Final Review Session SPR12Rป

Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

Review-Q1 Yonan Corporation's stock had a required return of 11.50% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Now suppose there is a shift in investor risk aversion, and the market risk premium increases by 2%. The risk-free rate and Yonan's beta remain unchanged. What is Yonan's new required return? (Hint: First calculate the beta, then find the required return.) Solution

Risk-free rate 5.50% Old market risk premium 4.75% New market risk premium 6.75% Old required return 11.50% = (rS – rF)/EMRP =(0.1150-0.055)/0.0475=1.26 Assuming that EMRP changes from 4.75 to 6.75, per CAPM required return after the change in risk aversion : rS = rF+ x EMRP  rS = 0.055+1.26 x 0.0675 =14% Review-Q2

Home Place Hotels, Inc., is entering into a 3-year remodelling and expansion project. The construction will have a limiting effect on earnings during that time, but when it is complete, it should allow the company to enjoy much improved growth in earnings and dividends. Last year, the company paid a dividend of $3.40 per share. It expects zero growth in the next year. In years 2 and 3, 5% growth is expected, and in year 4, 15% growth. In year 5 and thereafter, growth should be a constant 10% per year. What is the maximum price per share that an investor who requires a return of 14% should pay for Home Place Hotels common stock? Solution: Time 0 1 2 3 4

Dividends D0 D1 D2 D3 D4

5

D5

Dividends 3.4 3.4 3.57 3.75 4.31

4.74

We can find the stock price by using multi period growth model: N

P0 t 1

P0

(1 g1 )t

D0

(1 r)s

t

DN

1 (rsg N )

(1 r)

3.4

3.57

(1 0 .14)

(1 0 .14)

s

3.75 2

3 (1 0 .14)

1 2

4.31 4 (1 04.14)

1 (1

4.74 ) rs (0.14 0.10)

$81

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Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

Review-Q3

Assume that you are on the financial staff of Michelson Inc., and you have collected the following data: (1) The yield on the company’s outstanding bonds is 8.00%, and its tax rate is 40%. (2) The next expected dividend is $0.65 a share, and the dividend is expected to grow at a constant rate of 6.00% a year. (3) The price of Michelson's stock is $17.50 per share, and the flotation cost for selling new shares is F = 10%. (4) The target capital structure is 45% debt and the balance is common equity. What is Michelson's WACC, assuming it must issue new stock to finance its capital budget?

Solution

YTM Tax rate D1 g P0 F Weight debt Weight equity

8.00% 40% $0.65 6.00% $17.50 10.0% 45% 55%

After tax cost of debt=0.08 x (1-0.4)=4.80% rS =( D1/(P0*(1 – F)) + g =0.65/[(17.50)x(1-0.1)]=10.13% WACC =wDxrD +wExrS=(0.45 x 0.048) +(0.55)x(0.1013)=7.73% Review Q4:

Rough Manufacturing company manufactures industrial grade appliances. The company hired you to estimate the company’s beta. You have gathered the following equity betas for publicly traded companies that also manufacture industrial grade appliances. Firm

Equity Beta Debt

Slack & Mecker Gedders Corp Marie of Rome Dalton Inc. Hearlpool

1.19 1.20 2.14 3.25 1.83

4,100 5 380 375 10600

MV of Equity

Tax Rate

6,300 200 530 115 9,100

0.35% 0.35% 0.35% 0.35% 0.35%

Estimate Rough Manufacturing’s beta by using industry peers in the same line of business. Rough manufacturing’s effective tax rate is 25% and debt ratio for the foreseable future is expected to be 40%.

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Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

Solution:

Firm Slack & Mecker Gedders Corp Marie of Rome Dalton Inc.

Hearlpool Average

Equity Beta 1.19 1.2 2.14 3.25

Debt 4,100 5 380 375

MV of Equity 6,300 200 530 115

1.83

10600

9,100

Tax Rate

D/E

Unlevered Beta

35% 35% 35% 35%

0.651 0.025 0.717 3.261

0.84 1.18 1.46 1.04

35%

1.165

1.04 1.11

We can estimate RM’s beta by relevering the estimated asset beta.

bL=bU x [1+(1-Tax)xD/E] D/V=0.4 E/V=1-0.4=0.6 D/E=0.67 alternatively D/E=(D/V)/1-(D/V)=0.4/1-0.4=0.67 bL=1.11x[1+(1-0.25)x0.0.67]=1.65 Review-Q5

MGM Manufacturing is considering a major capital expenditure to begin production of a major new product. Key facts and assumptions about this new product appear below. Using this information, answer the questions following. Data Facts and Assumptions Yield to maturity on long-term government bonds Yield to maturity on company long-term bonds Market price of risk Estimated company and project asset beta Stock price per share Number of shares outstanding Market value of interest-bearing debt outstanding Tax rate Inflation rate Initial cost of investment Year 1 selling price per unit Year 1 variable manufacturing cost per unit Year 1 general selling & administrative expenses Expected project life Salvage value Depreciation schedule Working capital

5.00% 7.00% 6.90% 0.70 $60 2 million $80,000,000 35% 3% $200,000,000 $80 $55 $200,000,000 8 $40,000,000 Straight-line 20% of Sales

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Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

Sales Data: Year 0 1 2 3 4 5 6 7 8

Number of Units Sold

2,000,000 10,000,000 20,000,000 23,000,000 24,000,000 23,000,000 22,000,000 15,000,000

a. Estimate MGM's equity beta b. Estimate MGM's cost of equity capital c. Estimate MGM's weighted-average cost of capital d. Estimate the after-tax cash flows relevant to the investment. Assume salvage value is realized in year 8 and working capital is liquidated in year 8. e. Estimate the investment's net present value f. Estimate the investment's internal rate of return. Does the investment appear attractive financially? g. In market value terms, MGM's debt to capital ratio is 40%. Assume the company will finance the investment in the same proportions and estimate the cash flows from and to equity. (Assume the company will use an 8-year, 7% loan to be repaid in equal annual installments.) h. Estimate the net present value of the equity cash flows. (That is, analyze the investment from the equity perspective.) i. Estimate the internal rate of return to equity. j. Why is the NPV from the entity perspective higher than the NPV from the equity perspective, while the IRRs are in just the reverse order? k. Does the equity perspective tell you any more or less about the merits of the investment than the entity (firm) perspective? Which analysis is easier to perform?

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Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

Solution: a) Equity Beta:Asset Beta x (1+(1-T)x(D/E))=0.7 x (1+(0.35)(0.67))=1

b) rS=0.05+1 x 6.90=11.90% c) WACC=(0.4)x(0.07)x(1-0.35)+(0.6)x(0.1190)=0.0896 or 8.96%

d) In the table below, only first five year cash flows are shown. Year Initial investment Salvage value

0

1

2

3

4

5

$ (200)

Selling price per unit

80

82

85

87

90

Units sold Revenue

2 $ 160

10 $ 824

20 $ 1,697

23 $ 2,011

24 $ 2,161

Variable cost per unit

55

57

58

60

62

Cost of goods sold

110

567

1,167

1,382

1,486

Gross profit

50

258

530

628

675

Marketing and selling expenses

200

206

212

219

225

Depreciation

20

20

20

20

20

Earnings before interest & taxes

(170)

32

298

390

430

Tax

(59.5)

11

104

136

151

Earnings after tax

(110.5)

20

194

253

280

20 $ (91)

20 $ 40

20 $ 214

20 $ 273

20 $ 300

32

165

339

402

432

32 $ (123)

133 $ (92)

175 $ 39

63 $ 211

30 $ 270

+ Depreciation After-tax cash flow from operations Working capital Change in working capital Total after-tax cash flow

$ (200)

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Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

Note that as sales grow, company’s working capital investment grows. Incremental investmen ts in working capital are treated as cash outflows. While it is not shown in the table, sales revenues start to decline after the fifth year, and company reduces its working capital investment. These cash flows are treated as “cash inflows”. At the end of year 8, company has $295m of working capital which is ready to be liquidated. MGM’s cash net project cash flows for 8 years are given below:

Year Net Cash Flow

0 -200

1 -123

2 -92

3 39

4 211

5 270

6 295

7 285

8 607

In year 8, after tax operting cash flows are $147m. Because of the declining sales, reduction in working capital provides an additional an additional $125m cash inflow. If we also assume that entire working capital is liquidated, we get an additional $295m cash inflows, which brings the total cash flows to $567m. Note that annual straight line depreciation is $20m. This amount was determined by using initial project assets’ book value and estimated salvage value or (200,000,000-40,000,000)/8=20,000,000 This means that at the end of the 8th year the remaining book value of project is 40,000,000. If the project is liquidated at this price, there will be no capital gains and therefore no tax liability. In contrast, if the firm depreciated the assets over 8 year period to zero, it would allocate 200,000,000/8=25,000,000 and the book value at the end of the 8 th year would be 0. If project were liquidated at 40,000,000, then there would be 40,000,000 x0.4=16,000,000 tax liability, and the net terminal cash flow would be 40,000,000-16,000,000=24,000,000. In the above solution the fixed assets were depreciated to salvage value, and therefore there is no capital gains at the liquidation. e. Estimate the investment's net present value

Year Net Cash Flow

0 -200

1 -123

2 -92

3 39

4 211

5 270

6 295

7 285

8 607

Based on above cash flows and 8.96% WACC Project NPV is: NPV=603.41

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Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

f. Estimate the investment's internal rate of return. Does the investment appear attractive financially? Year Net Cash Flow

0 -200

1 -123

2 -92

3 39

4 211

5 270

6 295

7 285

8 607

Based on these cash flows IRR=30% g. In market value terms, MGM's debt to capital ratio is 40%. Assume the company will finance the investment in the same proportions and estimate the cash flows from and to equity. (Assume the company will use an 8-year, 7% loan to be repaid in equal annual installments.) Solution: The key difference here is the interest and principal payments made to creditors. We need to figure out these two sets of payments. If the loan will be amortized as described above, there will be equal payments with varying interest and prinicipal. A=80/PVAIF (n=8, i=7%)=13.4 Year 0 1

2 3 4 5 6 7 8

Payment

Interest

Principal

($13.40)

($5.60)

($7.80)

Loan Balance 80 $72.20

($13.40) ($13.40) ($13.40) ($13.40) ($13.40) ($13.40) ($13.40)

($5.05) ($4.47) ($3.85) ($3.18) ($2.46) ($1.70) ($0.88)

($8.34) ($8.93) ($9.55) ($10.22) ($10.94) ($11.70) ($12.52)

$63.86 $54.93 $45.38 $35.16 $24.22 $12.52 ($0.00)

Based on the EBIT calculated before we can calculate cash flows to equity as follows:

Earnings before interest & taxes Interest expense Earnings before tax Taxes Income after tax Depreciation Less Principal Payment Operating cash flow to equity Change in working capital Total cash flow to equity

0

1

2

3

($120)

-170 6 -176 -61 -114 20 8 ($102) 32 ($134)

32 5 26 9 17 20 8 $29 133 ($104)

298 4 294 103 191 20 9 $202 175 $27

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Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

Year 0 1 2 3 4 5 6 7

8

CFE -120 -134 -104 27 199 257 283 272

594

h. Estimate the net present value of the equity cash flows. (That is, analyze the investment from the equity perspective.) NPV of equity cash flows is: $479 i. Estimate the internal rate of return to equity. IRR=34% j. Why is the NPV from the entity perspective higher than the NPV from the equity perspective, while the IRRs are in just the reverse order? The entity NPV values an investment of $200 million. The equity NPV values a $120 million investment. Other things equal, a larger investment will tend to have a larger NPV. The IRRs look at payoff per dollar invested and are thus insensitive to the differing size of the investments. The IRRs reflect the familiar effect of financial leverage. The IRR to equity is higher than the IRR to the entity due to the leveraging effect of debt. The risk to equity is, of course, higher than the risk to the entity. k. Does the equity perspective tell you any more or less about the merits of the investment than the entity (firm) perspective? Which analysis is easier to perform? Both perspectives signal that the investment is attractive. The entity perspective can be harder to interpret because it reflects the combined effects of the project and decisions about how the project will be financed. The equity perspective requires a tedious evaluation of the loan payments and is thus somewhat harder to implement.

Review Q6: (Note that we did not go over this problem during the session)

Sorenson Stores is considering a project that has the following cash flows:

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Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

Year 0 1 2 3 4

Cash Flow CF0 = ? $2,000 3,000 3,000 1,500

The project has a payback of 2.5 years, and the firm’s cost of capital is 12%. What is the project’s

NPV? Solution: First, find the missing t = 0 cash flow. If payback = 2.5 years, this implies that the t = 0 cash flow must be CF0 + $2,000 + $3,000 + (0.5)$3,000 = 0, so CF0 = -$2,000 – $3,000 – (0.5)$3,000 = -$6,500. Then NPV = -$6,500 +2000/(1+0.12)+3000/(1+0.12)2 + 3000/(1+0.12)3 +1500/(1+0.12)4 = $765.91

Michaely Inc. is an all-equity firm with 200,000 shares outstanding. It has $2,000,000 of EBIT, which is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS). Its tax rate is 40%. The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock. The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs. Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would the price be following the recapitalization? Solution: Shares outstanding 200,000 Interest rate EBIT $2,000,000 Risk-free rate 6.5% Dividend payout ratio 100% Market risk premium Tax rate 40% Beta - before recap 0.90 Bonds issued = stock repurchased $5,000,000

10% 5.0% Beta - after recap

1.10

Before the recapitalization rS = rF + x EMRP=0.065+0.9 x 0.05=11.00% DPS = EPS = (EBIT)(1 – T)/Shares $6.00 P0 = DPS/rs $54.55 Shares repurchased = Bonds issued/P 0=5,000,000/54.55=91,667 After the recapitalization rS = rF + x EMRP=0.065+1.1 x 0.05=12.00% DPS = EPS = (EBIT − rd × Bonds)(1 – T)/Shares #Outstanding Shares=200,000-91,667=108,333 EBIT-Interest –Taxes= 2,000,000 -50,000-600,000=900,000 $900,000/108,333=$8.31 9

Managerial Finance/Final Review Session/SPR 2012/Dr. Bulent Aybar

P0 = DPS/rs =8.31/0.12=$69.23 As the example shows, leveraging (we call this recapitalization because company changed its capital structure by substituting equity with debt).

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