instructions: FIN470 – Cases in Financial ManagementProblem Set – #1
Spring 2016
Due: March 20, 2016
Please show ALL your work for full credit
1. You are a corporate finance analyst at a management consulting firm, which has been
approached by a company for advice on its capital structure decisions. The company, Boston
Turkey Inc., has been in existence for only two years, and its stock is currently trading at $20
per share (There are 100,000 shares outstanding.) The following are the most recent financial
statements of the company:
Income Statement
Revenues $ 1,000,000
– Expenses $ 400,000
– Depreciation $ 100,000
EBIT $ 500,000
– Interest Expense $ 100,000
Taxable Income $ 400,000
– Tax $ 160,000
Net Income $ 240,000
Balance Sheet
Assets Liabilities
Property, Plant & Equipment $ 1,500,000 Accounts Payable $ 500,000
Land & Buildings $ 500,000 Long Term Debt $ 1,000,000
Current Assets $ 1,000,000 Equity $ 1,500,000
Total $ 3,000,000 Total $ 3,000,000
The debt is not traded, but its estimated market value is 125% of face (book) value.
Due to its limited history, the beta of the stock cannot be estimated from past prices. You do have
information about comparable listed firms and their betas —
Firm Beta Debt/Equity Ratio
Kentucky Fried Chicken 1.05 20%
Hardee’s 1.20 50%
Popeye’s Fried Chicken 0.90 10%
Roy Rogers 1.35 70%
(The comparable firms all have the same tax rate as Boston Turkey). You can assume that the
market risk premium is 5.5%.
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As general information, you have also collected data on interest coverage ratios, ratings and interest
rate spreads, and they are summarized below:
RATING INTEREST COV RATIO SPREAD-OVER-T-BOND
AAA 9.65 ! 0.30%
AA 6.85 9.35 0.70%
A+ 5.65 6.849999 1.00%
A 4.49 5.649999 1.25%
A- 3.29 4.4899999 1.50%
BBB 2.76 3.2899999 2.00%
BB 2.17 2.7599999 2.50%
B+ 1.87 2.1699999 3.00%
B 1.57 1.8699999 4.00%
B- 1.27 1.5699999 5.00%
CCC 0.87 1.2699999 6.00%
CC 0.67 0.8699999 7.50%
C 0.25 0.6699999 9.00%
D -100000 0.2499999 12.00%
The Treasury bill rate is 3.00% and the Treasury bond rate is 6.25%.
a. What is the current cost of equity?
b. What is your best estimate of the current after-tax cost of debt? (The company is not rated
currently)
c. What is the current cost of capital?
2. SDL is a firm manufacturing perfumes and other cosmetics and it sells its products
worldwide. The financial statements for the most recent two years are included below.
Income Statements
(All figures in millions)
1993 1994
Revenues $ 150.00 $ 200.00
– Operating Expenses $ 115.00 $ 140.00
– Depreciation $ 10.00 $ 20.00
= EBIT $ 25.00 $ 40.00
– Interest Expenses $ 5.00 $ 6.50
= Taxable Income $ 20.00 $ 33.50
– Taxes $ 5.00 $ 13.50
= Net Income $ 15.00 $ 20.00
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Balance Sheets (in millions)
1993 1994 1993 1994
Fixed Assets $150 $175 Current Liabilities $40 $50
Current Assets $60 $75 Debt $90 $100
Equity $80 $100
Total $ 210 $ 250 Total $ 210 $250
In addition, you are provided the following information –
 The long-term Treasury bond rate is 6%.
 There are 10 million shares outstanding, trading at $ 40 per share currently; the stock has
been traded for only two years. A regression of stock returns against market returns yields a
beta of 0.9, with a standard error of 0.8. There are, however, five cosmetics firms which are
publicly traded, with the following estimates of betas for each.
Company Beta D/E Ratio
Alberto Culver 0.85 10%
Avon Products 1.3 40%
Gillette 1.25 25%
Helen of Troy 0.95 15%
Helene Curtis 0.85 20%
All these firms face a marginal tax rate of 40%.
 The debt on the balance sheet has two components. The first is traded bonds, with ten years
to expiration and a coupon rate of 7%; there are 50,000 bonds outstanding, trading at $ 850
apiece (the face value is $ 1000). The second is $50 million in bank debt, which also has a ten
year maturity, and carries an interest rate of 6%.
a. Estimate the cost of equity for SDL Inc. (2 points)
b. Estimate the market value of debt and the after-tax cost of debt for SDL Inc.
c. Estimate the cost of capital for this firm. (1 point)
3. You are an expert at working with PCs and are considering setting up a software
development business. To set up the enterprise, you anticipate that you will need to acquire
computer hardware costing $ 100000 (The lifetime of this hardware is five years for
depreciation purposes, and straight line depreciation will be used). In addition, you will have
to rent an office for $50000/ year. You estimate that you will need to hire five software
specialists at $ 50000/ year to work on the software, and that your marketing and selling
costs will be $ 100000/ year. You expect to price the software you produce at $100/unit and
to sell 6000 units a year. The actual cost of materials used to produce each unit is $ 20. Your
tax rate will be 40% and the appropriate opportunity cost is 12%.
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a. Should you accept the project? [Use various decision criteria to answer this question]
b. How sensitive is your decision to the number of units that you sell?
4. You are examining the viability of a capital investment that your firm is interested in. The project
will require an initial investment of $500,000 and the projected revenues are $400,000 a year for five
years. The projected cost-of-goods-sold is 40% of revenues and the tax rate is 40%. The initial
investment is primarily in plant and equipment and can be depreciated straight-line over five years.
(The salvage value is zero.) The project makes use of other resources that your firm already owns:
(a) Two employees of the firm, each with a salary of $40,000 a year, who are currently employed by
another division will be transferred to this project. The other division has no alternative use for
them, but they are covered by a union contract which will prevent them from being fired for three
years (during which they would be paid their current salary.)
(b) The project will use excess capacity in the current packaging plant. While this excess capacity has
no alternative use now, it is estimated that the firm will have to invest $ 250,000 in a new packaging
plant in year 4 as a consequence of this project using up excess capacity (instead of year 8 as
originally planned).
(c) The project will use a van currently owned by the firm. While the van is not currently used, it can
be rented out for $ 3000 a year for five years. The book value of the van is $10,000 and it is being
depreciated straight line (with five years remaining for depreciation).
The discount rate to be used for this project is 10%.
(1) What (if any) is the opportunity cost associated with using the two employees from
another division (described in (a))?
(2) What, if any, is the opportunity cost associated with the use of excess capacity of the
packaging plant?
(3) What, if any, is the opportunity cost associated with the use of the van?
(4) What is the after-tax operating cash-flow each year on this project?
(5) What is the net present value of this project?
5. You are considering a capital budgeting proposal to make ‘glow-in-the-dark’ pacifiers for anxious
first-time parents. You estimate that the equipment to make the pacifiers would cost you $50,000
(which you can depreciate straight line over the lifetime of the project, which is ten years) and that
you can sell 15,000 units a year at $2 a unit. The cost of making each pacifier would be $0.80 and the
tax rate that you would face would be 40%. You also estimate that you will need to maintain an
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inventory at 25% of revenues for the period of the project and that you can salvage 80% of this
working capital at the termination of the project. Finally, you will be setting up the equipment in
your garage, which means you have to pay $2000 a year to have your car garaged at a nearby private
facility (Assume that you can deduct this cost for tax purposes). To estimate the discount rate for
this project, you find that there are comparable firms being traded on the financial markets with the
following betas:
Company Debt-Equity ratio Tax rate Beta
Nook 0.50 0.40 1.3
Gerber 1.00 0.50 1.5
You expect to finance this project entirely with equity and the current T-bills rate is 8.5%.
(a) What is the appropriate discount rate to use for this project?
(b) What is the after-tax operating cash flow each year for the lifetime of the project?
(c) What is the NPV of this project?