Problem 1: Capital Budgeting Criteria
XYZ Inc. is considering two projects. Its WACC is 12 percent, and the projects' after-tax cash flows (in millions of dollars) would be as follows:
|
|
0
|
1
|
2
|
3
|
4
|
|
Project A
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-$30
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$5
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$10
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$15
|
$20
|
|
Project B
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-$30
|
$20
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$10
|
$8
|
$6
|
1. Calculate the projects' NPVs, IRRs, MIRRs, regular paybacks, and discounted paybacks.
2. How might conflicts exist between the NPV and the IRR when independent projects are evaluated? Explain your answer.
Problem 2: New Project Analysis
XYZ Inc. needs to install a new manufacturing machine. The base price is $100,000. Installation costs are $10,000. After 3 years the machine will be sold for $75,000. Applicable depreciation rates are 33 percent, 45 percent, 15 percent, and 7 percent. The machine would require a $5,000 increase in net operating working capital (increased inventory less increased accounts payables). Revenue would not be affected. Pretax labor costs would decline by $40,000 per year. The marginal tax rate is 40 percent, and the WACC is 10 percent. Also, the firm spent $7,000 in feasibility tests.
1. $7,000 was spent last year. How should this be handled?
2. For capital budgeting purposes, what is the initial investment outlay for the machine? That is, what is the Year 0 project cash flow?
Problem 3: XYZ Inc. sells on terms of 2/10, net 30. Total sales for the year are $1,000,000. Consider that 30 percent of the customers take discounts and pay on the 10th day, while the other 70 percent pay, on average, 45 days after their purchases.
1. What is the days' sale outstanding?
2. Determine the average amount of receivables.
3. For the customers who take the discount, what is the percentage cost of trade credit?
4. For the customers who do not take the discount and pay in 45 days, what is the percentage cost of trade credit?
5. What would happen to XYZ's accounts receivable if it created a new collection policy that required all non-discount customers to pay on the 30th day?
Problem 4: Optimal Capital Structure
XYZ Inc. is setting its target capital structure. The CFO of XYZ Inc. believes that the optimal debt-to-capital ratio is between 25 percent and 60 percent. Her staff derived following the projections. Various debt levels were considered.
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Debt/Capital Ratio Projected EPS Projected Stock Price
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Dept/Capital Ratio
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Projected EPS
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Projected Stock Price
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25%
|
$4.20
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$40.00
|
|
35%
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$4.45
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$41.50
|
|
45%
|
$4.75
|
$41.25
|
|
60%
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$4.50
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$40.59
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Assuming that the firm uses only debt and common equity, what is XYZ's optimal capital structure? At what debt-to-capital ratio is the company's WACC minimized?
Problem 5: Break-Even Analysis
XYZ Inc. sells photoframes for $20 each. The fixed costs are $60,000, and variable costs are $7 per photoframe.
1. What is the firm's gain or loss at sales of 6,000 photoframes? At 15,000 photoframes?
2. How would the break-even point be affected if the selling price was raised to $25? How is this analysis significant?
3. If the selling price was raised to $25 but variable costs rose to $13 a unit, what would happen to the break-even point?
Problem 6: WACC and Optimal Capital Structure
This problem is easiest to complete in Excel. Structure consists of only debt and common equity. XYZ's finance department staff created the following table showing the firm's debt cost at different debt levels:
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Debt-to-Capital Ratio
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Equity-to-Capital Ratio
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Debt-to-Equity Ratio
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Bond Rating
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Before-Tax Cost of Debt
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0.0
|
1.0
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0.00
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A
|
6.0%
|
|
0.2
|
0.8
|
0.25
|
BBB
|
7.0%
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|
0.4
|
0.6
|
0.67
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BB
|
9.0%
|
|
0.6
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0.4
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1.50
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C
|
11.0%
|
|
0.8
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0.2
|
4.00
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D
|
14.0%
|
XYZ uses the CAPM to estimate its cost of common equity and estimates that the risk-free rate is 4 percent, the market risk premium is 7 percent, and its tax rate is 35 percent. XYZ estimates that if it had no debt, its "unlevered" beta would be 1.5.
1. What would be its WACC at the optimal capital structure? What would the firm's optimal capital structure be?
2. If XYZ's managers anticipate that the company's business risk will increase in the future, what effect would this likely have on the firm's target capital structure?
3. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on XYZ's target capital structure?
Problem 7: Cost of Trade Credit and Bank Loan
XYZ Inc. buys $10 million of materials (net of discounts) on terms of 3/5, net 60, and it currently pays on the 5th day and takes discounts. XYZ plans to expand, which will mean additional financing.
1. If XYZ decides to forgo discounts, could it obtain much additional credit?
2. What would be the nominal and effective cost of that credit?
3. What would be the effective cost of the bank loan if the company could get the funds from a bank at a rate of 8 percent and if the interest was paid monthly? All of this should be based on a 365-day year.
4. Should XYZ use bank debt or additional trade credit? Explain.
Problem 8: Currency Appreciation
Suppose that 1 Euro could be purchased in the foreign exchange market today for $0.25. If the Euro appreciated 10 percent tomorrow against the dollar, how many Euros would a dollar buy tomorrow?
Problem 9: Cross Rates
Assume the exchange rate between US dollar and Indian Rupee is 60 Rupees = $1, and the exchange rate between dollar and British pound is 1 Pound = $1.5. What is the exchange rate between the Rupee and pound?