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Gordon’s Plants has the following partial income statement for 2012:
Earnings before interest and taxes $4,500
Interest (2,000)
Earnings before taxes $2,500
Taxes (40%) (1,000)
Net income $1,500
Number of common shares 1,000
What is the degree of financial leverage for Gordon’s? What does this value mean?
Consider the decision you might have to make if you won a state lottery worth $105 million. Which would you choose: a lump-sum payment of $54 million today or a payment of $3.5 million each year for the next 30 years? Which should you choose?
A. If your opportunity cost is 6 percent, which alternative should you select?
B. At what opportunity cost would you be indifferent between the two alternatives?
Suppose Ford Motor Company sold an issue of bonds with a 10-year maturity, a $1000 par value, a 10 percent coupon rate, and semiannual interest payments.
A. Two years after the bonds were issued, the going rate of interest on bonds such as these fell to 6 percent. At that price would the bonds sell?
B. Suppose that the interest rate remained at 6 percent for the next eight years. What would happen to the price of the Ford Motor Company bonds over time?
Your broker offers to sell you some shares of Wingler & Company common stock, which paid a dividend of $2 yesterday. You expect the dividend to grow at a rate of 5 percent per year into perpetuity. The appropriate rate of return for the stock is 12 percent.
A. If you purchase the Wingler & Company stock with the intent of selling it in three years, what cash flows will you receive each year?
B. What is the market value of Wingler’s stock?
The market and Stock S have the following probability distributions:
Probability rm rs
0.3 15% 20%
0.4 9 5
0.3 18 12
a. Calculate the expected rates of return for the market and Stock S
b. Calculate the standard deviations for the market and Stock S
c. Calculate the coefficients of variation for the market and Stock S
The Gupta Company’s cost of equity is 16 percent. It’s before-tax cost of debt is 13 percent, and its marginal tax rate is 40 percent. The stock sells at book value. Using the following balance sheet, calculate Gupta’s after-tax weighted average cost of capital:
Assets Liabilities and Equity
Cash $120 Long-term debt $1,152
Accounts receivable 240 Equity 1,728
Inventories 360
Net plant and equipment 2,160
Total assets $2,880 Total liabilities and equity $2,880
Your company is considering two mutually exclusive projects—C and R—whose costs and cash flows are shown in the following tables:
Expected Net Cash Flows
Year Project C Project R
0 $(14,000) $(22,840)
1 8,000 8,000
2 6,000 8,000
3 2,000 8,000
4 3,000 8,000
The projects are equally risky, and their required rate of return is 12 percent. You must make a recommendation concerning which project should be purchased. To determine which is more appropriate, compute the NPV and IRR of each project.
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