Numerade

Questions asked

INSTANT ANSWER

Celestila Moonn is one of the senior managers at the corporate finance department of New Heritage gathered the following market data for her analysis to identify the capital structure that maximizes the firm’s stock price and minimizes the weighted average cost of capital. In response to a question regarding capital structure theory, Moonn made the following statement: The deductibility of interest lowers the cost of debt and the cost of capital for the company as a whole. Adding the tax shield provided by debt to the Modigliani and Miller framework suggests that the optimal capital structure is all debt. Table 1 Market value of debt $100 milion Yield to maturity on debt 8.0% Market price per share of common stock $30 Number of shares of common stock 10milion Cost of capital if all equity-financed 10.3% Marginal tax rate 35% Table 2 Debt-to-Total Capital Ratio % Cost of Equity % Cost of debt % 20 7.7 12.5 30 8.4 13.0 40 9.3 14.0 50 10.4 16.0 According to the pecking order theory, New Heritage’s announced capital structure change: A. Is optimal because debt is cheaper than equity on an after-tax basis. B. May be optimal if new debt is issued after internally generated funds are made complete use of as a source of capital. C. May be optimal if new debt is issued after new equity is made complete use of as a source of capital.

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INSTANT ANSWER

Caleb opens The Wall street Journal and finds that the 30-year Treasury bond has a yield-to-maturity of 7.5%. He tells Vincent that this is an example of a nominal interest rate. After that he was reading the U.S. Treasury Bond Quotations table below and calculated the previous day’s asked price and the current yield to be $979.35 and 4.084%, respectively. Rate Maturity Mo/Yr Bid Price Asked Price Change Asked Yield 4 June 09 n 97:29 97:30 -1 4.92 Is Caleb correct with respect to his comment on the 30-year Treasury bond that has yield-to-maturity of 7.5%? A. Yes B. No, this is an example of a real interest rate. C. No, this is an example of an inflation rate.

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ANSWERED

Jerelyn Nevil

Numerade educator

Before making the final calculations, Caleb and Moonn discuss net present value analysis for the projects they are considering. Moonn tells Caleb, “When calculating the net present value of the two new projects, we also need to account for the costs expended as a result of researching the project options.” Caleb makes a note on his legal pad and says to Moonn, “There is no need to make any adjustments for inflation in our net present value calculations because inflation is included as part of the expected returns used to calculate our weighted average cost of capital.” After their conversation, Moonn and Caleb prepare their report to present to SchoolStreets’ Board of Directors meeting for approval. With respect to the dialogue between Caleb and Moon pertaining to NPV analysis: A. Only Moonn was correct B. Only Caleb was correct. C. Neither was correct

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INSTANT ANSWER

If Caleb decides to make the replacement, the HP462 copy machine can be sold today for $10,000. The new HP -777 copy machine will cost the firm $100,000. According to Moonn’s projections, the new HP -777 machine will increase revenue by $40,000 per year for 3 years but will also increase costs by $5,000 per year. The new HP -777 machine will be depreciated over a modified accelerated cost recovery system (MACRS) 3-year class life. At the end of year 3, the HP -777 machine will be sold for $20,000. The firm’s tax rate is 35 percent. The year 1 operating cash flow and year 3 total cash flow from the HP777 copy machine are closest to: A. The year 1 operating cash flow and year 3 total cash flow are $30,800 and $43,450, respectively. B. The year 1 operating cash flow and year 3 total cash flow are $34,300 and $48,000, respectively. C. The year 1 operating cash flow and year 3 total cash flow are $22,750 and $28,500, respectively.

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ANSWERED

Rashmi Sinha

Numerade educator

Caleb is also considering an investment in a new HP –XM900 digital copy machine. Moonn estimates that the new HP –XM900 digital copy machine will cost $50,000, and that shipping and installation costs will be $7,500. The addition of the digital machine will require a $2,000 investment in spare parts inventory at the inception of the project, but these parts can be resold for $2,000 at the project’s end. Compared with the manual process that SchoolStreet used to use for putting on faxing, emailing and copying, Moonn estimates that the new HP –XM900 digital machine will reduce costs by $25,000 per year for 4 years. The HP –XM900 digital machine will be depreciated over a MACRS 5-year class life. At the end of year 4, the equipment will be sold for $8,000. The initial cash out flow and the year 2 operating cash flows from the HP –XM900 digital copy machine are closest to: A. The initial cash out flow and the year 2 operating cash flows ($59,500) and $33,4000, respectively. B. The initial cash out flow and the year 2 operating cash flows ($59,500) and $22,690, respectively. C. The initial cash out flow and the year 2 operating cash flows ($57,500) and $34,650, respectively.

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ANSWERED

Danielle Fairburn

Numerade educator

Caleb tells Moonn that she should use the Capital Asset Pricing (CAPM)/security market line equation to determine the performance of Harvard, Inc. and Yale, Inc and made the following statement regarding CAPM: The CAPM is an equation for required return that should hold in equilibrium (the condition in which supply equals demand) if the model's assumptions are met; among the key assumptions are that investors are risk averse and that they make investment decisions based on the mean return and variance of returns of their total portfolio. The chief insight of the model is that investors evaluate the risk of an asset in terms of the asset's contribution to the systematic risk of their total portfolio (systematic risk is risk that cannot be shed by portfolio diversification). Because the CAPM provides an economically grounded and relatively objective procedure for required return estimation, it has been widely used in valuation. The risk-free rate | 5 percent The expected return on the market portfolio | 11.5 percent The beta of Harvard stock | 1.5 The beta of Yale stock | 0.8. Andy's forecasts of the returns on the Harvard stocks | 13.25 percent Andy's forecasts of the returns on the Yale stocks | 11.25 percent Moon made the following statements regarding the Harvard stock and Yale stock. Statement 7: Using the Security Market Line (SML) equation, I believe both Harvard and Yale stocks are overvalued. Is Caleb correct with respect to his statement regarding CAPM? A. No, because investors are not risk averse and that they do not make investment decisions based on the mean return and variance of returns of their total portfolio. B. No, he is only correct regarding systematic risk risk that cannot be shed by portfolio diversification. C. Yes.

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ANSWERED

Daniel Carr

Numerade educator

Factor 1: Currency appreciation/depreciation over time should just offset differences in interest rates. The specific concept is related in factor 1 is most accurately describes the: A. Purchasing power parity relation B. Interest rate parity relation. C. International Fisher relation.

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ANSWERED

Dave Kratz

Numerade educator

It is April 30, 2022. Caleb Jamal has worked for several years at SchoolStreet, Inc. Yesterday, the CEO informed Caleb that he would be retiring, effective immediately, and the Board of Directors has appointed Caleb the new CEO. After a brief celebration, Caleb arrives work today ready to accept his responsibilities. Caleb is immediately confronted with a number of investment and Corporate finance decisions. Caleb's first priority is to understand the company's capital budgeting analysis. He is looking at upgrading the firm's production capacity in an effort to improve the company's competitive position. Caleb estimates that SchoolStreet's cost of capital is 10%. Caleb is being assisted by Celestila Moonn, an UMB MBA intern at SchoolStreet. Moonn estimates that travel and hotel costs expended as a result of their research and the trade shows they attended amounted to $8,000. Caleb considers the money well spent because he now had two great projects for improving SchoolStreets' competitiveness in the industry. First of all, Caleb is considering replacing a HP462 copy machine. This machine was purchased for $50,000 3-year ago and is being depreciated over 5 years to a zero salvage value using straight-line depreciation. The firm has 2 years of depreciation remaining on the old machine. If Caleb decides to make the replacement, the HP462 copy machine can be sold today for $10,000. The new HP -777 copy machine will cost the firm $100,000. According to Moonn's projections, the new HP -777 machine will increase revenue by $40,000 per year for 3 years but will also increase costs by $5,000 per year. The new HP -777 machine will be depreciated over a modified accelerated cost recovery system (MACRS) 3-year class life. At the end of year 3, the HP -777 machine will be sold for $20,000. The firm's tax rate is 35 percent. Caleb is also considering an investment in a new HP -XM900 digital copy machine. Moonn estimates that the new HP -XM900 digital copy machine will cost $50,000, and that shipping and installation costs will be $7,500. The addition of the digital machine will require a $2,000 investment in spare parts inventory at the inception of the project, but these parts can be resold for $2,000 at the project's end. Compared with the manual process that SchoolStreet used to use for putting on faxing, emailing and copying, Moonn estimates that the new HP -XM900 digital machine will reduce costs by $25,000 per year for 4 years. The HP - XM900 digital machine will be depreciated over a MACRS 5-year class life. At the end of year 4, the equipment will be sold for $8,000. Before making the final calculations, Caleb and Moonn discuss net present value analysis for the projects they are considering. Moonn tells Caleb, "When calculating the net present value of the two new projects, we also need to account for the costs expended as a result of researching the project options." Caleb makes a note on his legal pad and says to Moonn, "There is no need to make any adjustments for inflation in our net present value calculations because inflation is included as part of the expected returns used to calculate our weighted average cost of capital." After their conversation, Moonn and Caleb prepare their report to present to SchoolStreets' Board of Directors meeting for approval. Depreciation schedules under MACRS are shown in the exhibit below:

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ANSWERED

Daniel Carr

Numerade educator

Table 1 Market value of debt: $100 milion Yield to maturity on debt: 8.0% Market price per share of common stock: $30 Number of shares of common stock: 10milion Cost of capital if all equity-financed: 10.3% Marginal tax rate: 35% Table 2 Debt-to-Total Capital Ratio % | Cost of Equity % | Cost of debt % 20 | 7.7 | 12.5 30 | 8.4 | 13.0 40 | 9.3 | 14.0 50 | 10.4 | 16.0 Holding operating earnings constant, an increase in the marginal tax rate to 40 percent would: A. Result in a higher cost of debt capital. B. Result in a lower cost of debt capital. C. Not affect the company's cost of capital.

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ANSWERED

Danielle Fairburn

Numerade educator

The CAPM is an equation for required return that should hold in equilibrium (the condition in which supply equals demand) if the model’s assumptions are met; among the key assumptions are that investors are risk averse and that they make investment decisions based on the mean return and variance of returns of their total portfolio. The chief insight of the model is that investors evaluate the risk of an asset in terms of the asset’s contribution to the systematic risk of their total portfolio (systematic risk is risk that cannot be shed by portfolio diversification). Because the CAPM provides an economically grounded and relatively objective procedure for required return estimation, it has been widely used in valuation. The risk-free rate | 5 percent The expected return on the market portfolio | 11.5 percent The beta of Harvard stock | 1.5 The beta of Yale stock | 0.8. Andy’s forecasts of the returns on the Harvard stocks | 13.25 percent Andy’s forecasts of the returns on the Yale stocks | 11.25 percent Moon made the following statements regarding the Harvard stock and Yale stock. Statement 7: Using the Security Market Line (SML) equation, I believe both Harvard and Yale stocks are overvalued. With respect to statement 7, Moonn is incorrect: A. Because CAPM return is 10.20% and the Yale stock is overvalued B. Because CAPM return is 14.75% and the Harvard stock is undervalued. C. Because CAPM return is 10.20% and the Yale stock is undervalued.

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Liana A.