expense R&D Expenditures Prepaid Insurance Other expenses Taxes Total Cash Disbursement Cash Budget: Total Cash Receipts Less: Total Cash Disbursements New Cash Flow Add: Beginning Balance Ending Balance Less: Minimum Cash Balance Required total financing (notes payable) Excess Cash balance (marketable securities)

May 300 =$B$6*C5 =C6*$B$7

June 290 =$B$6*D5 =D6*$B$7

425 =$B$6*E5 =E6*$B$7

______ =C6-C7

=$B$9*C5 ______ =+D6-D7+D9

=$B$9*D5 =$B$10*C5 =+E6-E7+E9+E10

0.6 0

=$B$13*D5 0

=$B$13*E5 0

=$B$13*F5 0

1 0.06 0.02 0.03 0.12

=$B$17*C5 =$B$18*C5 =$B$19*C5

=C13*$B$16 =$B$17*D5 =$B$18*D5 =$B$19*D5

=D13*$B$16 =$B$17*E5 =$B$18*E5 =$B$19*E5

=0.12 0.03 0.75 0.13

July

15 ______ ______ =SUM(C14:C23) =SUM(D14:D23)

______ =SUM(E14:E23)

=E11 =E24 =E27-E28 15 =E29+E30 15 =IF((E31-E32)<0,E31-E32,"") =IF((E31-E32)>0,E31-E32,"")

ACME Company Cash Budget July through December 2013

500 =$B$6*F5 =F6*$B$7

August

September 600 =$B$6*G5 =G6*$B$7

625 =$B$6*H5 =H6*$B$7

November 650 =$B$6*I5 =I6*$B$7

December 700 =$B$6*J5 =J6*$B$7

=$B$9*E5 =$B$10*D5 =+F6-F7+F9+F10

=$B$9*F5 =$B$10*E5 =+G6-G7+G9+G10

=$B$9*G5 =$B$10*F5 =+H6-H7+H9+H10

=$B$9*H5 =$B$10*G5 =+I6-I7+I9+I10

=$B$9*I5 =$B$10*H5 =+J6-J7+J9+J10

=$B$13*G5 0

=$B$13*H5 0

=$B$13*I5 0

=$B$13*J5 0

=$B$13*K5 0

=E13*$B$16 =$B$17*F5 =$B$18*F5 =$B$19*F5 =$B$20*F5

=F13*$B$16 =$B$17*G5 =$B$18*G5 =$B$19*G5 =$B$20*G5

=G13*$B$16 =$B$17*H5 =$B$18*H5 =$B$19*H5 =$B$20*H5

=H13*$B$16 =$B$17*I5 =$B$18*I5 =$B$19*I5

=I13*$B$16 =$B$17*J5 =$B$18*J5 =$B$19*J5

20

25 40 =SUM(G14:G23)

30

35

______ =SUM(H14:H23)

______ =SUM(I14:I23)

______ =SUM(F14:F23)

October

24 40 45 =SUM(J14:J23)

=F11 =G11 =H11 =I11 =J11 =F24 =G24 =H24 =I24 =J24 =F27-F28 =G27-G28 =H27-H28 =I27-I28 =J27-J28 =E31 =F31 =G31 =H31 =I31 =F29+F30 =G29+G30 =H29+H30 =I29+I30 =J29+J30 =$E$32 =$E$32 =$E$32 =$E$32 =$E$32 =IF((F31-F32)<0,F31-F32,"") =IF((G31-G32)<0,G31-G32,"") =IF((H31-H32)<0,H31-H32,"") =IF((I31-I32)<0,I31-I32,"") =IF((J31-J32)<0,J31-J32,"") =IF((F31-F32)>0,F31-F32,"") =IF((G31-G32)>0,G31-G32,"") =IF((H31-H32)>0,H31-H32,"") =IF((I31-I32)>0,I31-I32,"") =IF((J31-J32)>0,J31-J32,"")

Uma Corp.

Present Value of Expected Future Savings Period: 2013 through 2023 Discount rate for years 2013 - 2018 Discount rate for years 2019 - 2023

Year 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Year (n) 1 2 3 4 5 6 7 8 9 10 11

$

$

7% 11% Cash Flow 110,000 120,000 130,000 150,000 160,000 150,000 90,000 90,000 90,000 90,000 90,000 1,270,000 $

Present Value $102,803.74 104,812.65 106,118.72 114,434.28 114,077.79 99,951.33 54,027.75 48,673.65 43,850.13 39,504.62 35,589.75 863,844 (a)

(b) Based solely on the criteria set by management, the firm should undertake this project as the present value of the expected future saving total $863,844 which exceeds the $860,000 hurdle. (c ) The concept of interest-rate risk states that changes in the interest rates may adversely affect the value of an investor's securities portfolio.

While this is not a securities problem, the relationship between the change in rates and the subsequent change in the value of an asset hold true. If the the interest rates were to rise just 1 percent, the present value of the expected savings would fall below the required $860,000 limit set by mangement.

Uma Corp.

Present Value of Expected Future Savings Period: 2013 through 2023 Discount rate for years 2013 - 2018 Discount rate for years 2019 - 2023

Year 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Year (n) 1 2 3 4 5 6 7 8 9 10 11

0.07 0.11

Cash Present Flow Value 110000 =PV($E$5,C10,0,-D10) 120000 =PV($E$5,C11,0,-D11) 130000 =PV($E$5,C12,0,-D12) 150000 =PV($E$5,C13,0,-D13) 160000 =PV($E$5,C14,0,-D14) 150000 =PV($E$5,C15,0,-D15) 90000 =PV($E$5,$C$15,0,-PV($E$6,C16-$C$15,0,-D16)) 90000 =PV($E$5,$C$15,0,-PV($E$6,C17-$C$15,0,-D17)) 90000 =PV($E$5,$C$15,0,-PV($E$6,C18-$C$15,0,-D18)) 90000 =PV($E$5,$C$15,0,-PV($E$6,C19-$C$15,0,-D19)) 90000 =PV($E$5,$C$15,0,-PV($E$6,C20-$C$15,0,-D20)) =SUM(D10:D20) =SUM(E10:E20)

(a)

(b) Based solely on the criteria set by management, the firm should undertake this project as the present value of the expected future saving total $863,844 which exceeds the $860,000 hurdle. (c ) The concept of interest-rate risk states that changes in the interest rates may adversely affect the value of an investor's securities portfolio. While this is not a securities problem, the relationship between the change in rates and the subsequent change in the value of an asset hold true. If the the interest rates were to rise just 1 percent, the present value of the expected savings would fall below the required $860,000 limit set by mangement.

change in rates and the subsequent change in the value of an asset hold true. If the the interest rates were to rise just 1 percent, the present value of the expected savings would fall below the required

$860,000 limit set by mangement.

CSM Corporation Solving for yield to maturity and price of a semi-annually paying bond (a.)

YIELD TO MATURITY, SEMI ANNUAL INTEREST Coupon interest rate 6% Par value $1,000 Semi annual interest Payment $30 Number of years to maturity 15 Number of periods to maturity 30 Current bond price -874 Yield to Maturity 7.40%

(b.)

BOND VALUE, SEMI ANNUAL INTEREST Coupon interest rate 6% Par value $1,000 Semi annual interest Payment $30 Number of years to maturity 15 Number of periods to maturity 30 Yield to Maturity 9.40% Current bond price -729.49

(c.)

BOND VALUE, SEMI ANNUAL INTEREST Coupon interest rate 6% Par value $1,000 Semi annual interest Payment $30 Number of years to maturity 15 Number of periods to maturity 30 Yield to Maturity 5.40% Current bond price -1061.15

(d.)

When the yield to maturity is greater than the coupon rate than the price of the bond is below the par value and when the yield to maturity is lower than the coupon rate than the price of the bond is above the par value.

CSM Corporation Solving for yield to maturity and price of a semi-annually paying bond (a.)

YIELD TO MATURITY, SEMI ANNUAL INTEREST Coupon interest rate 0.06 Par value 1000 Semi annual interest Payment =D5*D6/2 Number of years to maturity 15 Number of periods to maturity =D8*2 Current bond price -874.42 Yield to Maturity =RATE(D9,D7,D10,D6)*2

(b.)

BOND VALUE, SEMI ANNUAL INTEREST Coupon interest rate 0.06 Par value 1000 Semi annual interest Payment =D14*D15/2 Number of years to maturity 15 Number of periods to maturity =D17*2 Yield to Maturity =D11+0.02 Current bond price =PV(D19/2,D18,D16,D15)

(c.)

BOND VALUE, SEMI ANNUAL INTEREST Coupon interest rate 0.06 Par value 1000 Semi annual interest Payment =D23*D24/2 Number of years to maturity 15 Number of periods to maturity =D26*2 Yield to Maturity =D11-0.02 Current bond price =PV(D28/2,D27,D25,D24)

(d.) When the yield to maturity is greater than the coupon rate than the price of the bond is below the par value and when the yield to maturity is lower than the coupon rate than the price of the bond is above the par value.

Common Stock of Azure Corporation (a.) Value of Azure Common under constant growth assumption: Given: Last dividend, D0 $3.00 constant growth, g 7.00% required return, r 10.00% model: Po = (Do (1 + g )) / (r - g) Price, P0 $107.00 (b.) Value of the required return, year later: Given: risk premuim of Azure 6.74% Risk free rate 5.25% model: r=risk free rate + risk premuim Required return 11.99% (c.) Value of Azure a year later with new required return Given: Required return, r 11.99% Constant growth, g 7.00% Last dividend, D0 $3.21 model: Po = (Do (1 + g )) / (r - g) Price $68.83 (d.) No, you would not want to buy additional shares of the stock at $73 because the intrinsic value is $68.83. Your belief would be that the stock is overvalued. (e.) Althought you would be looking at a loss, you would want to sell your current shares at $73 because the intrinsic value is only $68.83 which would be even a great loss.

Common Stock of Azure Corporation (a.) Value of Azure Common under constant growth assumption: Given: Last dividend, D0 3 constant growth, g 0.07 required return, r 0.1 model: Po = (Do (1 + g )) / (r - g) Price, P0 =B5*(1+B6)/(B7-B6) (b.) Value of the required return, year later: Given: risk premuim of Azure 0.0674 Risk free rate 0.0525 model: r=risk free rate + risk premuim Required return =B13+B14 (c.) Value of Azure a year later with new required return Given: Required return, r =B16 Constant growth, g =B6 Last dividend, D0 3.21 model: Po = (Do (1 + g )) / (r - g) Price =(B22*(1+B21))/(B20-B21) (d.) No, you would not want to buy additional shares of the stock at $73 because the intrinsic value is $68.83. Your belief would be that the stock is overvalued. (e.) Althought you would be looking at a loss, you would want to sell your current shares at $73 because the intrinsic value is only $68.83 which would be even a great loss.

Jane's Stock Portfolio Forecasted Returns, Expected Values, and Standard Deviations for Assets A, B, and C and Portfolios AB, AC, and BC

Year 2013 2014 2015 2016 2017 2018 2019 Statistics: Expected value Standard deviation CV

A 10% 13% 15% 14% 16% 14% 12%

(a.) (b.)

13.43% 1.99% 14.80%

Assets B 10% 11% 8% 12% 10% 15% 15%

11.57% 2.64% 22.79%

C 12% 14% 10% 11% 9% 9% 10%

AB 10.0% 12.0% 11.5% 13.0% 13.0% 14.5% 13.5%

Portfolios AC 11.0% 13.5% 12.5% 12.5% 12.5% 11.5% 11.0%

BC 11.0% 12.5% 9.0% 11.5% 9.5% 12.0% 12.5%

10.71% 1.80% 16.80%

12.50% 1.47% 11.78%

12.07% 0.93% 7.72%

11.14% (c.)

1.41% (d.)

12.62%

Note: In each of the two stock portfolios, the weights of each security are equal 50% 50% 50% (e) Stock A, by itself, has an expected return of 13.43% with a standard deviation of 1.99%. Investing in the portfolio comprised of stocks A and B delivers a lower return of 12.5% and is associated with a standatd deviation 1.47%. So there is both a lower amount of risk and return in the portfolio, she needs to find the coeffiecient of variation (CV). Here we can see the CV of variation of the portfolio is less than than stock A alone so the portfolio of AB should be recommended. (d) Stock B, by itself, has an expected return of 11.57% with a standard deviation of 2.64%. Investing in the portfolio comprised of stocks B and C delivers a lower return of 11.14% and is associated with a standard deviation of 1.41%. So once again both the return and risk of the portfolio are lower.

Considering the CV, however, Jane, can determine that the portfolio BC is preferable to stock B alone because the CV of is lower for the portfolio.

Forecasted Returns, Expected Values, and Sta Assets A, B, and C and Portfolios AB, Assets Year

A

2013 2014 2015 2016 2017 2018 2019 Statistics: Expected value Standard deviation CV

(a.) (b.)

B

C

0.1 0.13 0.15 0.14 0.16 0.14 0.12

0.1 0.11 0.08 0.12 0.1 0.15 0.15

0.12 0.14 0.1 0.11 0.09 0.09 0.1

=AVERAGE(C6:C12) =STDEV(C6:C12) =C16/C15

=AVERAGE(D6:D12) =STDEV(D6:D12) =D16/D15

=AVERAGE(E6:E12) =STDEV(E6:E12) =E16/E15

Note: In each of the two stock portfolios, the weights of each security are equal 0.5 0.5 0.5 (e.) Stock A, by itself, has an expected return of 13.43% with a standard deviation of 1.99%. Investing in the portfolio comprised of stocks A and B delivers a lower return of 12.5% and is associated with a standatd deviation 1.47%. So there is both a lower amount of risk and return in the portfolio, she needs to find the coeffiecient of variation (CV). Here we can see the CV of variation of the portfolio is less than than stock A alone so the portfolio of AB should be recommended. (d.) Stock B, by itself, has an expected return of 11.57% with a standard deviation of 2.64%. Investing in the portfolio comprised of stocks B and C delivers a lower return of 11.14% and is associated with a standard deviation of 1.41%. So once again both the return and risk of the portfolio are lower.

Considering the CV, however, Jane, can determine that the portfolio BC is preferable to stock B alone because the CV of is lower for the portfolio.

ns, Expected Values, and Standard Deviations for A, B, and C and Portfolios AB, AC, and BC

AB =SUMPRODUCT($C$21:$D$21,C6:D6) =SUMPRODUCT($C$21:$D$21,C7:D7) =SUMPRODUCT($C$21:$D$21,C8:D8) =SUMPRODUCT($C$21:$D$21,C9:D9) =SUMPRODUCT($C$21:$D$21,C10:D10) =SUMPRODUCT($C$21:$D$21,C11:D11) =SUMPRODUCT($C$21:$D$21,C12:D12)

Portfolios AC =($C$21*C6)+($E$21*E6) =($C$21*C7)+($E$21*E7) =($C$21*C8)+($E$21*E8) =($C$21*C9)+($E$21*E9) =($C$21*C10)+($E$21*E10) =($C$21*C11)+($E$21*E11) =($C$21*C12)+($E$21*E12)

=AVERAGE(G6:G12) =STDEV(G6:G12) =G16/G15

=AVERAGE(H6:H12) =STDEV(H6:H12) =H16/H15

os BC =SUMPRODUCT($D$21:$E$21,D6:E6) =SUMPRODUCT($D$21:$E$21,D7:E7) =SUMPRODUCT($D$21:$E$21,D8:E8) =SUMPRODUCT($D$21:$E$21,D9:E9) =SUMPRODUCT($D$21:$E$21,D10:E10) =SUMPRODUCT($D$21:$E$21,D11:E11) =SUMPRODUCT($D$21:$E$21,D12:E12)

=AVERAGE(I6:I12) =STDEV(I6:I12) =I16/I15

(c.) (d.)

Nova Corporation

Par value Coupon rate Maturity (yrs) Discount Floatation cost Tax Rate

$1,000 6.50% 10 $20 2.00% 40%

Par Value Annual Dividend Rate Floatation Cost Sales Price Before Cost Consideration

$100.00 6.00% $4

Current Price Expect cash dividend Constant growth rate Floatation Cost

$35.00 $3.25 5.00% $2.00

Source of Capital Long-term debt Preferred stock Common stock equity

Debt Annual Coupon Payment Net Proceeds Before Cost of Debt After-tax Cost of Debt

$65.00 960 7.07% 4.24% (a.)

Preferred Stock Annual Dividend Payment Net Proceeds Cost of Preferred Stock

$6.00 $98.00 6.12% (b.)

Common Stock Cost of Retained Earnings Cost of New Common

14.29% (c.)

14.85% (d.)

$102.00

Weighted Average Cost (WACC) Weight 35% WACC using retained earnings 12% WACC using new common 53%

9.79% (e.)

10.09% (f.)

Nova Corporation

Par value Coupon rate Maturity (yrs) Discount Floatation cost Tax Rate

1000 0.065 10 20 0.02 0.4

Debt Annual Coupon Payment Net Proceeds Before Cost of Debt After-tax Cost of Debt

=B4*B5 =(B4*(1-B8))-B7 =RATE(B6,E4,-E5,B4) =E6*(1-B9)

(a.)

Preferred Stock Annual Dividend Payment Net Proceeds Cost of Preferred Stock

=B12*B13 =B15-B14 =E12/E13

(b.)

Common Stock Cost of Retained Earnings Cost of New Common

=(B19/B18)+B20 =(B19/(B18-B21))+B20

(c.) (d.)

=(E7*B25)+(E14*B26)+(E18*B27) =(E7*B25)+(E14*B26)+(E19*B27)

(e.) (f.)

Par Value Annual Dividend Rate Floatation Cost

100 0.06 4

Sales Price Before Cost Consideration

102

Current Price Expect cash dividend Constant growth rate Floatation Cost

35 3.25 0.05 2

Source of Capital Long-term debt Preferred stock Common stock equity

Weighted Average Cost (WACC) Weight 0.35 WACC using retained earnings 0.12 WACC using new common 0.53

The Drillago Company Calculation of the NPV, IRR, and the Payback Period Given: Estimated Life cost-of-capital (r ) Initial Investment

Year 0 1 2 3 4 5 6 7 8 9 10

$

10 years 13% 15,000,000

Estimated Cash Outflows/Inflows NPV IRR $ (15,000,000) -15000000.00 -15000000.00 600,000 530973.45 600000.00 1,000,000 783146.68 1000000.00 1,000,000 693050.16 1000000.00 2,000,000 1226637.46 2000000.00 3,000,000 1628279.81 3000000.00 3,500,000 1681114.85 3500000.00 4,000,000 1700242.57 4000000.00 6,000,000 2256959.17 6000000.00 8,000,000 2663078.67 8000000.00 12,000,000 3535060.18 12000000.00 1,698,543.00 (a.)

14.76% (b.)

Payback period -15,000,000 -14,400,000 -13,400,000 -12,400,000 -10,400,000 -7,400,000 -3,900,000 100,000 6,100,000 14,100,000 26,100,000

0.03

6.03 years (d.)

(a.) Accept the project as the NPV > 0. (b.) Accept the project as the IRR (14.76%) > Cost of Capital (13%) (c.) When the decision is simply accept or reject then the NPV and IRR method will always produce the same results. However, when ranking several projects the NPV method is preferred over the IRR method because the IRR method assumes the cashflows are reinvested at the IRR not the required cost of capital. (d.) Since the payback period is less than 7 years the project is acceptable.

The Drillago Company Calculation of the NPV, IRR, and the Payback Period Given: Estimated Life 10 cost-of-capital (r ) 0.13 Initial Investment 15000000

Year 0 1 2 3 4 5 6 7 8 9 10

years

Estimated Cash Outflows/Inflows NPV =-B7 =B12/(1+$B$6)^A12 600000 =B13/(1+$B$6)^A13 1000000 =B14/(1+$B$6)^A14 1000000 =B15/(1+$B$6)^A15 2000000 =B16/(1+$B$6)^A16 3000000 =B17/(1+$B$6)^A17 3500000 =B18/(1+$B$6)^A18 4000000 =B19/(1+$B$6)^A19 6000000 =B20/(1+$B$6)^A20 8000000 =B21/(1+$B$6)^A21 12000000 =B22/(1+$B$6)^A22 =SUM(C12:C22) (a.)

Payback IRR period =B12/(1+$E$9)^A12 =B12 =B13/(1+$E$9)^A13 =G12+B13 =B14/(1+$E$9)^A14 =G13+B14 =B15/(1+$E$9)^A15 =G14+B15 =B16/(1+$E$9)^A16 =G15+B16 =B17/(1+$E$9)^A17 =G16+B17 =B18/(1+$E$9)^A18 =G17+B18 =B19/(1+$E$9)^A19 =G18+B19 =B20/(1+$E$9)^A20 =G19+B20 =B21/(1+$E$9)^A21 =G20+B21 =B22/(1+$E$9)^A22 =G21+B22 =IRR(E12:E22,0.1) (b.)

(a.) Accept the project as the NPV > 0. (b.) Accept the project as the IRR (14.76%) > Cost of Capital (13

(c.) When the decision is simply accept or reject then the NPV an method will always produce the same results. However, whe ranking several projects the NPV method is preferred over th method because the IRR method assumes the cashflows are reinvested at the IRR not the required cost of capital. (d.) Since the payback period is less than 7 years the project is acceptable.

=G19/B19

=A18+H19 years (d.)

14.76%) > Cost of Capital (13%)

cept or reject then the NPV and IRR e same results. However, when PV method is preferred over the IRR od assumes the cashflows are equired cost of capital. ss than 7 years the project is

The Damon Corporation Calculation of the Initial Investment Installed cost of proposed machine Cost of proposed machine plus: Installation costs Total installed cost - proposed (depreciable value)

$ 145,000 15,000 $ 160,000

After-tax proceeds from sale of present machine Proceeds from sale of present machine less: Tax on sale of present machine Total after-tax proceeds - present

$ 70,000 14,080 $ 55,920

Change in net working Capital

18,000

Initial investment

$ 122,080

Tax on sale of old machine cost of old machine MACRS year 1 20% year 2 32% year 3 19% Book Value Sale price of old machine Gain on sale Tax rate Tax Expense

Change in Working Capital $ 120,000 Increase in receivables increase in inventory 24,000 increase in payables 38,400 Net working capital 22,800 $ 34,800 $ 70,000 $ 35,200 40% $ 14,080

$ 15,000 19,000 16,000 $ 18,000

Depreciation Expense for Proposed and Present Machines for the Damon Corporation

Year

Cost

With proposed machine 1 $ 160,000 2 160,000 3 160,000 4 160,000 5 160,000 6 160,000 Total With present machine 1 $ 120,000 2 120,000 3 120,000 4 5 6

Applicable MACRS depreciation

Depreciation

20% 32% 19% 12% 12% 5% 100%

$32,000 51,200 30,400 19,200 19,200 8,000 $ 160,000

12% 12% 5%

$ 14,400 14,400 6,000 0 0 0

Total

$ 34,800 Calculation of Operating Cash Inflows for Damon Corporation Proposed and Present Machines

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 With proposed machine Earnings before depr. and int. $ 105,000 $ 110,000 $ 120,000 $ 120,000 $ 120,000 $ Depreciation 32,000 51,200 30,400 19,200 19,200 8,000 Earnings before interest and taxes $ 73,000 $ 58,800 $ 89,600 $ 100,800 $ 100,800 $ (8,000) Taxes 40% 29,200 23,520 35,840 40,320 40,320 -3,200 Net operating profit after taxes $ 43,800 $ 35,280 $ 53,760 $ 60,480 $ 60,480 $ (4,800) Depreciation 32,000 51,200 30,400 19,200 19,200 8,000 Operating cash inflows $ 75,800 $ 86,480 $ 84,160 $ 79,680 $ 79,680 $ 3,200 With present machine Earnings before depr. and int. and taxes $ Depreciation Earnings before interest and taxes $ Taxes 40% Net operating profit after taxes $ Depreciation Operating cash inflows $

95,000 $ 95,000 $ 95,000 $ 95,000 $ 95,000 $ 14,400 14,400 6,000 0 0

-

80,600 $ 80,600 $ 89,000 $ 95,000 $ 95,000 $ 32,240 32,240 35,600 38,000 38,000 48,360 $ 48,360 $ 53,400 $ 57,000 $ 57,000 $ 14,400 14,400 6,000 0 0 62,760 $ 62,760 $ 59,400 $ 57,000 $ 57,000 $

-

0

0 0 -

Calculation of the Terminal Cash Flow After-tax proceeds from sale of proposed machine Proceeds from sale of proposed machine Book value as of end of year 5 Net gain Tax on gain Total after-tax proceeds - proposed After-tax proceeds from sale of present machine Proceeds from sale of present machine Book value as of end of year 5 Net gain Tax on gain Total after-tax proceeds - present

$ 24,000 8,000 $ 16,000 40% 6,400

$ $ 40%

$

9,600

$

4,800

8,000 0 8,000 3,200

Change in net working capital

$ 18,000

Terminal Cash Flow

$ 22,800

Calcu Installed cost of proposed machine Cost of proposed machine plus: Installation costs Total installed cost - proposed (depreciable value) After-tax proceeds from sale of present machine Proceeds from sale of present machine less: Tax on sale of present machine Total after-tax proceeds - present Change in net working Capital Initial investment Tax on sale of old machine cost of old machine MACRS year 1 year 2 year 3

0.2 0.32 0.19 Book Value Sale price of old machine Gain on sale Tax rate Tax Expense

Depreciation Expense for Machines for the Da

Year With proposed machine 1 2 3 4 5 6 Total With present machine 1 2 3 4 5 6 Total

Cost

=H8 =B39 =B40 =B41 =B42 =B43

=D21 =B48 =B49

Calculation of Operating Cash In Proposed and Pre

With proposed machine Earnings before depr. and int. and taxes Depreciation Earnings before interest and taxes Taxes Net operating profit after taxes Depreciation Operating cash inflows With present machine Earnings before depr. and int. and taxes Depreciation Earnings before interest and taxes Taxes Net operating profit after taxes Depreciation Operating cash inflows

=D29

=D29

Calculation of the Te After-tax proceeds from sale of proposed machine Proceeds from sale of proposed machine Book value as of end of year 5 Net gain Tax on gain Total after-tax proceeds - proposed After-tax proceeds from sale of present machine Proceeds from sale of present machine Book value as of end of year 5 Net gain Tax on gain Total after-tax proceeds - present Change in net working capital Terminal Cash Flow

120000 =B23*$D$21 =B24*$D$21 =B25*$D$21 =D21-D23-D24-D25 =G12

Change in Working Capital Increase in receivables increase in inventory increase in payables

=D27-D26 0.4 =D28*D29

Applicable MACRS depreciation

0.2 0.32 0.19 0.12 0.12 0.05 =SUM(D39:D44)

0.12 0.12 0.05

Net working capital

Year 1

Year 2

Year 3

Year 4

105000 =H39 =C61-C62 =$B$64*C63 =C63-C64 =C62 =C65+C66

110000 =H40 =D61-D62 =$B$64*D63 =D63-D64 =D62 =D65+D66

120000 =H41 =E61-E62 =$B$64*E63 =E63-E64 =E62 =E65+E66

120000 =H42 =F61-F62 =$B$64*F63 =F63-F64 =F62 =F65+F66

95000 =H48 =C70-C71 =$B$73*C72 =C72-C73 =C71 =C74+C75

95000 =H49 =D70-D71 =$B$73*D72 =D72-D73 =D71 =D74+D75

95000 =H50 =E70-E71 =$B$73*E72 =E72-E73 =E71 =E74+E75

95000 =H51 =F70-F71 =$B$73*F72 =F72-F73 =F71 =F74+F75

=D29

=D29

145000 15000 =G6+G7

70000 =D30 =G12-G13 =H24 =H8-H14+H16

15000 19000 16000 =H21+H22-H23

Depreciation

=B39*D39 =B40*D40 =B41*D41 =B42*D42 =B43*D43 =B44*D44 =SUM(H39:H44)

=B48*D48 =B49*D49 =B50*D50 0 0 0 =SUM(H48:H53)

Year 5

Year 6

120000 =H43 =G61-G62 =$B$64*G63 =G63-G64 =G62 =G65+G66

0 =H44 =H61-H62 =$B$64*H63 =H63-H64 =H62 =H65+H66

95000 =H52 =G70-G71 =$B$73*G72 =G72-G73 =G71 =G74+G75

0 =H53 =H70-H71 =$B$73*H72 =H72-H73 =H71 =H74+H75

24000 =H44 =G81-G82 =F84*G83 =G83-G84

8000 0 =G88-G89 =F91*G90 =G90-G91 =H24 =H85-H92+H94

Comparison of Annualized Net Present Values of Two Projects with Unequal Lives Cost of Capital 10.0% Year-End Cash Flows Year Project Alpha Project Beta 0 ($5,500,000) ($6,500,000) 1 $300,000 $400,000 2 $500,000 $600,000 3 $500,000 $800,000 4 $550,000 $1,100,000 5 $700,000 $1,400,000 6 $800,000 $2,000,000 7 $950,000 $2,500,000 8 $1,000,000 $2,000,000 9 $1,250,000 $1,000,000 10 $1,500,000 11 $2,000,000 12 $2,500,000 NPV $383,498.68 $350,116.16 ANPV $56,283.54 $60,794.36 Choice of project under NPV: Project Alpha Because it has the higher NPV Choice of project under ANPV: Project Beta Because it has the higher ANPV Project Beta should be recommended because the ANPV method should be used when deciding between mutually exclusive investments with unequal lives.

Comparison of Annualized Net Present Values of Two Projects with Unequal Lives Cost of Capital 0.1 Year-End Cash Flows Year Project Alpha Project Beta 0 -5500000 -6500000 1 300000 400000 2 500000 600000 3 500000 800000 4 550000 1100000 5 700000 1400000 6 800000 2000000 7 950000 2500000 8 1000000 2000000 9 1250000 1000000 10 1500000 11 2000000 12 2500000 NPV =NPV(C3,B7:B18)+B6 =NPV(C3,C7:C15)+C6 ANPV =-PMT(C3,A18,B19,0) =-PMT(C3,A15,C19,0) Choice of project under NPV: =IF(B19>C19,B5,C5) Because it has the higher NPV Choice of project under ANPV: =IF(B20>C20,B5,C5) Because it has the higher ANPV =IF(B20>C20,B5,C5) should be recommended because the ANPV method should be used when deciding between mutually exclusive investments with unequal lives.

Calculation of Share Value Estimates Associated with Alternative capital Structures

$25.00

$20.00 Capital Structure Debt Ratio 0% 10 20 30 40 50 60

Expected Estimated EPS Required Return $1.75 11.40% 1.90 11.80% 2.25 12.50% 2.55 13.25% 3.18 18.00% 3.06 19.00% 3.10 25.00%

Estimated Share Value $15.35 $16.10 $18.00 $19.25 $17.67 $16.11 $12.40

$15.00

Estimated Share Value Earnings per Share

$10.00

$5.00

$0.00 0%

10

20

30

40

50

60

a.) The graph of the estimated EPS for the alternative capital structures shows that the firm will achieve a maximum EPS of $3.10 when it maintains a capital structure with a debt ratio of 60%. ( View Graph) b.) The graph of the estimated share values for the alternative capital structures shows that the firm will achieve a maximum share value of $19.25 when it maintains a capital structure with a debt ratio of 30%. (View graph)

c.) The goal of the financial manager should be to maximize shareholders' wealth, not profit. It is reasonable to believe that there is some relationship between profits and value but the link between profit maximization strategies and wealth maximization is not necessarily strong.

Due to the arbitrariness of earnings and the possible lack of any linkage between profit maximization and shareholder wealth maximization, the wealth of the firm's owners as reflected in the expected share value should be chosen as the criterion for choosing the optimal capital structure.

The major reason why there are conflicting optimal capital structures between the two methods is that the EPS maximization does not consider risk.

Calculation of Share Value Estimates Associated with Alternative capital Structures

Capital Structure Debt Ratio 0 10 20 30 40 50 60

Expected EPS 1.75 1.9 2.25 2.55 3.18 3.06 3.1

Estimated Required Return 0.114 0.118 0.125 0.1325 0.18 0.19 0.25

a.) The graph of the estimated EPS for the alternative capital structures shows that the firm will achieve a maximum

b.) The graph of the estimated share values for the alternative capital structures shows that the firm will achieve a m

c.) The goal of the financial manager should be to maximize shareholders' wealth, not profit. It is reasonable to bel maximization is not necessarily strong.

Due to the arbitrariness of earnings and the possible lack of any linkage between profit maximization and shareholder wealth maximization, the wealth of the firm's owners as reflected in the expected share value should be chosen as the criterion for choosing the optimal capital structure.

The major reason why there are conflicting optimal capital structures between the two methods is that the EPS maximization does not consider risk.

$25.00

$20.00 Estimated Share Value =B8/C8 =B9/C9 =B10/C10 =B11/C11 =B12/C12 =B13/C13 =B14/C14

$15.00

$10.00

$5.00

$0.00 0%

10

20

30

irm will achieve a maximum EPS of $3.10 when it maintains a capital structure with a debt ratio of 60%. ( View Graph)

hat the firm will achieve a maximum share value of $19.25 when it maintains a capital structure with a debt ratio of 30%. (View

ofit. It is reasonable to believe that there is some relationship between profits and value but the link between profit maximiza

Estimated Share Value Earnings per Share

30

40

50

60

io of 60%. ( View Graph)

ure with a debt ratio of 30%. (View graph)

t the link between profit maximization strategies and wealth

Rock-O Corporation Stockholders' Equity Section (a.) Before the Reverse Stock Split Common stock Paid-in-Capital Retained Earnings Total Stockholders' Equity

Stock Split Common stock Paid-in-Capital Retained Earnings Total Stockholders' Equity

700,000 shares

$ 1.00 par

$

$

(b.) Reverse Stock Split 2 for 3 466,667 shares $ 1.50 par

$

$

700,000 7,000,000 3,500,000 11,200,000

700,000 7,000,000 3,500,000 11,200,000

Rock-O Corporation Stockholders' Equity Section (a.) Before the Reverse Stock Split Common stock Paid-in-Capital Retained Earnings Total Stockholders' Equity

Stock Split Common stock Paid-in-Capital Retained Earnings Total Stockholders' Equity

700000

2

shares 1

par =C6*E6 7000000 3500000 =SUM(G6:G8)

(b.) Reverse Stock Split for 3 =(C6/D13)*B13 =D6 =(D13/B13)*(E6) =F6 =C14*E14 =G7 =G8 =SUM(G14:G16)

Analysis of Initiating a Cash Discount for Eboy Corporation

Increase in units due to discount Selling price @net 30 Variable Cost Per Unit Additional Profit Contribution from Sales:

50 $ 4,200 $ 2,600 $ 80,000 (a.)

Cost of Marginal Investment in Accounts Receivable Variable cost per unit Raw Material annual usage Accounts Receivable Sales Days Collection Period AR Turnover

$

2,600 1450 $ 443,000 $ 3,544,000 365 45.625 8.0

Average investment presently (w/o discount)

$ 471,250 (b.)

Variable cost per unit Raw Material annual usage Expected AR Turnover due to discount

$ 2,600.00 1500 12.0

Average investment presently (with cash discounts)

$ 325,000 (c.)

Reduction in accounts receivable investment

$ 146,250 (d.)

Opportunity cost of funds Cost Savings from reduced investment in AR

12.5%

Cash Discount term Percentage of customers to take discount Raw Material annual usage (new) Selling price per unit Cost of Cash Discount Net Profit (loss) from initiation of proposed cash discount

$ 18,281 (e.)

2.00% 70% 1500 $ 4,200 $ 88,200 (f.) $ 10,081 (g.)

Analysis of Initiating a Cash Discount for Eboy Corporation

Increase in units due to discount Selling price @net 30 Variable Cost Per Unit Additional Profit Contribution from Sales:

50 4200 2600 =E5*(E6-E7)

Cost of Marginal Investment in Accounts Receivable Variable cost per unit Raw Material annual usage Accounts Receivable Sales Days Collection Period AR Turnover

=E7 1450 443000 3544000 365 =D13/(D14/D15) =D15/D16

Average investment presently (w/o discount)

=(D11*D12)/D17 (b.)

Variable cost per unit Raw Material annual usage Expected AR Turnover due to discount

=D11 =D12+E5 12

Average investment presently (with cash discounts)

=(D21*D22)/D23 (c.)

Reduction in accounts receivable investment

=D19-D25

Opportunity cost of funds Cost Savings from reduced investment in AR

0.125

Cash Discount term Percentage of customers to take discount Raw Material annual usage (new) Selling price per unit Cost of Cash Discount Net Profit (loss) from initiation of proposed cash discount

(a.)

(d.)

=D27*D29

(e.)

0.02 0.7 =D22 =E6 =C32*C33*C34*C35 (f.) =E8+E30-E36

(g.)

Short-term Loans - Fixed vs. Floating Given Data: Days in year 365 Loan Amount $ 200,000.00 Prime Rate - today 7.00% Prime Rate - in 30 days 7.50% Maturity 60 days First American Premium 2.00% First Citizen Premium 1.50% First American Loan - Fixed Rate a. The total dollar interest cost on the First American Loan Loan Amount Prime+Prem Maturity $ 200,000.00 9.00% 0.164383562 b. The 60-day rate on the loan Total Dollar Interest Loan $ 2,958.90 $ 200,000.00 c. Effective annual rate of interest on fixed 60-day loan 60-day Rate Periods in Year 1.4795% 6.083333333

Total Dollar Interest $ 2,958.90

60-day Rate 1.4795%

Effective Annual Rate 9.3453%

First Citizen Loan - Floating Rate Loan d. The Initial Rate Prime Rate 7.00%

Premium 1.50%

e. Interest Rate for first and last 30-day periods Intial Rate + Prem Maturity 8.50% 0.082191781 Intial Rate + Prem Maturity 9.00% 0.082191781

Initial Rate-1st 30 day rate 8.50%

First 30 Day Rate 0.6986% Last 30 day rate 0.7397%

f. Total Dollar Interest Cost Loan 1st 30 Days Last 30-Days $ 200,000.00 0.6986% 0.7397% g. 60-Day rate of Interest Total Interest Cost Loan $ 2,876.71 $ 200,000.00 h. Effective Annual Interest Rate on 60-Day Loan 60-Day Rate Periods in Year 1.4384% 6.083333333 i. Which loan would you choose?

First Citizen

because it has the lowest effective rate.

Total Interest Cost $ 2,876.71

60-Day Rate 1.4384%

Effective Annual Rate 9.0762%

Short-term Loans - Fixed vs. Floating Given Data: Days in year Loan Amount Prime Rate - today Prime Rate - in 30 days Maturity First American Premium First Citizen Premium

365 200000 0.07 0.075 60 0.02 0.015

days

First American Loan - Fixed Rate a. The total dollar interest cost on the First American Loan =A5 Prime+Prem =B5 =B6+B9

Maturity =B8/B4

Total Dollar Interest =B15*C15*D15

b. The 60-day rate on the loan =F14 =F15

Loan

c. Effective annual rate of interest on fixed 60-day loan =F18 =F19

=B5

60-day Rate =B19/C19

Periods in Year =B4/B8

Effective Annual Rate =((1+B23)^C23)-1

First Citizen Loan - Floating Rate Loan d. The Initial Rate Prime Rate

Premium =B10

Initial Rate-1st 30 day rate =B28+C28

Intial Rate + Prem

Maturity =30/B4

First 30 Day Rate =B32*C32

Intial Rate + Prem

Maturity =30/B4

Last 30 day rate =B35*C35

Loan

1st 30 Days =F32

=B6 e. Interest Rate for first and last 30-day periods =F28

=B7+B10 f. Total Dollar Interest Cost =B5

Last 30-Days =F35

Total Interest Cost =B39*(C39+D39)

g. 60-Day rate of Interest =F38 =F39 h. Effective Annual Interest Rate on 60-Day Loan =F42 =F43

Loan =B5

60-Day Rate =B43/C43

Periods in Year =365/60

=F22 =((1+B47)^C47)-1

i. Which loan would you choose? =IF(F47>F23,"First American","First Citizen")

because it has the lowest effective rate.

Morris Company - Leasing Decision Cost of New Machine Tax Rate Lease Payment Option to purchase at end of lease Loan Rate Term of loan/lease Annual cost of maintenance

$30,000 40% $10,000 $3,000 8.50% 5 years $1,200

a. After-tax cash outflow from Lease Before tax payment Tax rate After-tax cash outflow b. Loan Payment Loan Maturity $30,000 5

Discount Rate 8.50%

$ $

10,000 40% 6,000

Payment 7612.9726

c. Determining the Interest and Principal Components of Loan Payment 8.50% Year Begining Balance Payment Principal Interest End Balance 0 $ 30,000 1 $ 30,000 $ 7,613 $ 5,063 $ 2,550 $ 24,937 2 $ 24,937 $ 7,613 $ 5,493 $ 2,120 $ 19,444 3 $ 19,444 $ 7,613 $ 5,960 $ 1,653 $ 13,483 4 $ 13,483 $ 7,613 $ 6,467 $ 1,146 $ 7,017 5 $ 7,017 $ 7,613 $ 7,017 $ 596 $ d. After-Tax Cash Outflows associated with Purchasing End of Year 1 2 3 4 5

Loan Payment $ $ $ $ $

Maintenance Costs 7,613 $ 1,200 7,613 $ 1,200 7,613 $ 1,200 7,613 $ 1,200 7,613 $ 1,200

MACRS Depreciation 20.0% $ 6,000 32.0% $ 9,600 19.0% $ 5,700 12.0% $ 3,600 11.0% $ 3,300

$ $ $ $ $

Total Interest Deductions 2,550 $ 9,750 2,120 $ 12,920 1,653 $ 8,553 1,146 $ 5,946 596 $ 5,096

$ $ $ $ $

40% Tax Shields 3,900 5,168 3,421 2,378 2,039

After-tax Cash Outflows $ 4,913 $ 3,645 $ 5,392 $ 6,435 $ 6,774

e. A Comparison of the Present Value of Cash Outflows Associated with Leasing v. Purchasing After-tax Cost of Debt 5.10% Leasing Puchasing After-Tax After-tax Year Cash Outflows PV Cash Outflows PV 1 $ 6,000 $5,708.85 $ 4,913 $4,674.57 2 $ 6,000 $5,431.83 $ 3,645 $3,299.94 3 $ 6,000 $5,168.25 $ 5,392 $4,644.43 4 $ 6,000 $4,917.45 $ 6,435 $5,273.59 5 $ 9,000 $7,018.25 $ 6,774 $5,282.72 $28,244.63 $23,175.25 PV of Cash Outflow PV of Cash Outflow f. Since the present value of cash outflows for purchasing ($23,175) is lower than for leasing ($28,245), the purchasing alternative is preferred.

Morris Company - Leasing Decision Cost of New Machine Tax Rate Lease Payment Option to purchase at end of lease Loan Rate Term of loan/lease Annual cost of maintenance

30000 0.4 10000 3000 0.085 5 1200

years

a. After-tax cash outflow from Lease Before tax payment Tax rate After-tax cash outflow b. Loan Payment Loan =C3

Maturity =C8

=C5 =C4 =D12*(1-D13)

Discount Rate =C7

Payment =-PMT(C7,C8,C3,0)

c. Determining the Interest and Principal Components of Loan Payment Year 0 1 2 3 4 5

Begining Balance =F23 =F24 =F25 =F26 =F27

Payment =D18 =C24 =C25 =C26 =C27

Principal =C24-E24 =C25-E25 =C26-E26 =C27-E27 =C28-E28

=C18 Interest

End Balance =A18 =$E$21*F23 =F23-D24 =$E$21*F24 =F24-D25 =$E$21*F25 =F25-D26 =$E$21*F26 =F26-D27 =$E$21*F27 =F27-D28

d. After-Tax Cash Outflows associated with Purchasing End of Year 1 2 3 4 5

Loan Payment =D18 =B34 =B35 =B36 =B37

Maintenance Costs 1200 1200 1200 1200 1200

MACRS 0.2 0.32 0.19 0.12 0.11

Depreciation Interest =$A$18*D34 =E24 =$A$18*D35 =E25 =$A$18*D36 =E26 =$A$18*D37 =E27 =$A$18*D38 =E28

Total Deductions =C34+E34+F34 =C35+E35+F35 =C36+E36+F36 =C37+E37+F37 =C38+E38+F38

e. A Comparison of the Present Value of Cash Outflows Associated with Leasing v. Purchasing After-tax Cost of Debt =C7*(1-C4) Leasing Puchasing After-Tax After-tax Year Cash Outflows PV Cash Outflows PV 1 =$D$14 =B45/(1+C41) =I34 =E45/(1+$C$41)^A45 2 =$D$14 =B46/((1+$C$41)^A46) =I35 =E46/(1+$C$41)^A46 3 =$D$14 =B47/((1+$C$41)^A47) =I36 =E47/(1+$C$41)^A47 4 =$D$14 =B48/((1+$C$41)^A48) =I37 =E48/(1+$C$41)^A48 5 9000 =B49/((1+$C$41)^A49) =I38 =E49/(1+$C$41)^A49 =SUM(C45:C49) =SUM(F45:F49) PV of Cash Outflow PV of Cash Outflow f. Since the present value of cash outflows for purchasing ($23,175) is lower than for leasing ($28,245), the purchasing alternative is preferred.

=C4 Tax Shields =$H$31*G34 =$H$31*G35 =$H$31*G36 =$H$31*G37 =$H$31*G38

After-tax Cash Outflows =B34+C34-H34 =B35+C35-H35 =B36+C36-H36 =B37+C37-H37 =B38+C38-H38

Net Present Value of the Ram Electric Company Acquisition

Years 1 2 3 4 5 6 7 8 9 10

Expected Cash Inflows $ 100,000 100,000 100,000 100,000 100,000 125,000 125,000 125,000 125,000 125,000

Present Value

(a.) $ (b.) $

89285.71 79719.39 71178.02 63551.81 56742.69 61145.14 52711.32 45440.80 39173.10 33769.91 592,718 Present value of inflows 325,000 Less: Cash purchase price 267,718 Net Present value

(c.) Since the NPV > 0, the acquisition is acceptable.

* Discount rate over the expected first five years ** Discount rate over the expected second five years

12% 16%

Note: The key to determining the present value of the $125,000 cash inflows, is to recognize that the cash flows are discounted at 16 percent over the years 6 through 10 and discounted at 12 percent over the years 1 through 5.

Net Present Value of the Ram Electric Company Acquisition

Years 1 2 3 4 5 6 7 8 9 10

Expected Cash Inflows 100000 100000 100000 100000 100000 125000 125000 125000 125000 125000

Present Value =B5/(1+$D$23)^A5 =B6/(1+$D$23)^A6 =B7/(1+$D$23)^A7 =B8/(1+$D$23)^A8 =B9/(1+$D$23)^A9 =(B10/(1+$D$24)^(A10-$A$9))/(1+$D$23)^$A$9 =(B11/(1+$D$24)^(A11-$A$9))/(1+$D$23)^$A$9 =(B12/(1+$D$24)^(A12-$A$9))/(1+$D$23)^$A$9 =(B13/(1+$D$24)^(A13-$A$9))/(1+$D$23)^$A$9 =(B14/(1+$D$24)^(A14-$A$9))/(1+$D$23)^$A$9

(a.) =SUM(C5:C14) 325000 (b.) =C16-C17

Present value of inflows Less: Cash purchase price Net Present value

(c.) Since the NPV > 0, the acquisition is acceptable.

* Discount rate over the expected first five years ** Discount rate over the expected second five years

0.12 0.16

Note: The key to determining the present value of the $125,000 cash inflows, is to recognize that the cash flows are discounted at 16 percent over the years 6 through 10 and discounted at 12 percent over the years 1 through 5.

Calculating the Net exposure to Each Currency in US Dollars

Foreign Currency

Total Inflows

Total Outflows

(a) Net Cash Flows

Current Exchange Rate ($/FC)

Value of Exposure

Mexican peso (MXP)

100,000,000

25,000,000

75,000,000

$0.10

$7,500,000

British pound (BP)

17,000,000

11,000,000

6,000,000

$1.66

$9,960,000

(c.) The peso and the pound move in the same direction against the US dollar. Both the pound and peso exposure reveal positive net inflows. Because of this situation, their exposure will likely be magnified if their exchange rates against the US dollar continue to be highly correlated.

Calculating the Net exposure to Each Currency in US Dollars

Foreign Currency

Total Inflows

Total Outflows

(a) Net Cash Flows

Current Exchange Rate ($/FC)

Value of Exposure

Mexican peso (MXP) 100000000

25000000

=B8-C8

0.1

=D8*E8

British pound (BP)

11000000

=B10-C10

1.66

=D10*E10

17000000

(c.) The peso and the pound move in the same direction against the US dollar. Both the pound and peso exposure reveal positive net inflows. Because of this situation, their exposure will likely be magnified if their exchange rates against the US dollar continue to be highly correlated.