Appendix A

Solutions to Self-Test Questions and Problems

Note: Except for Chapter 1, we do not show an answer for ST-1 problems because
they are verbal rather than quantitative in nature.

Chapter 1
ST-1 Refer to the marginal glossary definitions or relevant chapter sections to
check your responses.

Chapter 3
ST-2 a. EBIT $5,000,000
Interest 1,000,000
EBT $4,000,000
Taxes 40% 1,600,000
Net income $2,400,000

b. Current liabilities 5 Accounts payable 1 Accruals 1 Notes payable

   5 $3,000,000 1 $1,000,000 1 $2,000,000
   5 $6,000,000
NOWC 5 (Current assets 2 Excess cash) 2 (Current liabilities 2 Notes payable)
5 ($14,000,000 2 $0) 2 ($6,000,000 2 $2,000,000)
5 $10,000,000

c. NWC 5 Current assets 2 Current liabilities

   5 $14,000,000 2 $6,000,000
   5 $8,000,000

d. FCF5sEBIT(1 2 T) 1 Depreciationd2 1expenditures

Capital
1
Increase in net operating
working capital 2
5 f$5,000,000(0.6) 1 $1,000,000g 2 f$4,000,000 1 0g
5 $4,000,000 2 $4,000,000
5 $0

Note that capital expenditures are equal to the change in net plant and
equipment plus the annual depreciation expense.
e. Rattner’s end-of-year Statement of Stockholders’ Equity is calculated
as follows:
Statement of Stockholders’ Equity
Common Stock
Retained Total Stockholders’
Shares Amount Earnings Equity
Balances, beginning of year 500,000 $5,000,000 $11,200,000 $16,200,000
Net income 2,400,000
Cash dividends −1,200,000
Addition to retained earnings 1,200,000
Balances, end of year 500,000 $5,000,000 $12,400,000 $17,400,000

A-1

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A-2 Appendix A Solutions to Self-Test Questions and Problems

f. MVA 5 (P0 3 Number of shares) 2 Book value of equity

5 ($52 3 500,000) 2 $17,400,000
5 $8,600,000
g. Before we can calculate the firm’s EVA, we need to calculate the firm’s total
invested capital. We know that the firm uses no preferred stock, and we
know that Assets 5 Liabilities 1 Equity. From the information provided in
the problem, we know the following:
Accounts payable $  3,000,000
Accruals 1,000,000
Notes payable    2,000,000
Current assets $14,000,000 Current liabilities $  6,000,000
Long-term debt ?
Net fixed assets 15,000,000 Common equity   17,400,000
Total assets $29,000,000 Total liabilities & equity $  29,000,000

We calculated common equity in part e, so the only value we don’t know on

the balance sheet is long-term debt. However, we have enough information
to calculate it:
Long-term debt 5 $29,000,000 2 $17,400,000 2 $6,000,000
Long-term debt 5 $5,600,000

Now, we can find the firm’s total invested capital:

Total invested capital 5 Notes payable 1 Long-term debt 1 Common equity
Total invested capital 5 $2,000,000 1 $5,600,000 1 $17,400,000
Total invested capital 5 $25,000,000

Now, we can calculate the firm’s EVA:

EVA 5 EBIT(1 2 T) 2 fTotal invested capital 3 After-tax % cost of capitalg
EVA 5 $5,000,000(0.6) 2 f$25,000,000 0.09g
EVA 5 $3,000,000 2 $2,250,000 5 $750,000

Chapter 4
ST-2 Billingsworth paid $2 in dividends and retained $2 per share. Because
total retained earnings rose by $12 million, there must be 6 million
shares outstanding. With a book value of $40 per share, total common
equity must be $40(6 million) 5 $240 million. Because Billingsworth has
$120 million of total debt, its total debt to total capital ratio must be 33.3%:

Total debt $120 million

5
Total debt 1 Equity $120 million 1 $240 million
5 0.333 5 33.3%

ST-3 a. In answering questions such as this, always begin by writing down
the relevant definitional equations, and then start filling in numbers.
Note that the extra zeros indicating millions have been deleted in the
following calculations.
Accounts receivable
(1) DSO 5
Salesy365
AyR
    40.55 5
Salesy365
     AyR 5 40.55($2.7397) 5 $111.1 million

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 Appendix A Solutions to Self-Test Questions and Problems A-3

Current assets
(2) Current ratio 5 5 3.0
Current liabilities
Current assets
     5 5 3.0
$105.5
    Current assets 5 3.0($105.5) 5 $316.50 million

(3) Total assets 5 Current assets 1 Fixed assets

5 $316.5 1 $283.5 5 $600 million
(4) ROA 5 Profit margin 3 Total assets turnover
Net income Sales
5 3
Sales Total assets
$50 $1,000
5 3
$1,000 $600
5 0.05 3 1.667 5 0.083333 5 8.3333%
Assets
(5) ROE 5 ROA 3
Equity
$600
12.0% 5 8.3333% 3
Equity
(8.3333%)($600)
Equity 5
12.0%
Equity 5 $416.67 million

(6) Current assets 5 Cash and equivalents1Accounts receivable1Inventories

$316.5 5 $100.0 1 $111.1 1 Inventories
Inventories 5 $105.4 million
Current assets 2 Inventories
Quick ratio 5
Current liabilities
$316.5 2 $105.4
5 5 2.00
$105.5
(7) Total assets 5 Total claims 5 $600 million
Current liabilities 1 Long-term debt 1 Equity 5 $600 million
$105.5 1 Long-term debt 1 $416.67 5 $600 million
Long-term debt 5 $600 2 $105.5 2 $416.67 5 $77.83 million

Note: We could have found equity as follows:

Net income
ROE 5
Equity
$50
12.0% 5
Equity
Equity 5 $50y0.12
Equity 5 $416.67 million

Then we could have gone on to find long-term debt.

b. Kaiser’s average sales per day were $1,000y365 5 $2.74 million. Its
DSO was 40.55, so AyR 5 40.55($2.74) 5 $111.1 million. Its new DSO
of 30.4 would cause AyR 5 30.4($2.74) 5 $83.3 million. The reduction
in receivables would be $111.1 2 $83.3 5 $27.8 million, which would
equal the amount of cash generated.
(1) New equity 5 Old equity 2 Stock bought back
5 $416.7 2 $27.8
5 $388.9 million

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A-4 Appendix A Solutions to Self-Test Questions and Problems

Thus,
Net income
New ROE 5
New equity
$50
5
$388.9
5 12.86% (versus old ROE of 12.0%)

Net income
(2) New ROA 5
Total assets 2 Reduction in AyR
$50
   5
$600 2 $27.8
   5 8.74% (versus old ROA of 8.33%)
(3) Total debt before the asset reduction is the same as total debt after the asset
reduction. Neither notes payable nor long-term debt was impacted by the
asset reduction. However, after the asset reduction equity has declined, so
total capital has declined.

Total debt 5 Notes payable 1 Long-term debt

$97.8 5 $20 1 $77.8

New total assets 5 Old total assets 2 Reduction in AyR

5 $600 2 $27.8
5 $572.2 million

Before asset reduction:

Total capital 5 Total debt 1 Old equity
5 $97.8 1 $416.7
5 $514.5 million
Total debt $97.8
5 5 19.0%
Old total capital $514.5
After asset reduction:
Total capital 5 Total debt 1 New equity
5 $97.8 1 $388.9
5 $486.7 million
Total debt $97.8
5 5 20.1%
New total capital $486.7

Chapter 5
ST-2 a. 1/1/18 1/1/19 1/1/20 1/1/21
8%

21,000 FV 5 ?
$1,000 is being compounded for 3 years, so your balance on January 1,
2021, is $1,259.71:

FVN 5 PV(1 1 I)N 5 $1,000(1 1 0.08)3 5 $1,259.71

Alternatively, using a financial calculator, input N 5 3, IyYR 5 8,

PV 5 21000, PMT 5 0, and FV 5 ? Solve for FV 5 $1,259.71.

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 Appendix A Solutions to Self-Test Questions and Problems A-5

b. 1/1/18 1/1/19 1/1/20 1/1/21

2%

21,000 FV 5 ?

FVN 5 PV 1 1 S INOM
M D MN
5 FV12 5 $1,000(1.02)12 5 $1,268.24

Alternatively, using a financial calculator, input N 5 12, IyYR 5 2,

PV 5 21000, PMT 5 0, and FV 5 ? Solve for FV 5 $1,268.24.

c. 1/1/18 1/1/19 1/1/20 1/1/21

8%

2333.333
2333.333 2333.333
FV 5 ?
Using a financial calculator, input N 5 3, IyYR 5 8, PV 5 0,
PMT 5 2333.333, and FV 5 ? Solve for FV 5 $1,082.13.

d. 1/1/18 1/1/19 1/1/20 1/1/21

8%

2333.333 2333.333 2333.333 FV 5 ?

Using a financial calculator in begin mode, input N 5 3, IyYR 5 8, PV 5 0,
PMT 5 2333.333, and FV 5 ? Solve for FV 5 $1,168.70.

e. 1/1/18 1/1/19 1/1/20 1/1/21

8%

? ? ?
FV 5 1,259.71
Using a financial calculator, input N 5 3, IyYR 5 8, PV 5 0, FV 5 1259.71,
and PMT 5 ? Solve for PMT 5 2$388.03. Therefore, you would
have to make three payments of $388.03 beginning on January 1,
2019.
ST-3 a. Set up a time line like the one in the preceding problem:

1/1/18 1/1/19 1/1/20 1/1/21 1/1/22

8%

PV 5 ? FV 5 1,000
Note that your deposit will grow for 4 years at 8%. The deposit on
January 1, 2018, is the PV, and the FV is $1,000. Using a financial calcu-
lator, input N 5 4, IyYR 5 8, PMT 5 0, FV 5 1000, and PV 5 ? Solve
for PV 5 2$735.03.
FVN $1,000
PV 5 5 5 $735.03
(1 1 I)N (1.08)4

b. 1/1/18 1/1/19 1/1/20 1/1/21 1/1/22

8%

? ? ? ?
FV 5 1,000
Here, we are dealing with a 4-year annuity whose first payment occurs
1 year from today, on January 1, 2019, and whose future value must
equal $1,000. You should modify the time line to help visualize the
situation. Using a financial calculator, input N 5 4, IyYR 5 8, PV 5 0,
FV 5 1000, and PMT 5 ? Solve for PMT 5 2$221.92.

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A-6 Appendix A Solutions to Self-Test Questions and Problems

c. This problem can be approached in several ways. Perhaps the sim-

plest is to ask this question: “If I received $750 on January 1, 2019, and
deposited it to earn 8%, would I have the required $1,000 on January 1,
2022?” The answer is no.

1/1/18 1/1/19 1/1/20 1/1/21 1/1/22

8%

2750 FV 5 ?
FV3 5 $750(1.08)(1.08)(1.08) 5 $944.78

This indicates that you should let your father make the payments
of $221.92 rather than accept the lump sum of $750 on January 1,
2019.
You could also compare the $750 with the PV of the payments, as
shown below:

1/1/18 1/1/19 1/1/20 1/1/21 1/1/22

8%

2221.92 2221.92 2221.92 2221.92

PV 5 ?

Using a financial calculator, input N 5 4, IyYR 5 8, PMT 5 2221.92,

FV 5 0, and PV 5 ? Solve for PV 5 $735.03.
This is less than the $750 lump sum offer, so your initial reaction
might be to accept the lump sum of $750. However, this would be a
mistake. The problem is that when you found the $735.03 PV of the
annuity, you were finding the value of the annuity today, on January 1,
2018. You were comparing $735.03 today with the lump sum of $750
one year from now. This is, of course, not correct. What you should
have done was take the $735.03, recognize that this is the PV of an
annuity as of January 1, 2018, multiply $735.03 by 1.08 to get $793.83,
and compare $793.83 with the lump sum of $750. You would then take
your father’s offer to make the payments of $221.92 rather than take the
lump sum on January 1, 2019.

d. 1/1/18 1/1/19 1/1/20 1/1/21 1/1/22

I5?

2750 1,000

Using a financial calculator, input N 5 3, PV 5 2750, PMT 5 0,

FV 5 1000, and IyYR 5 ? Solve for IyYR 5 10.0642%.
e. 1/1/18 1/1/19 1/1/20 1/1/21 1/1/22
I5?

2200 2200 2200 2200

FV 5 1,000

Using a financial calculator, input N 5 4, PV 5 0, PMT 5 2200,

FV 5 1000, and IyYR 5 ? Solve for IyYR 5 15.09%.
You might be able to find a borrower willing to offer you a 15%
interest rate, but there would be some risk involved—he or she might
not actually pay you the $1,000!

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 Appendix A Solutions to Self-Test Questions and Problems A-7

f. 1/1/18 1/1/19 1/1/20 1/1/21 1/1/22

4%

2400 ? ? ? ? ? ?
FV 5 1,000
Find the future value of the original $400 deposit:
FV6 5 PV(1.04)6 5 $400(1.2653) 5 $506.13

This means that on January 1, 2022, you need an additional sum of

$493.87:
$1,000.00 2 $506.13 5 $493.87

This will be accumulated by making six equal payments that earn

8% compounded semiannually, or 4% each 6 months. Using a finan-
cial calculator, input N 5 6, IyYR 5 4, PV 5 0, FV 5 493.87, and
PMT 5 ? Solve for PMT 5 2$74.46.
Alternatively, input N 5 6, IyYR 5 4, PV 5 2400, FV 5 1000,
and PMT 5 ? Solve for PMT 5 2$74.46. Note that the sign on the
PV amount entered in the calculator was negative because the initial
deposit will offset the total amount needed. If the signs on both the
FV and PV amounts had been the same, you would have calculated a
larger payment than was necessary.

g. Effective annual rate 5 1 1 S M

INOM
2 1.0 D M

5 11 S 0.08 2
2 D
2 1 5 (1.04)2 2 1

5 1.0816 2 1 5 0.0816 5 8.16%

APR 5 IPER 3 M
5 0.04 3 2 5 0.08 5 8%
ST-4 Bank A’s effective annual rate is 8.24%:

Effective annual rate 5 1 1 S 0.08 4

4
2 1.0 D
5 (1.02)4 2 1
5 1.0824 2 1
5 0.0824 5 8.24%
Now Bank B must have the same effective annual rate:

S 11
INOM
12 D 12
2 1.0 5 0.0824

S 11
INOM
12 D 12
5 1.0824

INOM
11 5 (1.0824)1/12
12

INOM
11 5 1.00662
12

INOM
5 0.00662
12
INOM 5 0.07944 5 7.94%

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A-8 Appendix A Solutions to Self-Test Questions and Problems

Thus, the two banks have different quoted rates—Bank A’s quoted rate
is 8%, while Bank B’s quoted rate is 7.94%; however, both banks have
the same effective annual rate of 8.24%. The difference in their quoted
rates is due to the difference in compounding frequency.

Chapter 6
ST-2 a. Average inflation over 4 years 5 (2% 1 2% 1 2% 1 4%)/4 5 2.5%
b. T4 5 rRF 1 MRP4
5 r* 1 IP4 1 MRP4
5 3% 1 2.5% 1 (0.1)3%
5 5.8%

c. C4,BBB 5 r* 1 IP4 1 MRP4 1 DRP 1 LP

5 3% 1 2.5% 1 0.3% 1 1.3% 1 0.5%
5 7.6%

d. T8 5 r* 1 IP8 1 MRP8
5 3% 1 (3 3 2% 1 5 3 4%)y8 1 0.7%
5 3% 1 3.25% 1 0.7%
5 6.95%

e. C8,BB 5 r* 1 IP8 1 MRP8 1 DRP 1 LP

5 3% 1 3.25% 1 0.7% 1 1.3% 1 0.5%
5 8.75%

f. ­ T9 5 r* 1 IP9 1 MRP9

   7.3% 5 3% 1 IP9 1 0.8%
   IP9 5 3.5%
   3.5% 5 (3 3 2% 1 5 3 4% 1 X)y9
   31.5% 5 6% 1 20% 1 X
   5.5% 5 X

X 5 Inflation in Year 9 5 5.5%

ST-3 T1 5 6%; T2 5 6.2%; T3 5 6.3%; T4 5 6.5%; MRP 5 0
a. Yield of 1-year security, 1 year from now, is calculated as follows:
(1.062)2 5 (1.06)(1 1 X)
(1.062)2
511X
1.06
1.064 5 1 1 X
6.4% 5 X

b. Yield of 1-year security, 2 years from now, is calculated as follows:

(1.063)3 5 (1.062)2(1 1 X)
(1.063)3
511X
(1.062)2
1.065 5 1 1 X
6.5% 5 X

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 Appendix A Solutions to Self-Test Questions and Problems A-9

c. Yield of 2-year security, 1 year from now, is calculated as follows:

(1.063)3 5 (1.06)(1 1 X)2

(1.063)3
5 (1 1 X)2
1.06
1.13317 5 (1 1 X)2
(1.13317)1y2 5 1 1 X
6.45% 5 X

d. Yield of 3-year security, 1 year from now, is calculated as follows:

(1.065)4 5 (1.06)(1 1 X)3

(1.065)4
5 (1 1 X)3
1.06
1.213648 5 (1 1 X)3
(1.213648)1/3 5 1 1 X
6.67% 5 X

Chapter 7
ST-2 a. 
Pennington’s bonds were sold at par; therefore, the original YTM
equaled the coupon rate of 12%.
50 $120y2 $1,000
o
S D S D
b. VB 5 1
t51 0.10 t
0.10 50
11 11
2 2
With a financial calculator, input the following: N 5 50, IyYR 5 5,
PMT 5 60, FV 5 1000, and PV 5 ? Solve for PV 5 $1,182.56.

c. Current yield 5 Annual coupon payment/Price

5 $120y$1,182.56
5 0.1015 5 10.15%

Capital gains yield 5 Total yield 2 Current yield

  
5 10% 2 10.15% 5 20.15%
   Total return 5 YTM 5 10%
d. With a financial calculator, input the following: N 5 13, PV 5 2916.42,
PMT 5 60, FV 5 1000, and rdy2 5 IyYR 5 ? Calculator solution 5
rdy2 5 7.00%; therefore, rd 5 YTM 5 14.00%.
Current yield 5 $120y$916.42 5 13.09%
Capital gains yield 5 14% 2 13.09% 5 0.91%
Total return 5 YTM 5 14.00%
e. The following time line illustrates the years to maturity of the bond:

1/1/17 7/1/17 1/1/18 7/1/18 1/1/19 12/31/23

3/1/17

Thus, on March 1, 2017, there were 13 2/3 periods left before the bond
matured. Bond traders actually use the following procedure to deter-
mine the price of the bond:

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A-10 Appendix A Solutions to Self-Test Questions and Problems

(1) Find the price of the bond on the next coupon date, July 1, 2017.
Using a financial calculator, input N 5 13, IyYR 5 7.75, PMT 5 60,
FV 5 1000, and PV 5 ? Solve for PV 5 $859.76.
(2) Add the coupon, $60, to the bond price to get the total value of the
bond on the next interest payment date: $859.76 1 $60.00 5 $919.76.
(3) Discount this total value back to the purchase date (March 1, 2017).
Using a financial calculator, input N 5 4y6, IyYR 5 7.75, PMT 5 0,
FV 5 919.76, and PV 5 ? Solve for PV 5 $875.11.
(4) Therefore, you would have written a check for $875.11 to complete
the transaction. Of this amount, $20 5 (1y3)($60) would represent
accrued interest and $855.11 would represent the bond’s basic
value. This breakdown would affect both your taxes and those of
the seller.
(5) This problem could be solved very easily using a spreadsheet or
a financial calculator with a bond valuation function, such as the
HP-12C or the HP-17BII. This is explained in the calculator manual
under the heading, “Bond Calculations.”
ST-3 a. (1) 
$100,000,000y10 5 $10,000,000 per year, or $5 million each 6 months.
  (2) VDC will purchase bonds on the open market if they’re selling
at less than par. So, the sinking fund payment will be less than
$5,000,000 each period.
b. The debt service requirements will decline. As the amount of bonds
outstanding declines, so will the interest requirements (amounts given
in millions of dollars). If the bonds are called at par, the total bond
service payments are calculated as follows:

Semiannual Sinking Outstanding

Payment Fund Bonds on which Interest Total Debt
Period Payment Interest Is Paid Paymenta Service
(1) (2) (3) (4) (2) 1 (4) 5 (5)

1 $5 $100 $6.0 $11.0

2 5   95 5.7 10.7
3 5   90 5.4 10.4
o o o o o
20 5    5 0.3   5.3
a
Interest is calculated as (0.5)(0.12)(column 3); for example, Interest in Period 2 5
(0.5)(0.12)($95) 5 $5.7.

The company’s total cash bond service requirement will be $21.7 mil-
lion per year for the first year. For both options, interest will decline
by 0.12($10,000,000) 5 $1,200,000 per year for the remaining years. The
total debt service requirement for the open market purchases cannot
be precisely determined, but the amounts would be less than what’s
shown in column 5 of the table above.
c. Here we have a 10-year, 7% annuity whose compound value is $100
million, and we are seeking the annual payment, PMT. The solution can
be obtained with a financial calculator. Input N 5 10, IyYR 5 7, PV 5 0,
and FV 5 100000000, and press the PMT key to obtain $7,237,750. This
amount is not known with certainty as interest rates over time will
change, so the amount could be higher (if interest rates fall) or lower
(if interest rates rise).

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 Appendix A Solutions to Self-Test Questions and Problems A-11

d. Annual debt service costs will be $100,000,000(0.12) 1 $7,237,750 5

$19,237,750.
e. If interest rates rose, causing the bond’s price to fall, the company
would use open market purchases. This would reduce its debt service
requirements.

Chapter 8
ST-2 a. The average rate of return for each stock is calculated simply by aver-
aging the returns over the 5-year period. The average return for Stock A
is

rAVg A 5 (224.25% 1 18.50% 1 38.67% 1 14.33% 1 39.13%)y5

5 17.28%

The average return for Stock B is

rAvg B 5 (5.50% 1 26.73% 1 48.25% 1 24.50% 1 43.86%)y5
5 23.97%

The realized rate of return on a portfolio made up of Stock A and Stock

B would be calculated by finding the average return in each year as
rA(% of Stock A) 1 rB(% of Stock B) and then averaging these annual
returns:

Year Portfolio AB’s Return, rAB

2013 (9.38%)
2014 22.62
2015 43.46
2016 4.92
2017 41.50
rAvg 5 20.62%

b. The standard deviation of returns is estimated, using Equation 8.2a, as

follows:

Estimated  5 Î N

o (r 2 r
t51
t

N21
Avg
)2

For Stock A, the estimated s is 25.84%:

A 5 Î (224.25%217.28%)2 1 (18.50% 2 17.28%)2 1 (38.67% 2 17.28%)2 1

(14.33% 2 17.28)2 1 (39.13% 2 17.28%)2
521
5 25.84%

The standard deviations of returns for Stock B and for the portfolio are
similarly determined, and they are as follows:

Stock A Stock B Portfolio AB

Standard deviation 25.84% 23.15% 22.96%

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A-12 Appendix A Solutions to Self-Test Questions and Problems

c. 
The Sharpe ratio is calculated as (Return 2 Risk-free rate)/
Standard deviation. For Stock A, we calculate the Sharpe ratio as
(17.28% 2 3.5%)/25.84% 5 0.5333. The Sharpe ratios for Stock B and
the portfolio are similarly determined, and they are as follows:

Stock A Stock B Portfolio AB

Sharpe ratio 0.5333 0.8842 0.7456

d. Because the risk reduction from diversification is small (sAB falls only
to 22.96%), the most likely value of the correlation coefficient is 0.8. If
the correlation coefficient were 20.8, the risk reduction would be much
larger. In fact, the correlation coefficient between Stocks A and B is 0.76.
e. If more randomly selected stocks were added to a portfolio, sp would
decline to somewhere in the vicinity of 20% (see Figure 8.6); sp would
remain constant only if the correlation coefficient were 11.0, which is most
unlikely. sp would decline to zero only if the correlation coefficient, r, were
equal to zero and a large number of stocks were added to the portfolio, or
if the proper proportions were held in a two-stock portfolio with r 5 21.0.

ST-3 a. b 5 (0.6)(0.70) 1 (0.25)(0.90) 1 (0.1)(1.30) 1 (0.05)(1.50)


5 0.42 1 0.225 1 0.13 1 0.075 5 0.85
b. 
rRF 5 4%; RPM 5 5%; b 5 0.85 (calculated in part a)
  r 5 4% 1 (5%)(0.85)
  5 8.25%
c. 
bN 5 (0.5)(0.70) 1 (0.25)(0.90) 1 (0.1)(1.30) 1 (0.15)(1.50)
  5 0.35 1 0.225 1 0.13 1 0.225
   5 0.93
   r 5 4% 1 (5%)(0.93)
  5 8.65%

Chapter 9
ST-2 The first step is to solve for g, the unknown variable, in the constant
growth equation. Because D1 is unknown, but D0 is known, substitute
D0(1 1 g) for D1 as follows:
⁄ D1 D0(1 1 g)
P0 5 P0 5 5
rs 2 g rs 2 g
$2.40(1 1 g)
$36 5
0.12 2 g
Solving for g, we find the growth rate to be 5%:
$4.32 2 $36g 5 $2.40 1 $2.40g
$38.4g 5 $1.92
g 5 0.05 5 5%
The next step is to use the growth rate to project the stock price 5 years
hence:
⁄ D0(1 1 g)6
P5 5
rs 2 g
$2.40(1.05)6
5
0.12 2 0.05
5 $45.95
⁄
(Alternatively, P5 5 $36(1.05)5 5 $45.95)
⁄
Therefore, the firm’s expected stock price 5 years from now, P5, is $45.95.

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 Appendix A Solutions to Self-Test Questions and Problems A-13

ST-3 a. (1) Calculate the PV of the dividends paid during the supernormal

growth period:
D1 5 $1.1500(1.15) 5 $1.3225
D2 5 $1.3225(1.15) 5 $1.5209
D3 5 $1.5209(1.13) 5 $1.7186
$1.3225 $1.5209 $1.7186
PV D 5 1 1
1.12 (1.12)2 (1.12)3
5 $1.1808 1 $1.2125 1 $1.2233
5 $3.6166 < $3.62
(2) Find the PV of the firm’s stock price at the end of Year 3:

⁄ D4 D3(1 1 g)
P3 5 5
rs 2 g rs 2 g
$1.7186(1.06)
5
0.12 2 0.06
5 $30.36
⁄ $30.36
PV P3 5 5 $21.61
(1.12)3
(3) Sum the two components to find the value of the stock today:
⁄
P0 5 $3.62 1 $21.61 5 $25.23

Alternatively, the cash flows can be placed on a time line as follows:

0 1 2 3 4
12%
g 5 15% g 5 13% g 5 6%
1.3225 1.5209 1.7186 1.8217
$1.8217
30.3617 5
0.12 2 0.06
32.0803
Enter the cash flows into the cash flow register (remembering that
CF0 5 0) and IyYR 5 12, and press the NPV key to obtain P0 5 $25.23.

b.  ⁄ $1.5209 $1.7186 $30.36

P1 5 1 1
1.12 (1.12)2 (1.12)2
5 $1.3579 1 $1.3701 1 $24.2028
5 $26.9308 < $26.93

(Calculator solution: $26.93)

⁄ $1.7186 $30.36
P2 5 1
1.12 1.12
5 $1.5345 1 $27.1071
5 $28.6416 < $28.64

(Calculator solution: $28.64)

c. Year Dividend Yield 1 Capital Gains Yield 5 Total Return

1 $1.3225 $26.93 2 $25.23 < 12%

< 5.24% < 6.74%
$25.23 $25.23
2 $1.5209 $28.64 2 $26.93 < 12%
< 5.65% < 6.35%
$26.93 $26.93
3 $1.7186 $30.36 2 $28.64 < 12%
< 6.00% < 6.00%
$28.64 $28.64

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A-14 Appendix A Solutions to Self-Test Questions and Problems

ST-4 0 1 2 3 4
10%
g 5 4%
5 9 12 12.48
12.48
208 5
(0.10 2 0.04)
5 9 220

Value of Company’s Operations 5 $5/1.10 1 $9/(1.10)2 1 $220/(1.10)3

5 $4.5454 1 $7.4380 1 $165.2893

5 $177.2727 million.
Value of Company 5 Value of Company’s Operations 1 Market Value
of Non-Operating Assets

5 $177.2727 1 $10

5 $187.2727 million.
Market Value of Equity 5 Value of Company 2 Market Value of Debt

5 $187.2727 2 $27.2727

5 $160 million
P0 5 $160/5 5 $32.00 per share.

Chapter 10
ST-2 a. Component costs are as follows:
D1 D0(1 1 g)
Common: rs 5 1g5 1g
P0 P0
$3.60(1.09)
5 1 0.09
$54
5 0.0727 1 0.09 5 16.27%
Preferred dividend $11
Preferred: rp 5 5 5 11.58%
Pp $95

Debt: rd(1 2 T) 5 12%(0.6) 5 7.20%

b. WACC calculation:
WACC 5 wdrd(1 2 T) 1 wprp 1 wcrs

5 0.25(7.2%) 1 0.15(11.58%) 1 0.60(16.27%) 5 13.30%

c. Retained earnings Addition to retained earnings for the year

5
beakpoint Equity fraction
0.7($34,285.72)
  5 5 $40,000
0.6
At a capital budget greater than $40,000, new common stock would
have to be issued, and the firm’s WACC would increase above 13.3%.
Therefore, only Projects A, B, and C can be accepted for a total capital
budget of $40,000.

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 Appendix A Solutions to Self-Test Questions and Problems A-15

Chapter 11
ST-2 a. Net present value (NPV):
$6,500 $3,000 $3,000 $1,000
NPVX 5 2$10,000 1 1 1 1 5 $966.01
(1.12)1 (1.12)2 (1.12)3 (1.12)4

$3,500 $3,500 $3,500 $3,500

NPVY 5 2$10,000 1 1 1 1 5 $630.72
(1.12)1 (1.12)2 (1.12)3 (1.12)4

Alternatively, using a financial calculator, input the cash flows into

the cash flow register, enter IyYR 5 12, and then press the NPV key to
obtain NPVX 5 $966.01 and NPVY 5 $630.72.

Internal rate of return (IRR):

To solve for each project’s IRR, find the discount rates that equate each
NPV to zero:
IRRX 5 18.0%
IRRY 5 15.0%

Modified internal rate of return (MIRR):

To obtain each project’s MIRR, begin by finding each project’s terminal
value (TV) of cash inflows:

TVX 5 $6,500(1.12)3 1 $3,000(1.12)2 1 $3,000(1.12)1 1 $1,000 5 $17,255.23

TVY 5 $3,500(1.12)3 1 $3,500(1.12)2 1 $3,500(1.12)1 1 $3,500 5 $16,727.65

Now, each project’s MIRR is the discount rate that equates the PV of the
TV to each project’s cost, $10,000:
MIRRX 5 14.61%
MIRRY 5 13.73%

Payback:
To determine the payback, construct the cumulative cash flows for each
project:
Cumulative Cash Flows

Year Project X Project Y

0 ($10,000) ($10,000)
1 (3,500) (6,500)
2 (500) (3,000)
3 2,500 500
4 3,500 4,000

$500
PaybackX 5 2 1 5 2.17 years
$3,000

$3,000
PaybackY 5 2 1 5 2.86 years
$3,500

Discounted payback:
To determine the discounted payback, construct the cumulative dis-
counted cash flows at the firm’s WACC of 12% for each project:

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A-16 Appendix A Solutions to Self-Test Questions and Problems

Project X
Years 0 1 2 3 4

Cash Flow 210,000 6,500 3,000 3,000 1,000

Discounted Cash Flow 210,000 5,803.57 2,391.58 2,135.34 635.52
Cumulative Discounted Cash Flow 210,000 24,196.43 21,804.85 +330.49 +966.01
Discounted PaybackX = 2 + $1,804.85/$2,135.34 = 2.85 years
Project Y
Years 0 1 2 3 4

Cash Flow 210,000 3,500 3,500 3,500 3,500

Discounted Cash Flow 210,000 3,125.00 2,790.18 2,491.23 2,224.31
Cumulative Discounted Cash Flow 210,000 26,875.00 24,084.82 21,593.59 +630.72
Discounted PaybackY = 3 + $1,593.59/$2,224.31 = 3.72 years

b. The following table summarizes the project rankings by each method:

Project That Ranks

Higher
NPV X
IRR X
MIRR X
Payback X
Discounted payback X

Note that all methods rank Project X over Project Y. In addition, both
projects are acceptable under the NPV, IRR, and MIRR criteria. Thus,
both projects should be accepted if they are independent.
c. In this case, we would choose the project with the higher NPV at
r 5 12%, or Project X.
d. To determine the effects of changing the cost of capital, plot the NPV
profiles of each project. The crossover rate occurs between 6% and 7%
(<6.22%). See the graph on the next page.
If the firm’s cost of capital is less than 6.22%, a conflict exists
because NPVY . NPVX, but IRRX . IRRY. Therefore, if r were 5%, a con-
flict would exist. Note, however, that when r 5 5.0%, MIRRX 5 10.64%
and MIRRY 5 10.83%; hence, the modified IRR ranks the projects cor-
rectly, even if r is to the left of the crossover point because the size of
the projects is equal.
e. The basic cause of the conflict is differing reinvestment rate
assumptions between NPV and IRR. NPV assumes that cash flows
can be reinvested at the cost of capital, while IRR assumes rein-
vestment at the (generally) higher IRR. The high reinvestment rate
assumption under IRR makes early cash flows especially valuable,
and hence short-term projects look better than long-term projects
under IRR.

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 Appendix A Solutions to Self-Test Questions and Problems A-17

NPV Profiles for Projects X and Y

NPV
($)

NPVY
4,000

3,000

Crossover Rate 5 6.22%

NPVX
2,000

1,000

0
5 10 15 20 Cost of Capital
IRR Y (%)
IRRx

21,000

Cost of Capital NPVX NPVY

   0% $3,500 $4,000
4 2,545 2,705
8 1,707 1,592
12 966 631
16 307 (206)
18 5 (585)

Chapter 12
ST-2 a. Estimated investment requirements:
Price ($55,000)
Installation ( 10,000)
Change in net operating working capital (  2,000)
Total investment outlay ($67,000)

b. Depreciation schedule:
Equipment cost 5 $65,000; MACRS 3-year class
Years

1 2 3

MACRS depreciation rates 33% 45% 15%

Equipment depreciation expense $21,450 $29,250 $9,750

Note that the remaining book value of the equipment at the end of the
project’s life is 0.07 3 $65,000 5 $4,550.

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A-18 Appendix A Solutions to Self-Test Questions and Problems

c. Year 0 Year 1 Year 2 Year 3

Investment Outlays:
Equipment purchase ($65,000)
Change in NOWC (2,000)
Operating Cash Flows over
  Project’s Life:
Revenues (4,000 3 $50) $200,000 $200,000 $200,000
Variable costs (70%) 140,000 140,000 140,000
Fixed costs 30,000 30,000 30,000
Depreciation   21,450   29,250    9,750
EBIT $  8,550 $    750 $ 20,250
Taxes on operating income (40%)    3,420      300    8,100
AT project operating income $  5,130 $    450 $ 12,150
Add back: Depreciation   21,450 29,250    9,750
EBIT(1 2 T) 1 Depreciation $ 26,580 $ 29,700 $ 21,900
Terminal Cash Flows:
Salvage value 10,000
Tax on salvage value   (2,180)
AT salvage value $  7,820
Recovery of NOWC 2,000
Project free cash flows ($67,000) $ 26,580 $ 29,700 $ 31,720

0 1 2 3
11%

267,000 26,580 29,700 31,720

d. From the time line shown in part c, the project’s NPV can be calculated
as follows:
NPV 5 2$67,000 1 $26,580y(1.11)1 1 $29,700y(1.11)2 1 $31,720y)(1.11)3
5 $4,245

Alternatively, using a financial calculator, you would enter the following

data: CF0 5 267000; CF1 5 26580; CF2 5 29700; CF3 5 31720; IyYR 5 11;
and then solve for NPV 5 $4,245.
Because the NPV is positive, the project should be accepted.
e. Project analysis if unit sales turned out to be 20% below forecast:
Initial projection 5 4,000 units; however, if unit sales turn out to be
only 80% of forecast, then unit sales 5 3,200.

Year 0 Year 1 Year 2 Year 3

Investment Outlays:
Equipment purchase ($65,000)
Change in NOWC (2,000)
Operating Cash Flows over
Project’s Life:
Revenues (3,200 3 $50) $160,000 $160,000 $160,000
Variable costs (70%) 112,000 112,000 112,000
Fixed costs 30,000 30,000 30,000
Depreciation   21,450    29,250    9,750
EBIT ($ 3,450) ($ 11,250) $  8,250
Taxes on operating income (40%)   (1,380)    (4,500)    3,300
AT project operating income ($ 2,070) ($ 6,750) $  4,950
Add back: Depreciation   21,450    29,250    9,750
EBIT(1 2 T) 1 Depreciation $ 19,380 $ 22,500 $ 14,700
(Continued)

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 Appendix A Solutions to Self-Test Questions and Problems A-19

Year 0 Year 1 Year 2 Year 3

Terminal Cash Flows:
Salvage value 10,000
Tax on salvage value (2,180)
AT salvage value $ 7,820
Recovery of NOWC    2,000
Project free cash flows ($67,000) $19,380 $22,500 $24,520

NPV calculation:
0 1 2 3
11%

267,000 19,380 22,500 24,520

NPV 5 2$67,000 1 $19,380y(1.11)1 1 $22,500y(1.11)2 1 $24,520y(1.11)3

5 2$13,350

Alternatively, using a financial calculator, you would enter the fol-

lowing data: CF0 5 267000; CF1 5 19380; CF2 5 22500; CF3 5 24520;
IyYR 5 11; and then solve for NPV 5 2$13,350.
Because the NPV is negative, the project should not be accepted. If unit
sales were 20% below the forecasted level, the project would no longer
be accepted.
f. Best-case scenario: Unit sales 5 4,800; Variable cost % 5 65%

Year 0 Year 1 Year 2 Year 3

Investment Outlays:
Equipment purchase ($65,000)
Change in NOWC (2,000)
Operating Cash Flows over
Project’s Life:
Revenues (4,800 3 $50) $240,000 $240,000 $240,000
Variable costs (65%) 156,000 156,000 156,000
Fixed costs 30,000 30,000 30,000
Depreciation   21,450   29,250    9,750
EBIT $ 32,550 $ 24,750 $ 44,250
Taxes on operating income (40%)   13,020    9,900   17,700
AT project operating income $ 19,530 $ 14,850 $ 26,550
Add back: Depreciation   21,450   29,250    9,750
EBIT(1 2 T) 1 Depreciation $ 40,980 $ 44,100 $ 36,300
Terminal Cash Flows:
Salvage value 10,000
Tax on salvage value    (2,180)
AT salvage value $  7,820
Recovery of NOWC 2,000
Project free cash flows ($67,000) $ 40,980 $ 44,100 $ 46,120

Project NPV:
0 1 2 3
11%

267,000 40,980 44,100 46,120

NPV 5 2$67,000 1 $40,980y(1.11)1 1 $44,100y(1.11)2 1 $46,120y(1.11)3

5 $39,434

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A-20 Appendix A Solutions to Self-Test Questions and Problems

Alternatively, using a financial calculator, you would enter the fol-

lowing data: CF0 5 267000; CF1 5 40980; CF2 5 44100; CF3 5 46120;
IyYR 511; and then solve for NPV 5 $39,434.
Base-case scenario: The NPV was calculated in part d as $4,245.
Worst-case scenario: Unit sales 5 3,200; Variable cost % 5 75%

Year 0 Year 1 Year 2 Year 3

Investment Outlays:
Equipment purchase ($65,000)
Change in NOWC (2,000)
Operating Cash Flows over
Project’s Life:
Revenues (3,200 3 $50) $160,000 $160,000 $160,000
Variable costs (75%) 120,000 120,000 120,000
Fixed costs 30,000 30,000 30,000
Depreciation    21,450    29,250    9,750
EBIT ($ 11,450) ($ 19,250) $    250
Taxes on operating income (40%)    (4,580)    (7,700)     100
AT project operating income ($ 6,870) ($ 11,550) $    150
Add back: Depreciation    21,450    29,250    9,750
EBIT(1 2 T) 1 Depreciation $ 14,580 $ 17,700 $  9,900
Terminal Cash Flows:
Salvage value 10,000
Tax on salvage value   (2,180)
AT salvage value $  7,820
Recovery of NOWC                            2,000
Project free cash flows ($67,000) $ 14,580 $ 17,700 $ 19,720

Project NPV:

0 1 2 3
11%

267,000 14,580 17,700 19,720

NPV 5 2$67,000 1 $14,580y(1.11)1 1 $17,700y(1.11)2 1 $19,720y(1.11)3
5 2$25,080

Alternatively, using a financial calculator, you would enter the fol-

lowing data: CF0 5 267000; CF1 5 14580; CF2 5 17700; CF3 5 19720;
IyYR 5 11; and then solve for NPV 5 2$25,080.

Scenario Probability NPV

Best case 25% $39,434
Base case 50 4,245
Worst case 25 −25,080
Expected NPV 5 $ 5,711

NPV 5 f0.25($39,434 2 $5,711)2 1 0.50($4,245 2 $5,711)2 1 0.25(2$25,080 2 $5,711)2g1y2

NPV 5 f$284,310,182 1 $1,074,578 1 $237,021,420g1y2
NPV 5 $22,856
CVNPV 5 $22,856y$5,711 5 4.0

g. The project’s CV 5 4.0, which is significantly larger than the firm’s typi-
cal project CV. So, the WACC for this project should be adjusted upward,
11% 1 3% 5 14%.

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 Appendix A Solutions to Self-Test Questions and Problems A-21

To calculate the expected NPV, standard deviation, and coefficient of

variation you would recalculate each scenario’s NPV by discounting
the project cash flows by 14% rather than 11%.

Best-case scenario:

0 1 2 3
14%

267,000 40,980 44,100 46,120

NPV 5 2$67,000 1 $40,980y(1.14)1 1 $44,100y(1.14)2 1 $46,120y(1.14)3
5 $34,011

Alternatively, using a financial calculator, you would enter the fol-

lowing data: CF0 5 267000; CF1 5 40980; CF2 5 44100; CF3 5 46120;
IyYR 5 14; and then solve for NPV 5 $34,011.

Base-case scenario:
0 1 2 3
14%

267,000 26,580 29,700 31,720

NPV 5 2$67,000 1 $26,580y(1.14)1 1 $29,700y(1.14)2 1 $31,720y(1.14)3
5 $579

Alternatively, using a financial calculator, you would enter the fol-

lowing data: CF0 5 267000; CF1 5 26580; CF2 5 29700; CF3 5 31720;
IyYR 5 14; and then solve for NPV 5 $579.

Worst-case scenario:
0 1 2 3
14%

267,000 14,580 17,700 19,720

NPV 5 2$67,000 1 $14,580y(1.14)1 1 $17,700y(1.14)2 1 $19,720y(1.14)3
5 2$27,281

Alternatively, using a financial calculator, you would enter the fol-

lowing data: CF0 5 267000; CF1 5 14580; CF2 5 17700; CF3 5 19720;
IyYR 5 14; and then solve for NPV 5 2$27,281.

Scenario Probability NPV

Best case 25% $34,011
Base case 50 579
Worst case 25 −27,281
Expected NPV 5 $ 1,972

NPV 5 f0.25($34,011 2 $1,972)2 1 0.50($579 2 $1,972)2 1 0.25(2$27,281 2 $1,972)2g1y2

NPV 5 f$256,624,380 1 $970,255 1 $213,934,502g1y2
NPV 5 $21,715
CVNPV 5 $21,715y$1,972 5 11.01

The expected NPV of the project is still positive, so the project would
still be accepted, but it is a risky project.

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A-22 Appendix A Solutions to Self-Test Questions and Problems

ST-3 a. Machine W:
0 10% 1 2

2500,000 300,000 300,000

$300,000 $300,000
NPVW 5 2$500,000 1 1
(1.10)1 (1.10)2
5 $20,661.16

Machine WW:

0 10% 1 2 3 4

2500,000 165,000 165,000 165,000 165,000

$165,000 $165,000 $165,000 $165,000
NPVWW 5 2$500,000 1 1 1 1
(1.10)1 (1.10)2 (1.10)3 (1.10)4
5 $23,027.80

Because the projects are independent and both have positive NPVs,
both projects should be accepted.
b. Because the projects are mutually exclusive, only one project can be
accepted. Because the projects are not repeatable, the NPVs calculated
in part a can be used to answer this question. Machine WW has the
higher NPV and should be chosen.
c. (1) Machine W’s NPV needs to be recalculated under the assumption
that it is repeated in Year 2.

Replacement chain analysis:

Machine W:
0 10% 1 2 3 4

2500,000 300,000 300,000

2500,000 300,000 300,000
2200,000

$300,000 2$200,000 $300,000 $300,000

NPVW 5 2 $500,000 1 1 1 1
(1.10)1 (1.10)2 (1.10)3 (1.10)4
5 37,736.49

Machine WW:
NPVww 5 $23,027.80 (NPV remains the same because it is calculated over a
4-year life.)

Because the projects are mutually exclusive but repeatable, Machine

W should be chosen because its 4-year NPV is higher than Machine
WW’s.
  (2) Equivalent annual annuity analysis:
Machine W:
Using a financial calculator, enter N 5 2, I/YR 5 10, PV 5 −20661.16,
and FV 5 0, and then solve for EAAW 5 PMT 5 $11,904.76.

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 Appendix A Solutions to Self-Test Questions and Problems A-23

Machine WW:
Using a financial calculator, enter N 5 4, I/YR 5 10, PV 5 −23027.80,
and FV 5 0, and then solve for EAAW 5 PMT 5 $7,264.60.
The equivalent annual annuity analysis arrives at the same decision
as the replacement chain method. EAAW 5 $11,904.76 and EAAWW 5
$7,264.60; therefore, Machine W should be chosen if the projects
are mutually exclusive and can be repeated indefinitely because
EAAW . EAAWW.
d Yes. If the two projects can be repeated indefinitely over time but the
cash flows are expected to change, the replacement chain analysis can
be used. The analysis would be similar to what was done in part c(1)
except that the repeated cash flows would not be identical to the origi-
nal cash flows.

Chapter 13
ST-2 a. No abandonment considered; WACC 5 12%
Years: 0 1 2 3 NPV
25% −25,000 18,000 18,000 18,000 $18,233
50% −25,000 12,000 12,000 12,000   3,822
25% −25,000 −8,000 −8,000 −8,000 −44,215
Expected NPV 5 −$ 4,585

Because the expected NPV is negative, the project would not be

undertaken.
b. Abandonment considered; WACC 5 12%
Years: 0 1 2 3 NPV
25% −25,000 18,000 18,000 18,000 $18,233
50% −25,000 12,000 12,000 12,000   3,822
25% −25,000 −8,000
Abandon project 15,000 0 −20,185
Expected NPV 5 $ 1,423

If the project can be abandoned, the project’s expected NPV is now

positive, so the project would be undertaken.
c. Value of the abandonment option:
NPV with abandonment $1,423
NPV without abandonment      0
Value of abandonment option $1,423

If the project could not be abandoned, the project would not be under-
taken, so its NPV without the abandonment option is zero.

Chapter 14
ST-2 a. The following information is given in the problem:
Q 5 Units of output (sales) 5 5,000
P 5 Average sales price per unit of output 5 $100
F 5 Fixed operating costs 5 $200,000
V 5 Variable costs per unit 5 $50
EBIT 5 Operating income 5 $50,000
Total assets 5 $500,000
Common equity 5 $500,000

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A-24 Appendix A Solutions to Self-Test Questions and Problems

(1) Determine the new EBIT level if the change is made:

New EBIT 5 P2(Q2) 2 F2 2 V2(Q2)
New EBIT 5 $95(7,000) 2 $250,000 2 $40(7,000)
5 $135,000
(2) Determine the incremental EBIT:

DEBIT 5 $135,000 2 $50,000 5 $85,000

(3) Estimate the approximate rate of return on the new investment:

DEBIT $85,000
DROA 5 5 5 21.25%
Investment $400,000

Because the ROA exceeds Olinde’s average cost of capital, this

analysis suggests that the firm should go ahead and make the
investment.
b. The change would increase the break-even point. Still, with a lower
sales price, it might be easier to achieve the higher new break-even
volume.

F $200,000
Old: QBE 5 5 5 4,000 units
P 2 V $100 2 $50
F2 $250,000
New: QBE 5 5 5 4,545 units
P2 2 V2 $95 2 $40

c. The incremental ROA is

DProfit DSales
DROA 5 3
DSales DAssets

Using debt financing, the incremental profit associated with the invest-
ment is equal to the incremental profit found in part a minus the inter-
est expense incurred as a result of the investment:

DProfit 5 New profit 2 Old profit 2 Interest

5 $135,000 2 $50,000 2 0.10($400,000)

5 $45,000

The incremental sales is calculated as

DSales 5 P2Q2 2 P1Q1

5 $95(7,000) 2 $100(5,000)

5 $665,000 2 $500,000

5 $165,000
$45,000 $165,000
DROA 5 3 5 11.25%
$165,000 $400,000

The return on the new investment still exceeds the average cost of capi-
tal, so the firm should make the investment.
ST-3 a. Total capital 5 $5,000,000 and remains the same at all levels of debt;
Tax rate 5 35%; Original shares outstanding 5 200,000; EBIT 5 $500,000
at all levels of debt.

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 Appendix A Solutions to Self-Test Questions and Problems A-25

From the data given in the problem, we can develop the following
table:

Net Shares
wd wc rd EBIT Interesta Incomeb Outstandingc EPSd

0.00 1.00 5.00% $500,000 $      0 $325,000 200,000 $1.63

0.25 0.75 6.00 500,000 75,000 276,250 150,000 1.84
0.50 0.50 8.30 500,000 207,500 190,125 100,000 1.90
0.75 0.25 11.00 500,000 412,500 56,875 50,000 1.14
Notes:
Interest expense is calculated as wd 3 Total capital 3 rd.
a

Net income is calculated as (EBIT 2 Interest) (1 2 T)

b

Shares outstanding is calculated as Original shares outstanding 2

c

(wd 3 Original shares outstanding).

EPS is calculated as Net income divided by Shares outstanding.
d

b. EPS is maximized at a capital structure consisting of 50% debt and 50%

equity. At that capital structure, the firm’s EPS is $1.90.
c. Tax rate 5 35%; rRF 5 3.5%; bU 5 1.25; rM 2 rRF 5 4.5%.
From data given in the problem, we can develop the following table:

wd wc D/E rd rd(1 2 T) bLa rsb WACCc

0.00 1.00 0.0000 5.00% 3.25% 1.25 9.13% 9.13%

0.25 0.75 0.3333 6.00 3.90 1.52 10.34 8.73
0.50 0.50 1.0000 8.30 5.40 2.06 12.78 9.09
0.75 0.25 3.0000 11.00 7.15 3.69 20.09 10.39
Notes:
These beta estimates were calculated using the Hamada equation,
a

bL 5 bU[1 1 (1 2 T) (DyE)].
These rs estimates were calculated using the CAPM, rs 5 rRF 1 (rM 2 rRF)b.
b

These WACC estimates were calculated with the following equation:

c

WACC 5 wd(rd)(12T) 1 (wc)(rs).

d. 
Carlisle’s WACC is minimized at a capital structure consisting of
25% debt and 75% equity. At that capital structure, the firm’s WACC
is 8.73%.
e. The capital structure at which the firm’s WACC is minimized is the
optimal capital structure, that is, the capital structure at which the
firm’s value is maximized. For Carlisle, this capital structure con-
sists of 25% debt and 75% equity. This is not the same capital struc-
ture at which EPS is maximized, because the additional risk taken
on is not measured in the EPS calculation, but it is measured in the
WACC calculation. (That is, the costs of debt and equity increase at
additional debt levels, and those component costs are used in the
WACC calculation.)
f. As an analyst (on the basis of these data), the recommendation to
the firm would be to issue $1,250,000 of debt (calculated as 0.25 3
$5,000,000) with a 6% coupon rate (this is rd at this debt level) and use
these funds to repurchase 50,000 shares of common stock.

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A-26 Appendix A Solutions to Self-Test Questions and Problems

Chapter 15
ST-2 a. Projected net income $2,000,000
Less projected capital investments    800,000
Available residual $1,200,000

Shares outstanding 200,000

DPS 5 $1,200,000y200,000 shares 5 $6 5 D1

b. EPS 5 $2,000,000y200,000 shares 5 $10

   Payout ratio 5 DPSyEPS 5 $6y$10 5 60%, or

   Total dividendsyNI 5 $1,200,000y$2,000,000 5 60%
D1 $6 $6
c. Currently, P0 5 5 5 5 $75.00
rs 2 g 0.14 2 0.06 0.08
Under the former circumstances, D1 would be based on a 20% payout
on an EPS of $10, or 0.2 3 $10 5 $2. With rs 5 14% and g 5 12%, we
solve for P0:
D1 $2 $2
P0 5 5 5 5 $100
rs 2 g 0.14 2 0.12 0.02

Although CMC has suffered a severe setback, its existing assets will
continue to provide a good income stream. More of these earnings
should now be passed on to the shareholders, as the slowed internal
growth has reduced the need for funds. However, the net result is a
25% decrease in the value of the shares.
d. If the payout ratio were continued at 20%, even after internal invest-
ment opportunities had declined, the price of the stock would drop to
$2y(0.14 2 0.06) 5 $25 rather than to $75.00. Thus, an increase in the
dividend payout is consistent with maximizing shareholder wealth.
Because of the diminishing nature of profitable investment oppor-
tunities, the greater the firm’s level of investment, the lower the aver-
age ROE. Thus, the more money CMC retains and invests, the lower
its average ROE will be. We can determine the average ROE under
different conditions as follows:
Old situation (with founder active and a 20% payout):
g 5 (1.0 2 Payout ratio)(Average ROE)
12% 5 (1.0 2 0.2)(Average ROE)
Average ROE 5 12%y0.8 5 15% . rs 5 14%

Note that the average ROE is 15%, whereas the marginal ROE is pre-
sumably equal to 14%.

New situation (with founder retired and a 60% payout as explained in part c):
g 5 6% 5 (1.0 2 0.6)(ROE)
ROE 5 6%y0.4 5 15% . rs 5 14%

This suggests that a new payout of 60% is appropriate and that the
firm is taking on investments down to the point at which marginal
returns are equal to the cost of capital. Note that if the 20% payout was
maintained, the average ROE would be only 7.5%, which would imply
a marginal ROE far below the 14% cost of capital.

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 Appendix A Solutions to Self-Test Questions and Problems A-27

Chapter 16
ST-2    The Calgary Company: Alternative Balance Sheets

Restricted Moderate Relaxed

(40%) (50%) (60%)

Current assets $1,200,000 $1,500,000 $1,800,000

Fixed assets    600,000    600,000    600,000
Total assets $1,800,000 $2,100,000 $2,400,000

Debt $ 900,000 $1,050,000 $1,200,000

Equity    900,000 1,050,000 1,200,000
Total liabilities and equity $1,800,000 $2,100,000 $2,400,000

   The Calgary Company: Alternative Income Statements

Restricted Moderate Relaxed

Sales $3,000,000 $3,000,000 $3,000,000

EBIT 450,000 450,000 450,000

Interest (10%)    90,000 105,000 120,000
Earnings before taxes $ 360,000 $ 345,000 $ 330,000
Taxes (40%) 144,000 138,000 132,000
Net income $ 216,000 $ 207,000 $ 198,000
ROE 24.0% 19.7% 16.5%

ST-3 a and b.
Income Statements for Year Ended December 31, 2018 (thousands of
dollars)

Vanderheiden Press Herrenhouse Publishing

a b a b

EBIT $ 30,000 $ 30,000 $ 30,000 $ 30,000

Interest   12,400   14,400   10,600   18,600
Taxable income $ 17,600 $ 15,600 $ 19,400 $ 11,400
Taxes (40%)    7,040    6,240    7,760    4,560
Net income $ 10,560 $  9,360 $ 11,640 $  6,840

Equity $100,000 $100,000 $100,000 $100,000

Return on equity 10.56%    9.36% 11.64%    6.84%

The Vanderheiden Press has a higher ROE than Herrenhouse

Publishing when short-term interest rates are high, whereas
Herrenhouse Publishing does better than Vanderheiden Press when
rates are lower.
c. Herrenhouse’s position is riskier. First, its profits and return on equity
are much more volatile than Vanderheiden’s. Second, Herrenhouse
must renew its large short-term loan every year, and if the renewal
comes up at a time when money is very tight, when its business is
depressed, or both, then Herrenhouse could be denied credit, which
could put it out of business.

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A-28 Appendix A Solutions to Self-Test Questions and Problems

Chapter 17
ST-2 To solve this problem, we define DS as the change in sales and g as the
growth rate in sales, and then we use the three following equations:
DS 5 S0g
S1 5 S0(1 1 g)
AFN 5 (A*0yS0)(DS) 2 (L*0yS0)(DS) 2 MS1(1 2 Payout)
Set AFN 5 0, substitute in known values for A*yS
0 0
, L*yS
0 0
, M, pay-
out, and S0, and then solve for g:
0 5 1.6($100g) 2 0.4($100g) 2 0.10f$100(1 1 g)g(1 2 0.45)
0 5 $160g 2 $40g 2 0.055($100 1 $100g)
0 5 $160g 2 $40g 2 $5.5 2 $5.5g
$114.5g 5 $5.5
g 5 $5.5y$114.5 5 0.048 5 4.8%
g 5 Maximum growth rate without external financing
ST-3 Assets consist of cash, marketable securities, receivables, inventories, and
fixed assets. Therefore, we can break the A*0yS0 ratio into its components—
cashysales, inventoriesysales, and so forth. Then
A*0 A*0 2 Inventories Inventories
5 1 5 1.6
S0 S0 S0

We know that the inventory turnover ratio is Sales/Inventories 5 3 times,

so InventoriesySales 5 1y3 5 0.3333. Further, if the inventory turnover
ratio can be increased to 4 times, then the Inventory/Sales ratio will fall to
1y4 5 0.25, a difference of 0.3333 2 0.2500 5 0.0833. This, in turn, causes
the A*0yS0 ratio to fall from A*0yS0 5 1.6 to A*0yS0 5 1.6 2 0.0833 5 1.5167.
This change has two effects: First, it changes the AFN equation, and
second, it means that Weatherford currently has excessive inventories.
Because it is costly to hold excess inventories, Weatherford will want to
reduce its inventory holdings by not replacing inventories until the excess
amounts have been used. We can account for this by setting up the revised
AFN equation (using the new A*0yS0 ratio), estimating the funds that will
be needed next year if no excess inventories are currently on hand, and
then subtracting out the excess inventories that are currently on hand:
Present conditions:
Sales $100
5 53
Inventories Inventories
so
Inventories 5 $100/3 5 $33.3 million at present

New conditions:
Sales $100
5 54
Inventories Inventories
so
New level of inventories 5 $100/4 5 $25 million

Therefore,
Excess inventories 5 $33.3 2 $25 5 $8.3 million

Forecast of funds needed:

DS 5 0.2($100 million) 5 $20 million
AFN 5 1.5167($20) 2 0.4($20) 2 0.1(1 2 0.45)($120) 2 $8.3
5 $30.3 2 $8 2 $6.6 2 $8.3
5 $7.4 million

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 Appendix A Solutions to Self-Test Questions and Problems A-29

Chapter 18
ST-2
Current stock price $32.00
Current stock price $32.00
Range of values $30.00 $55.00
Range of values $30.00 $55.00
Exercise price $35.00
Exercise price $35.00
rRF rRF
4.50% 4.50%
Time until expiration Time until expiration
1 year 1 year

Binomial Approach:
Ending Stock Ending Option Ending Portfolio
Value Payoff Payoff
$55.00 $20.00 $35.00

Current
Option
Current Stock Price Price
$32.00 ?

Ending Stock Ending Option Ending Portfolio

Value Payoff Payoff
$30.00 $0.00 $30.00

Range of outcomes: $25.00 $20.00 $5.00

Equalize ranges $20/$25 5 0.8000 Buy 0.8000 shares and sell 1 option

Hedge Portfolio:
Ending Stock Ending Option Ending Portfolio
Value Payoff Payoff
$55  0.8 5 $44.00 $20.00 $24.00

Current
Option
Current Stock Price Price
$32.00  0.8 5 $25.60 ?

Ending Stock Ending Option Ending Portfolio

Value Payoff Payoff
$30  0.8 5 $24.00 $0.00 $24.00

Range of outcomes: $20.00 $20.00 $0.00

PV of portfolio 5 $24/1.045 5 $22.97

Current option price 5 Stock price 2 PV of portfolio

5 $25.60 2 $22.97 5 $2.63
Thus, the value of this option is $2.63.

ST-3 V 5 P[N(d1)] 2 Xe2r t[N(d2)] RF

5 [$33(0.63369)] 2 [$33(0.95123)(0.55155)]
5 $20.91 2 $17.31
5 $3.60

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A-30 Appendix A Solutions to Self-Test Questions and Problems

Chapter 19

ST-2 Euros Euros US$

5 3
C$ US$ C$
€0.80 $1 €0.80
5 3 5 5 €0.6400 per Canadian dollar
$1 C$1.25 C$1.25

Chapter 20
ST-2 a. Cost of leasing

BEGINNING OF YEAR

0 1 2 3

Lease payment (AT)a ($ 6,000) ($6,000) ($6,000) ($6,000)

Total PV cost of leasing 5 ($22,038)
a
After-tax payment 5 $10,000(1 − T) 5 $10,000(0.6) 5 $6,000

Using a financial calculator, input the following data after switching your
calculator to “BEG” mode: N 5 4, I/YR 5 6, PMT 5 6000, and FV 5 0.
Then press the PV key to arrive at the answer of ($22,038). Switch your
calculator back to “END” mode. Note that the interest rate used is the
after-tax cost of debt, 10%(1 − T) 5 6%.
b. Cost of owning:
Depreciable basis 5 $40,000

Here are the cash flows under the borrow-and-buy alternative:

END OF YEAR

0 1 2 3 4

1. Depreciation schedule
(a) Depreciable basis $40,000 $40,000 $40,000 $40,000
(b) Allowance 0.33 0.45 0.15 0.07
(c) Depreciation 13,200 18,000 6,000 2,800
2. Cash flows
(d) Net purchase price ($40,000)
(e) Depreciation tax savings 5,280b 7,200 2,400 1,120
(f ) Maintenance (AT) (600) (600) (600) (600)
(g) Salvage value (AT) 6,000
(h) Total cash flows ($40,000) $ 4,680 $ 6,600 $ 1,800 $ 6,520
Total PV cost of owning 5 ($23,035)
b
Depreciation(T) 5 $13,200(0.40) 5 $5,280

Input the cash flows for the individual years into the cash flow register,
and enter I/YR 5 6. Then press the NPV key to arrive at the answer of
($23,035). Because the present value of the cost of leasing is less than
that of owning, the truck should be leased: $23,035 − $22,038 5 $997, net
advantage to leasing.

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 Appendix A Solutions to Self-Test Questions and Problems A-31

c. The discount rate is based on the cost of debt because most cash flows
are fixed by contract and consequently are relatively certain. Thus, the
lease cash flows have about the same risk as the firm’s debt. Also, leas-
ing is considered to be a substitute for debt. We use an after-tax cost
rate because the cash flows are stated net of taxes.
d. The firm could increase the discount rate on the salvage value cash
flow. This would increase the PV cost of owning and make leasing
even more advantageous.

Chapter 21
ST-2 Time line numbers are in millions of dollars:

0 12% 1 2 3 4

PV 5 ? 1.5 2.0 3.0 5.0

CV 5 75.0*
80.0

rs 5 6% 1 4%(1.5)
5 12%
$5(1.05)
*Continuing value 5 5 $75.00
0.12 2 0.05
To solve this problem, use your financial calculator to enter CF0 5 0,
CF1 5 1.5, CF2 5 2.0, CF3 5 3.0, CF4 5 80, and I/YR 5 12. Then solve for
NPV 5 55.91 million.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
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 Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.