The BirdieGolf-Hybrid Golf Merger Case - Solution

Solution
Birdie Golf, Inc. has been in merger talks with Hybrid Golf Company for thepast six months. After several rounds of negotiations, the offer underdiscussion is a cash offer of $440 million for Hybrid Golf. Both companies haveniche markets in the golf club industry, and the companies believe a mergerwill result in significant savings in general and administrative expenses.
Bryce Bichon, the financial officer for Birdie, has been instrumental in the mergernegotiations. Bryce has prepared the following pro forma financial statementsfor Hybrid Golf assuming the merging takes place. The financial statementsinclude all synergistic benefits from the merger:

	2010	2011	2012	2013	2014
Sales	$640,000,000	$720,000,000	$800,000,000	$900,000,000	$1,000,000,000
Production Cost	$449,000,000	$504,000,000	$560,000,000	$632,000,000	$705,000,000
Depreciation	$60,000,000	$64,000,000	$66,000,000	$66,000,000	$67,000,000
Other Expenses	$64,000,000	$72,000,000	$80,000,000	$90,000,000	$97,000,000
EBIT	$67,000,000	$80,000,000	$94,000,000	$112,000,000	$131,000,000
Interest	$15,200,000	$17,600,000	$19,200,000	$20,000,000	$21,600,000
Taxable Income	$51,800,000	$62,400,000	$74,800,000	$92,000,000	$109,400,000
Taxes (40%)	$20,720,000	$24,960,000	$29,920,000	$36,800,000	$43,760,000
Net Income	$31,080,000	$37,440,000	$44,880,000	$55,200,000	$65,640,000

Bryce is also aware that the Hybrid Golf Division will require investments eachyear for continuing operations, along with sources of financing. The followingtable outlines the required investments and sources of financing.
2010 2011 2012 2013 2014
Investments:

Investments	2010	2011	2012	2013	2014
Net Working Capital	$1,60,00,000	$2,00,00,000	$2,00,00,000	$2,40,00,000	$2,40,00,000
Fixed Assets	$1,20,00,000	$2,00,00,000	$1,40,00,000	$9,60,00,000	$56,00,000
Total	$2,80,00,000	$4,00,00,000	$3,40,00,000	$12,00,00,000	$2,96,00,000

Sources of financing:

New Debt	$2,80,00,000	$1,28,00,000	$1,28,00,000	$1,20,00,000	$96,00,000
Profit Retention	$0	$2,72,00,000	$2,16,00,000	$2,16,00,000	$2,00,00,000
Total	$2,80,00,000	$4,00,00,000	$3,44,00,000	$3,36,00,000	$2,96,00,000

The management of Birdie Golf feels that the capital structure at Hybrid Golfis not optimal. If the merger take place, Hybrid Golf will immediately increaseits leverage with a 88 million debt issue, which would be followed by a 120 milliondividend payment to Birdie Golf. This will increase Hybrid's debt to equityration from .50 to 1.00. Birdie Golf will also be able to use a 20 million taxloss carry forward in 2011 and 2012 from Hybrid Golf's previous operations. Thetotal value of Hybrid Golf is expected to be 720 million in five years, and thecompany will have 240 million in debt at that time.
Stock in Birdie Golf currently sells for 94 a share, and the company has 14.4million shares of stock outstanding. Hybrid Golf has 6.4millionshares of stock outstanding. Both companies can borrow at an 8% interest rate.The risk-free rate is 6%, and the expected return on the market is 13%. Brycebelieves the current cost of capital for Birdie Golf is 11%. The beta for HybridGolf stock at its current capital structure is 1.30.
Bryce has asked you to analyze the financial aspects of the potential merger.Specifically, he has asked you to answer the following questions:
1. Suppose Hybrid shareholders will agree to a merger price of 68.75 per share.Should birdie proceed with the merger?

2. What is the highest price per share that Birdie should be willing to pay forHybrid?

3. Suppose Birdie is unwilling to pay cash for the merger but will consider astock exchange. What exchange ratio would make the merger terms equivalent tothe original merger price of 68.75 per share?
4. What is the highest exchange ratio Birdie would be willing to pay and stillundertake the merger?

Question Set 86-Solution

Solution
Using Yahoo! Finance find the value of beta for your reference company. Write a two page paper discussing the following items:

• What is the estimated beta coefficient of your company? What does this beta mean in terms of your choice to include this company in your overall portfolio?
• Given the beta of your company, the present yield to maturity on U.S. government bonds maturing in one year (currently about 4.5% annually) and an assessment that the market risk premium (that is - the difference between the expected rate of return on the 'market portfolio' and the risk-free rate of interest) is 6.5%, use the CAPM equation in order to find out what is the present 'cost of equity' of your company? Explain what is the meaning of the 'cost of equity'?
• Choose two other companies, look up their "Beta" and report the names of these companies and their betas. Suppose you invest one third of your money in each of the stocks of these companies. What will the beta of the portfolio be? Given the data in (b), what will the Expected Rate of Return on this portfolio be? Do you feel that the three-stock portfolio is sufficiently diversified or does it still have risk that can be diversified away? Explain.

Questions Set 85: Solution

Solution

Matterhorn Company’s charter allows it to sell 250,000 shares of $2 par value common stock. To date, the firm has sold 100,000 shares for a total of $600,000. Matterhorn has reacquired 4,000 shares from shareholders at a price of $8 per share. Retained earnings equals $250,000. (10 points)

• What total amount of contributed capital should Matterhorn report?
• What amount should be reported for the Common Stock account?
• What was the average selling price of each share of common stock?
• How many shares of stock are outstanding?
• What amount should be reported for stockholders’ equity?

Questions Set 84: Solution

Solution

How would you explain that, although the efficient market hypothesis applies to the stock market, you can’t successfully invest by randomly selecting stocks?

1. The hypothesis fails to fully explain the real market environment.
2. The hypothesis fails to consider these monopolies, which dominate certain segments of the market.
3. Random selection of stocks would ignore an individual investor’s goals.
4. New theories are needed to explain stock price behavior in the new economy

At what rate does $1,000 grow to $1,953 after three years? Use the formula for the future value of a lump sum, and assume annual compounding.

1. 25 percent
2. 75 percent
3. 31.8 percent
4. 95.3 percent

Given a choice between calculating returns using the holding period return (HPR) or the formula for the future value, you should select the future value formula because the

1. HPR fails to consider the discounted value of the purchase price.
2. future value formula incorporates the timing of cash flows.
3. HPR overstates the internal rate of return in direct proportion to the discount rate.
4. future value formula incorporates cash payments that are omitted in the HPR.

Which of the following statements most accurately explains the utility of the dividend growth model?

1. Dividend growth increases the total return earned on equity investments.
2. Projected dividend growth can be incorporated into calculation of the discounted value of cash flows.
3. Stocks with rising dividends generally outperform stocks that don’t pay dividends or that pay relatively static dividends.
4. Rising dividends, plotted as a function of time, appear as an exponential function with a positive slope.

ABC Corporation recently announced its plans to pay a 5 percent stock dividend in addition to its scheduled $0.32 quarterly dividend, which has been paid on its common stock in all of the previous 13 quarters. The ex-dividend date will be one month after the announcement. ABC Corporation hadn’t paid a stock dividend in the past nine years. You own 100 shares of ABC Corporation common stock valued at $68 per share. Which of the following explanations accurately projects the effect of these transactions?

1. Dilution will effect a 5 percent decline in price per share. That will be offset by the 2 percent (annualized) dividend for a net decline of 3 percent in the stock price.
2. The 5 percent stock dividend is equivalent to 1-for-20 stock split. Stock prices generally rise after stocks split, so the 5 percent dilution effect will be reduced to either a price rise or a decline that’s smaller than 5 percent.
3. The stock price will drop about 5 percent if all other factors remain constant.
4. The discounted value of the stock split and will render a price decline smaller than 5 percent.

In the absence of compelling empirical data to support technical analysis, which of these arguments supports its use?

1. The Dow Theory has a long history of successful use and has earned respect in non-academic circles.
2. Traders of odd lots tend to be smaller, less sophisticated investors who reliably make the wrong investment decisions.
3. Emotions lead to irrational investment decisions that can be overcome by applying a strict set of technical methods.
4. Several technical methods capitalize on empirical data supporting the contention that security prices move in the same direction.

Which of the following statements is correct?

1. Security selection can be a complex process that’s aided by Internet financial information services.
2. Security selection is most efficiently practiced by applying both technical and fundamental analysis.
3. Security selection requires only the use of accounting ratios.
4. Security selection simplifies investment decisions.

Which of the following reasons best explains why you would include inflation in a fundamental analysis of stock values?

1. Inflation exerts broad influence on factors that underlie the economy.
2. Inflation generally increases stock prices at a faster rate than other prices.
3. Inflation generally increases stock prices prices because cash inflows increase.
4. High inflation corresponds with high interest rates and low bond values.

In fundamental analysis, the value added by industry analysis is particularly apparent

• When inflation rates are high and have a broad negative impact on business in general.
• In industries where business levels significantly change in certain seasons or in relation to the business cycle.
• During recessions when business levels are suppressed across most industries.
• During the rapid growth stage of an economy.

Questions Set 83: Solution

Solution

• You received $30,000 from your grandparents. You want to investment it to fund your mortgage down-payment in four years. You want to buy a house that is at least $200,000 but no more than $300,000. Normally, banks require home buyers to make 20% (of the house price) down-payment. What is the minimum and maximum interest rates that you need to earn on your investment?
• You want to buy a Volvo in 4 years, after you graduate from college. The car is currently selling for $35,000, and the price will increase at a rate of 5% per year. Your friend, Bob, introduces to you a one-time chance to earn 14% per year over the next 4 years. And you want to grab this chance to plan for your purchase. How much do you need to invest today so that you are able to buy your dream car after graduation?
• If inflation rate runs at 3% annually, how long does it take for prices to double?
• Your current bank is paying a 6.25% annual simple interest rate with monthly compounding. You can move your money to Harris Bank that pays 6.25% annual compound interest rate, or to First Chicago Bank, which pays 6.8% compounded semiannually. To maximize your return, which bank should you choose?

Questions Set 82: Solution

Solution

To guide cost allocation decisions, the cause-and-effect criterion:
may allocate corporate salaries to divisions based on profits
is used less frequently than the other criteria
is the primary criterion used in activity-based costing
is a difficult criterion on which to obtain agreement
Which cost-allocation criterion is superior when making an economic decision?
the fairness or equity criterion
the ability to bear criterion
the cause-and-effect criterion
All of these answers are correct.
The MOST likely reason for NOT allocating corporate costs to divisions include that:
divisions receive no benefits from corporate costs
these costs are not controllable by division managers
these costs are incurred to support division activities, not corporate activities
division resources are already used to attain corporate goals
Identifying homogeneous cost pools: (Points: 3)
requires judgment and should be reevaluated on a regular basis
should include the input of management
should include a cost-benefit analysis
All of these answers are correct
The Hassan Corporation has an Electric Mixer Division and an Electric Lamp Division. Of a $20,000,000 bond issuance, the Electric Mixer Division used $14,000,000 and the Electric Lamp Division used $6,000,000 for expansion. Interest costs on the bond totaled $1,500,000 for the year. Which corporate costs should be allocated to divisions? (Points: 3)
Variable Costs
Fixed Costs
Neither fixed nor variable costs
Both fixed and variable costs
All of the following are methods that aid management in analyzing the expected results of capital budgeting decisions EXCEPT: (Points: 3)
payback method
future-value cash-flow method
discounted cash-flow method
accrual accounting rate-of-return method
Assume your goal in life is to retire with one million dollars. How much would you need to save at the end of each year if interest rates average 6% and you have a 20-year work life? (Points: 3)
$376,476
$120,102
$27,184
$14,565
The definition of an annuity is: (Points: 3)
similar to the definition of a life insurance policy
a series of equal cash flows at intervals
an investment product whose funds are invested in the stock market
Both 1 and 2 are correct
An important advantage of the net present value method of capital budgeting over the internal rate-of-return method is: (Points: 3)
the net present value method is expressed as a percentage
the net present values of individual projects can be added to determine the effects of accepting a combination of projects
There is no advantage
Both 1 and 2 are correct
The Zeron Corporation wants to purchase a new machine for its factory operations at a cost of $950,000. The investment is expected to generate $350,000 in annual cash flows for a period of four years. The required rate of return is 14%. The old machine can be sold for $50,000. The machine is expected to have zero value at the end of the four-year period. What is the net present value of the investment? Would the company want to purchase the new machine? Income taxes are not considered. (Points: 3)
$119,550; yes
$326,750; no
$1,019,550; yes
$69,550; no

Questions Set 80: Solution

Solution
Duncombe Village Golf Course is considering the purchase of new equipment that will cost $1,200,000 if purchased today and will generate the following cash disbursements and receipts. Should Duncombe pursue the investment if the cost of capital is 8 percent? Why? Clearly label your calculations in your analysis. See attachment for additional information for this problem.

Year	Cash Receipts	Cash Disbursements	Net Cash Flow
1	1,000,000	500,000	500,000
2	925,000	475,000	450,000
3	800,000	450,000	350,000
4	750,000	430,000	320,000

Questions Set 79: Solution

Solution
Financial Forecasting
As a financial analyst of FalconBuy.com, you need to prepare pro forma financial statements for 2012. FalconBuy.com has the following balance sheet as of December 31, 2011 ($ millions).
_____________________________________________________________________________________
Cash $ 3.5 Accounts payable $ 9.0
Receivables 26.0 Notes payable 18.0
Inventory 58.0 Accruals 8.5
Total current assets $ 87.5 Total current liabilities $ 35.5
Net fixed assets 35.0 Mortgage loan 6.0
Common stock 15.0
Retained earnings 66.0
Total Assets $122.5 Total Liab. & Capital $122.5
===== ======
_____________________________________________________________________________________
In 2011, FalconBuy.com had sales of $350 million, net income of $10.5 million, and paid dividends of $4.2 million to common stockholders. The firm has been operating at full capacity. Assume that all ratios remain constant.
For the year 2012, FalconBuy.com projects its sales to be $420 million (an increase of $70 million). (1) Use the AFN general formula to compute the projected additional funds needed (AFN) for 2012; (2) What does your estimated AFN figure tell you about FalconBuy.com’s financing to support the sales increase in 2012?
Short-Term Financing Choices
Falcon Ski Company estimates that for the next quarter there is a 60% probability that it will have a $2 million cash deficit, and a 40% probability that it will have no deficit at all. The company can either (1) take out a 90-day unsecured loan at an interest rate of 1% per month or (2) establish a line of credit, costing an interest rate of 1% per month on the amount borrowed plus a commitment fee of $15,000. Both alternatives also require a 20% compensating balance for outstanding loans, and excess cash can be reinvested at a quarterly rate of 2.5%. Which source of financing gives the lower expected cost? Which financing option would you recommend?
Long-Term Financing Decisions
Falcon Air Conditioner (FAC) has $1 million in EBIT for year ended 2011 with the following balance sheet:
Balance Sheet As of December 31, 2011
_____________________________________________________________________________________
Assets Liabilities & Capital
_____________________________________________________________________________________
Current assets $2,000,000 Debt(@ 8%) $1,250,000
Net fixed assets 4,750,000 Common stock; $10 par 2,500,000
Preferred stock (@ 10%) 2,000,000
Retained earnings 1,000,000
Total Assets $6,750,000 Total Liabilities & Capital $6,750,000
======== ========
_____________________________________________________________________________________
FAC expects that the existing debt and preferred stock will not be retired until the year 2014; hence they will remain in the same amount next year. FAC is expected to maintain its dividend payout ratio on common stock at the level of 10% next year. FAC’s corporate tax rate is 40%.
FAC plans to undertake an expansion project, which is expected to increase EBIT to $1.2 million in 2012 (an increase of $200,000 from the year 2008 EBIT). It needs $500,000 of external capital to finance the expansion, and it is considering the following three possibilities:
1. New bank term loan, with an interest rate of 10%; its sinking fund provision requires the loan to be fully amortized over the next 5 years, commencing in 2013.
2. New preferred stock, with a dividend rate of 12%.
3. 50,000 shares of new common stock to net the firm $10 per share.
Given the information above, compute the EPS under each alternative for the year 2012 using the following table (you don’t have to fill up all cells).

Items	DEBT	PREFERRED STOCK	COMMON STOCK
EBIT	$1,200,000	$1,200,000	$1,200,000
EPS

Questions Set 76: Solution

Solution
Options versus Futures. Explain the difference between foreign currency options and futures and when either might be used most appropriately.
Future Terminology. Explain the meaning and probable significance for international business of the following contract specifications:
Specific – sized contract
Standard method of stating exchange rates
Standard maturity date
Collateral and maintenance margins
Counterparty
Puts and Calls. What is the basic difference between a put on British pounds sterling and a call on sterling?
Buying a European Option. You have the same information as in Question 6, except that the pricing is for a European option. What is different?
Paulo’s Puts. Paulo writes a put option on Japanese yen with a strike of $0.008000/¥ (¥125.00/$) at a premium of 0.0080 cents per yen and with an expiration date six month from now. The option is for ¥12,500,000. What is Paulo’s profit or loss at maturity if the ending spot rates are ¥110/$, ¥115/$, ¥120/$, ¥125/$, ¥130/$, ¥135/$, and ¥140/$.
Black River Investments. Jennifer Magnussen, a currency trader for Chicago-based Black River Investments, uses the future quotes (shown at the bottom of the page) on the British pound to speculate on its value:
If Jennifer buys 5 June pound futures, and the spot rate at maturity is $1.3980/pound, what is the value of her position?
If Jennifer sells 12 March pound futures, and the spot rate at maturity is $1.4560/pound, what is the value of her position?
If Jennifer buys 3 March pound futures, and the spot rate at maturity is $1.4560/pound, what is the value of her position?
If Jennifer sells 12 June pound futures, and the spot rate at maturity is $1.3980/pound, what is the value of her position?
Madera Capital. Katya Berezovsky is a currency speculator for Madera Capital of Los Angeles. Her latest speculative position is to profit from her expectation that the U.S. dollar will rise significantly against the Japanese yen. The current spot rate is ¥120.00/$. She must choose between the following 90 – day options on the Japanese yen.
Should Katya buy a put on yen or a call on yen?
Using your answer to part a, what is Katya’s break – even price?
Using your answer to part a, what is Katya’s gross profit and net profit (including the premium) if the spot rate at the end of the 90 days is ¥140/$?
Call Profits. Assume that a call option on euros is written with a strike price of $1.25/€ at a premium of 3.80 cents per euro ($0.0380/€) and with an expiration date three months from now. The option is for €100,000. Calculate your profit or loss should you exercise before maturity at a time when the euro is traded spot at
$1.10/€
$1.15/€
$1.20/€
$1.25/€
$1.30/€
$1.35/€
$1.40/€
Giri the Contrarian. Giri Patel works for CIBC Currency Funds in Toronto. Giri is something of a contrarian – as opposed to most of the forecasts, he believes the Canadian dollar (C$) will appreciate versus the U.S. dollar over the coming 90 days. The current spot rate is $0.6750/C$. Giri may choose between the following options on the Canadian dollar:
Should Giri buy a put on Canadian dollars or a call on Canadian dollars?
Using your answer to part a, what is Giri’s break-even price?
Using your answer to part a, what is Giri’s gross profit and net profit (including the premium) if the spot rate at the end of the 90 days is indeed $0.7600/C$?
Using your answer to part a, what is Giri’s gross profit and net profit (including the premium) if the spot rate at the end of the 90 days is indeed $0.8250/C$?

Questions Set 75: Solution

Solution

The economic perspective entails:

irrational behavior by individuals and institutions

a comparison of marginal benefits and marginal costs in decision making

short term but not long term thinking

the rejection of the scientific method



Microeconomics is concerned with

the aggregate or total levels of income, employment, and output.

a detailed examination of specific economic units that make up the economic system.

positive economics, but not normative economics

the establishing of an overall view of the operation of the economic system.



A production possibilities curve shows:

that resources are unlimited

that people prefer one of the goods more than the other

the maximum amount of two goods that can be produced assuming the full and efficient use of available resources

combinations of capital and labor necessary to produce specific levels of output



An increase in the price of a product will reduce that amount of it purchased because:

supply curves are upward sloping

the higher price means that real incomes have risen

consumers will substitute other products for the one whose price has risen

consumers substitute relatively high priced for relatively low priced products



Assume in a competitive market that price is initially above the equilibrium level. We can predict that price will:

decrease, quantity demanded will decrease, and quantity supplied will increase.

decrease and quantity demanded and quantity supplied will both decrease.

decrease, quantity demanded will increase, and quantity supplied will decrease.

increase, quantity demanded will decrease, and quantity supplied will increase



Refer to the below graph. A surplus of 160 units would be encountered if price was:


$1.60,

$1.10, that is $1.60 minus $.50

$1.00

$.50



For a linear demand curve:

demand is elastic at high prices elasticity is constant along the curve

elasticity is unity at every point along the curve

demand is elastic at low prices

elasticity is constant along the curve





0.8

1.0

1.2

2.0





10 and supply is elastic

1 and supply is unit elastic

0.25 and supply is inelastic

2.5 and supply is elastic



We would expect the cross elasticity of demand for Pepsi in relation to other soft drinks to be greater than that for soft drinks generally because:

soft drinks are normal goods

the income effect always exceeds the substitution effect

there are fewer good substitutes for soft drinks generally than for Pepsi

there are more good substitutes for soft drinks generally than for Pepsi



Marginal utility is the:

sensitivity of consumer purchases of a good to changes in the price of that good.

change in total utility obtained by consuming one more unit of a good.

change in total utility obtained by consuming another unit of a good divided by the change in the price of that good.

total utility associated with the consumption of a certain number of units of a good divided by the number of units consumed.



An increase in the quantity demanded means that:

the demand curve has shifted to the right.

given supply, the price of the product can be expected to decline.

the demand curve has shifted to the left.

price has declined and consumers therefore want to purchase more of the product.



The price elasticity of demand coefficient measures:

buyer responsiveness to price changes.

the extent to which a demand curve shifts as incomes change.

the slope of the demand curve.

how far business executives can stretch their fixed costs.



If total utility is increasing, marginal utility:

is positive, but may be either increasing or decreasing.

must also be increasing.

may be either positive or negative.

will be increasing at an increasing rate.



Where total utility is at a maximum, marginal utility is:

negative.

positive and increasing.

zero.

positive but decreasing.



Marginal utility:

is equal to total utility divided by the number of units consumed.

is equal to total utility if the demand curve is linear.

increases as more of a product is consumed.

diminishes as more of a product is consumed.



The theory of consumer behavior assumes that

consumers behave rationally, maximizing their satisfactions.

consumers have unlimited money incomes.

consumers do not know how much marginal utility they obtain from successive units of various products.

marginal utility is constant.



An increase in demand means that:

given supply, the price of the product will decline.

the demand curve has shifted to the right.

price has declined and consumers therefore want to purchase more of the product.

the demand curve has shifted to the left.



When product prices change, consumers are inclined to purchase larger amounts of the now cheaper products and less of the now more expensive products. This describes:

the cost effect

the price effect

the income effect

the substitution effect



Assumptions made in conjunction with economic theorizing:

can be unrealistic, if when they are relaxed, the outcome is essentially unchanged.

make the output of economic modeling useless.

must be avoided to the extent possible.

must be realistic and consistent with known real-world conditions if the predictions of the theory are to be useful for practical purposes.



The production possibilities curve illustrates the basic principle that:

an economy's capacity to produce increases in proportion to its population size

more of one good can be produced without a decrease in the production of the other good while holding inputs and technology constant.

the production of more and more of one good will require larger and larger cuts in the production of the other good.

an economy will automatically seek that level of output at which all of its resources are employed.



The concept of opportunity cost:

is irrelevant if the production possibilities curve is shifting to the right.

is irrelevant in socialist economies because of central planning.

suggests that the cost of resources for any particular product is the alternative outputs foregone because these resources are not available for alternative production.

suggests that insatiable wants can be fulfilled only if the opportunity costs for fulfilling them approach zero or are negative while the society continues to pay the prevailing wage.



The Illinois Central Railroad once asked the Illinois Commerce Commission for permission to increase its commuter rates by 20 percent. The railroad argued that declining revenues made this rate increase essential. Opponents of the rate increase argued that the railroad's revenues would fall because of the rate hike. It can be concluded that:

the railroad felt that the demand for passenger service was elastic and opponents of the rate increase felt that it was inelastic.

the railroad felt that the demand for passenger service was inelastic and opponents of the rate increase felt that it was elastic.

elasticity of demand was not at issue, that railroad felt they needed more revenue to continue operations.

none of the above.



If the price elasticity of demand for gasoline is .30 and there is a 10% decrease in the price of gasoline, this will cause the quantity of gasoline demanded to:

increase by 30%.

increase by 3%.

decrease by 3%.

decrease by 30%



What is elasticity of the labor market and what factors determine the elasticity of the market demand and supply of labor.

Questions Set 74: Solution

Solution
Grace Hesketh is the owner of an extremely successful dress boutique in downtown Chicago. Although high fashion is Grace’s first love, she’s also interested in investments, particularly bonds and other fixed income securities. She actively manages her own investments and over time has built up a substantial portfolio of securities. She’s well versed on the latest investment techniques and is not afraid to apply those procedures to her own investments.
Grace has been playing with the idea of trying to immunize a big chunk of her bond portfolio. She’d like to cash out this part of her portfolio in seven years and use the proceeds to buy a vacation home in her home state of Oregon. To do this, she intends to use the $ 200,000 she now has invested in the following four corporate bonds (she currently has $ 50,000 invested in each one).
1. A 12 year, 7.5% bond that’s currently priced at $ 895.
2. A 10 year, zero coupon bond priced at $ 405.
3. A 10 year, 10% bond priced at $ 1,080.
4. A 15 year, 9.25% bond priced at $ 980. (Note: These are all noncallable, investment grade, nonconvertible / straight bonds.)
Questions
a. Given the information provided, find the current yield and the promised yield for each bond in the portfolio. (Use annual compounding.)
b. Calculate the Macaulay and modified durations of each bond in the portfolio and indicate how the price of each bond would change if interest rates were to rise by 75 basis points. How would the price change if interest rates were to fall by 75 basis points?
c. Find the duration of the current four bond portfolio. Given the seven year target that Grace has, would you consider this to be an immunized portfolio? Explain.
d. How could you lengthen or shorten the duration of this portfolio? What’s the shortest portfolio duration you can achieve? What’s the longest?
e. Using one or more of the four bonds described above, is it possible to come up with a $ 200,000 bond portfolio that will exhibit the duration characteristics Grace is looking for? Explain.
f. Using one or more of the four bonds, put together a $ 200,000 immunized portfolio for Grace. Because this portfolio will now be immunized, will Grace be able to treat it as a buy and-hold portfolio one she can put away and forget about? Explain.

Questions Set 73:

Solution

1. The Wall Street Journal reported the following spot and forward rates for the Swiss franc ($/SF) in june of 2009:

Spot……………………$0.8466
30-day forward………………$0.8504
90-day forward………………..$0.8540
180-day forward………………$0.8587

• Was the Swiss franc selling at a discount or premium in the forward market?
• What was the 30-day forward premium (or discount)?
• What was the 90-day forward premium (or discount)?
• Suppose you executed a 90-day forward contract to exchange 100,000 Swiss francs into U.S. dollars. How many dollars would you get 90 days hence?
• Assume a Swiss bank entered into a 180-day forward contract with Citicorp to buy $100,000. How many francs will the swiss bank deliver in six months to get U.S. Dollars?

Questions Set 72:

Solution

1) Five years ago, a pharmaceutical company bought a machine that produces pain-reliever medicine at a cost of $2 million. The machine has been depreciated over the past five years, and the current book value is $1,100,000. The company decides to sell the machine now at its market price of $1 million. The marginal tax rate is 34 percent.
What is the relevant cash flow for the machine project?
What is the relevant cash flow if the market price of the machine is $600,000 instead?


2)Healthy Potions, Inc., is considering investing in a new production line of eye drops. Other than investing in the equipment, the company needs to increase its cash and cash equivalents by $10,000, increase the level of inventory by $50,945, increase accounts receivable by $25,000, and increase accounts payable by $5,000 at the beginning of the investment. Healthy Potions will recover these changes in working capital at the end of the project 9 years later. If the appropriate discount rate is 14.9 percent what is the net effect on the today's value of the project?


3Given the soaring price of gasoline, Ford is considering introducing a new production line of gas-electric hybrid sedans. The expected annual sales number of such hybrid cars is 21,000; the price is $22,000 per car. Variable costs of production amount to $13,000 per car. The fixed overhead including salary of top executives is $80 million per year. However, the introduction of the hybrid sedan will decrease Ford’s sales of regular sedans by 7,000 cars per year; the regular sedans have a unit price of $20,000 and unit variable cost of $12,000, and fixed costs of $250,000 per year. Depreciation costs of the production plant are $50,000 per year. The marginal tax rate is 40 percent. What is the incremental annual cash flow from operations?
The incremental annual cash flow from operations is $


4)FITCO is considering the purchase of new equipment. The equipment costs $250,000, and an additional $90,000 is needed to install it. The equipment will be depreciated straight-line to zero over a five-year life. The equipment will generate additional annual revenues of $220,000, and it will have annual cash operating expenses of $83,000. The equipment will be sold for $85,000 after five years. An inventory investment of $73,000 is required during the life of the investment. FITCO is in the 40 percent tax bracket and its cost of capital is 11 percent.
(Round your intermediate calculations to four decimal places and round your final answer to the nearest dollar. If the answer is negative number then put "-" before answer, i.e. -10,000.)
The project's NPV is


5)Archers Daniels Midland Company is considering buying a new farm that it plans to operate for 10 years. The farm will require an initial investment of $13,250,000. The investment will consist of $2,000,000 for land and $11,250,000 for trucks and other equipments. The land, all trucks, and all other equipment are expected to be sold at the end of 10 years at a price of $5 million, $2 million above book value. The farm is expected to produce revenue of $2,000,000 each year, and an after tax annual cash flow from operations of $1,720,000. The marginal tax rate is 35 percent, and the appropriate discount rate is 14.00 percent. NPV = $

Questions Set 71:

Solution

Cash Flow DOL: The law firm of Dewey, Cheatem, and Howe has monthly fixed costs of $115,000, EBIT of $278,000, and depreciation charges on its office furniture and computers of $7,700. The firm’s Cash Flow DOL is



EBIT: WalkAbout Kangaroo Shoe Stores forecasts that it will sell 7,930 pairs of shoes next year. The firm buys its shoes for $50 per pair from the wholesaler and sells them for $75 per pair. The firm will incur fixed costs plus depreciation and amortization of $100,000 per year. If actual sales next year are 9,746 pairs of shoes, EBIT will increase by





EBIT: Specialty Light Bulbs anticipates selling 3,000 light bulbs this year at a price of $16 per bulb. It costs Specialty $10 in variable costs to produce each light bulb, and the fixed costs for the firm are $10,000. Specialty has an opportunity to sell an additional 1,000 bulbs next year at the same price and variable cost, but by doing so the firm will incur an additional fixed cost of $5,000 if it chooses to sell the additional bulbs. The additional sales would change Specialty’s EBIT by $___, and therefore Specialty Should or Should not produce and sell the additional bulbs.





Pretax operating cash flow break-even: Dandle’s Candles will be producing a new line of dripless candles in the coming years and has the choice of producing the candles in a large factory with a small number of workers or a small factory with a large number of workers. Each candle will be sold for $10. If the large factory is chosen, the cost per unit to produce each candle will be $2.50, while the cost per unit will be $7.30 for the small factory. The large factory would have fixed cash costs of $2 million and a depreciation expense of $300,000 per year, while those expenses would be $500,000 and $100,000 in the small factory. The pretax operating cash flow breakeven point for the large factory is ____. The pretax operating cash flow breakeven point for the small factory is _____.





Profitability index: Suppose that you faced the following projects but had only $30,000 to invest. You should invest in project(s)



A. A and B only
B. B and C only
C. A, B, and C only
D. B, C and D only
C. C and D only

Project



Cost ($)



NPV($)



A



$8,000



$4,000



B



11,000



7,000



C



9,000



5,000



D



7,000



4,000



Accounting operating profit break-even: Dandle’s Candles will be producing a new line of dripless candles in the coming years and has the choice of producing the candles in a large factory with a small number of workers or a small factory with a large number of workers. Each candle will be sold for $10. If the large factory is chosen, the cost per unit to produce each candle will be $2.32, while the cost per unit will be $7.47 for the small factory. The large factory would have fixed cash costs of $2.1 million and a depreciation expense of $300,000 per year, while those expenses would be $470,000 and $100,000 in the small factory. If Dandle uses the small factory, the accounting break-even point is ___ units. If Dandle uses the large factory, the accounting break-even point is ____units.





Cash Flow DOL: The Vinyl CD Co. is going to take on a project that will increase its EBIT by $81,000 next year. The firm’s fixed cost cash expenditures are expected to increase by $82,000, and depreciation and amortization will increase by $74,000 next year. If the project yields an additional 10 percent in revenue, the percentage increase in pretax operating cash flow driven by the additional revenue will be____%





Silver Polygon, Inc., has determined that if its revenues were to increase by 10 percent, then EBIT would increase by 27 percent to $140,000. The fixed costs (cash only) for the firm are $102,000. Given the same 10 percent increase in revenues, EBITDA would change by___%



You are analyzing two proposed capital investments with the following cash flows:



Year



Project X ($)



Project Y ($)



0



$(20,000)



$(20,000)



1



12,617



6,375



2



5,797



6,375



3



5,663



6,375



4



1,840



6,375



The cost of capital for both projects is 10 percent. The PI for project X is ___ and the PI for project Y is ____. If you have unlimited funds you should invest in both projects, project X, project Y, or neither projects. If they are mutually exclusive you should invest in project Y, neither project, or project X.

Profitability index: Suppose that you faced the following projects but had only $25,000 to invest. You should invest in project(s)



Project



Cost ($)



NPV($)



A



$8,000



$4,000



B



11,000



7,000



C



9,000



5,000



D



7,000



4,000





A. A, B, and C only
B. A and B only
C. B and D only
D. A, C and D only
E. B and C only

Question Set 70:

Solution
Cost of debt using both methods Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax bracket.
a) Find the net proceeds from sale of the bond, Nd.
b) Show the cash flows from the firm’s point of view over the maturity of the bond.
c) Use the IRR approach to calculate the before-tax and after-tax costs of debt.
d) Use the approximation formula to estimate the before-tax and after-tax costs of debt.
e) Compare and contrast the costs of debt calculated in parts c and d. Which approach do you prefer? Why?
EPS and optical debt ratio: Williams glassware has estimated at various debt ratio the expected earnings per share and the standard deviation of the earnings per share as shown in the following table:

Debt ratio	Earnings per share (EPS)	Standard Deviation of EPS
0%	$2.30	$1.15
20%	$3.00	$1.80
40%	$3.50	$2.80
60%	$3.95	$3.95
80%	$3.80	$5.53

a) Estimate the optimal debt ratio on the basis of the relationship between earnings per share and the debt ratio. You will probably find it helpful to graph the relationship.
b) Graph the relationship between the coefficient of variation and the debt ratio. Label the areas associated with business risk and financial risk.
Dividend constraints The Howe Company’s stockholders’ equity account follows:

Common Stock (400,000 shares at $4 par)	$16,00,000
Paid in capital in excess of par	$10,00,000
Retained earnings	$19,00,000
Total Stockholder’s Equity	$45,00,000

The earnings available for common stockholders from this period’s operations are $100,000, which have been included as part of the $1.9 million retained earnings.
a) What is the maximum dividend per share that the firm can pay? (Assume that legal capital includes all paid-in capital.)
b) If the firm has $160,000 in cash, what is the largest per-share dividend it can pay without borrowing?
c) c. Indicate the accounts and changes, if any, that will result if the firm pays the dividends indicated in parts a and b.
d) Indicate the effects of an $80,000 cash dividend on stockholders’ equity.