Extra Exercise 2017

(questions from previous year final exam)

1) A firm’s stock has a beta of 1.05, the expected return on the market is 12 percent, and the risk-free

rate is 5 percent. The firm’s marginal tax rate is 30%. If the firm were to issue new common stocks,

investment bank will charge 6% flotation cost. From this information, if the firm decides to spend

retained earnings in positive NPV project, what would be the cost of the retained earnings?

2) JKL preferred stocks have the par value of $90 and pay dividend of 9%. Currently the

market trades JKL’s preferred stock at a required return of 12.5%. JKL’s marginal tax rate is

20%. If there are 2,000,000 of preferred shares outstanding traded in the market, how much

money does JKL need to retire all of these preferred shares?

3) AMZ Co. has bonds outstanding with total market value of $80,000,000. This bond has yield to

maturity of 7.55% for investors. The company also has $150,000,000 worth of common stock

outstanding. The stock has a beta of 1.23. The risk free rate is currently at 1.0% and the market risk

premium is 6%. AMZ Co.’s tax rate is 35%. What is AMZ’s weighted average cost of capital?

4) A firm has zero debt in its capital structure. Its overall cost of capital (all-equity firm’s cost

of capital) is 10%. The firm is considering a new capital structure with 40% debt to total

assets. The interest rate on the debt would be 7%. Assuming the tax rate is 20% and there’s no

other imperfections, its cost of equity capital with the new capital structure would be …?

5) A firm has EBIT of $58,000. It has to pay interest of 7.5% on $300,000 long-term debts. This firm

pays tax at the rate of 25%. What is the amount of money that belongs to shareholders and lenders,

combined?

6) Shawhan Supply plans to maintain its optimal capital structure of 30% debt, 30% preferred stock,

and 40% common stock into the future. The required return on each component is: interest rate from

commercial bank loan = 11%; preferred stock = 11%; and common stock = 16%. Assuming a 30%

marginal tax rate, what after-tax rate of return must Shawhan Supply earn on its investments if the

value of the firm is to remain unchanged?

Page 2 of 3

7) Briefly explain which one of these three portfolios that you would choose to invest.

Portfolio A: expected return = 11.0%; standard deviation = 12%

Portfolio B: expected return = 10.5%; standard deviation = 12%

8)

Burr Habit Corporation is considering a new product line. The company currently manufactures several

lines of snow skiing apparel. The new products, insulated ski shorts, are expected to generate gross

profit of $1 million per year for the next five years. They expect that during this five year period, they

will lose about $250,000 per year in gross profit on their existing lines of longer ski pants as a result of

the introduction of the new product line. The new line will require no additional equipment or space in

the plant and can be produced in the same manner as the existing apparel products. The new project will,

however, require that the company spend an additional $80,000 per year on insurance in case customers

sue for frostbite. Also, a new marketing director would be hired to oversee the line at $45,000 per year

in salary and benefits. Because of the different construction of the shorts, an increase in inventory of

3,800 would be required initially. If the marginal tax rate is 30%, compute the incremental free cash

flows for year 1-5.

9)

Your company is considering replacing an old steel cutting machine with a new one. Two years ago, you

sent the company engineers and a marketing manager to evaluate business opportunity (feasibility

study) from the new machine’s operation and efficiency. The $3,500 cost for this feasibility study has

already been paid. If the new machine is purchased, it would require $5,500 in installation and

modification costs to make it suitable for operation in your factory. The old machine originally cost

$50,000 five years ago and is being depreciated by $5,000 per year. The new machine will cost $85,000

before installation and modification. The old machine can be sold today for $10,000. The marginal tax

rate for the firm is 20%.

a) What is the after-tax cash flows from selling the old machine?

b) Compute the relevant initial outlay in this capital budgeting decision (netting out

money from selling old machine).

Page 3 of 3

10)

A portfolio composes of $200 worth of stock A and $100 worth of B. What is the portfolio

risk and return? All details are in the following table. You are expected to show necessary

calculations (not just give the answers).

Rate of return if state occurs

State of

economy

Probability of

state of economy

Stock A Stock B

Recession 30% -6% 3%

Normal 60% 11% 9%

Expanding 10% 12% -5%

Value of each stock

in the portfolio

$200

$100

11)

A firm is trying to determine whether to replace an existing asset. The proposed asset has a purchase

price of $50,000 and has installation costs of $3,000. The asset will be depreciated over its five year life

using the straight-line method. The new asset is expected to increase sales by $17,000 and nondepreciation

expenses by $2,000 annually over the life of the asset. Due to the increase in sales, the firm

expects an increase in working capital during the asset’s life of $1,500, and the firm expects to be able to

sell the asset for $6,000 at the end of its life. The existing asset was originally purchased three years ago

for $25,000, has a remaining life of five years, and is being depreciated using the straight-line method.

The expected salvage value at the end of the asset’s life (i.e., five years from now) is $5,000; however,

the current sale price of the existing asset is $20,000, and its current book value is $15,625. The firm’s

marginal tax rate is 34 percent and its required rate of return is 12 percent.

a) The net initial outlay if the new asset is purchased is:

b) The net incremental free cash flows from this new investment are:

c) The after-tax terminal cash flow (at the end of year 5) is:

d) The NPV for this replacement decision is: