978-1259289903 Chapter 12 Solution Manual Part 2

CHAPTER 12 B – 1

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

Total costs = $24,000,000 + 1,420,000

Total costs = $25,420,000

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

We can solve this equation to find the debt-equity ratio as follows:

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

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

RS = .1268, or 12.68%

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

for the cost of equity. Additionally, and perhaps more importantly, each method of estimating

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

CHAPTER 12 B – 2

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:

TV5 = CF6/(RWACC – g)

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

V0 = $7,344,000/1.10 + $7,931,520/1.102 + $8,566,042/1.103 + $9,251,325/1.104

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:

Share price = $114,723,941/2,400,000

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:

XB = $115,000,000/($115,000,000 + 350,000,000)

XB = .2473, or 24.73%

Net income

7,316,000

8,047,600

8,852,360

9,737,596

10,711,356

Depreciation

944,000

1,038,400

1,142,240

1,256,464

1,382,110

OCF

$8,260,000

$9,086,000

$9,994,600

$10,994,060

$12,093,466

– Capital spending

1,770,000

1,947,000

2,141,700

2,355,870

2,591,457

– Change in NWC

1,062,000

1,168,200

1,285,020

1,413,522

1,554,874

Cash flow from assets

$5,428,000

$5,970,800

$6,567,880

$7,224,668

$7,947,135

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

TV5 = CF6/(RWACC – g)

TV5 = $7,947,135(1 + .03)/(.0920 – .03)

TV5 = $132,034,141

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:

S = $110,252,456 – 28,600,000

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

or:

Share price = $81,652,456/1,850,000

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:

EBITDA = $17,276,380 + 1,382,110

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 Year 5

terminal value. So, the value of the company today is:

CHAPTER 12 B – 4

V0 = $5,428,000/1.0920 + $5,970,800/1.09202 + $6,567,880/1.09203

+ $7,224,668/1.09204 + $149,267,923/1.09205

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

debt, or:

S = $116,233,188 – 28,600,000

S = $87,633,188

or:

Share price = $87,633,188/1,850,000

Share price = $47.37

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 given for

accounts payable to calculate the weight of accounts payable and the weight of long-term debt. The

weight of each will be:

Accounts payable weight = .20/1.20

Accounts payable weight = .17

Long-term debt weight = 1/1.20

Long-term debt weight = .83

Since the accounts payable has the same cost as the overall WACC, we can write the equation for the

WACC as:

RWACC = (1/1.45)(.13) + (.45/1.45)[(.20/1.2)RWACC + (1/1.2)(.07)(1 – .35)]

CHAPTER 12 B – 5

capital structure is:

XB = .75/1.75

XB = .4286, or 42.86%

And the weight of equity is:

XS = 1 – .4286

flotation costs:

Amount raised(1 – .0507) = $130,000,000

Amount raised = $130,000,000/(1 – .0507)

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

fT = (.5714)(.07)(1 – .60) + (.4286)(.025)

fT = .0267, or 2.67%

CHAPTER 12 B – 6

Amount raised(1 – .0107) = $130,000,000

Amount raised = $130,000,000/(1 – .0107)

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

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:

B = 280,000($1,000)(1.03)

B = $288,400,000

S = 9,800,000($73)

S = $715,400,000

P = 450,000($87)

P = $39,150,000

The total market value of the company is:

V = $288,400,000 + 715,400,000 + 39,150,000

V = $1,042,950,000

equity using the CAPM, so:

RS = .032 + 1.20(.075)

RS = .1220, or 12.20%

P0 = $1,030 = $32(PVIFAR%,50) + $1,000(PVIFR%,50)

R = 3.082%

RB = (1 – .35)(.0616)

CHAPTER 12 B – 7

The cost of preferred stock is:

RP = $5.10/$87

RP = .0586, or 5.86%

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:

fT = .6859(.065) + .2765(.03) + .0375(.045)

fT = .0546, or 5.46%

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

the flotation costs:

Amount raised(1 – .0546) = $45,000,000

Amount raised = $45,000,000/(1 – .0546)

RWACC = .6859(.1220) + .2765(.0401) + .0375(.0586)]

RWACC = .0970, or 9.70%

The company wants to use the subjective approach to this project because it is located overseas.

The adjustment factor is 2 percent, so the required return on this project is:

Project required return = 9.70% + 2%

Project required return = 11.70%

CHAPTER 12 B – 8

$45,000,000/8 = $5,625,000

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

BV5 = $45,000,000 – 5($5,625,000)

BV5 = $16,875,000

OCF = [(P – v)Q – FC](1 – tC) + tCD

OCF = [($12,900 – 11,250)(18,000) – 8,100,000](1 – .35) + .35($45,000,000/8)

OCF = $16,008,750

QA = (FC + D)/(P – v)

QA = ($8,100,000 + 5,625,000)/($12,900 – 11,250)

QA = 8,318.18 units

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

project are:

Year Flow Cash

0 –$56,097,436

1 16,008,750

2 16,008,750

3 16,008,750

4 16,008,750

5 36,240,000

NPV = –$56,097,436 + $16,008,750(PVIFA11.70%,4) + $36,240,000/1.11705

NPV = $13,684,071.10

Year Flow Cash

0 –$56,178,245

CHAPTER 12 B – 9

1 16,008,750

2 16,008,750

3 16,008,750

4 16,008,750

5 36,240,000

NPV = $13,603,261.97

And the IRR is: