On January 1, 2011, Boston Company completed the following transactions (use a 9 percent annual interest rate for all transactions a. Borrowed $103,000 for nine years. Will pay $9,270 interest at the end of each year and repay the $103,000 at the end of the 9th year. In transaction (a), determine the present value of the debt. 1. We find PV of ANnuity of $1 for 9 Yrs at 9% = 5.9952
PV of $1 for 9Yrs @9% = 0.4604
So PV of debt = 9270*5.9952 + 103000*0.4604 = $1,02,997
b. Established a plant addition fund of $520,000 to be available at the end of year 8. A single sum that will grow to $520,000 will be deposited on January 1, 2011. In transaction (b), what single sum amount must the company deposit on January 1, 2011? PV of $1 for 8Yrs @9% = 0.5019
So Single amount deposited = 520000*0.5019 = $2,60,988
c. Agreed to pay a severance package to a discharged employee. The company will pay $84,000 at the end of the first year, $122,500 at the end of the second year, and $146,000 at the end of the third year. In transaction (c), determine the present value of this obligation PV = 84000*PVIF(1,9%) + 122500*PVIF(2,9%)+146000*PVIF(3,9%)
d. Purchased a $130,000 machine on January 1, 2011, and paid cash, $35,000. A eightyear note payable is signed for the balance. The note will be paid in eight equal yearend payments starting on December 31, 2011. What is the total amount of interest revenue that will be earned? So Note Payable amt = 13000035000 = 95000
So PVIFA(8,9%) = 5.5348
So Annual Inst = 95000/5.5348 = $17,164
So 8 Ints =8*17164 = $1,37,312
So Int Rev = 13731295000 = $42,312
...
FINC5001 Capital Market and Corporate Finance

Workshop 5 – Capital Budgeting II
1. Basic Concepts Review
a) In applying Net PresentValue, what factors do we include, and what factors do we ignore?
Use cash flows not accounting income
Ignore
* sunk costs
* financing costs
Include
* opportunity costs
* side effects
* working capital
* taxation
* inflation
2. Practice Questions
a) After spending $3 million on research, Better Mousetraps has developed a new trap. The project requires an initial investment in plant and equipment of $6 million. This investment will be depreciated straightline over five years to a value of zero, but, when the project comes to an end in five years, the equipment can in fact be sold for $500,000. The firm believes that working capital at each date must be maintained at 10% of next year's forecasted sales. Production costs are estimated at $1.50 per trap and the traps will be sold for $4 each. (There are no marketing expenses.) Sales forecasts are given in the following table. The firm pays tax at 35% and the required return on the project is 12%. What is the NPV?

Figures in 000's  
Year  0  1  2  3  4  5 
Unit Sales   500  600  1,000  1,000  600 
Revenues   2,000  2,400  4,000  4,000  2,400 
Costs  ...
...situations wherein the agent can take unseen actions for personal benefit even though such actions are costly to the principal.
a. 0 Moral hazard
b. 0 Zerosum game
c. 0 Adverse selection
d. 0 The behavioral principle
Objective: Discuss 12 principles of foundational corporate finance.
3. Which of the following correctly completes the next sentence? The value of any asset is the presentvalue of all future
a. 0 profits it is expected to provide
b. 0 revenue it is expected to provide
c. 0 net working capital it is expected to provide
d. 0 cash flows it is expected to provide
Objective: Compare and contrast the market value of an asset or liability from the book value.
4. Original maturity refers to
a. 0 a technical accounting term that encompasses the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time
b. 0 the price for which something could be bought or sold in a reasonable length of time, where reasonable length of time is defined in terms of an item’s liquidity
c. 0 the length of an asset’s life when it is issued
d. 0 the net amount, or net book value, for something shown in quarterly accounting statements
Week Two: Business Valuation
Objective: Apply the capitalasset pricing model to calculate a business’s required return.
5. The principle of __________ implies that the expected return for an asset...
...longterm (fixed) assets. Ensures investment projects create (vs destroy) value.
Finance>>Working capital management: The management of shortterm assets and liabilities. Ensures cash inflows = cash outflows at all times.
Finance>>Capital Structure: The management of longterm financing. Balances debt & equity to maximize value.
Payout>>Dividends and Share Repurchases: The management of discretionary cash and cash flow. Balances dividend payments and cash retention needs.
Value = the discounted sum of cash outflows & inflows. The CF capture the economic costs and benefits. Discounting adjusts for cash flow timing and risk.
Investment Policy: The Capital Budgeting Process – Firm Cash Flows
Company finance analysis: Stock PriceRevenue & ExpenseRatio Analysis (Fixed Asset turn over ratio=Total Sales/Avg. Fixed Asset; Return on equity=Earnings/Avg. shareholder’s fund)
5890260116649560121801036955BS
00BS
52711351055674BS footnote
00BS footnote
4834559677545IS
00IS
48660051067767IS
00IS
5398770699439BS footnote
00BS footnote
5396334108267500589280076009500535892675819000
OCF =Total operating revenues – COGS – SGA +Other Income–Current Tax (Topdown) =EBIT + Depreciation – current taxes(Common) =Net Income + Deferred Taxes+ Interest expense+ Depreciation(Bottomup)
CAPEX == NWC = Current assets – Current liabilities
Investment Policy: The Capital Budgeting Process – Time...
...the fleet from GM for $325,000, and Hertz is able to issue $200,000 of five year, 8% debt in order to finance the project. All principal will be repaid in one balloon payment at the end of the fifth year. What is the Adjusted PresentValue (APV) of the project?
17.1 a. The maximum price that Hertz should be willing to pay for the fleet of cars with allequity funding
is the price that makes the NPV of the transaction equal to zero.
NPV = Purchase Price + PV[(1 TC )(Earnings Before Taxes and Depreciation)] +
PV(Depreciation Tax Shield)
Let P equal the purchase price of the fleet.
NPV = P + (10.34)($100,000)A50.10 + (0.34)(P/5)A50.10
Set the NPV equal to zero.
0 = P + (10.34)($100,000)A50.10 + (0.34)(P/5)A50.10
P = $250,191.93 + (P)(0.34/5)A50.10
P = $250,191.93 + 0.2578P
0.7422P = $250,191.93
P = $337,095
Therefore, the most that Hertz should be willing to pay for the fleet of cars with allequity funding is $337,095.
b. The adjusted presentvalue (APV) of a project equals the net presentvalue of the project if it were funded completely by equity plus the net presentvalue of any financing side effects. In Hertz’s case, the NPV of financing side effects equals the aftertax presentvalue of the cash flows resulting from the firm’s debt.
APV = NPV(AllEquity) +...
...in 1 year = $50,000 x 1.06 = $53,000 interest and principal.
b. What is the presentvalue of each cash flow discounted at the market rate? What is the total presentvalue?
$56,000 ( 1.06 = $52,830.19 = PV of CF1
$53,000 ( (1.06)2 = $47,169.81 = PV of CF2
= $100,000.00 = PV Total CF
c. What proportion of the total presentvalue of cash flows occurs at the end of 6 months? What proportion occurs at the end of the year?
Proportiont=.5 = $52,830.19 ( $100,000 x 100 = 52.830 percent.
Proportiont=1 = $47,169.81 ( $100,000 x 100 = 47.169 percent.
d. What is the duration of this loan?
Time Cash Flow PVof CF PV of CF x t
½ year $56,000 $52,830.19 $26,415.09
1 year $53,000 $47,169.81 $47,169.81
$100,000.00 $73,584.91
Duration = $73,584.91/$100,000.00 = 0.735849 years
Answer question 3
Two banks are being examined by the regulators to determine the interest rate sensitivity of their balance sheets. Bank A has assets composed solely of a 10year, 12 percent, $1 million loan. The loan is financed with a 10year, 10 percent, $1 million CD. Bank B has assets composed solely of a 7year, 12 percent zerocoupon bond with a current (market) value of $894,006.20 and a maturity (principal) value of $1,976,362.88. The bond is financed with a 10year, 8.275 percent...
...measuring the value of the options they may be considering for investing or choosing projects and how to pay for them in a competitive market.
Let me explain by first telling you what a market price is. A market price is the current
price at which an asset or service can be bought or sold according to Investopedia Financial Dictionary online. So a market price can be used to evaluate the cost and benefits of a decision in terms of cash today. (Berk, DeMarzo, Harford, (2009). By having that information available, the financial manager can make informed decisions as to which investments and which projects will increase the value of his firm.
The Valuation Principle is helpful to financial managers because, it seeks to increase
Shareholder’s wealth. The Valuation Principle states that when the value of the investments or
project (benefit) exceed the value of the cost, the financial manager should choose this option
because, the decision will make a profit and increase the firms value. “Valuations are needed
for many reasons such as investment analysis, capital budgeting, merger and acquisition
transactions, financial reporting, taxable events to determine the proper tax liability, and in
litigation.” (http://en.wikipedia.org/wiki/Valuation_(finance)
Net PresentValue rule relates to costbenefit analysis because they both examine, compare, and...
...1
1
2604161
(Introduction to Finance)
1. You have just calculated the presentvalue of the expected cash flows of a potential
investment. Management thinks your figures are too low. Which of the following actions
would increase the presentvalue of your cash flows?
a. assume a longer stream of cash flows of the same amount
b. increase the discount rate
c. decrease the discount rate
d. a and c
2. Your bank balance is exactly $10,000. Three years ago you deposited $7,938 and have
not touched the account since. What annually compounded rate of interest has the bank
been paying?
a. 8.65%
b. 26.00%
c. 8.00%
d. 6.87%
3. A project has a life of ten years starting today. What is the presentvalue today of a
$1,000 annuity that begins at the end of the third year and continues until the end of the
tenth year, given a 12% discount rate.
a. $4,811
b. $3,248
c. $4,734
d. $5,650
e. $3,960
4. Which of the following statements is most correct?
a. An investment which compounds interest semiannually, and has a nominal rate of
10 percent, will have an effective rate less than 10 percent.
b. The presentvalue of a threeyear $100 annuity due is less than the presentvalue of
a threeyear $100 ordinary annuity.
c. The proportion of the payment of a fully amortized loan which goes toward interest
declines over time.
d. Statements a and c are correct....
...Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $100 million purchase. Since interest payments are tax deductible, debt in the firm’s capital structure will decrease the firm’s taxable income, creating a tax shield that will increase the overall value of the firm.
2. Since Stephenson is an allequity firm with 15 million shares of common stock outstanding, worth
$32.50 per share, the market value of the firm is:
Market value of equity = $32.50(15,000,000)
Market value of equity = $487,500,000
So, the market value balance sheet before the land purchase is:
Market value balance sheet
Assets $487,500,000
Total assets $487,500,000
Equity $487,500,000
Debt & Equity $487,500,000
3. a. As a result of the purchase, the firm’s pretax earnings will increase by $25 million per year in perpetuity. These earnings are taxed at a rate of 40 percent. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by:
Earnings increase = $25,000,000(1 – .40)
Earnings increase = $15,000,000
Since Stephenson is an allequity firm, the appropriate discount rate is the firm’s unlevered cost of equity, so the NPV of the purchase is:
NPV = –$100,000,000 + ($15,000,000 / .125)
NPV = $20,000,000
b. After the announcement, the value of Stephenson will increase by $20 million,...