SECTION I – PROBLEM ANALYSIS
Use the following information to respond to the next two items, below.
Assume today is December 31, 2009. As a financial analyst interested in valuing the common
stock of Bootes, Inc., you have estimated the following end-of-year free cash flows (FCFs) for the
company:
End of
Year
2010
2011
2012
2013
Estimated FCF ($ millions)
$135.0
135.0
185.0
220.0
You estimate that after 2013, the FCF of the firm will grow at a constant 5% per year forever.
You estimate that the weighted average cost of capital for the firm is 14%.
1. What is your estimate of the terminal (horizon) value of the firm? (5 points)
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2. What is your estimate of the value of the entire firm in today’s dollars? (5 points)
Use the following information to respond to the next four items, below.
You have collected the following information on two mutually exclusive investment proposals:
Estimated After-tax Cash Flows
End of
Year
0
1
2
3
Project J
-$100,000
20,000
45,000
80,000
Project K
-$100,000
45,000
45,000
45,000
You estimate the cost of capital applicable to each project is 12% and have computed the
following measures for Project K:
NPV = $8,082.41
IRR = 16.65%
MIRR = 14.94%
3. Compute the net present value for Project J. (5 points)
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4. Compute the internal rate of return for Project J. (5 points)
5. Compute the modified internal rate of return for Project J. (10 points)
6. Given your calculations above, which project (if any) do you prefer? Why? (5 points)
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Use the following information to respond to the next five (5) items.
Redstone Corporation is considering a leasing arrangement to finance some special manufacturing
tools that it needs for production during the next three years. A planned change in the firm's production
technology will make the tools obsolete after 3 years. The firm will depreciate the cost of the tools on
a straight-line basis over three years (i.e. depreciation expense is 1/3 of the purchase price at the end of
each year for three years). Thus, the book value and the salvage value at the end of the third year will
be zero. The firm can borrow $4,800,000, the purchase price, at a pre-tax cost of 10 percent to buy the
tools, or it can make three equal beginning-of-year lease payments of $2,100,000 that include
maintenance. The firm's tax rate is 40 percent. Annual maintenance costs associated with purchasing
the equipment are estimated at $240,000 per year and are paid at the beginning of each year.
7.
Compute the after-tax lease payments and enter in the table, below. Note: You do not necessarily
need to use all the cells in the table. (5 points)
Lease Alternative
End of year:
0
1
2
3
8. Compute the present value of the lease alternative. (5 points)
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9.
Compute the operating cash flows for years t = 0 through t = 3 and place them in the table, below.
Note: You do not necessarily need to use all the cells in the table. (10 points)
Purchase Alternative
End of year:
0
1
2
3
10. Compute the present value of the purchasing alternative. (5 points)
11. Should Redstone purchase or lease the equipment? To answer this question, compute the net
advantage to leasing (NAL) and interpret the results. (5 points)
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12. Jackson Co. has the following balance sheet as of December 31, 2009:
Assets
Current assets
Fixed assets
Liabilities & Equity
$600,000
400,000
Accounts payable
Accruals
Notes payable
Total current liabilities
Long-term debt
Total equity
Total Assets
$1,000,000
Total Liabilities & Equity
$100,000
100,000
100,000
$300,000
300,000
400,000
$1,000,000
In 2009, the company reported sales of $5 million, net income of $100,000, and dividends of $60,000.
The company anticipates its sales will increase 20 percent in 2010 and its dividend payout will remain
at 60 percent. Assume the company is at full capacity, so its assets and spontaneous liabilities will
increase proportionately with the increase in sales.
Assume the company uses the AFN formula and all additional funds needed (AFN) will come from
issuing new long-term debt. Given its forecast, how much long-term debt will the company have to
issue in 2010? (10 points)
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Use the following information to respond to the next 3 items, below.
You have been asked by the president of your company to evaluate the proposed acquisition of the
new MLM Model 53 spectrometer for your firm’s R&D department. The equipment’s invoice
price is $100,000, and it would cost another $10,000 to modify it for special use by your firm. The
spectrometer, which falls into the MACRS 3-year class, would be sold after 3 years for $12,700.
Use of the equipment would require an increase in net working capital (spare parts inventory) of
$3,000 which is expected to be fully recovered at the end of the project. The spectrometer is
expected to increase revenues by $60,000 per year, but would also increase operating costs by
$20,000 per year. Last year, the firm spent $10,000 to assess the various spectrometers in the
marketplace before deciding that the MLM Model 53 was the best choice among the available
models. The firm’s marginal federal-plus-state tax rate is 40%.
13. What is the net cost of the spectrometer, i.e. what is the time 0 net cash flow? (5 points)
14. What is the non-operating (terminal) cash flow at the end of year 3? (5 points)
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15. What are the net operating cash flows in years 1, 2 and 3? Do not include the termination cash
flows that you computed in the previous item. Note: You do not necessarily need to use all of the
spaces provided below. (10 points)
Item
End of
Year 1
End of
Year 2
End of
Year 3
Net After-Tax Cash
Flow
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SECTION II – SHORT ESSAY QUESTION
16. As the Chief Financial Officer (CFO) for Canes Venatici Company, Inc., one of your staff
financial analysts has presented you with a capital budgeting proposal. He has estimated that the
internal rate of return for the proposed project is 26% and goes on to state, “I think we should
undertake the project. After all, a 26% return on our investment is great in the current economic
environment.” (Assume that the net present value of the project is positive and the project meets
all other corporate-wide capital budgeting guidelines.) How do you respond to your staff analyst’s
claim? (5 points)
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