1. Given the proposed financing plan, describe your approach (qualitatively) to value AirThread. Should Ms. Zhang use WACC, APV or some combination thereof? Explain. (2 points) * From the statement of AirThread case, we know that American Cable Communication want to raise capital by Leveraged Buyout (LBO) approach. This means ACC will finance money though equity and debt to buy AirThread and pay the debt by the cash flows or assets of AirThread. * In another word, it’s a highly levered transaction using a fixed WACC discount rate; however the leverage is changing in fact. * If we want to use WACC method, one assumption must be met: this program will not change the debt-equity ratio of AirThread. Under LBO approach, it’s impossible. * So we decide to use APV method to value AirThread. WACC method is not appropriate here, but we still need to calculate the weight average cost of capital (WACC) of AirThread.

Approach to value AirThread before considering any synergy
1. Develop a projection of unlevered free cash flow for AirThread. * Discount AirThread’s unlevered free cash flows at unlevered WACC. 2. Determine the PV of interest tax shield:
* Discount AirThread’s interest tax shield by debt cost of capital (interest rate of debt). 3. Add the unlevered value to the PV of interest tax shield to get the value of the acquisition. 4. Using Dividend Discount Model (Gordon Growth Model) to estimate the terminal value. 5. Estimate the value of operating assets based on the above (without synergies). 6. Add the value of non-operating assets (excess cash, securities, investments) to get a total value of AirThread. 7. Minus the debt value from the total value of ATC to get an equity value of AirThread. 2. What discount rate should Ms. Zhang use for 2008 through 2012? Should she use the same discount rate to value the terminal value? Why or why not? (2 points)

Chart 1
In order to calculate the discount rate:
* We need to get the. We can get...

...consideration in capital budgeting? a Will an investment generate adequate cashflows to promptly recover its cost? b Will an investment generate an acceptable rate of return? c Will an investment have a positive netpresentvalue? d Will an investment have an adverse effect on the environment? 3 Which of the following is not considered when using the payback period to evaluate an investment? a The profitability of the investment over its entire life. b The annual netcashflow of the investment. c The cost of the investment. d The expected life of the investment. Use the following data for questions 4 and 5. Stone Mfg. is considering expanding operations by investing $300,000 in equipment. The equipment has a useful life of eight years, with no salvage value. Straight-line depreciation is used. Stone predicts that net income will increase $37,500 per year as a result of this strategy. 4 Refer to the above data. The payback period for this investment is: a 8 years. b 4 years. c Over 13 years. d 2.5 years. 5 Refer to the above data. Return on average investment for this investment is: a 25%. b 20%. c 12 1/2%. d 15%.
CHAPTER 26 10-MINUTE QUIZ B
NAME SECTION
#
Physician’s Pharmacy is considering the purchase of a copying machine which it will make available to customers at a per-copy charge. The copying machine has an initial...

...APV approach would be more suitable to valuate the cashflows between 2008 and 2012.
After 2012, AirThread will de-lever to industry norm and thus, they will have a target leverage ratio; therefore WACC is best to estimate the terminal value.
Finally, regarding the valuation of non-operating investments in equity affiliates, due to limited data, market multiple approach would be better to use.
2 – Valuation of AirThread
Regarding the estimation of the long-term growth rate, Ms. Zhang knows that the long-term growth rate would be a function of the company’s return on capital (ROC) and reinvestment rate. According to the definition given in the case, ROC is defined as net operating profits after taxes divided by the book value of equity and debt. Since, there is not enough data on book value of the comparable firms; we can use the market value of equity and debt for estimation. AirThread’s ROC should be in line with its peers at 3.0%, calculated below :
Equity Mrkt Debt/ Debt Net
Comparable Companies: Value Equity Value Income ROC
Universal Mobile 65,173 92.3% 60,160 3,794 0.030
Neuberger Wireless 94,735 41.4% 39,261 4,103 0.031
Agile Connections 37,942 24.1% 9,144 (30) (0.001)
Big Country Communications 47,314 31.7% 15,003 3,384 0.054
Rocky Mountain Wireless 5,299 44.4% 2,353 240 0.031
Avrge ROC...

...(D)
2.
$158.80
$253.06
Bill plans to fund his individual retirement account with the maximum
contribution of $2,000 at the end of each year for the next 20 years. If Bill can
earn an effective return of 12 per cent per annum on his contributions, how much
will he have accumulated at the end of twenty years, rounded to the nearest
dollar?
(A)
(B)
$19,292
(C)
$144,105
(D)
3.
$14,938
$40,000
A firm’s profit before tax is $150 000 and depreciation expense is $30,000.
Assuming a company tax rate of 30%, the firm’s cashflow from operations is:
(A)
$840,000
(B)
$180,000
(C)
$135,000
(D)
$75,000
4.
Given an effective annual interest rate of 14 per cent, the presentvalue of a
perpetuity consisting of yearly payments of $25,000 starting immediately is,
rounded to the nearest dollar
(A)
(B)
$203,571
(C)
$178,571
(D)
5.
$232,071
$156,641
If the presentvalue of a perpetual income stream is increasing, the discount rate
must be
(A)
(B)
decreasing
(C)
increasing proportionally
(D)
6.
increasing
changing unpredictably
Janice would like to send her parents on a cruise for their 25th wedding
anniversary. She has priced the cruise at $15,000 and she has 5 years to
accumulate this money. To the nearest dollar, how much must Janice deposit
annually in an account paying interest of 10 per...

...Bonds pay semi-annual coupons unless otherwise stated;
7) Bonds have a par value (or face value) of $1,000; and
8) You may use the back of the exam paper as your scrap paper.
Good Luck.
32 Calculation Questions (4 marks each)
1. The common stock of Robin's Tools sells for $24.50. The firm's beta is 1.2, the riskfree rate is 4%, and the return on the market portfolio is 12%. Next year's dividend is
expected to be $1.50. Assuming that dividend growth is expected to remain constant
for Robin’s Tools over the foreseeable future, what is the firm's anticipated dividend
growth rate?
A)
B)
C)
D)
E)
6.65%
7.48%
9.15%
13.6%
15.0%
Solution: B
r = 4% + 1.2 x (12% - 4%) = 13.6% and
$24.50 = $1.50 / (13.6% - g)
Leads to g = 7.48%
2. What is the yield to maturity on a 10-year zero-coupon bond with a $1,000 face value
selling at $742?
A)
B)
C)
D)
E)
3.03%
7.42%
13.48%
34.78
42.37%
Solution: A
YTM = (1000/742) 1/10 -1 = .03029 or 3.03%
3. Consider the following monthly cashflows (see the diagram below):
X
Today
Z
X
Z
X
Z
1
2
3
4
19
20
Cashflows of an amount X are made for months 1, 3, 5, …, 17 and 19 (the ten oddnumbered months) and cashflows of an amount Z are made for months 2, 4, 6, …, 18
and 20 (the ten even-numbered months). The APR is 6% and is compounded on a...

...Freecashflow
In corporate finance, freecashflow (FCF) is cashflow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on.
G. Bennett Stewart - the "economic model of value holds that share prices are determined by just two things: the cash to be generated over the lifetime of a business and the risk of the cash receipts”.
GSB (1990), “The Quest for Value”
FCF is the cashflow generated by a company’s operations that is free, or net, of the new capital invested for growth. Imagine all a company’s cash receipts are deposited in a cigar box, and that all of its cash operating outlays are taken out, regardless of whether they are capital expenditures on balance sheet or on income statement as expenses (where cash outflows are recorded makes no difference, unless it affects taxes). What’s left over is FCF.
Sales revenue | X |
Less: Operating costs | (X) |
Operating profit | X |
Add: depreciation | X |
Less: cash tax | (X) |
Operating cashflow | X |
Less: investment in fixed assets | (X) |
Less: investment (change) in working capital | (X) |...

...to the introduction and production of a new product, a liquid detergent called Blast. Need to consider what types and which cashflows should be included in capital budgeting analysis.
D&D was producing and marketing two major product lines:
1. Lift-Off: Low –suds, concentrated powder.
2. Wave: Traditional powder detergent.
Questions & Answers:
1. If you were in Steve Gasper’s place, would you argue to include the cost from market testing as a cash outflow?
If I’m Steven Gasper’s I would not include the cost from market testing as a cash outflow. The reason is because the cost from market testing was considered as sunk costs. A sunk cost is an outlay that has already occurred, hence by decision under consideration would not been affected by the costs. Since sunk costs are not incremental cost they should not be included in the analysis. In this case initial cost for Blast, $500,000 for test marketing, which was conducted in the Detroit area and completed in the previous June was consider as a sunk cost and it will not affect Danforth & Donnalley Laundry future cashflows regardless of whether or not the new branch is built.
2. What would your opinion be as to how to deal with the question of working capital?
Working capital management deals with the management of current assets which are inventories, payroll, and other cash needs and...

...CONSTRUCTION OF FREECASHFLOWS A PEDAGOGICAL NOTE. PART I
Ignacio Vélez-Pareja ivelez@javeriana.edu.co Department of Management Universidad Javeriana Bogotá, Colombia Working Paper N 5
First version: 5-Nov-99 This version: January 2001
This paper can be downloaded from the
Social Science Research Network Electronic Paper Collection: http://papers.ssrn.com/paper.taf?abstract_id=196588
CONSTRUCTION OF FREECASHFLOWS
A PEDAGOGICAL NOTE. PART I1
Ignacio Vélez-Pareja ivelez@javeriana.edu.co
ABSTRACT
This is the first part of a paper where the construction of the freecashflow is studied. Usually a great deal of effort is devoted in typical financial textbooks to the mechanics of the calculations of time value of money equivalencies: payments, future values, presentvalues, etc. This is necessary. However less or no effort is devoted to how to arrive at the figures required to calculate a NPV or Internal Rate of Return, IRR. In Part I, pro forma financial statements (Balance Sheet (BS), Profit and Loses Statement (P &L) and Cash Budget (CB) are...

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