Market Values

1. Use the following information to answer questions A through G.
Market Values
Current cap. Structure
Proposed cap. Structure
Assets
$15 million
$15 million
Debt
$0
$6 million
Equity
$15 million
$9 million
Share price
$25.00
$22.50
Shares outstanding 600,000
???
Bond Interest rate
N/A
8%
There are no taxes. EBIT is expected to be $2.5 million, but could be as high as $3.5 million if
an economic expansion occurs, or as low as $2 million if a recession occurs. All values are
market values.
A. What are EPS under the current and proposed capital structure for the three state of
economy?
B. What are ROE under the current and proposed capital structure for the three state of
economy?
C. How many shares are outstanding under the proposed capital structure?
D. What is the weighted average cost of capital before and after recapitalization?
E. What are EPS and ROE if the tax rate is 40%?
F. What is the WACC if the tax rate is 40%?
G. What is the expected net income and levered value of the firm when the tax rate is 40%?
2. As manager of operation at the First California Bank (FCB), Vince Carter is responsible to
reduce operational costs, keep FCB competitive with other banks such as National Bank of
California (NBC), and provide the best customer service to the FCB’s customers.
Four years ago, he installed an automated teller machine (ATM) at one of its branches.
The machine had the capacity to accept deposits, make withdrawals, and handle inquiries
regarding account balances. Not long afterward, National Bank of California, NBC, installed
its own superior and reliable ATM and called it MoneyMax ATM. MoneyMax can do
everything the FCN’s ATM can do, and more, including transferring customers’ funds between
checking and savings, card retraction, receipt printing, customer service requests, dot-matrix
Journal printing or electronic journal and any online banking that a computer could do.
Since the NBC installed its MoneyMax, FCB has lost many of its customers. As a
result, Vince Carter is planning to install a new, more efficient and productive ATM called
Transax Mini-Bank, because it will handle complete banking activities outside of the bank.
When FCB purchased its first ATM, it cost $500,000 and was estimated to have a useful
economic life of 10 years. The bank has been depreciating its ATM on a straight -line basis
(over 10 years) to an estimated book salvage value of $100,000. The current actual market
value of the old ATM is $200,000.
Transax Mini-Bank will cost $800,000 and have an expected economic life of 6 years.
FCB plans to depreciate the new ATM over 5 years using MACRS. FCB believes that its
Transax Mini-Bank will attract new customers, which are expected to generate $300,000 in
new revenues during the first year. Revenues from these new customers are expected to grow
at 5% per year over the 6-year life of the Transax ATM. Vince Carter also estimated the

Tranax Mini-Bank ATM would require $40,000 additional Working Capital at the time
installation. Thereafter, the working capital would grow with revenue at a constant rate of 6%
per year. As an additional cost, annual maintenance costs on the new ATM will be $10,000
during the first year and to increase at a rate of 5% per year over the annual maintenance costs
of the old ATM.
First California Bank has a 40% marginal tax rate, and has the following capital structure:
Capital Structure
(in millions)
Debt
$10
Preferred Stock
$10
Common Stock ($5 par,1 million shares)
$5
Paid-in-capital
$5
Retained Earnings
$10
Total
$40
The debt is based on the FCB bond that the bank issued several years ago. The bond has a 10%
coupon rate, a par value of $1,000 and 10 years maturity left. Today, the bond is selling for
$900. The preferred stock has a price of $25 with annual dividend of $2.50 per share.
The common stock is selling for $31 per share and FCB is expected to pay $3.0 dividend per
share this year. The dividend payment has increased from $1.84 since 10 years ago.
Part I
a) Compute the net investment required to purchase the new ATM.
b) Compute the annual incremental net cash flows for each year of the ATM’s expected 6year life.
c) Compute the net present value of Transax Mini-Bank, assuming the new ATM to be of
average risk.
d) Based on the calculations performed in Questions 1-3, should First California Bank
purchase the new ATM?
e) If FCB required a payback of less than 4 years, should FCB purchase new ATM?
Part II
The bank’s board of directors require that a risk-adjusted discount rate be used to evaluate any
new capital investment that are seen as expanding the bank’s services. Assume that the board
considers the new Transax Mini-Bank as falling into this category, and that the Board requires
an additional risk premium to be added when evaluating such an investment. Vince Carter has
estimated that the Beta of this investment to be equal 1.5 with return on the market portfolio of
15% and risk-free rate of 5%.
f) What is the cost of capital?
g) Should the bank purchase the new ATM? Support your answer with calculating either
NPV or IRR of the new ATM.
3. The manager of Alpha Beta Funds is considering addition of the following stocks in his
portfolio:
Stocks
Standard Deviation Covariance
Expected (Ri)
A
18%
0.012
20%
B
15%
0.0075
12%

WRITE THIS ESSAY FOR ME

Tell us about your assignment and we will find the best writer for your paper.

Get Help Now!

C
10%
0.011
14%
D
20%
0.0175
16%
E
14%
0.016
15%
RM
10%
1.0
14%
RF
0
0.9
6%
a. Calculate the required rate of return for each stock.
b. Determine which stock(s) the manager of Alma Funds should include in his
portfolio.
4. The Sun Co. was founded five years ago by three former Moon Company employees. The
three founders own 100% of the Sun Company’s stock which has a market value of $5 per
share. Below is the Balance Sheet of the company.
The boards of directors of Sun Company have asked Frank Norman, the financial officer of the
company, to make the first major decision for the company’s future financial planning.
The board has asked Frank to evaluate the profitability of two new investments (Table 1) that
the company considers to acquire for its future survival.
The two investments are different in their characteristics and descriptions.
Table 1
Investment A
Investment B
Purchase Price
$1,000,000
$4,000,000
Output
2,500
2,500
Growth in Output
5%
6%
Variable Cost
$800
$600
Growth in Costs
3%
3%
Unit Price
$1,000
$1,500
Price Increase
4%
4%
Beta
1
1.4
Tax Rate
40%
40%
The investments would be depreciated on a straight line basis over their five-year life to a zero
salvage value.
Frank Norman, being a sophisticated financial analyst, obtained the following information in
Table 2 for the analysis of various investment and financial proposals.
Market and Company
Varianc
Information
Expected Return
e
Cov (Ri,RM)
Risk-Free Rate
10%
Market Portfolio
20%
20%
Sun Co.
8%
Part I
a. What is the cost of capital for each investment?
b. Which of the two investments should be adopted? Why?
c. What would be the Sun’s cost of capital if these two investments are adopted?
d. Based on the expected rate of return of each investment which investment should be
accepted? Why?
Part II

The financial officer has long believed that Sun’s capital structure is not optimal, and he
believes by financing half of total investment of each investment by debt at the 10% and
retires the debt over the life of the investment, the value of each investment will be
maximized. If Frank Norman is correct with his assumptions and if his financial plan is
adopted, what would the following be?
e. Weighted Average Cost of Capital (WACC).
f. Value of each investment.
Sun Company
Balance Sheet (in thousands)
Cash
$100,000
Accounts Payable
$150,000
Account
Receivable
$300,000
Notes Payable
$50,000
Inventory
$250,000
Accrued Wages
$75,000
Current Assets
$650,000
Current Liabilities
$275,000
Gross Fixed
Assets
less: Accumulated
Depreciation
Net Fixed Assets
Total Assets

$1,850,00
0

Common Stocks (1M shares at par
value of $1.5)
($300,000) Retained Earnings
$1,550,00
0
Equity
$2,200,00
0
Total Debt & Equity

$1,500,000
$425,000
$1,925,000
$2,200,000

5. On August 2, 2012, Yen Dollar, a portfolio manager at NewPoint, a mutual fund management
firm, pored over analysts’ write-ups of Global Traders Corp. Global Traders is an expanding
conglomerate, is a manufacturing company whose product lines consist of lighting fixtures,
videodiscs, electronic timing devices, travel agencies, and self-storage space. Dollar was
considering buying some shares for the fund she managed, the NewPoint Large-Cap Fund with
an emphasis on value investing. Global Traders Corp’s analyst has projected the following
income statement for the next four years (in millions of dollars):
Pro Forma Income Statement
2013
2014
2015
2016
Growth Rate
0.2
0.2
0.15
0.1
Net sales
$120 $144
$166
$182
($78
Cost of goods sold
)
($94)
($108) ($118)
($20
Selling/administrative expense
)
($24)
($28)
($30)
($10
Depreciation
)
($12)
($15)
($18)
EBIT
$12
$14
$15
$16
Interest
($5)
($6)
($8)
($10)
EBT
$7
$8
$7
$6
Taxes (40%)
($3)
($3)
($3)
($2)

Net income
$4
$5
$4
$4
All incomes are assumed to occur at end-of-year and it is expected to grow at rate of 5% after
2016. Global Traders currently has a market value capital structure of 20 percent debt with
interest rate 10% and a beta of 2. Depreciation-generated funds would be used to finance the
needs in capital equipment, so they would not be available to 5 million Global Traders’
shareholders. The risk-free rate is 6 percent and the market risk premium is 8 percent.
a.
What is the value of the Global Traders based on WACC model?
b.
What is the value to shareholders?