DUKE UNIVERSITY

Fuqua School of Business

FINANCE 351 - CORPORATE FINANCE
Problem Set #1
Prof. Simon Gervais Fall 2011 Term 2
Questions
1. Two years ago, you put $20,000 dollars in a savings account earning an annual interest rate
of 8%. At the time, you thought that these savings would grow enough for you to buy a new
car ve years later (i.e., in three years from now). However, you just re-estimated the price
that you will have to pay for the new car in three years at $36,000.
(a) How much more money do you need to put in your savings account now for it to grow
to this new estimate in three years?
(b) Now suppose that you know that the car company will oer you to pay for the car
over some time. In particular, you will have the opportunity to make a down-payment
of $12,000 at the time you get the car (three years from now) and to make additional
payments of $13,000 at the end of each of the following two years. With this oer, how
much money do you need to add to your account now?
2. A rich entrepreneur would like to set up a foundation that will pay a scholarship to one
deserving student every year. The rst such scholarship will pay $5,000 (in nominal terms)
and is to be awarded in three years from now. A scholarship will be awarded in perpetuity
every year after that (even after the entrepreneurs death), but will be indexed at 2% a year
to account for ination. How much money should the entrepreneur put in the foundations
account, if that account earns 10% a year?
3. Your parents make you the following oer. They will give you $10,000 at the end of every
year for the next ve years if you agree to pay them back $10,000 at the end of every year for
the following ten years. Should you accept this oer if your opportunity cost (discount rate)
is 12% a year?
4. You have a rm that starts out with $60,000 in cash in the bank. You have three investment
opportunities: (1) You can invest $30,000 today and get back a gross payo of $45,000 next
year; (2) you can invest $20,000 today and get back a payo of $24,000 next year; (3) you
can invest $10,000 today and get back a payo of $20,000 next year. You can undertake any
or all of these investment opportunities.
(a) Suppose the interest rate is 30%. What investment policy do you undertake, and what
is the value of your rm today after you announce your investment policy?
(b) Suppose you want to consume $30,000 today and the rest next year. How much money
do you need to borrow or lend? How much can you consume tomorrow?
(c) Suppose a fourth investment opportunity (4) is added to the problem: invest $15,000
today and get back $50,000 next year. In which projects should you invest?
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5. In the following gure, the sloping straight line represents the opportunities for investment
in the capital market, and the solid curved line represents the opportunities for investment
in plant and machinery (real assets). The companys only asset at present is $2.6 million in
cash.
$ today
$ tomorrow
4 2.6 1.6
3
5
4
1
3.75
Owner's preferred
consumption patttern
(a) What is the interest rate?
(b) How much should the company invest in plant and machinery?
(c) How much will this investment be worth next year?
(d) What is the average rate of return on the investment?
(e) What is the marginal rate of return?
(f) What is the present value of this investment?
(g) What is the net present value of this investment?
(h) What is the total present value of the company?
(i) How much will the individual consume today?
(j) How much will he consume tomorrow?
(k) Is he a borrower or a lender?
6. Draw a gure (like the ones we drew for Mr. Rossi in the courses rst lecture) to represent
the following situation.
A rm starts out with $10 million in cash.
The rate of interest r is 10%.
To maximize net present value, the rm invests today $6 million in real assets. This
leaves $4 million which can be paid out to shareholders.
The net present value of the investment is $2 million.
When you have nished, answer the following questions.
(a) How much cash is the rm going to receive in year 1 from its investment?
(b) What is the marginal return from the rms investment?
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(c) What is shareholders wealth (today) after the rm has announced its investment plan?
(d) What is the present value of the projects cash ows?
(e) Suppose shareholders want to spend $6 million today. How can they do this?
(f) How much will they then have to spend next year?
7. Sonos is in the process of assessing the attractiveness of a new project. The project has an
estimated life of three years. The projects revenue estimates are as follows:
Sales = 50,000 units/year.
Per unit price: $100 in year 1, $110 in year 2, $130 in year 3.
The projects cost estimates are as follows:
Up-front for new equipment = $2,400,000.
Annual overhead = $1,300,000.
Per unit cost = $50.
The expected life of the new equipment is 4 years, and it will be depreciated straight-line
over that time. Because the project will be over by the end of year 3 however, Sonos plans
to resell this equipment for $800,000 at the end of year 3.
In terms of net working capital, the following assumptions have been agreed upon:
The project will have no cash or inventory requirement (i.e., manufactured products are
shipped directly to customers).
Payables are expected to be 10% of annual COGS (as Sonos may purchase some of the
products necessary for production on credit).
Receivables are expected to be 10% of annual sales (as customers may take some time
to pay for the goods, and so not all cash ows are received by year end).
Net working capital will fall back to zero in year 4 (i.e., all outstanding payments from
customers are received, and all outstanding bills are paid that year).
What is the net present value of this project if the corporate tax rate is 35% and the cost of
capital (i.e., discount rate) is 16%?
8. The rm Nalyd is considering an investment in equipment to produce a new product. The
cost of the equipment is $150,000. This equipment falls into the 5-year asset class and thus
would have to be capitalized and depreciated over 6 years at rates 20%, 32%, 19.2%, 11.52%,
11.52%, and 5.76%. Nalyd expects to use the equipment for three years and then to sell it
for $60,000. For the three years of operation, the equipment will generate revenues of $40,000
per year and will have operating costs of $3,000 per year.
If the opportunity cost of capital for Nalyd is 12% and its tax rate is 35%, should Nalyd
purchase this equipment? For simplicity, assume that net working capital stays at zero
throughout the projects life. Also, assume that Nalyds other projects are and will remain
protable, so that any negative tax on this one project can be considered a positive cash ow.
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9. Conocococonut is considering the purchase of a new harvester. They are currently involved in (Dicult)
deliberations with the manufacturer and as of yet the parties have not come to a settlement
regarding the nal purchase price. The management of Conocococonut has hired you, a high-
priced consultant, to establish the maximum price it should be willing to pay for the harvester
(i.e., the break-even price such that the NPV of the project would be zero). This will be of
obvious use to Conocococonut in their haggling with the capital equipment manufacturer.
You are given the following facts:
The new harvester would replace an existing one that has a current market value of
$20,000.
The new harvester is not expected to aect revenues, but before-tax operating costs will
be reduced by $10,000 per year for ten years.
The old harvester is now ve years old. It is expected to last for another ten years and
to have a resale value of $1,000 at the end of those ten years.
The old harvester was purchased for $50,000 and is being depreciated to zero on a
straight-line basis over ten years.
The new harvester will be depreciated straight-line over its 10 year life to a zero book
value. Conocococonut expects to be able to sell the harvester for $5,000 at the end of
the ten years.
The corporate tax rate is 34% and the rms cost of capital is 15%.
For simplicity, assume that net working capital stays at zero throughout. Also, if you solve
this problem using a spreadsheet feel free to assume that annual revenues are $50,000 (for
both harvesters) and that annual costs are $20,000 ($10,000) for the old (new) harvester.
10. (Mini-case, taken from Ross, Westereld and Jae, 6th edition) After extensive research (Optional)
and development, Goodweek Tires, Inc., has recently developed a new tire, the SuperTread,
and must decide whether to make the investment necessary to produce and market the Su-
perTread. The tire would be ideal for drivers doing a large amount of wet weather and o-road
driving in addition to its normal freeway usage. The research and development costs so far
total about $10 million. The SuperTread would be put on the market beginning this year and
Goodweek expects it to stay on the market for a total of four years. Test marketing costing
$5 million shows that there is a signicant market for a SuperTread-type tire.
As a nancial analyst at Goodweek Tires, you are asked by your CFO, Mr. Adam Smith, to
evaluate the SuperTread project and provide a recommendation on whether to go ahead with
the investment. You are informed that all previous investments in the SuperTread are sunk
costs and only future cash ows should be considered. Except for the initial investment (in
production equipment and working capital) which will occur immediately, assume all cash
ows will occur at year-end.
Goodweek must initially invest $120 million in production equipment to make the SuperTread.
The equipment is expected to have a seven-year useful life. This equipment can be sold for
$51,428,571 at the end of four years. Goodweek intends to sell the SuperTread to two distinct
markets:
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(a) The Original Equipment Manufacturer (OEM) Market. The OEM market consists pri-
marily of the large automobile companies (e.g., General Motors) who buy tires for new
cars. In the OEM market, the SuperTread is expected to sell for $36 per tire. The
variable cost to produce each tire is $18.
(b) The Replacement Market. The replacement market consists of all tires purchased after
the automobile has left the factory. This market allows higher margins and Goodweek
expects to sell the SuperTread for $59 per tire there. Variable costs are the same as in
the OEM market.
Goodweek Tires intends to raise prices at 1 percent above the ination rate.
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Variable costs
will also increase 1 percent above the ination rate. In addition, the SuperTread project will
incur $25 million in marketing and general administration costs the rst year (this gure is
expected to increase at the ination rate in the subsequent years).
Goodweeks corporate tax rate is 40 percent. Annual ination is expected to remain constant
at 3.25 percent. The company uses a 15.9 percent discount rate to evaluate new product
decisions.
Automotive industry analysts expect automobile manufacturers to produce 2 million new cars
this year and production to grow at 2.5 percent per year thereafter. Each new car needs four
tires (the spare tires are undersized and are in a dierent category). Goodweek Tires expects
the SuperTread to capture 11 percent of the OEM market. Industry analysts estimate that
the replacement tire market size will be 14 million tires this year and that it will grow at
2 percent annually. Goodweek expects the SuperTread to capture an 8 percent market share.
You decide to use the MACRS depreciation schedule (seven-year property class), which is as
follows.
Year 1 2 3 4 5 6 7 8
Depreciation % 14.29% 24.49% 17.49% 12.49% 8.93% 8.93% 8.93% 4.45%
You also decide to consider net working capital (NWC) requirements in this scenario. The
immediate initial working capital requirement is $11 million, and thereafter the net working
capital requirements will be 15 percent of sales. What will be the NPV and IRR on this
project?
Note: You should use a spreadsheet to solve this problem.
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Feel free to use g = i + 1% or g = (1 + i)(1.01) 1, where i is the ination rate. I will use the latter in my
solution.
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Solutions
1. (a) Let us rst gure out how much money (FV ) is now in the account.
-2 0 3
20,000
(1.08)
2
FV
FV = 20,000(1.08)
2
= 23,328.00.
Now, the account should have an amount PV in it for it to grow to $36,000 in three
years.
-2 0 3
PV
(1.08)
3
36,000
PV =
36,000
(1.08)
3
= 28,577.96.
So, you need to put $28,577.96 $23,328.00 = $5,249.96 in the account.
(b) The present value (at time 0) of these three payments is
PV =
12,000
(1.08)
3
+
13,000
(1.08)
4
+
13,000
(1.08)
5
= 27,928.96.
So, you need to add $27,928.96 $23,328.00 = $4,600.96 to the account.
2. First, let us calculate how much money will need to be in the account at the end of the second
year; let us denote that amount by PV

.
0 1 2 3 4 5
5,000 5, 000(1.02) 5, 000(1.02)
2

PV

=
5,000
0.100.02
For the account to be worth this much in two years, the amount that the entrepreneur needs
to contribute initially is
PV = PV

1
(1.10)
2
=
5,000
0.08

1
(1.10)
2
= 51,652.89.
3. The present value of what you get is given by
PV
+
=
10,000
0.12
_
1
1
(1.12)
5
_
= 36,047.76.
The present value of what you will have to pay back is given by
PV

=
10,000
0.12
_
1
1
(1.12)
10
_
1
(1.12)
5
= 32,060.88.
Since the present value of the money you will get is larger than that you will have to pay
back (PV
+
> PV

), you should accept the oer.

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4. (a) Compute the rate of returns on the three projects:
r
1
=
45,000 30,000
30,000
= 50% > 30%,
r
2
=
24,000 20,000
20,000
= 20% < 30%,
r
3
=
20,000 10,000
10,000
= 100% > 30%.
You should therefore invest in (1) and (3) and have $20,000 for todays consumption.
The projects NPVs are
NPV
1
= 30, 000 +
45,000
1.30
= 4,615,
NPV
2
= 20, 000 +
24,000
1.30
= 1,538,
NPV
3
= 10, 000 +
20,000
1.30
= 5,385,
After your announcement of the selection of projects (1) and (3) (before consumption),
the rm should be worth
60,000 +NPV
1
+NPV
3
= 70,000.
In other words, this is how much you can sell the rm for at the time.
(b) From the answer to part (a), you need to borrow an extra 30,000 20,000 = 10,000 in
order to achieve the consumption goal of $30,000 today. (You should not forego any of
the positive NPV projects, instead you can make use of the capital market to adjust
your consumption.) Tomorrows consumption level is
45,000 + 20,000 (10,000 1.30) = 52,000.
(c) Also invest in project (4), in addition to projects 1 and 3:
r
4
=
50,000 15,000
15,000
= 233.33%.
5. (a)
5
4
1 = 25%.
(b) $2.6 million $1.6 million = $1.0 million.
(c) $3 million.
(d)
3
1
1 = 200%.
(e) 25%.
(f) $4 million $1.6 million = $2.4 million.
(g) $2.4 million $1 million = $4 million $2.6 million = $1.4 million.
(h) $4 million.
(i) $1 million.
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(j) $3.75 million.
(k) He is a lender (since he consumes less than $1.6 million today).
6. The following gure shows the solution to the rst part of the question.
$million
period 0
$million
period 1
13.2
11
8.8
4 10 12
Real investment
opportunities
-1.1
NPV
Real
investment
Here is how the numbers in that gure are calculated:
4 = 10 6;
11 = 10(1 +r) = 10(1.1);
12 = 10 +NPV = 10 + 2;
13.2 = 12(1 +r) = 12(1.1);
8.8 = (12 4)(1 +r) = 8(1.1).
(a) 13.2 4(1.1) = $8.8 millions.
(b) The rm will invest (in real assets) until its marginal rate of return (from these assets)
is equal to the interest rate, i.e. the marginal return is 10%.
(c) 10 +NPV = $12 millions.
(d) The net present value is NPV = PV (future cash ow from projects)I

. We know that
I

= 6, and we know that NPV = 2. This implies that

PV (future cash ow from projects) = NPV +I

= 2 + 6 = 8.
(e) Let the rm invest $6 millions in real assets; this leaves the shareholders with $4 millions
today. Then borrow $2 millions at 10% from period 1 (next year) consumption using
the capital markets; this provides shareholders with an additional $2 millions today, for
a total of $6 millions.
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(f) Next year, the rms real investments will have generated $8.8 millions, but the share-
holders owe 2(1.1) = $2.2 millions. Their consumption (spending) in period 1 will there-
fore be 8.8 2.2 = $6.6 millions.
7. We can forecast the unlevered net income for this project as follows (all numbers in 000):
End of year
0 1 2 3
Sales 5,000 5,500 6,500
Cost of Goods Sold -2,500 -2,500 -2,500
Gross Prot 2,500 3,000 4,000
General & Administrative -1,300 -1,300 -1,300
Depreciation -600 -600 -600
EBIT 600 1,100 2,100
Income Tax (35%) -210 -385 -735
Unlevered Net Income 390 715 1,365
To calculate the projects free cash ows, we need to add back depreciation, subtract capital
expenditures, and subtract annual changes in net working capital.
The initial capital expenditure is $2,400,000. In year 3, the equipment sale will generate
a positive cash ow of $800,000. The excess over the book value of the machine (2.4M
0.6M 0.6M 0.6M = 600,000) is considered a taxable gain. The tax is 35% (800,000
600,000) = 70,000. Therefore, the net capital inow from the sale of the machine in year 3 is
800,000 70,000 = 730,000.
The following table shows how the annual changes in net working capital are calculated:
End of year
0 1 2 3 4
Cash Requirements
Plus: Inventory
Plus: Receivables 500 550 650
Minus: Payables -250 -250 -250
Net Working Capital 250 300 400 0
Increase in NWC 250 50 100 -400
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The projects free cash ows are therefore as follows:
End of year
0 1 2 3 4
Unlevered Net Income 390 715 1,365
Plus: Depreciation 600 600 600
Minus: CapEx -2,400 730
Minus: Increase in NWC -250 -50 -100 400
Free Cash Flow -2,400 740 1,265 2,595 400
The projects net present value is
NPV = 2,400 +
740
1.16
+
1,265
(1.16)
2
+
2,595
(1.16)
3
+
400
(1.16)
4
= 1,061.
8. The solution spreadsheet is available on the Downloads section of the courses website. As
shown in this spreadsheet, the projects free ows are as follows:
End of year
0 1 2 3
Revenues 40,000 40,000 40,000
Operating Costs -3,000 -3,000 -3,000
Depreciation -30,000 -48,000 -28,000
EBIT 7,000 -11,000 8,200
Income Tax (35%) -2,450 3,850 -2,870
Unlevered Net Income 4,550 -7,150 5,330
Depreciation 30,000 48,000 28,800
Capital Expenditures -150,000 54,120
Free Cash Flow -150,000 34,550 40,850 88,250
The projects net present value is
NPV = 150,000 +
34,550
1.12
+
40,850
(1.12)
2
+
88,250
(1.12)
3
= 23,772.
Alternatively, one could calculate the projects NPV as
NPV =cost of equipment +PV (after-tax net operating prots)
+PV (depreciation tax shield) +PV (equipment sale) PV (tax on equipment sale).
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These PVs are calculated as follows:
PV (after-tax net operating prots) = (1 0.35)
40,000 3,000
0.12
_
1
_
1
1.12
_
3
_
= 57,764.04;
PV (depreciation tax shield) = 0.35(150,000)
_
0.2
1.12
+
0.32
(1.12)
2
+
0.192
(1.12)
3
_
= 29,942.60;
PV (equipment sale) =
60,000
(1.12)
3
= 42,706.81;
PV (tax on equipment sale) =
0.35
_
60,000 (1 0.2 0.32 0.192)150,000

(1.12)
3
= 4,185.27.
Again, this gives us NPV = 23,771.81 < 0. So Nalyd should not purchase this equipment.
9. The solution spreadsheet is available on the Downloads section of the courses website. To
nd the break-even price (of 60,019) using Excel, we make use of Goal Seek:
Without Excel, the calculations are as follows. The current book value of the old harvester is
50,000 5
_
50,000
10
_
= 25,000.
The incremental cash ow at t = 0 if the new harvester is purchased is therefore
C
0
= 20,000 + 0.34(25,000 20,000) P = 21,700 P
where we have have taken into account the tax eect of the book loss on the sale of the old
harvester. The incremental cash ow between years 1 and 5 equals the after-tax cost savings
plus the tax eect of the incremental depreciation:
C
t
= (1 0.34)10,000 + 0.34
_
P
10
5,000
_
= 4,900 + 0.034P (t = 1, . . . , 5)
After year 5, the old harvester would have been completely depreciated, so that the incre-
mental cash ow between years 6 and 9 is:
C
t
= (1 0.34)10,000 + 0.34
P
10
= 6,600 + 0.034P (t = 6, . . . , 9)
Finally, the incremental cash ow in year 10 reects the incremental salvage value of the new
harvester and the consequent tax increase:
C
10
= (1 0.34)10,000 + 0.34
P
10
+ (5,000 1,000) 0.34(5,000 1,000)
= 9,240 + 0.034P
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The NPV of the project is then:
NPV =
10

t=0
C
t
1.15
t
= 21,700 P +
4,900 + 0.034P
0.15
_
1
1
(1.15)
5
_
+
6,600 + 0.034P
0.15 (1.15)
5
_
1
1
(1.15)
4
_
+
9,240 + 0.034P
(1.15)
10
= 49,778 0.829P.
Setting NPV = 0 and solving for P gives P = 60,019. This is the maximum price that
Conocococonut would be willing to pay for the new harvester.
10. See solution spreadsheet posted on the Downloads section of the courses website.
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