# FIN325/ Corporate Finance, Assignment #2

June 8, 2016

Question
FIN325/ Corporate Finance, Assignment #2

Case 1.

You have finally saved \$10,000 and are ready to make your first investment. You have the three following alternatives for investing that money:

• Capital Cities ABC, Inc. bonds with a par value of \$1,000 and a coupon interest rate of 8.75 percent, are selling for \$1,314 and mature in 12 years.

• Southwest Bancorp preferred stock is paying a dividend of \$2.50 and selling for \$25.50.

• Emerson Electric common stock is selling for \$30.75. The stock recently paid a \$1.32 dividend and the firm’s earnings per share has increased from \$1.49 to \$3.06 in the past five years. The firm expects to grow at the same rate for the foreseeable future.

Your required rates of return for these investments are 6 percent for the bond, 7 percent for the preferred stock, and 20 percent for the common stock. Using this information, answer the following questions.

a. Calculate the value of each investment based on your required rate of return.

b. Which investment would you select? Why?

c. Assume Emerson Electric’s managers expect an earnings downturn and a resulting decrease in growth of 1 percent. How does this affect your answers to parts a and b?

d. What required rates of return would make you indifferent to all three options?

Case 2.

The Nealon Manufacturing Company is in the midst of negotiations to acquire a plant in Fargo, North Dakota. The company CFO, James Nealon, is the son of the founder and CEO of the company and heir-apparent to the CEO position, so he is very concerned about making such a large commitment of money to the new plant. The cost of the purchase is \$40 million, which is roughly one-half the size of the company today.

To begin his analysis, James has launched the firm’s first ever cost-of-capital estimation. The company’s current balance sheet, restated to reflect market values, has been converted to percentages as follows:

Nealon, Inc., Balance Sheet—2013

Type of Financing

Percentage of Future Financing

Bonds (8%, \$1,000 par, 30-year maturity)

38%

Preferred stock (5,000 shares outstanding, \$50 par, \$1.50 dividend)

15%

Common stock

47%

Total

100%

The company paid dividends to its common stockholders of \$2.50 per share last year, and the projected rate of annual growth in dividends is 6 percent per year for the indefinite future. Nealon’s common stock trades over the counter and has a current market price of \$35 per share. In addition, the firm’s bonds have an AA rating. Moreover, AA bonds are currently yielding 7 percent. The preferred stock has a current market price of \$19 per share.

FIN325/ Corporate Finance, Assignment #2

a. If the firm is in a 34 percent tax bracket, what is the weighted average cost of capital (i.e., firm WACC)?

b. In the analysis done so far we have not considered the effects of flotation costs. Assume now that Nealon is raising a total of \$40 million using the above financing mix. New debt financing will require that the firm pay 50 basis points (i.e., one-half a percent) in issue costs, the sale of preferred stock will require the firm to pay 200 basis points in flotation costs, and the common stock issue will require flotation costs of 500 basis points.

i. What are the total flotation costs the firm will incur to raise the needed \$40 million?

ii. How should the flotation costs be incorporated into the analysis of the \$40 million investment the firm plans to make? Recalculate the WACC with flotation costs.

Case 3.

Your first assignment in your new position as assistant financial analyst at Caledonia Products is to evaluate two new capital-budgeting proposals. Because this is your first assignment, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at assessing your understanding of the capital-budgeting process. This is a standard procedure for all new financial analysts at Caledonia, and it will serve to determine whether you are moved directly into the capital-budgeting analysis department or are provided with remedial training. The memorandum you received outlining your assignment follows:

To: The New Financial Analysts

From: Mr. V. Morrison, CEO, Caledonia Products

Re: Capital-Budgeting Analysis

Provide an evaluation of two proposed projects, both with 5-year expected lives and identical initial outlays of \$165,000. Both of these projects involve additions to Caledonia’s highly successful Avalon product line, and as a result, the required rate of return on both projects has been established at 12 percent. The expected free cash flows from each project are as follows:

PROJECT A

PROJECT B

Initial outlay

−\$165,000

−\$165,000

Inflow year 1

30,000

60,000

Inflow year 2

45,000

60,000

Inflow year 3

60,000

60,000

Inflow year 4

75,000

60,000

Inflow year 5

105,000

60,000

In evaluating these projects, please respond to the following questions. For questions from (a) to (j) assume that the projects are independent. That is both could be accepted if both are acceptable.

a. What is the payback period on each project? If Caledonia imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?

b. What are the criticisms of the payback period?

c.Determine the NPV for each of these projects. Should they be accepted?

d. Describe the logic behind the NPV.

e.Determine the PI for each of these projects. Should they be accepted?

f.Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?

FIN325/ Corporate Finance, Assignment #2

g. Determine the IRR for each project. Should they be accepted?

h. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?

i. Determine the MIRR for each project. Should they be accepted?

j. Describe the logic behind the MIRR.

k. Rank the two project based on all above criteria and make a recommendation as to which (if either) should be accepted under the assumption that the projects are mutually exclusive.

l. Caledonia is considering two additional mutually exclusive projects. The free cash flows associated with these projects are as follows:

PROJECT A

PROJECT B

Initial outlay

-\$150,000

-\$150,000

Inflow year 1

48,000

0

Inflow year 2

48,000

0

Inflow year 3

48,000

0

Inflow year 4

48,000

0

Inflow year 5

48,000

300,000

The required rate of return on these projects is 11 percent.

1. What is each project’s payback period?

2. What is each project’s NPV?

3. What is each project’s IRR?

4. What has caused the ranking conflict?

5. Which project should be accepted? Why?

Case 4.Calculating Free Cash Flow and Project Valuation

It’s been two months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation, but also to respond to a number of questions aimed at judging your understanding of the capital-budgeting process.

To: The Assistant Financial Analyst

From: Mr. V. Morrison, CEO, Caledonia Products

Re: Cash Flow Analysis and Capital Rationing

We are considering the introduction of a new product. Currently we are in the 34 percent tax bracket with a 15 percent discount rate. This project is expected to last five years and then, because this is somewhat of a fad project, it will be terminated. The following information describes the new project:

Cost of new plant and equipment:

\$ 7,900,000

FIN325/ Corporate Finance, Assignment #2

Shipping and installation costs:

\$

100,000

Unit sales:

Year

Units Sold

1

70,000

2

120,000

3

140,000

4

80,000

5

60,000

Sales price per unit:

\$

300/unit in Years 1–4 and

\$

260/unit in Year 5

Variable cost per unit:

\$

180/unit

Annual fixed costs:

\$

200,000 per year

Working capital requirements: There will be an initial working capital requirement of \$100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during Years 1 through 3, then decrease in Year 4. Finally, all working capital is liquidated at the termination of the project at the end of Year 5.

Depreciation method: Straight-line over five years assuming the plant and equipment have no salvage value after five years.

a. Why should Caledonia focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project?

b. What are the incremental cash flows for the project in Years 1 through 5, and how do these cash flows differ from accounting profits or earnings?

c. What is the project’s initial outlay?

d. What is the project’s net present value?

e. Should the project be accepted? Why or why not?

Case 5. (Computing interest tax savings)

Presently, H. Swank, Inc. does not use any financial leverage and has total financing equal to \$1 million. It is considering refinancing and issuing \$500,000 of debt that pays 5 percent interest and using that money to buy back half the firm’s common stock. Assume that the debt has a 30-year maturity such that Swank will have no principal payments for 30 years. Swank currently pays all of its net income to common shareholders in the form of cash dividends and intends to continue to do this in the future. The corporate tax rate on the firm’s earnings is

35 percent.

Swank’s current income statement (before the debt issue) is as follows:

Earnings before interest and taxes (EBIT)

\$100,000

Less: Interest expense

0

Equals: Earnings before tax

\$100,000

Less: Taxes

(35,000)

Equals: Net income

\$ 65,000

a. If Swank issues the debt and uses it to buy back common stock, how much money can the firm distribute to its stockholders and bondholders next year if the firm’s EBIT remains equal to \$100,000?

FIN325/ Corporate Finance, Assignment #2

b. What are Swank’s interest tax savings from the issuance of the debt?

c.Are Swank’s stockholders better off after the debt issue? Why or why not?

d. If there were no corporate taxes on income (and consequently interest expense was not deducted from the firm’s taxable income), how would this affect your responses to parts a through c?

Case 6

Assume that you write a column for a very widely followed financial blog titled, “Finance Questions: Ask the Expert.” Your job is to field readers’ questions that deal with finance. This week you are going to address two questions from your readers that have to do with dividends.

Question 1: In the spring of 2015 the CFO of Placebo Pharmaceuticals, Inc. took a proposal to the firm’s board of directors to distribute a noncash dividend to the firm’s shareholders in the form of new shares of common stock. Specifically, the CFO proposed that the company pay 0.025 shares of stock to the holders of each share of common stock such that the holder of 1,000 shares of stock would receive an additional 25 shares of common stock.

a. If Placebo had total net income for the year of \$10,000,000 and 20,000,000 shares of common stock outstanding before the stock dividend, what are firm earnings per share?

b. After paying the stock dividend, what is the firm’s earnings per share?

c. If you owned 1,000 shares of stock before the stock dividend, how many dollars of earnings did the firm earn on your 1,000 share investment? After the stock dividend is paid, how many dollars of earnings did the firm earn on your larger share holdings? What effect would you expect from the payment of the stock dividend on your total investment in the firm?

Question 2: The Dunn Corporation is planning to pay dividends of \$500,000. There are 250,000 shares outstanding, and earnings per share are \$5. The stock should sell for \$50 after the ex-dividend date. If, instead of paying a dividend, the firm decides to repurchase stock,

a.What should be the repurchase price?

b. How many shares should be repurchased?

c.What if the repurchase price is set below or above your suggested price in part (a)?

d. If you own 100 shares, would you prefer that the company pay the dividend or repurchase stock?