Question

1. You have been hired by the Board of Directors of firm XYZ as a part of a team, tasked with the valuation of a potential acquisition target. You have collected the following publicly available information about the target company: • The common stock of the company is currently selling for an average of $40 per share. There are 6.5 million shares outstanding. The annual dividend that the company just paid was $2.60 per share. • The company has two bond issues outstanding; both bonds pay interest annually. The 5.4 percent 20-year bond was issued 13 years ago and is currently selling at 98.3% of par. The 4 percent 15-year bond was issued 2 years ago. The 20-year issue has 80,000 bonds outstanding and the 15-year issue has 30,000 bonds outstanding. You have also estimated that: • The long-term growth rate of dividends should be 4.75 percent. The company’s beta should be 1.03. The expected return of the market is 11.5 percent and the risk-free rate is 3.5 percent. • The market-required rate of return on the 15-year bond should be 6.1 percent. What is your best estimate for the cost of capital of the acquisition target company? (15 points)

2. You need a new computer to be able to run your small business on the road. You have identified two alternatives: a $1,000 computer that will last 3 years and a $2,000 computer that will last twice as long as the first one. You estimate that the annual benefits from both computers will be $800. Which of the two computers is a better choice if your opportunity cost of capital is 10 percent? Use both the EAA and the replacement chain methods to justify your choice. (5 points)

3. After graduating from college, you landed a $75,000 job and were happy with it until your friends started going back to school. Now the MBA is on your mind as well. The cost of a good MBA program is $40,000 a year and such programs require that you are a full-time student. It will take you two years to graduate and you will have to leave your job, while attending school. You expect that the starting salary for an MBA professional will be $120,000 by the time you graduate and will increase by 2 percent every year. If you stay at your current job, your salary will be $77,500 at age 25 and will increase by 1% until you retire. Your opportunity cost of capital is 12%. Is this a good decision, if you start your MBA program when you are 25 and retire when you turn 55 (assume the same retirement age for both options.) (5 points)

4. FR&AM Incorporated just introduced a new light-weight tennis racket. The rackets will sell for $865 and have a variable cost of $425. The company has spent $500,000 for a marketing study that determined the company will sell 70,600 light-weight rackets per year for seven years. The marketing study also determined that the company will lose sales of 13,800 its high-priced rackets. The high-priced rackets sell at $1,235 and have variable costs of $695. The fixed costs each year will be $10,750,000. The company has also spent $2,900,000 on research and development for the new racket. The plant and equipment will cost $39,200,000 and will be depreciated on a straight-line basis to zero over the 10-year tax life of the project. After 7 years the equipment will be sold for 1,250,000. The new rackets will also require an increase in net working capital of $3,600,000. The tax rate is 21 percent, and the cost of capital is 12 percent. What are the NPV and IRR of the project? (10 points)

5. What is the crossover rate for projects K and L? Which project should be accepted if the cost of capital is 15 percent? (5 points) K L Year 0 -555,000 -505,000 Year 1 250,000 175,000 Year 2 200,000 250,000 Year 3 150,000 325,000 Year 4 100,000 150,000 Year 5 50,000 -50,000

Answer 1

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