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Problem 18-8 Problem 18-13

Corporate Finance by Ross, Westerfield, and Jaffe, and Roberts -- Fourth Edition Copyright 2005 McGraw-Hill Ryerson

File: 138253460.xls.ms_office

Copyright 1999 Irwin/McGraw-Hill

Printed: 4/5/2013

Corporate Finance
Ross, Westerfield, and Jaffe, and Roberts -- Fourth Edition
Problem 18-8 Objective Evaluate a potential capital investment Student Name: Course Name: Student ID: Course Number: Neon Corporation's stock returns have a covariance with the market of 0.031. The standard deviation of the market returns is 0.16, and the historical market premium is 8.5 percent. Neon's bonds yield 11% per annum. The market value of the bonds is $24 million. Neon has 4 million shares of common stock outstanding, each worth $15. Neon's CEO considers the firm's current debt-to-equity ratio optimal. The tax rate is 34 percent, and the Treasury bill rate is 7% per annum. Neon is considering the purchase of additional equipment that would cost $27.5 million. The expected unlevered cash flows (UCF) from the new equipment are $9 million a year for five years. (Unlevered cash flows are defined as the after-tax cash flows the equipment would generate under all-equity financing.) Purchasing the equipment will not change the risk level of the firm. a. Use the weighted average cost of capital approach to determine whether or not Neon should purchase the equipment. b. Suppose Neon decides to fund the purchase of the equipment entirely with debt. By how much will the weighted average cost of capital used in part a change? Explain your answer.

Solution
Problem 18-8 Instructions Enter formulas to calculate the requirements of this problem. Use the Excel PV function to calculate the Net Present Value (NPV). Assumptions Stock returns covariance with market Standard deviation of market returns Historical market premium Bond coupon rate Bond yield Market value of bonds Number of shares of stock outstanding Share price of stock Tax rate Treasury bill rate

0.031 0.16 8.50% 13.00% 11.00% $24,000,000 4,000,000 $15 34% 7%

0.085 0.13 0.11

0.34 0.07

a. Use the weighted average cost of capital approach to determine whether or not Neon should purchase the equipment. Weighted Average Cost of Capital Cost of Equity: Beta Required rate of return on stock Cost of Debt Value of firm Weighted average cost calculation Weights 71.43% 28.57% 100% Costs 17.29% 7.26% WACC 12.35% 2.07% 14.43%

1.21 17.2930% 7.26% $84,000,000

1.21%

Stock Bonds

Net present value calculation Assumptions Cost of equipment $27,500,000 Annual cash flow $9,000,000 Term 5 years NPV $3,083,700 Yes Should Neon buy the equipment? (enter an X) b. Suppose Neon decides to fund the purchase of the equipment entirely with debt. By how much will the weighted average cost of capital used in part a change? Explain your answer. No

Copyright 2005 Irwin/McGraw-Hill

FAST Workbooks by Ross, Westerfield, and Jaffe

Problem: 17-8

Corporate Finance
Ross, Westerfield, and Jaffe, and Roberts -- Fourth Edition
Problem 18-13 Objective Evaluate capital investments that are not scale-enhancing. Student Name: Course Name: Student ID: Course Number: Blue Angel, Inc., a new firm in the holiday gift industry, is considering a project. To better assess the risk of the project, the firm obtained the following information on ten other firms in industry:
Industry Average Blue Angel

Debt-equity ratio Beta rB

30% 1.5 10%

35% ? 10%

The expected market return on the market portfolio is 17 percent, and the risk-free rate is 9 percent. Blue Angel is subject to a corporate tax rate of 40%. The project requires an initial outlay of $325,000 and is expected to result in a $55,000 cash inflow at the end of the first year. The project will be financed at Blue Angel's target debt-equity ratio. Annual cash flow from the project will grow at a constant rate of 5% until the end of the fifth year and remain constant forever thereafter. Should Blue Angel invest in the project?

Solution
Problem 18-13 Instructions Enter formulas, data, and comments to solve the requirements of this problem. Assumptions Expected market return Risk-free interest rate Corporate tax rate First year annual cash flow Cash flow annual growth rate Expected rate on Industry Average

17% 9% 40% $55,000 5% (until end of fifth year) FORMULA

Below is the calculation of the weighted average cost of capital for the "Benchmark". Weighted Average Cost of Capital (Industry Average) Weights FORMULA 100% 100% Cost 0% 6% WAAC 0.0% 6.0% 6.0%

Equity Debt

Since rwacc industry average = rwacc project Therefore, the Rs project can be found by setting the rwacc project to rwacc industry average as calculated above. Weighted Average Cost of Capital (Project) Weights Cost 74% FORMULA 26% 6.00% 100% WAAC 0.0% 1.6% 1.6%

Equity Debt

Present value of project Year 1 2 3 4 5 6 and thereafter Less Initial Investment Net present value Cash Flow $55,000 $57,750 $60,638 $63,669 $66,853 $66,853 Present Value $54,158 $55,994 $57,894 $59,857 $61,887 $3,978,469 $4,268,258 ($325,000) $3,943,258

Should the project be pursued and why or why not?

Copyright 2005 Irwin/McGraw-Hill

FAST Workbooks by Ross, Westerfield, and Jaffe

Problem: 17-13