The Yoran Yacht Company (YYC), a prominent sailboat builder in Newport, may design a new 30-foot sailboat based on the “winged” keels first introduced on the 12-meter yachts that raced for the America’s Cup. First, YYC would have to invest $10,000 at t 5 0 for the design and model tank testing of the new boat. YYC’s managers believe there is a 60% probability that this phase will be successful and the project will continue. If Stage 1 is not successful, the project will be abandoned with zero salvage value. The next stage, if undertaken, would consist of making the molds and producing two prototype boats. This would cost $500,000 at t = 1. If the boats test well, YYC would go into production. If they do not, the molds and prototypes could be sold for $100,000. The managers estimate the probability is 80% that the boats will pass testing and that Stage 3 will be undertaken. Stage 3 consists of converting an unused production line to produce the new design. This would cost $1 million at t = 2. If the economy is strong at this point, the net value of sales would be $3 million; if the economy is weak, the net value would be $1.5 million. Both net values occur at t =3, and each state of the economy has a probability of 0.5. YYC’s corporate cost of capital is 12%. a. Assume this project has average risk. Construct a decision tree and determine the projects expected NPV. b. Find the project’s standard deviation of NPV and coefficient of variation of NPV. If YYC’s average project had a CV of between 1.0 and 2.0, would this project be of high, low, or average stand-alone risk?
> Why do conflicts sometimes arise between the net present value (NPV) and internal rate of return (IRR) methods; that is, what conditions can lead to conflicts? Can similar conflicts arise between modified internal rate of return (MIRR) and NPV rankings,
> Describe the six primary capital budgeting decision criteria. What are their pros and cons, and how are they related to maximizing shareholder wealth? Should managers use just one criterion, or are there good reasons for using two or more criteria in the
> Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included.
> What would you expect to happen to an all-equity firm’s stock price if its management announced a recapitalization under which debt would be issued and used to repurchase common stock?
> Should firms focus on book value or market value capital structures? How would the calculated WACC be affected by the use of book weights rather than market weights?
> What does it mean to be at the optimal capital structure? What is optimized? What is maximized and what is minimized?
> In general, does the market view the announcement of a new stock issue to be a good signal? Does the signaling theory lead to the same conclusions regarding the optimal capital structure as the trade-off theory and/or the MM theory?
> What is the trade-off theory of capital structure? How does it differ from MM’s theory?
> Does the MM theory appear to be correct according to either empirical research or observations of firms’ actual behavior? How do assumptions affect your conclusion about whether the MM theory appears to be correct?
> Who are Modigliani and Miller (MM), and what were their conclusions regarding the effect of capital structure on a firm’s value and cost of capital under the assumption of no corporate taxes? How do their conclusions change when they introduce corporate
> What is financial risk? How is it related to business risk?
> What is business risk? List and then discuss some factors that affect business risk.
> In 2003, President Bush proposed a change in the tax law that would have eliminated the tax on dividends received by stockholders. The same proposal also would have increased the basis of stocks by the amount of new retained earnings per share—in effect
> Operating cash flows, rather than accounting profits, are used in project analysis. What is the basis for this emphasis on cash flows as opposed to net income?
> What is a stock split? As an investor, would you like to see shares you own be split?
> If a company is thinking about distributing excess cash through a stock repurchase program in lieu of continuing to pay regular cash dividends, what are some factors it should consider before making the change?
> Describe the residual dividend model. Explain how it operates and how firms use it in practice. In your answer, discuss any influences signaling and the clientele effect might have on a firm’s decision to use, not use, or modify this model.
> How should (a) signaling and (b) the clientele effect be taken into account by a firm as it considers its dividend decision? Do signaling and clientele effects make it easier or harder to determine if investors prefer high or low payout ratios? Do thes
> Describe the three theories that have been advanced regarding whether investors in the aggregate tend to favor high or low dividend payout ratios. What results were reached from empirical tests of these theories?
> In your judgment, what are some characteristics of the type of investor who would likely prefer a high dividend payout, and what are some characteristics of one who would prefer a low payout? Would you personally prefer to own a stock with a high or a lo
> Good managers not only identify and evaluate real options in projects—they also structure projects so as to create real options. Suppose a company is considering a project to build an electric generating plant. Name some real options that might be built
> Suppose a company uses the NPV method, along with risk-adjusted WACCs, to calculate project NPVs. However, it has not been considering real options in its capital budgeting decisions. Now suppose the company changes its capital budgeting process to take
> Option values are extinguished when they are exercised. How does this influence capital budgeting decisions? What considerations, or types of analysis, might lead management to “take the plunge” and proceed with a project rather than keep delaying it?
> Real options can be analyzed using a scenario approach with decision trees or using the Black-Scholes Option Pricing Model. What are the pros and cons of the two approaches? Is one procedure “better” than the other?
> In theory, market risk should be the only “relevant” risk. However, companies focus as much on stand-alone risk as on market risk. What are the reasons for the focus on stand-alone risk?
> What’s the difference between a financial option and a real option? What are some specific types of real options? Do real options just occur, or can they be “created”?
> What are real options, and why are they important to capital budgeting?
> Discuss some ways the company could estimate the project’s risk, and then explain how risk might be incorporated into the decision analysis.
> If the company’s capital budgeting analyst decided to show all projected cash flows, both positive and negative, in current dollars rather than inflation-adjusted dollars, would this affect the calculated NPV?
> If Congress shortened depreciation lives for tax purposes, how would this affect the energy project’s NPV, assuming nothing else changes?
> Define (a) externalities and (b) sunk costs, and then give examples of each that might be involved in a proposal by an energy company to build a new coal-fired electric power generating unit. How would these factors be worked into the analysis?
> How do project cash flows as calculated in this chapter affect a firm’s corporate free cash flows as defined in Chapter 6 and then used in Chapter 9 to calculate a firm’s value? How does a proposed project’s estimated NPV affect the value of the firm?
> At any one time, should the same WACC be used to evaluate each of a company’s capital budgeting projects? If not, how should the WACC be adjusted for the different projects?
> For a given firm, why does WACC change over time? Can the firm control the factors that lead to changes in the WACC and thus determine its WACC?
> How do flotation costs affect the cost of capital? Are these costs about the same for each of the three capital components? How do they change as the firm raises larger and larger amounts of capital, and how do flotation costs affect the way a company ra
> Distinguish among beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a project being considered for inclusion in a firm’s capital budget.
> Describe each of the following methods for estimating the cost of equity: (a) the CAPM, (b) DCF, and (c) the bond-yield-plus-risk-premium. Where can you obtain inputs for each of these methods, and how accurate are estimates based on each procedure? C
> What weights should be used when you calculate the WACC? Discuss the choice between book value and market value weights, and the role of the “target” capital structure for a firm whose actual capital structure is far removed from the target.
> What are the main components of a company’s cost of capital? Rank these components from lowest to highest cost (a) on a before-tax and (b) on an after-tax cost basis, and explain why these differences exist.
> How have events such as the accounting frauds at AIG, Enron, WorldCom, and several other companies affected people’s ideas about corporate governance, the government’s role in corporate governance, and the use of options for management compensation?
> What are some of the pros and cons of using stock options to compensate managers?
> Managers of corporations don’t always take actions that are in the best interest of the corporation’s owners. What are some of those actions, and how can corporations structure the management contract to help control them?
> What is an agent and what is a principal? What kinds of situations in companies give rise to conflicts between these two, called agency conflicts?
> The funds requirement can be forecasted by the forecasted financial statement approach, but you could also use the AFN formula. What is this formula, and how does it operate? What are its advantages and disadvantages relative to the financial statement m
> Define the following terms and then explain the role they might play in your forecast. (a) Economies of scale. (b) Lumpy assets. (c) Excess capacity.
> Why is corporate governance important to investors? Explain how each of the following is related to corporate governance: (a) management entrenchment, (b) hostile takeovers, (c) incentive compensation plans, (d) greenmail, (e) poison pills, (f) str
> Define each of the following terms: a. Project cash flow; accounting income b. Incremental cash flow; sunk cost; opportunity cost; externality; cannibalization; expansion project; replacement project c. Net operating working capital changes; salvage valu
> A major component of financial planning is to forecast future financial statements. If you had a company’s balance sheets and income statements for the past 5 years but no other information, how could you use the forecasted financial statement approach t
> List and discuss briefly the major components of a firm’s financial plan. What role do projections of financial statements play in the development of the financial plan?
> Singleton Supplies Corporation (SSC) manufactures medical products for hospitals, clinics, and nursing homes. SSC may introduce a new type of X-ray scanner designed to identify certain types of cancers in their early stages. There are a number of uncerta
> The Bartram-Pulley Company (BPC) must decide between two mutually exclusive investment projects. Each project costs $6,750 and has an expected life of 3 years. Annual net cash flows from each project begin 1 year after the initial investment is made and
> DeYoung Entertainment Enterprises is considering replacing the latex molding machine it uses to fabricate rubber chickens with a newer, more efficient model. The old machine has a book value of $450,000 and a remaining useful life of 5 years. The current
> The Everly Equipment Company’s flange-lipping machine was purchased 5 years ago for $55,000. It had an expected life of 10 years when it was bought and its remaining depreciation is $5,500 per year for each year of its remaining life. As older flange-lip
> Madison Manufacturing is considering a new machine that costs $350,000 and would reduce pre-tax manufacturing costs by $110,000 annually. Madison would use the 3-year MACRS method to depreciate the machine, and management thinks the machine would have a
> Shao Industries is considering a proposed project for its capital budget. The company estimates the project’s NPV is $12 million. This estimate assumes that the economy and market conditions will be average over the next few years. The
> Define each of the following terms: a. Capital budgeting; regular payback period; discounted payback period b. Independent projects; mutually exclusive projects c. DCF techniques; net present value (NPV) method; internal rate of return (IRR) method; prof
> St. Johns River Shipyard’s welding machine is 15 years old, fully depreciated, and has no salvage value. However, even though it is old, it is still functional as originally designed and can be used for quite a while longer. A new welder will cost $182,5
> Talbot Industries is considering launching a new product. The new manufacturing equipment will cost $17 million, and production and sales will require an initial $5 million investment in net operating working capital. The company’s tax rate is 40%. a. W
> Davis Industries must choose between a gas-powered and an electric powered forklift truck for moving materials in its factory. Because both forklifts perform the same function, the firm will choose only one. (They are mutually exclusive investments.) The
> Edelman Engineering is considering including two pieces of equipment, a truck and an overhead pulley system, in this year’s capital budget. The projects are independent. The cash outlay for the truck is $17,100 and that for the pulley s
> Your division is considering two investment projects, each of which requires an up-front expenditure of $15 million. You estimate that the investments will produce the following net cash flows: a. What are the two projects’ net present
> Refer to Problem 12-1. What is the project’s discounted payback period? Problem 12-1: A project has an initial cost of $40,000, expected net cash inflows of $9,000 per year for 7 years, and a cost of capital of 11%.
> Refer to Problem 12-1. What is the project’s payback period? Problem 12-1: A project has an initial cost of $40,000, expected net cash inflows of $9,000 per year for 7 years, and a cost of capital of 11%.
> Refer to Problem 12-1. What is the project’s PI? Problem 12-1: A project has an initial cost of $40,000, expected net cash inflows of $9,000 per year for 7 years, and a cost of capital of 11%.
> The Perez Company has the opportunity to invest in one of two mutually exclusive machines that will produce a product it will need for the foreseeable future. Machine A costs $10 million but realizes after-tax inflows of $4 million per year for 4 years.
> Shao Airlines is considering the purchase of two alternative planes. Plane A has an expected life of 5 years, will cost $100 million, and will produce net cash flows of $30 million per year. Plane B has a life of 10 years, will cost $132 million, and wil
> Suppose a firm estimates its overall cost of capital for the coming year to be 10%. What might be reasonable costs of capital for average-risk, high-risk, and low-risk projects?
> Define each of the following terms: a. Operating plan; financial plan b. Spontaneous liabilities; profit margin; payout ratio c. Additional funds needed (AFN); AFN equation; capital intensity ratio; self-supporting growth rate d. Forecasted financial
> Amfac Company manufactures a single product. The company keeps careful records of manufacturing activities from which the following information has been extracted: The company’s manufacturing overhead cost consists of both variable an
> Sawaya Co., Ltd., of Japan is a manufacturing company whose total factory overhead costs fluctuate considerably from year to year according to increases and decreases in the number of direct labor-hours worked in the factory. Total factory overhead costs
> Pleasant View Hospital of British Columbia has just hired a new chief administrator who is anxious to employ sound management and planning techniques in the business affairs of the hospital. Accordingly, she has directed her assistant to summarize the co
> A number of graphs displaying cost behavior patterns are shown below. The vertical axis on each graph represents total cost, and the horizontal axis represents level of activity (volume). Required: 1. For each of the following situations, identify the g
> Morrisey & Brown, Ltd., of Sydney is a merchandising company that is the sole distributor of a product that is increasing in popularity among Australian consumers. The company’s income statements for the three most recent months fol
> Marwick’s Pianos, Inc., purchases pianos from a large manufacturer and sells them at the retail level. The pianos cost, on the average, $2,450 each from the manufacturer. Marwick’s Pianos, Inc., sells the pianos to its customers at an average price of $3
> St. Mark’s Hospital contains 450 beds. The average occupancy rate is 80% per month. In other words, on average, 80% of the hospital’s beds are occupied by patients. At this level of occupancy, the hospital’s operating costs are $32 per occupied bed per d
> Espresso Express operates a number of espresso coffee stands in busy suburban malls. The fixed weekly expense of a coffee stand is $1,200 and the variable cost per cup of coffee served is $0.22. Required: 1. Fill in the following table with your estimat
> Lubricants, Inc., produces a special kind of grease that is widely used by race car drivers. The grease is produced in two processing departments: Refining and Blending. Raw materials are introduced at various points in the Refining Department. The follo
> Weston Products manufactures an industrial cleaning compound that goes through three processing departments—Grinding, Mixing, and Cooking. All raw materials are introduced at the start of work in the Grinding Department. The Work in Pro
> Birch Company normally produces and sells 30,000 units of RG-6 each month. RG-6 is a small electrical relay used as a component part in the automotive industry. The selling price is $22 per unit, variable costs are $14 per unit, fixed manufacturing overh
> Cooperative San José of southern Sonora state in Mexico makes a unique syrup using cane sugar and local herbs. The syrup is sold in small bottles and is prized as a flavoring for drinks and for use in desserts. The bottles are sold for $12 each. (The Mex
> Old Country Links Inc. produces sausages in three production departments—Mixing, Casing and Curing, and Packaging. In the Mixing Department, meats are prepared and ground and then mixed with spices. The spiced meat mixture is then trans
> Builder Products, Inc., manufactures a caulking compound that goes through three processing stages prior to completion. Information on work in the first department, Cooking, for May follows: Production data: Pounds in process, May 1; materials 100% compl
> Sunspot Beverages, Ltd., of Fiji makes blended tropical fruit drinks in two stages. Fruit juices are extracted from fresh fruits and then blended in the Blending Department. The blended juices are then bottled and packed for shipping in the Bottling Depa
> Alaskan Fisheries, Inc., processes salmon for various distributors. Two departments are involved— Cleaning and Packing. Data relating to pounds of salmon processed in the Cleaning Department during July are presented below: A total of
> Superior Micro Products uses the weighted-average method in its process costing system. During January, the Delta Assembly Department completed its processing of 25,000 units and transferred them to the next department. The cost of beginning inventory an
> Scribners Corporation produces fine papers in three production departments—Pulping, Drying, and Finishing. In the Pulping Department, raw materials such as wood fiber and rag cotton are mechanically and chemically treated to separate th
> Helix Corporation produces prefabricated flooring in a series of steps carried out in production departments. All of the material that is used in the first production department is added at the beginning of processing in that department. Data for May for
> Pureform, Inc., manufactures a product that passes through two departments. Data for a recent month for the first department follow: The beginning work in process inventory was 80% complete with respect to materials and 60% complete with respect to lab
> Hielta Oy, a Finnish company, processes wood pulp for various manufacturers of paper products. Data relating to tons of pulp processed during June are provided below: Required: 1. Compute the number of tons of pulp completed and transferred out during
> Distinguish between discretionary fixed costs and committed fixed costs.
> Chocolaterie de Geneve, SA, is located in a French-speaking canton in Switzerland. The company makes chocolate truffles that are sold in popular embossed tins. The company has two processing departments—Cooking and Molding. In the Cooki
> Maria Am Corporation uses a process costing system. The Baking Department is one of the processing departments in its strudel manufacturing facility. In June in the Baking Department, the cost of beginning work in process inventory was $3,570, the cost o
> Data concerning a recent period’s activity in the Prep Department, the first processing department in a company that uses process costing, appear below: A total of 20,100 units were completed and transferred to the next processing dep
> Superior Micro Products uses the weighted-average method in its process costing system. Data for the Assembly Department for May appear below: Required: 1. Compute the cost per equivalent unit for materials, for labor, and for overhead. 2. Compute the
> Clonex Labs, Inc., uses a process costing system. The following data are available for one department for October: The department started 175,000 units into production during the month and transferred 190,000 completed units to the next department. Re
> Quality Brick Company produces bricks in two processing departments—Molding and Firing. Information relating to the company’s operations in March follows: a. Raw materials were issued for use in production: Molding Department, $23,000; and Firing Departm
> Losses have been incurred at Millard Corporation for some time. In an effort to isolate the problem and improve the company’s performance, management has requested that the monthly income statement be segmented by sales region. The comp
> The Midwest Consulting Group (MCG) helps companies build balanced scorecards. As part of its marketing efforts, MCG conducts an annual balanced scorecard workshop for prospective clients. As MCG’s newest employee, your boss has asked you to participate i
> Diversified Products, Inc., has recently acquired a small publishing company that Diversified Products intends to operate as one of its investment centers. The newly acquired company has three books that it offers for sale—a cookbook, a
> Vulcan Company’s contribution format income statement for June is given below: Vulcan Company Income Statement For the Month Ended June 30 Sales ................................................. $750,000 Variable expenses ............................. 3
