978-1259709685 Chapter 13 Solution Manual Part 2

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CHAPTER 13 B-

18. The total cost of the equipment including flotation costs was:

Using the equation to calculate the total cost including flotation costs, we get:

Now, we know the weighted average flotation cost. The equation to calculate the percentage flotation

costs is:

19. a. Using the dividend discount model, the cost of equity is:

b. Using the CAPM, the cost of equity is:

c. When using the dividend growth model or the CAPM, you must remember that both are

20. We are given the total cash flow for the current year. To value the company, we need to calculate the

cash flows until the growth rate levels off at a constant perpetual rate. So, the cash flows each year

will be:

Year 1: $6,800,000(1 + .08) = $7,344,000

Year 2: $7,344,000(1 + .08) = $7,931,520

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We can calculate the terminal value in Year 5 since the cash flows begin a perpetual growth rate.

Since we are valuing Arras, we need to use the cost of capital for that company since this rate is

based on the risk of Arras. The cost of capital for Schultz is irrelevant in this case. So, the terminal

value is:

Now we can discount the cash flows for the first 5 years as well as the terminal value back to today.

Again, using the cost of capital for Arras, we find the value of the company today is:

The market value of the equity is the market value of the company minus the market value of the

debt, or:

21. a. To begin the valuation of Joe’s, we will begin by calculating the RWACC for Happy Times. Since

both companies are in the same industry, it is likely that the RWACC for both companies will be

the same. The weights of debt and equity are:

Next, we need to calculate the cash flows for each year. The EBIT will grow at 10 percent per

year for 5 years. Net working capital, capital spending, and depreciation are 9 percent, 15

percent, and 8 percent of EBIT, respectively. So, the cash flows for each year over the next 5

years will be:

Year 1 Year 2 Year 3 Year 4 Year 5

EBIT $16,800,000

$18,480,00

$20,328,00

$22,360,80

0 $24,596,880

CHAPTER 13 B-

OCF $11,760,000

$12,936,00

$14,229,60

$15,652,56

0 $17,217,816

After Year 5 the cash flows will grow at 3 percent in perpetuity. We can find the terminal value

of the company in Year 5, using the cash flow in Year 6, as:

Now we can discount the cash flows and terminal value to today. Doing so, we find:

The market value of the equity is the market value of the company minus the market value of

the debt, or:

To find the maximum offer price, we divide the market value of equity by the shares

outstanding, or:

b. To calculate the terminal value using the EV/EBITDA multiple we need to calculate the Year 5

EBITDA, which is EBIT plus depreciation, or:

We can now calculate the terminal value of the company using the Year 5 EBITDA, which will

be:

Note, this is the terminal value in Year 5 since we used the Year 5 EBITDA. We need to

calculate the present value of the cash flows for the first 4 years, plus the present value of the

CHAPTER 13 B-

The market value of the equity is the market value of the company minus the market value of

the debt, or:

To find the maximum offer price, we divide the market value of equity by the shares

outstanding, or:

Challenge

22. We can use the debt–equity ratio to calculate the weights of equity and debt. The debt of the

company has a weight for long-term debt and a weight for accounts payable. We can use the target

ratio given for accounts payable to calculate the weight of accounts payable and the weight of long-

term debt. The weight of each will be:

Solving for WACC, we find:

We will use the same equation to calculate the weighted average flotation cost, except we will use

the flotation cost for each form of financing. Doing so, we get:

Since the cash flows go to perpetuity, we can calculate the present value using the equation for the

PV of a perpetuity. The NPV is:

CHAPTER 13 B-

23. We can use the debt–equity ratio to calculate the weights of equity and debt. The weight of debt in

the capital structure is:

XB = .85 / 1.85 = .4595, or 45.95%

Now we can calculate the weighted average flotation costs for the various percentages of internally

raised equity. To find the portion of equity flotation costs, we can multiply the equity costs by the

percentage of equity raised externally, which is one minus the percentage raised internally. So, if the

company raises all equity externally, the flotation costs are:

If the company uses 60 percent internally generated equity, the flotation cost is:

fT = (.5405)(.08)(1 – .60) + (.4595)(.035)

fT = .0334, or 3.34%

And the initial cash flow will be:

If the company uses 100 percent internally generated equity, the flotation cost is:

And the initial cash flow will be:

24. The $7.5 million cost of the land 3 years ago is a sunk cost and irrelevant; the $7.1 million appraised

value of the land is an opportunity cost and is relevant. The $7.4 million land value in 5 years is a

relevant cash flow as well. The fact that the company is keeping the land rather than selling it is

CHAPTER 13 B-

unimportant. The land is an opportunity cost in 5 years and is a relevant cash flow for this project.

The market value capitalization weights are:

The total market value of the company is:

The weight of each form of financing in the company’s capital structure is:

Next we need to find the cost of funds. We have the information available to calculate the cost of

equity using the CAPM, so:

And the aftertax cost of debt is:

a. The weighted average flotation cost is the sum of the weight of each source of funds in the

capital structure of the company times the flotation costs, so:

The initial cash outflow for the project needs to be adjusted for the flotation costs. To account

for the flotation costs:

CHAPTER 13 B-

There is an important caveat to this solution. This solution assumes that the increase in net

working capital does not require the company to raise outside funds; therefore the flotation

Total cost of NWC including flotation costs:

b. To find the required return on this project, we first need to calculate the WACC for the

company. The company’s WACC is:

c. The annual depreciation for the equipment will be:

$40,000,000 / 8 = $5,000,000

So, the book value of the equipment at the end of five years will be:

d. Using the tax shield approach, the OCF for this project is:

e. The accounting breakeven sales figure for this project is:

f. We have calculated all cash flows of the project. We just need to make sure that in Year 5 we

add back the aftertax salvage value and the recovery of the initial NWC. The cash flows for the

project are:

Year Flow Cash

0 –$50,794,408

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Using the required return of 11.81 percent, the NPV of the project is:

And the IRR is:

If the initial NWC is assumed to be financed from outside sources, the cash flows are:

Year Flow Cash

0 –$50,874,712

1 13,580,000

2 13,580,000

And the IRR is: