ACF 103 2015 Revision Qns and Solns
Chapter 2
1.Text book Ch 2 questions #1-3, p.36
1. The principal advantage of the corporate form of business organization is that the
corporation has limited liability. The owner of a small family restaurant might be required
to personally guarantee corporate borrowings or purchases anyway, so much of this
advantage might be eliminated. The wealthy individual has more at stake and unlimited
liability might cause, one failing business to bring down the other healthy businesses.
2. The liability is limited to the amount of the investment in both the limited partnership and in
the corporation. However, the limited partner generally does not have a role in selecting the
management or in influencing the direction of the enterprise. On a pro rata basis,
stockholders are able to select management and affect the direction of the enterprise. Also,
partnership income is taxable to the limited partners as personal income whereas corporate
income is not taxed unless distributed to the stockholders as dividends.
3. With both a sole proprietorship and partnership, a major drawback is the legal liability of
the owners. It extends beyond the financial resources of the business to the owners
personally. Fringe benefits are not deductible as an expense. Also, both forms of
organization lack the corporate feature of “unlimited life”. With the partnership there are
problems of control and management. The ownership is not liquid when it comes to
planning for individual estates. Decision making can be cumbersome. An LLC generally
lacks the feature of “unlimited life”, and complete transfer of an ownership interest is
usually subject to the approval of at least a majority of the other LLC members.
2.Text book Ch 2 Self-test question #1, p.37
See solution p.38
3.Text book Ch 2 problem #1, p.37
a. Under the partnership, $418,000 in actual liabilities. If sued, they could lose up to their
full combined net worths. As a corporation, their exposure is limited to the $280,000 in
equity that they have in the business.
b. Creditors should be less willing to extend credit, because the personal net worths of the
owners no longer back the claims.
Chapter 3
1.What is the total present value of the following series of cash flows, discounted at 10%?
End of yearCash flow
1$1,000
21,000
3-2,000
43,000
Answer:
PV = $1,000(PVIFA10%,2) + (-$2,000)(PVIF10%,3)+$3,000(PVIF1%,4)
= $1,000(1.736) - $2,000(0.751) + $3,000(0.683)
= $1,736 - $1,502 + $2,049 = $2,283
3.At your brother's 20th birthday party, he asks you how much he would have to deposit at the end of every quarter to finance a $8,500 motorcycle on his 25th birthday. He plans to put the money in a 12% savings account that compounds interest quarterly.
Answer:
The future value interest factor of an ordinary annuity of $1 per month for 20 quarters (five years) at 3% per quarter (12% per year) is 26.870.
Then $8,500/26.870 = $316.34 must be deposited at the end of each quarter.
4.Text book Ch 3 question # 9 (p.66)
Answer:
Year Amount PV Factor at 14% Present Value
1 $1,200 0.877 $1,052.40
2 2,000 0.769 1,538.00
3 2,400 0.675 1,620.00
4 1,900 0.592 1,124.80
5 1,600 0.519 830.40
Subtotal (a) ...... $6,165.60
1–10 (annuity)*1,400 5.216 $7,302.40
1–5 (annuity)*1,400 3.433 –4,806.20
Subtotal (b) ...... $2,496.20
Total Present Value (a + b) ...... $8,661.80
Alternatively, to get sub-total (b):
5-10 (annuity)1,400(5.216 – 3.433)2,496.20
6.Text book Ch 3 question # 13 (p.67)
Answer:
$190,000 = PMT (PVIFA17%, 20) = PMT(5.628)
PMT = $190,000/5.628 = $33,760
7.It is January 1 and you have made a New Year's resolution to invest $5,000 in a savings account at the end of every year for the next 30 years. If your money is compounded at an average annual rate of 9%, how much will you have accumulated at the end of 30 years?
Answer:
FVA30= PMT(FVIFA9%,30),
FVA30= $5,000(136.308) = $681,540
8.Congratulations! You have just won first prize in a raffle and must choose between $50,000 in cash today or an annuity of $12,000 a year for five years. (The annuity payments would come to you at the end of each year.) Which of these two choices is worth more, assuming a 7% discount rate? Show your calculations.
Answer:
PVA5= PMT(PVIFA7%,5),
($12,000)(4.100) = $49,200
The annuity is worth less than the $50,000 in cash today.
Chapter 4
1.Delphi Products Corporation currently pays a dividend of $2.50 per share, and this dividend
is expected to grow at a 12% annual rate for three years, and then at an 8% p.a. rate forever.
What value would you place on the stock if an 18% rate of return was required?
Phases 1 and 2: Present Value of Dividends to Be Received Over First 6 Years
End ofPresent Value CalculationPresent Value
Year (Dividend × PVIF18%,t) of Dividend
1 $2.50 (1.12)1 = $2.80 × 0.847 = $ 2.37
2 2.50 (1.12)2 = 3.14 × 0.718 = 2.25
3 2.50 (1.12)3 = 3.51 × 0.609 = 2.14
6.76
Phase 3: Present Value of Constant Growth Component
Dividend at the end of year 4 = $3.51(1.08)= $3.79
Value of stock at the end of year 3 = D4/(ke + g)= $ 3.79/(0.18 – 0.08) = $37.90
Present value of $37.90 at end of year 3= ($37.90) (PVIF18%,3)
= ($37.90)(0.609) = $23.08
Present Value of Stock
V = $6.76 + $23.08 = $29.84
2.The 9-percent-coupon-rate bonds of the Melbourne Mining Company have exactly
15 years remaining to maturity. The current market value of one of these $1,000-parvalue
bonds is $700. Interest is paid semiannually. Melanie Gibson places a nominal
annual required rate of return of l4 percent on these bonds. What dollar intrinsic value
should Melanie place on one of these bonds (assuming semiannual discounting)?
V = (I/2)(PVIFA7%, 30) + $1,000(PVIF7%, 30)
= $45(12.409) + $1,000(0.131)
= $558.41 + $131 = $689.41
Chapter 5
1.Salt Lake City Services, Inc., provides maintenance services for commercial buildings.
Currently, the beta on its common stock is 1.08. The risk-free rate is now l0%, and
the expected return on the market portfolio is 15%. It is January l, and the company
is expected to pay a $2 per share dividend at the end of the year, and the dividend is
expected to grow at a compound annual rate of l1% for many years to come. Based
on the CAPM and other assumptions you might make, what dollar value would you place
on one share of this common stock?
Required return = Rf + (Rm - Rf)β
= 0.10 + (0.15 – 0.10)(1.08)
= 0.10 + .054 = 0.154 or 15.4%
Assuming that the dividend growth model is appropriate, we get
V = D1/(ke – g) = $2/(0.154 –0.11) = $2/0.044 = $45.45
2. Sorbond Industries has a beta of 1.45. The risk-free rate is 8% and the expected
return on the market portfolio is 13%. The company currently pays a dividend of
$2 a share, and investors expect it to experience a growth in dividends of l0% per annum for many years to come'
a. What is the stock's required rate of return according to the CAPM?
b. What is the stock's present market price per share, assuming this required return?
a.Required return = Rf + (Rm – Rf)β
=0.08 + (0.13 – 0.08)1.45
=15.25%
b. Using the dividend growth model, we would have
P0 = D1/(ke – g)
=2(1.10)/(0.1525 – 0.10)
=$41.90
Chapters 8-11, Gitman Chs 14-5
1.Hobbit Enterprises expects credit sales of $400 million next year. If the firm can invest funds at the rate of 10% a year, what is the value of collecting accounts payable three days earlier (use a 365-day year)?
Answer: Sales per day = $400,000,000/365 = $1,095,890
Benefit = ($1,095,890)(0.10)(3) = $328,767
2.Chou Dou Fu receives an average of $600,000 a day in payments from its franchisees through the mail. The average time it takes to have funds available at its bank is eight days from the postmark date. The firm has asked you to evaluate the following three alternatives. Which offers the greatest financial benefit to Chou Dou Fu? (Assume that the firm can earn 10% annually on its marketable securities investments.)
a. Bank Shanghai offers concentration banking that will reduce the time to have funds available from eight to five days. Bank Shanghai charges a fee of $105,000 annually to set up and administer the system.
b. KaifengBank offers a system that will reduce the time to available funds to four days. Kaifeng Bank requires a $1,500,000 compensating balance in order to administer the system.
c. Bank of Henan offers to set up an Electronic Funds Transfer system that will reduce the time to available funds to two days. Bank of Henan charges an annual fee of $300,000 for this service.
Answer:
a. Bank Shanghai
Cash Available = Time Saved x Collections per Day
= 3 days x $600,000 = $1,800,000
Financial Benefit = Reduction in Cash x Opportunity Cost
= $1,800,000 x 0.10 = $180,000 benefit
Gain on change = $180,000 - 105,000 = $75,000 net gain
b. KaifengBank
Additional Cash = Time Saved x Collections per Day
= 4 days x $600,000 = $2,400,000
Cash Available = $2,400,000 - $1,500,000 Compensating Balance
= $900,000
Financial Benefit= Reduction in Cash x Opportunity Cost
= $900,000 x 0.10 = $90,000 benefit
Gain on change = $90,000 net gain
c. Bank of Henan
Cash Available = Time Saved x Collections per Day
= 6 days x $600,000 = $3,600,000
Financial Benefit = Reduction in Cash x Opportunity Cost
= $3,600,000 x 0.10 = $360,000 benefit
Loss on change = $360,000 - 300,000 = $60,000 gain
Choose b, the system offered by KaifengBank.
3.Indo Processing Corp uses 20,000 gallons of solvent a year. The cost of carrying the solvents is $1.62 a gallon per year, while the cost per order is $200. What would the average inventory level if Indio wished to maintain a 400 gallon safety stock?
EOQ= √2(O)(S)/C = √2(200)(20,000)/1.62=2,222
Ave inventory = 2,222/2 + 400 = 1,511
4.Alexis Limited uses 1,200 units of a product per year on a continuous basis. The product has a fixed cost of $70 per order and its carrying cost is $3 per unit per year. It takes five days to receive a shipment after an order is placed, and the firm wishes to hold in inventory 10 days’ usage as a safety stock.
a.Calculate the EOQ.
b.Determine the average level of inventory.
c.Determine the reorder point.
Answer:
EOQ, reorder point and safety stock
a.EOQ= √(2SO)/C
=√(2 x 1,200 x 70)/3
=236.6
=237 units
b.Daily usage= Yearly usage / Days in operation = 1,200 / 365 = 3.29
Average level of inventory=Minimum inventory +
=3.29 × 10 + 237/2 = 151.4 units
c.Reorder point= (Lead time + Safety stock) in days × Daily usage
= (5 + 10) × 3.29 = 49.35 units = 50 units
5.Chapter 10 homework problem - See Tutorial 6
Homework problem
1.The ABC Company wishes to establish an EOQ for a particular item. The annual usage is 12,000 units, order costs are $20, and the annual carrying cost is $0.48 per unit. The EOQ equals ______.
A.10 units
B.100 units
* C.1,000 units
D.10,000 units
EOQ= √2(O)(S)/C = √(2 x 20 x 12,000)/0.48 = 1,000
6.Gitman Chapter 15, #15--38 homework problem - See Tutorial 6
Homework problem
12.15–38 (Inventory financing) Raymond Manufacturing faces a liquidity crisis—it needs a loan of $100,000 for 30 days. Having no source of additional unsecured borrowing, the firm must find a secured short-term lender. The firm’s accounts receivable are quite low, but its inventory is considered liquid and reasonably good collateral. The book value of the inventory is $300,000, of which $120,000 is finished goods.
(1) City-Wide Bank will make a $100 000 loan against the finished goods inventory. The annual interest rate on the loan is 12% on the outstanding loan balance plus a 0.25% administration fee levied against the $100,000 initial loan amount. Because it will be liquidated as inventory is sold, the average amount owed over the month is expected to be $75,000.
(2) Sun State Bank is willing to lend $100,000 on the book value of inventory for the 30-day period at an annual interest rate of 13%.
(3) Citizens’ Bank will loan $100,000 against the finished goods inventory and charge 15% annual interest on the outstanding loan balance. A 0.5% warehousing fee will be levied against the average amount borrowed. Because the loan will be liquidated as inventory is sold, the average loan balance is expected to be $60,000.
a.Calculate the dollar cost of each of the proposed plans for obtaining an initial loan amount of $100,000.
b.Which plan do you recommend? Why?
c.If the firm had made a purchase of $100,000 for which it had been given terms of 2/10 net 30, would it increase the firm’s profitability to forgo the discount and not borrow as recommended in part b? Why or why not?
Answer:
Inventory financing
a.City-Wide Bank:
Sun State Bank:
Citizens’ Bank:
b.City-Wide Bank is the best alternative, since it has the lowest cost.
c.
Effective interest rate on loan
Since the cost of giving up the discount (37.24%) is higher than borrowing at City-Wide Bank (16%), the firm should borrow to take the discount.
Chapter 13
1.Your firm is considering two mutually exclusive projects, P and Q, that would each require an initial cash outflow of $10,000. They would generate the following incremental, after-tax, operating cash flows:
Project PProject Q
Year 1$5,000$3,000
Year 24,0004,000
Year 33,0006,000
If the firm's required rate of return is 12%, which would you select?
Project P CFPVIF12%,3PVProject Q CFPVIF12%,3PV
Year )-$10,0001.0000-$10,000-$10,0001.0000-$10,000
Year 1$5,0000.8934,465$3,0000.8932,679
Year 24,0000.7973,1884,0000.7973,188
Year 33,000 0.7122,1366,000 0.7124,272
Net Present Value-211139
Select Project Q
2.A firm is considering two mutually exclusive investment alternatives, both of which cost $5,000. The firm's hurdle rate is 12%. The after-tax cash flows associated with each investment are:
YearInvestment AInvestment B
1$2,000$1,000
21,5001,500
31,5002,000
41,0003,000
For each alternative, calculate the payback period, the net present value, and the profitability index. Which alternative (if any) should be selected?
Answer:
Alternative A:
Payback: $2,000 + $1,500 + $1,500 = $5,000 (3 years)
NPV at 12% = ($2,000)(0.893) + ($1,500)(0.797) + ($1,500)(0.712) + ($1,000)(0.636) - $5,000 =-$314.50
PI=(1,786 + 1,196 + 1,068 + 636)/5,000=0.94
Alternative B:
Payback: $1,000 + $1,500 + $2,000 + $500 = $5,000
(3 + 500/3000 = 3.167 years)
NPV at 12 percent = ($1,000)(0.893) + ($1,500)(0.797)
+ ($2,000)(0.712) + ($3,000)(0.636) - $5,000 = $420.50
PI=(893 + 1,196 + 1,424 + 1,908)/5,000=1.08
Option B is the BEST alternative as it INCREASES shareholder wealth.
3.The Capital City Company (CCC) is considering the purchase of a new laundromat to replace the one currently being used. The present machine is expected to last another seven years and have no salvage value. The laundromat in current use has a book value of $700 and can be sold today for $400. CCC pays $300 a year maintenance on the press. The new laundromat will cost $1,500. It is expected to last seven years, at which time it will be sold for $100. The maintenance cost of the new machine is expected to be $150 a year. CCC depreciates its assets on the straight-line basis and pays 30% taxes. If its opportunity cost of funds is 10%, should it buy the new machine?
Answer:
Initial cost$1,500
less sale of old machine -400
loss on sale 700 – 400 = 300
tax recovered 300 x 0.30 = - 90
$1,010
Annual savings after tax= ($300 - $150)(0.70)
= $105
Change in depreciation= ($1,500 - $100)/7 - $700/7 = $100 per yr
Tax saving on depr. change= ($100)(0.30)
= $30
NPV at 10% = ($105 + $30)(4.868) + ($100)(0.513) - $1,010=-$355.66
Since the NPV is negative, we would REJECT this project at this time.
4.A firm is considering the following projects, all of which are independent of one another. Available funds are limited to $2 million in this capital budgeting period, but future periods will have no capital budget constraints.
Present Value of
ProjectInitial OutlayCash Inflows
1$1,300,000$1,200,000
21,000,0001,250,000
3800,000900,000
4600,000700,000
5500,000550,000
6400,000470,000
7300,000280,000
8100,000105,000
Which projects should be accepted without exceeding the budget?
Answer:
ProjectProfitability IndexCumulative Investment
21,250,000/1,000,000= 1.25 $1,000,000
6470,000/400,000= 1.18 1,400,000
4700,000/600,000= 1.17 2,000,000
3900,000/800,000 = 1.132,800,000
5550,000/500,000 = 1.103,300,000
8105,000/100,000 = 1.053,400,000
7280,000/300,000 = 0.93Reject
11,200,000/1,300,000 = 0.92Reject
Projects 2, 6, and 4 should be accepted; they exhaust the budget.
5. Text book Ch 13 #9 p.348. See also Ch 12 #3 p.320
Period 8%PVIF RockbuiltPVBulldogPVSavingsPV
0 1.000$(74,000)(74,000)$ (59,000)(59,000)$(15,000)(15,000)
1 .926 (2,000)(1,852)(3,000)(2,778)1,000926
2 .857(2,000)(1,714)(4,500)(3,857)2,5002,142
3 .794(2,000)(1,588)(6,000)(4,764)4,0003,176
4 .735(2,000)(1,470)(22,500)(16,538)20,50015,068
5 .681(13,000)(8,853)(9,000)(6,129)(4,000)(2,724)
6 .630 (4,000)(2,520)(10,500)(6,615)6,5004,095
7 .583(4,000)(2,332)(12,000)(6,996)8,0004,664
8 .5405,000*2,700(8,500)**(4,590)13,5007,290
PV of cash flows at 8% $(91,629) $(111,267) $ 19,637
* $4,000 maintenance cost plus salvage value of $9,000.
** $13,500 maintenance cost plus salvage value of $5,000.
The Rockbuilt bid should be accepted as the lower maintenance and rebuilding expenses
more than offset its higher cost.
b.
Amount of cash outflow:
Period15%PVIF Rockbuilt PV BulldogPVSavingsPV
0 1.000$(74,000)(74,000) $ (59,000)(59,000)$(15,000)(15,000)
1.870 (2,000) (1,740)(3,000)(2,610)1,000870
2 .756 (2,000) (1,512)(4,500) (3,402)2,5001,890
3 .658 (2,000) (1,316)(6,000) (3,948)4,0002,632
4 .572 (2,000) (1,144)(22,500) (12,870)20,50011,726
5 .497 (13,000)(6,461) (9,000) (4,473)(4,000)(1,988)
6 .432 (4,000) (1,728)(10,500) (4,536)6,5002,808
7 .376 (4,000) (1,504)(12,000) (4,512)8,0003,008
8 .327 5,000* 1,635(8,500)** (2,780)13,5004,415
Present value of
cash flows at 15% $(87,770) $(98,131)$ 10,361
* $4,000 maintenance cost plus salvage value of $9,000.
** $13,500 maintenance cost plus salvage value of $5,000.
No. With a higher discount rate, more distant cash outflows become less important relative
to the initial outlay. But, the lower maintenance and rebuilding expenses related to the
Rockbuilt bid continue to be more than its higher cost.
Chapter 15
1.Text book Ch 15 #5 p.412
(1) (2) (1) × (2)
After-tax Cost Proportion of Total Financing WACC
Debentures7.8%37.5% 2.93%
Preferred Stock 12.0 12.5 1.50
Common Stock 17.0 50.0 8.50
100.0%12.93% = ko
2.Using the capital-asset pricing model, determine the required return on equity for the
following situations:
SituationExpected returnRisk free rateBeta
1 15% 10% 1.00
2 18 14 0.70
3 15 8 1.20
4 17 11 0.80
5 16 10 1.90
What generalisations can you make?
Equation: Rf + ( Rm – Rf )ß
Situation Return Required
1 10% + (15% – 10%) 1.00 15.0%
2 14% + (18% – 14%) 0.70 16.8
3 8% + (15% – 8%) 1.20 16.4
4 11% + (17% – 11%) 0.80 15.8
5 10% + (16% – 10%) 1.90 21.4
The greater the risk-free rate, the greater the expected return on the market portfolio, and the
greater the beta, the greater will be the required return on equity, all other things being the
same. In addition, the greater the market risk premium (Rm – Rf ) , the greater the required
return, all other things being the same.
3.K-Far Stores has launched an expansion program that should result in the saturation of
the Bay Area marketing region of California in six years. As a result, the company is
predicting a growth in earnings of 12% for three years and 6% thereafter forever. The company expects to increase its annual dividend per share, most recently $2, in keeping with this growth pattern. What is the expected market price of the stock if the required rate of return is 15%?
If the current market price of the stock is $25, is the stock under-priced, or over-priced?
PeriodDividend15% PVIFPV
02.00
12(1.12)2.240.8701.95
22.24(1.12)2.510.7561.90
32.51(1.12)2.810.6581.85
42.81(1.06)2.985.70
P3=D4/(ke – g)=2.98/(0.15 – 0.06)=33.11 x 0.658 =21.79
Value of stock now=27.49
Stock is under-priced because you can buy it for less than its intrinsic value.
Chapter 16
1.Majong Corporation currently has 1,000,000 shares of common stock outstanding at a market price of $20 a share, and $20 million in 9% bonds. The company needs to raise $10 million in order to implement a series of investment projects. This amount can be raised by either (1) issuing 500,000 new shares of common at $20 a share, or (2) selling bonds with an 11% yield. If the firm's tax rate is 30%, and the EBIT with the new projects is projected at $6 million, which alternative will result in the highest earnings per share?
Issue new shares = 1,500,000 total outstanding
EBIT=6,000,000
Less interest1,800,000
EBT4,200,000
Tax1,260,000
Earnings2,940,000
EPS=2,940,000/1,500,000 = $1.96
New debt=10,000,000
Interest (11%) = 1,100,000
+ existing (9%)= 1,800,000
Total interest=2,900,000
EBIT= 6,000,000
Less interest=2,900,000
EBT=3,100,000
Tax= 930,000
Earnings=2,170,000
EPS=2,170,000/1,000,000=$2.17
2.The Crazy Horse Hotel has a capacity to stable 50 horses. The fee for stabling a horse
is $100 per month. Maintenance, depreciation, and other fixed operating costs total
$1,200 per month. Variable operating costs per horse are $12 per month for hay and
bedding and $8 per month for grain.
a. Determine the monthly operating break-even point (in horses stabled).
b. Compute the monthly operating profit if an average of 40 horses are stabled.
a. QBE = $1,200/($100 – $20) = 15 horses
b. EBIT = 40($100 – $20) – $1,200 = $2,000
3.Pan Guo has fixed costs of $120,000 directly attributable to producing a particular product. The product sells for $3 a unit and variable costs are $2.40.
What is the break-even point in units produced?
If the firm sold 250,000 units last year and expects volume to increase by 5%, what percentage increase in profits would Pan Guo see with this increase in volume?
What is the Degree of Operating Leverage (DOL) at 250,000 units? At 262,500 units?
Answer:
QBE= $120,000/($3 - $2.40) = 200,000 units.
At volume of 250,000 units:
Profit = (250,000)($3) - $120,000 – (250,000)($2.40) = $30,000
At volume of 262,500 units:
Profit = (262,500)($3) - $120,000 – (262,5000)($2.40) = $37,500
Therefore, the percentage increase in profit equals ($37,500 - $30,000)/$30,000 =25%
DOL250,000= (EBIT + FC) / EBIT = ($30,000 + $120,000)/$30,000 = 5.00.
DOL262,500 = (EBIT + FC) / EBIT = ($37,500 + $120,000)/$37,500 = 4.2.
Chapter 17
1.Jiang Chan Corporation has earnings before interest and taxes of $4.5 million and a 30% tax rate. It is able to borrow at an interest rate of 12%, whereas its equity capitalization rate in the absence of borrowing is 16%. The earnings of the company are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. In the presence of corporate but no personal taxes, what is the value of the company in an M&M world with no financial leverage? With $5 million in debt? With $10 million in debt?