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MAIN MENU -- CHAPTER 14

Problem 14-4 Problem 14-10 Problem 14-23

Fundamentals of Corporate Finance by Ross, Westerfield, and Jordan -- Fifth Edition

Copyright © 2000 Irwin/McGraw-Hill and KMT Software, Inc. (www.kmt.com)

File: 766209948.xls Copyright © 1997 Richard D. Irwin, Inc. Printed: 06/21/2024

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File: 766209948.xls Copyright © 1997 Richard D. Irwin, Inc. Printed: 06/21/2024

 Fundamentals of Corporate Finance
Ross, Westerfield, and Jordan -- Fifth Edition

Problem 14-4 Objective

Estimate DCF growth rate.

Student Name:
Course Name:
Student ID:
Course Number:

Suppose Nicholas Ltd. just issued a dividend of $.60 per share on its common stock. The company paid
dividends of $.35, $.40, $.45 and $.50 per share in the last four years. If the stock currently sells for $10,
what is your best estimate of the company's cost of equity capital?

Solution
Instructions
Enter formulas to calculate the dividend growth rates, then use the average growth rate to calculate the
estimated cost of equity capital.

Stock price $10

Dividends Growth
Years Per Share Rates
1 $0.35
2 $0.40 FORMULA
3 $0.45 FORMULA
4 $0.50 FORMULA
5 $0.60 FORMULA

Average growth rate #DIV/0!

Estimated cost of equity capital FORMULA

What-if Analysis
Instructions

Click one of the scenario buttons to see the "what if" question. With each scenario, refer back to the
original data of the problem. Solve the scenario question by utilizing the template given below.
Be sure to print your results before moving on to the next scenario.

What-if: (Scenario 1)
The stock price is $25.00

Student's "What-if" Solution

Scenario 1
Stock price

Dividends Growth
Years Per Share Rates
1 $0.35
2 $0.40 14.29%
3 $0.45 12.50%
4 $0.50 11.11%
5 $0.60 20.00%

Average growth rate 14.47%

Estimated cost of equity capital FORMULA

Scenario 2
Stock price

Dividends Growth
Years Per Share Rates
1 $0.35
2 $0.40 14.29%
3 $0.45 12.50%
4 $0.50 11.11%
5 $0.75 50.00%

Average growth rate 21.97%

Estimated cost of equity capital FORMULA

File: 766209948.xls Copyright © 1997 Richard D. Irwin, Inc. Printed: 06/21/2024

 Fundamentals of Corporate Finance
Ross, Westerfield, and Jordan -- Fifth Edition

Problem 14-10 Objective

Calculate the WACC.

Student Name:
Course Name:
Student ID:
Course Number:

Modigliani Manufacturing has a target debt-equity ratio of .50. Its cost of equity is 18 percent and its cost
of debt is 11 percent. If the tax rate is 35 percent, what is Modigliani's WACC?

Solution
Instructions
Enter formulas and data to complete the problem.

Debt-equity ratio 50%

Cost of equity 18%
Cost of debt 11%
Tax rate 35%

Cost of After Tax

Weights Capital Cost WACC
Debt FORMULA FORMULA #VALUE!
Equity #VALUE! 18.00% #VALUE!
#VALUE!

File: 766209948.xls Copyright © 1997 Richard D. Irwin, Inc. Printed: 06/21/2024

 Fundamentals of Corporate Finance
Ross, Westerfield, and Jordan -- Fifth Edition

Problem 14-23 Objective

Evaluate a proposed capital project.

Student Name:
Course Name:
Student ID:
Course Number:

This is a comprehensive project evaluation problem bringing together much of what you have learned in this
and previous chapters. Suppose you have been hired as a financial consultant to Defense Electronics, Inc.
(DEI), a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). The
company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs.

This will be a five-year project. The company bought some land three years ago for $6 million in anticipation
of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the
chemicals instead. The land was appraised last week for $1.30 million. The company wants to build its
new manufacturing plant on this land; the plant will cost $6.5 million to build. The following market data on
DEI's securities are current:

Debt: 10,000 percent coupon bonds outstanding, 15 years to

maturity, selling for 92 percent of par; the bonds have a
$1,000 par value each and make semiannual payments.

Common stock: 250,000 shares outstanding selling for $55 per share;
the beta is 1.4.

Preferred stock: 10,000 shares of 6 percent preferred stock outstanding,

selling for $85 per share.

Market: 7 percent expected market risk premium, 5 percent risk-

free rate.

DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 14 percent on new
common stock issues, 9 percent on new preferred stock issues, and 5 percent on new debt issues.

Wharton has included all direct and indirect issuance costs (along with its profit) in setting these spreads.
Wharton has recommended to DEI that it raise the funds needed to build the plant by issuing new shares
of common stock. DEI's tax rate is 34 percent.

Solution
Instructions
Answer the questions below. Where ever possible, enter formulas and Excel functions to determine your
answer.

Preliminary calculations:
Market value of the bonds FORMULA

Market value of the equity FORMULA

Market value of preferred FORMULA

Total market value of capitalization $0

Cost of equity FORMULA

Cost of debt:
Yield to maturity FORMULA
After tax cost #VALUE!

Cost of preferred FORMULA

a. Calculate the project's initial Time 0 cash flow, taking into account all side effects.

Cost of external financing #VALUE!

Add opportunity cost of land
Initial working capital investment $750,000
Time 0 cash flow #VALUE!

b. The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is
being located overseas. Management has told you to use an adjustment factor of +2 percent to account for
increased riskiness. Calculate the appropriate discount rate to use when evaluating DEI's project.

Weights Cost WACC

Debt FORMULA #VALUE! #VALUE!
Preferred FORMULA #VALUE!
Common FORMULA #VALUE!
Risk factor
#VALUE!

c. The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of
the project (i.e., the end of Year 5), the plant can be scrapped for $2 million. What is the after-tax salvage
value of this manufacturing plant?

Year 5 Book value $2,437,500

After tax salvage value FORMULA

d. The project requires $750,000 in initial net working capital investment to get operational. The company
will incur $200,000 in annual fixed costs. The plan is to manufacture 10,000 RDSs per year and sell them
at $10,000 per machine; the variable costs are $8,000 per RDS. What is the annual operating cash flow
from this project?

Annual Revenue FORMULA

Variable costs FORMULA
Fixed costs
Depreciation FORMULA
EBIT #VALUE!
Taxes #VALUE!
EAT #VALUE!
Add depreciation
OCF #VALUE!

e. DEI's comptroller is primarily interested in the impact of DEI's investments on the bottom line of reported
accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this
project?

Break-even point FORMULA units

f. Finally, DEI's president wants you to throw all your calculations, assumptions, and everything else into
the report for the chief financial officer; all he wants to know is what the RDS project's internal rate of
return (IRR) and net present value (NPV) are. What will you report?

Cash
Year Flow
0
1
2 #VALUE!
3 #VALUE!
4 #VALUE!
5 $16,243,000

IRR FORMULA
NPV FORMULA

File: 766209948.xls Copyright © 1997 Richard D. Irwin, Inc. Printed: 06/21/2024