ASSIGNMENT 2

Name:
ERP ID:
Course:

Saif Ali Momin

08003
Business Finance II

Solution
Coefficient of Variation COV = Risk / Return = /
for Stock D
COV = 8/10 = 0.8
for Stock E
COV = 24/36 = 0.67
Hence, Stock D has greater risk per unit of return than Stock E

Solution
=

= 1.8

= 16%
=

= ?
We know from CAPM
)
=
+(
16% =
+ (10%
= . %

)1.8

= 10%

Solution
a. Expected rate of return for Stock Y

= (35 0.1) + (0 0.2) + (20 0.4) + (25 0.2) + (45 0.1) = 14%

b.
Standard Deviation for Stock X
Expected Return
Average Return
-10
12
2
12
12
12
20
12
38
12

(Variance)2
484
100
0
64
676

Probability
0.1
0.2
0.4
0.2
0.1

(Variance)2 x Probability
48.4
20
0
12.8
67.6
Sum = 100.4

(Variance)2
2401
196
36
121
961

Probability
0.1
0.2
0.4
0.2
0.1

(Variance)2 x Probability
240.1
39.2
14.4
24.2
96.1
Sum = 414

= 100.4 = 10.02
10.02
= =
= 0.835
12
Standard Deviation for Stock Y
Expected Return
Average Return
-35
14
0
14
20
14
25
14
45
14
= 414 = 20.35
20.35
= =
= 1.453
14
With the above mentioned probabilities it would not be possible to regard Stock Y as less risky. However, if other
investors have more sample data and have different probabilities than mentioned which might reduce its COV.

Solution
Portfolio: $7,500 in each 20 different common stock
= 1.12
7500

= =
= 0.05
7500 20
Sold a stock for $7,500 having = 1
= 1.75
=
+
+ +
since weightage is same for all stocks
= ( + + +
)
1.12 = 0.05(1 + + +
)
+ + +
= 21.4
Now adding stock of $7,500 with new beta
= (
+ + +
)
= 0.05(1.75 + 21.4)
= .

Solution
a. Expected value of gamble
There is 50/50 chance of getting head or tail if coin if flipped once.
So, Expected value = 50% x $1,000,000 + 50% x $0 = $500,000
b. I would prefer to take sure $500,000 because in gamble there is a chance of getting nothing.
c. I am a risk averter based on my choice of not to gamble
d. 1) Expected dollar profit on stock investment, considering 50/50 chance of worthless
Expected profit on stock = 50% x $(1,150,000 500,000) + 50% x $( 500,000) = $75,000
d. 2) Expected rate of return on stock investment
Expected rate of return on stock = 75,000 / 500,000 = 15%
d. 3) Considering the returns and 50% risk of loss associated with stock I would invest in T-bond to make my investment
secure
d. 4) It would depend upon the risk taken. I would prefer to take more than 15% (more than twice of the T-bond)
d. 5) If all stocks lose at the same time and profit at the same time then there is no change in the return as shown below,
(50% x $(11,500 5,000) + 50% x $(5,000) x 100 = $75,000

If we consider half of the stocks position are positively correlated with market and other negatively, then it would
reduce the risk of complete loss in case of all stocks get worthless at year end. This would make sure that at least half of
the expected return (75,000/2 = $37,500) is always there at the year end.
So, correlation here will definitely matter in portfolio of different stocks.

Solution
a. Average rate of return for each stock
Stock A
18 + 33 + 15 .5 + 27
=
= 11.3%
5
Stock B
14.5 + 21.8 + 30.5 7.6 + 26.3
=
= 11.3%
5
b. Realized Return for both stock with 50/50 weightage
= 50%

+ 50%

= 0.5 11.3 + 0.5 11.3 = 11.3%

c. & d. Standard Deviation and COV for both stocks and for portfolio
Stock A
Year

Stock A
Returns

2004
2005
2006
2007
2008

Average
Return

-18
33
15
-0.5
27

11.3
11.3
11.3
11.3
11.3

(Variance)2
858.49
470.89
13.69
139.24
246.49
Sum 1728.8

= 1728.8 = 41.58
41.58
= =
= 3.679
11.3
Stock B
Year
2004
2005
2006
2007
2008

Average
Stock B
Return
Returns
-14.5
11.3
21.8
11.3
30.5
11.3
-7.6
11.3
26.3
11.3

(Variance)2
665.64
110.25
368.64
357.21
225
Sum 1726.74

= 1725.74 = 41.55
41.55
= =
= 3.677
11.3
Portfolio

Year
2004
2005
2006
2007
2008

Stock A
Stock B
Portfolio Returns
Returns
Returns
50% + 50%
-18
-14.5
-16.25
33
21.8
27.4
15
30.5
22.75
-0.5
-7.6
-4.05
27
26.3
26.65

Average
Return
11.3
11.3
11.3
11.3
11.3

(Variance)2
759.0025
259.21
131.1025
235.6225
235.6225
Sum 1620.56

= 1620.56 = 40.26
40.26
= =
= 3.562
11.3
e. If I am risk averse I will prefer Portfolio investment. As the risk per unit return i.e. COV is somewhat less than
individual COVs for Stock A and Stock B. However, there is not a huge gap between COVs calculated above so other
options are also good.

ASSIGNMENT 3
Name:
ERP ID:
Course:

Saif Ali Momin

08003
Business Finance II

Solution
Increase in earnings before depreciation = $54,000 $27,000 per year = $27,000 per year
Cost of new machine = $82,500
Life of new machine = 8 years ;
Depreciation of new machine over MACRS 5-years
Tax rate = T = 40%
;
Required rate of return = r = 12%

Y0
Investment
Cost of new machine
Net cash flow from sale of old machine
Operating Cash flows
Earnings before depreciation
MACRS Year-5 %ages
Depreciation
EBT
in Tax (40%)
NOI
Adding back depreciation
Operating Cash flow

Y1

Y2

Y3

Y4

27,000
20%
(16,500)
10,500
(4,200)
6,300
16,500
22,800

27,000
32%
(26,400)
600
(240)
360
26,400
26,760

27,000
19%
(15,675)
11,325
(4,530)
6,795
15,675
22,470

27,000
12%
(9,900)
17,100
(6,840)
10,260
9,900
20,160

amounts in $
Y5
Y6

(82,500)
(82,500)
27,000
11%
(9,075)
17,925
(7,170)
10,755
9,075
19,830

Terminal Cash flow

Net salvage value of new machine
Terminal cash flow
Incremental cash flow
Present Value of cashflows at 12%RR
Net Present Value NPV

27,000
6%
(4,950)
22,050
(8,820)
13,230
4,950
18,180

22,800
(82,500) 20,357
8,458

26,760
21,333

22,470
15,994

20,160
12,812

Since the NPV comes out to be positive so old riveting machine is worth replacing with new one.

19,830
11,252

18,180
9,211

Solution

Projects
LOM
QUE
YUP
DOG

NPV

RR

Risk

Add/Subtract
2% points in
Average RR
2%
-2%
0%
-2%

1,500.00
12.5%
High
11.0%
Low
800.00
10.0% Average
(150.00)
9.5%
Low
Average RR
10.8%
Assuming equal weightage of all projects for calculating average RR

IRR
12.75%
8.75%
10.75%
8.75%

Based on above table risk adjusted discount rate (IRR) is greater than required rate for projects LOM and YUP and they
also have positive NPV. So project LOM and YUP may be purchased in this scenario.

Solution
Machine base price = $108,000 ;
Cost of modification in machine for special use = $12,500
MACRS 3-years class
Sold after 3 years = Salvage value = $65,000
NWC = $5,500
Saving from new machine = $44,000 per year in before tax operating cost
Tax rate = T = 34%
a. Initial investment outlay at Year 0
Machine price + Modification cost to bring into special use + NWC = 108,000 + 12,500 + 5,500 = $126,000
b. Incremental operating cash flow in year 1, 2 and 3
Y1

Y2

Y3

Operating Cash flows

Savings before tax
44,000
44,000
44,000
MACRS 3-Year class
33%
45%
15%
Depreciation on (cost + modification) = $120,500 (39,765)
(54,225)
(18,075)
EBT
4,235
(10,225)
25,925
in Tax (34%)
(1,440)
3,477
(8,815)
NOI
2,795
(6,749)
17,111
Adding back depreciation
39,765
54,225
18,075
Operating Cash flow
$42,560 $47,477
$35,186

c. Terminal cash flow in Year 3

Net Salvage Value
Book Value
Depreciable base
Depreciation Y1 - Y3
Book value at Y3
Tax Effect
Selling price
Book value
Gain (loss) on sale
Tax on gain (loss) 34%
Net Salvage Value
Cash flow from sale of machine
Tax effect
Net salvage value

120,500
(112,065)
8,435

65,000
(8,435)
56,565
19,232

65,000
(19,232)
45,768

Terminal Cash flow

Return of NWC
Net salvage value of new machine
Terminal cash flow

Y3
5,500
45,768
$51,268

d. Decision to purchase or not

Investment
Operating Cash flow
Terminal Cash flow
Incremental Cash flow
Present Value of Cash flows at 12% RR
Net Present Value NPV

Y0
(126,000)

Y1

Y2

Y3

42,560

47,477

42,560

47,477

35,186
51,268
86,453

(126,000) 38,000
$11,384

37,848

61,536

Since the NPV comes out to be positive, investment in new milling machine may be made.

Solution
a. Expected value of annual net cash flow
Project A
= (6000 x 0.2) + (6750 x 0.6) + (7500 x 0.2) = $6,750
Project B
= (0 x 0.2) + (6750 x 0.6) + (18000 x 0.2) = $7,650
b. CVNPV for Project A
=

Since

, so we suppose zero return to simplify calculation as return will cancel out.

NPV
Average
6000 x 3 = 18000
20250
6750 x 3 = 20250
20250
7500 x 3 = 22500
20250
=
Since

Var2
Probability (Var)2 x Probability
5062500
0.2
1012500
0
0.6
0
5062500
0.2
1012500
Sum
2025000

= .
= 0.706, which means Project A is less riskier than Project B.

c. Risk adjusted NPV

Project

Project
Risk

A
B

Low
High

Required Estimated
Initial
Return
Life
Investment
10%
12%

3
3

(6,750)
(6,750)

Incremental
Operating Cash
flows of each year
6,750
7,650

PV of 3
Years CF
16,786.25
18,374.01

Risk
Adjusted
NPV
10,036.25
11,624.01

d. If Project B was negatively co-related with firms cash flow then Project A positively, then Project B would support
firm during cash crunch while Project A will not. If firm seems to face cash crunch during the project execution then
Project B would be good option. Similarly if Project B cash flows are negatively co-related with GNP then we would again
see the portfolio of firms investments, and if the firm do not have enough investments which can support in the time of
economic crisis of the country then we may choose Project B.

Solution
Net cost of tractor = $72,000
Increase in operating cash flows (EBDT) = $24,000
Depreciation on straight line basis over 5 years = $14,400 per year
Tax rate = T = 40%
Required rate of return = r = 10%
For the Scenario analysis we would consider following scenarios with their expected probabilities as per discussion of
directors.
Scenario
Best case
Most likely case
Worst case

Life
8 Years
5 Years
4 Years

Probability
of Outcome
0.1
0.7
0.2

Now we would calculate NPV for all scenarios by keeping life of tractor as variable.

1. Worst case scenario (4 years life)

Net Present Value NPV
Y1

Y2

Investment
Cost of new machine

(72,000)

Operating Cashflows
Savings before tax
Depreciation
EBT
in Tax (40%)
NOI
Adding back depreciation
Operating Cashflow

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

Y3

Y4

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

Terminal Cashflow
Net salvage value of new machine
Terminal cashflow
Incremental cashflow

(51,840)

20,160

20,160

5,760
5,760
25,920

Present Value PV of cashflows

Net Present Value NPV (4 year life)

(51,840)
$2,623

18,327

16,661

19,474

Net Salvage Value

Y4

Book Value
Depreciable base
Depreciation
Book value

72,000
(57,600)
14,400

Tax Effect
Selling price
Book value
Gain (loss) on sale
Tax on gain (loss) 40%

(14,400)
(14,400)
(5,760)

Net Salvage Value

Cash flow from sale of machine
Tax effect
Net salvage value

5,760
5,760

2. Most likely case scenario (5 years life)

Y1

Y2

Investment
Cost of new machine

(72,000)

Operating Cashflows
Savings before tax
Depreciation
EBT
in Tax (40%)
NOI
Adding back depreciation
Operating Cashflow

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

Y3

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

Y4

Y5

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

Terminal Cashflow
Net salvage value of new machine
Terminal cashflow
Incremental cashflow

(51,840)

20,160

20,160

20,160

20,160

Present Value PV of cashflows

Net Present Value NPV (5 year life)

(51,840)
$12,064

18,327

16,661

15,147

13,770

3. Best case scenario (8 years life)

Y1
Investment
Cost of new machine

(72,000)

Operating Cashflows
Savings before tax
Depreciation
EBT
in Tax (40%)
NOI
Adding back depreciation
Operating Cashflow

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

Y2

24,000
(14,400)
9,600
(3,840)
5,760
14,400
20,160

Y3

Y4

Y5

24,000
24,000
24,000
(14,400) (14,400) (14,400)
9,600
9,600
9,600
(3,840) (3,840) (3,840)
5,760
5,760
5,760
14,400
14,400
14,400
20,160
20,160
20,160

Y6

Y7

Y8

24,000

24,000

24,000

24,000
(9,600)
14,400
14,400

24,000 24,000
(9,600) (9,600)
14,400 14,400
14,400 14,400

Terminal Cashflow
Net salvage value of new machine
Terminal cashflow

Incremental cashflow

(51,840)

Present Value PV of cashflows

Net Present Value NPV (8 year life)

(51,840)
$36,524

20,160
18,327

20,160
16,661

20,160
15,147

20,160
13,770

14,400
8,941

14,400
8,128

14,400
7,389

Scenario
Best case
Most likely case
Worst case

Life

Probability of
Outcome

NPV
8 Years
5 Years
4 Years

36,524
12,064
2,623

0.1
0.7
0.2
Expected NPV
NPV
CVNPV

NPV x Probability
3,652
8,445
525
12,622
8,795
0.697

With the supposed probability of each scenario the expected NPV comes out to be positive and the risk per unit return is
also less than 1. Moreover with the 5 years expected life of tractor and even with the worst case scenario of 4 years the
NPV is positive in each case. So investing in tractor may be valuable.

ASSIGNMENT 4
Name:
ERP ID:
Course:

Saif Ali Momin

08003
Business Finance II

Solution
Price of share = P0 = $65 per share
Common Stock @ January 1, 2008 = 7,800,000 shares x $65 per share = $507,000,000
D2008 = 55% of expected EPS2008
Interest rate before tax = rd = 9%
Tax rate = T = 40%
Debt to Equity Ratio from given capital structure = 40 / 60
From given historical EPS data we can calculate growth for each year subsequent to 1998 as given below.
Year
EPS
%Growth
1998 $
3.90

Year
1999
2000
2001
2002
2003
2004
2005
2006
2007

$
$
$
$
$
$
$
$
$

EPS
4.21
4.55
4.91
5.31
5.73
6.19
6.68
7.22
7.80

%Growth
7.9%
8.1%
7.9%
8.1%
7.9%
8.0%
7.9%
8.1%
8.0%

Average growth = g = 8.0%

So , EPS2008 = 7.8 x 1.08 = $8.42
DPS2008 = 55% of EPS2008 = 0.55 x 8.42 = $4.63
a.
Cost of after tax new debt
rdT = rd x (1 T) = 9% x (1 0.4) = 5.4%
Cost of common equity
rs = (D2008 / P0)+ g = (4.63 / 65) + 0.08 = 15.13%

b. WACC no new common stock maintaining existing capital structure

WACC = (5.4% x 0.4) + (15.13% x 0.6) = 11.24%

c. Breakpoint to issue new equity (Assuming retained earnings are 45% of 2008 earnings)
Retained Earnings = 0.45 x EPS2008 x Shares Outstanding = 0.45 x $8.42 x 7,800,000 = $29,554,200
BPRetained Earnings = $29,550,200 / 60% = $49,257,000
Above $49,257,000 capital investment new equity need to be issued.
d. WACC with new equity
Cost of new equity = re = (D2008 / NP0) + g = (4.63 / 58.5) + 0.08 = 15.91%
Assume, we raise $60 million greater than break point of retained earnings to add new equity portion in WACC.
Breakup of $60M Investment
Debt: 40% of 60,000,000 = $24,000,000
Breakup of $60M Investment

WACC =

Equity: 60% of 60,000,000 = $36,000,000

Retained Earnings: $29,554,200

New Common Stock: $6,445,800

24,000,000
29,554,200
6,445,800
5.4% +
15.13% +
15.91% = 11.31%
60,000,000
60,000,000
60,000,000

or if we take Retained earnings cost equal to external equity to find maximum WACC then,
WACC = 0.4 x 5.4% + 0.6 x 15.91% = 11.706%

Solution
Earnings = $2,500,000
Dividend payout ratio = 60% of earnings
Retained earnings = 60% of 2,500,000 = $1,500,000
Market price of share = P0 = $22
Last dividend = D0 = $2.20
Growth = g = 5%

Floatation cost = F = 10%

Loan Schedule
upto 500k
9%
on incremental amount
upto 900k
11%
on incremental amount
above 900k 13%
on incremental amount
Tax = 40%
a. Breakpoints
Debt
Up to 500k loan;
Up to 900k loan;

BP1 = 500,000/0.45 = $1,111,111.11 capital can be raised

BP2 = 900,000/0.45 = $2,000,000.00 capital can be raised

Equity
Retained earnings;

BP3 = 2,500,000/0.55 = $2,727,272.73 capital can be raised with 2.5m retained earnings

b. WACC between breakpoints

Costs
cost of debt = r
= 9%(1 0.4) = 5.4%
cost of debt = r
= 11%(1 0.4) = 6.6%
cost of debt = r
= 13%(1 0.4) = 7.8%
2.2 1.05
cost of internal equity = r =
+ 0.05 = 15.5%
22
2.2 1.05
cost of external equity = r =
+ 0.05 = 16.67%
22 (1 0.1)
1. From $0 to 1,111,111.11
Capital
Capital Structure
Breakup
Cost
45%
Debt (upto 500k)
500,000.00
5.40%
Retained Earnings
611,111.11
15.50%
55%
New Stocks
Total
100%
1,111,111.11

Weightage
45.00%
55.00%
0.00%
100.00%

WACC
2.43%
8.53%
0.00%
10.96%

Cost
6.60%
15.50%

Weightage
45.00%
55.00%
0.00%
100.00%

WACC
2.97%
8.53%
0.00%
11.50%

Cost
7.80%
15.50%

Weightage
45.00%
55.00%
0.00%
100.00%

WACC
3.51%
8.53%
0.00%
12.04%

2. From $1,111,111.11 to 2,000,000

Capital Structure
Debt (500k - 900k)
Retained Earnings
New Stocks
Total

45%
55%
100%

Capital
Breakup
900,000.00
1,100,000.00
2,000,000.00

3. From $2,000,000 to 2,727,272.73

Capital Structure
Debt (500k - 900k)
Retained Earnings
New Stocks
Total

45%
55%
100%

Capital
Breakup
1,227,272.73
1,500,000.00
2,727,272.73

c. IRR for Project 1 and Project 3

Since we know from annuity PV =

For Project 1
1
675,000 = 155,401

1
(1 + IRR)
IRR

iterating above equation in scientific calculator we get

IRR = 13.58%
For Project 2
1
375,000 = 161,524

1
(1 + IRR)
IRR

iterating above equation in scientific calculator we get

IRR = 14%
d. IOS and MCC schedule
Sorting projects in descending order of IRR and calculating WACC / MCC with cumulative cost of projects to select
Cumulative
Project
Cost
MCC
IRR
Cost
2
900,000
900,000 10.96% 15.00%
3
375,000
1,275,000 11.50% 14.00%
1
675,000
1,950,000 11.50% 13.58%
4
562,500
2,512,500 12.04% 12.00%
5
750,000
3,262,500 12.14% 11.00%
or by plotting MCC breakpoint schedule and IRR schedule
16.00%

15.00%

14.00%

P2

12.00%
10.00%

14.00%

P3

13.58%
12.04%

P1

12.00%

11.50%

10.96%

12.14% 12.68%

P4

11.00%

8.00%

P5
MCC

6.00%

IRR

4.00%
2.00%
0.00%
0

0.5

1.5

2.5

3.5

4
Millions

e. Project selection
We can see from IOS & MCC schedule that at project 4 MCC outstrip IRR, so we would select Project 1, Project 2 and
Project 3.
f. If the selected projects having above average risk then the firm may get into loss. Required return on such projects
should be increased by considering appropriate risk factor.
g. If the payout ratio changes from 60% to 100% retained earnings would become zero and the partial capital that was
raised through RE would then be raised through external equity which has higher cost than RE. This means it would
increase the WACC. Similarly in-case of payout in between 60% to 100% WACC would increase. The increase in WACC
may lead to disqualification of some projects that are selected in earlier case.

ASSIGNMENT 5
Name:
ERP ID:
Course:

Saif Ali Momin

08003
Business Finance II

Solution
a. ROE of each firm
HL
Debt/Asset
Assets
Debt
Equity

(Debt/Asset Ratio) x Asset

Asset - Debt

50%
20,000,000

30%
20,000,000

10,000,000
10,000,000

6,000,000
14,000,000
4,000,000
10%
40%
2,160,000
15.43%

EBIT
Interest on Debt
Tax
Net Income

(EBIT-(EBITxI))x(1-T)

4,000,000
12%
40%
2,112,000

ROE

Net Income / Equity

21.12%

b. New ROE for LL

LL
Debt/Asset
Assets
Debt
Equity

30%
20,000,000
(Debt/Asset Ratio) x Asset
Asset - Debt

LL

12,000,000
8,000,000

EBIT
Interest on Debt
Tax
Net Income

(EBIT-(EBITxI))x(1-T)

4,000,000
15%
40%
2,040,000

ROE

Net Income / Equity

25.50%

Solution
a. Sales Forecast and DOL
Product Price per unit
Variable Cost per unit
Fixed Operating Cost
Sales (units)
Sales Revenue
Variable Cost per unit
Gross Profit
Fixed Operating Cost
EBIT

Product price x sales

Variable cost x sales
Sales Variable Cost

DOL

Gross Profit / EBIT

Sales - Var. Cost - Fixed Cost

Method A
12.00
6.75
675,000.00
200,000

Method B
12.00
8.25
401,250.00
200,000

2,400,000
(1,350,000)
1,050,000
(675,000)
375,000

2,400,000
(1,650,000)
750,000
(401,250)
348,750

2.80

2.15

In Method A EBIT will be adversely affected if sales does not reach expected level, since in Method A 100%
(increase/decrease) in sales would (increase/decrease) EBIT by 280%. However, in Method B it is 215% of Sales.

b. DFL
Assets required
Debt / Asset Ratio
Debt
rd

(Debt / Asset Ratio)

EBIT
Financial Cost
Net Income

Sales - Var. Cost - Fixed Cost

rd x Debt

DFL

EBIT/(EBIT-I)

Method A
2,250,000.00
40%
900,000.00
10%

Method B
2,250,000.00
40%
900,000.00
10%

375,000
(90,000)
285,000

348,750
(90,000)
258,750

1.32

1.35

Method B will give more increase in net income over increase in EBIT, since in Method B 100% (increase/decrease) in
EBIT would (increase/decrease) Net Income by 135%. However, in Method A it is 132% of Sales.
c. DTL
DTL

DOL x DFL

Method A
3.68

Method B
2.90

Method A is more risker than Method B, since in Method A change in sales affects more to Net Income i.e. 368% than
290% in method B.
d.
For calculating debt ratio taking DTLA = DTLB = 2.90 then;
2.90 = DOLA x DFLA
Gross Profit
EBIT

EBIT
EBIT I
1,050,000
375,000
2.90 =

375,000
375,000 I
I = Interest charges = ,
.
2.90 =

Debt = Interest / rd
Debt Ratio = (12,931.03 / 10%) / 2,250,000 = 6%

Solution
Amount to raise = $270,000,000
Option 1; Stock of $60 per share
Option 2; Bond yielding 12%
EPS = ?
Expected EPS & EPS = ?
Debt to Asset Ratio and TIE at Expected Sales Level

Option 1 (New Stock)

New stock issuance will not impact any Income Statement item, so EPS against given probable sales would be:
Existing common stock @ $3 par = 60 / 3 = 20 Million shares
New common stock for option 2= 270 / 60 = 4.5 Million shares
Total shares = 20 + 4.5 = 24.5

Sales
Oper Cost
EBIT
Interest Short Term Debt
Interest Long Term Debt
EBT
Tax
Net Income
No. of shares
EPS

2,250.00
(2,025.00)
225.00
(15.00)
(30.00)
180.00
(72.00)
108.00

2,700.00
(2,430.00)
270.00
(15.00)
(30.00)
225.00
(90.00)
135.00

in Millions
3,150.00
(2,835.00)
315.00
(15.00)
(30.00)
270.00
(108.00)
162.00

24.5
4.41

24.5
5.51

24.5
6.61

Expected EPS = 4.41 x 0.3 + 5.51 x 0.4 + 6.61 x 0.3 = 5.51

EPS
4.41
5.51
6.61

Expected
EPS
5.51
5.51
5.51

(Variance)2

Probability

1.214
0.000
1.214

0.3
0.4
0.3
Sum
EPS

Probability x
Variance2
0.364
0.000
0.364
0.729
0.854

Since there is no change in debt, however assets increased by 270 million

Debt / Asset Ratio = (652.50 + 300) / (1,350 + 270) = 58.8%
@ expected EPS 5.51
Times Interest Earned = EBIT / Interest Charges = 270 / (30 + 15) = 6
Option 2 (New Debt)
New debt issuance will impact interest expense in Income Statement item, so EPS against given probable sales would be:

Sales
Oper Cost
EBIT
Interest Short Term Debt
Interest Long Term Debt
Interest on New Debt
EBT
Tax

2,250.00
(2,025.00)
225.00
(15.00)
(30.00)
(32.40)
147.60
(59.04)

2,700.00
(2,430.00)
270.00
(15.00)
(30.00)
(32.40)
192.60
(77.04)

in Millions
3,150.00
(2,835.00)
315.00
(15.00)
(30.00)
(32.40) => 12% of 270 Million
237.60
(95.04)

Net Income
No. of shares
EPS

88.56

115.56

142.56

20
4.43

20
5.78

20
7.13

Expected EPS = 4.43 x 0.3 + 5.78 x 0.4 + 7.13 x 0.3 = 5.78

EPS
4.43
5.78
7.13

Expected
EPS
5.78
5.78
5.78

(Variance)2

Probability

1.823
0.000
1.823

0.3
0.4
0.3
Sum
EPS

Probability x
Variance2
0.547
0.000
0.547
1.094
1.046

Since there is change in debt and assets increased by 270 million

Debt / Asset Ratio = (652.50 + 300 + 270) / (1,350 + 270) = 75.46%
@ expected EPS 5.78
Times Interest Earned = EBIT / Interest Charges = 270 / (30 + 15 + 32.4) = 3.49
If we calculate COV (Risk / Return), option 1 (New equity) may be good option as it has lesser risk per unit return.

ASSIGNMENT 6
Name:
ERP ID:
Course:

Saif Ali Momin

08003
Business Finance II

Solution
Debt / Equity = 50/50
Interest rate = rd= 10%; so rdt= 10%(1 0.4) = 6%
Cost of retained earning = 14%
Cost of new stock = 16%
T = 40%
Net Income = $7,287,500
Calculation WACC for selection of projects
(7,500,000 6%) + (7,287,500 14%) + (212,500 16%)
WACC =
= 10.03%
15,000,000
Comparing IRR and WACC, Project A & B should be selected.
Total Investment = $10 million
$5 million from debt and $5 million from retained earnings
Residual earnings after investments = 7,287,500 5,000,000 = $2,287,500
Payout ratio = 2,287,500 / 7,287,500 = 31.39%

Solution
20% stock dividend
Po = $7.00 per share
a. Stock dividend = 20% of 10,000 = 2,000 shares
b. Additional paid-in capital
Dollar transferred from RE = 2,000 x $7.00 = $14,000
From $14,000; (2,000 x $5) $10,000 added to Common stock and (14,000 10,000) $4,000 added to paid in capital
So, Additional paid-in capital = 20,000 + 4,000 = $24,000
c. RE after stock dividend
Retained earnings = 30,000 14,000 = $16,000

Solution
Stock Dividend = 6%
Po = $37.50 per share
Stock dividend = 6% x 75,000,000 = 4,500,000 shares
Total shares = 75,000,000 + 4,500,000 = 79,500,000
Retain earnings transferred = 4,500,000 x $37.50 = $168,750,000
Remaining retained earnings = 1,125,000,000 168,750,000 = 956,250,000
From $168,750,000; (4,500,000 x $1) $4,500,000 added to Common stock and (168,750,000 4,500,000) $164,250,000
added to paid in capital
So, Paid-in capital = 300,000,000 + 164,250,000 = 464,250,000
Balance Sheet after stock dividend
Cash
$ 112.5 Debt
Other assets
2,887.5 Common stock (79.5 million
shares outstanding, $1 par)
Paid-in capital
Retained earnings
Total assets
$3,000.00 Total liabilities and equity

$ 1,500.0
79.5
464.25
956.25
$3,000.00

Solution
(2008) Dividend = $3.6 million on Net Income = $10.8 million
Growth in earnings = 10%
(2009) Expected Earnings = 14.4 million
Investment opportunity = $8.4 million
Debt ratio = 40%
a. 1) D2009 = D2008 x 1.1 = 3.6 x 1.1 = $3.96 million
a. 2) Dividend payout in 2008 = 3.6 / 10.8 = 33.33%
Dividend payout in 2009 = 33.33% = D2009 / 14.4
D2009 = $4.8 million
a. 3) 60% of $8.4 million i.e. $5.04 million is financed by RE
Residual amount in RE for dividend payout = 14.4 5.04 = $9.36 million
a. 4) Regular dividend plus extra policy
Regular dividend = 3.6 x 1.1 = $3.96 million
Extra dividend = Residual amount regular dividend = 9.36 3.96 = $5.4 million
Total = $9.36 million
b. Residual dividend policy is recommended since it is flexible with respect to amount of dividend to be paid. But it
requires good planning of future projects and justifications to keep profits in RE for projects. In other cases there is a
chance that after payment of dividend at fixed percentage the residual amount may not be sufficient to cover for future
projects. But in this case shareholder may be un-happy due to unexpected business situations.

c. Cost of Equity
r =

D
+g
P

r =

9
+ 0.1 =
180

d. Average ROE
g = (1 payout rate) ROE
10% = (1 33.33%) ROE
= %

e. Since Cost and Return over equity are equal so the company is not getting any benefit above the cost of equity. So the
dividend may be decreased to reduce the cost of equity or keep it at $9 million where there is no loss or benefit against
equity. But it should not be increased.

ASSIGNMENT 7
Name:
ERP ID:
Course:

Saif Ali Momin

08003
Business Finance II

Solution
Unit selling price = $25
FC = $140,000 for 30,000 watches
VC = $15
a. Gain or loss
Sale
Variable Cost
Fixed Cost
Gain or (Loss)

@ 8000 units sale

200,000
(120,000)
(140,000)
(60,000)

@ 18000 units sale

450,000
(270,000)
(140,000)
40,000

b. Operating breakeven point

Breakeven point = 140,000 / (25 15) =
14,000 units

c. DOL
DOL @ 8,000 units = Gross profit / EBIT = 80,000 / -60,000 = -1.33
DOL @ 18,000 units = Gross profit / EBIT = 180,000 / 40,000 = 4.50
d. Operating breakeven at $31 price
Breakeven point = 140,000 / (31 15) = 8750 units
e. Operating breakeven at $31 price and VC $23
Breakeven point = 140,000 / (31 23) = 17,500 units

Solution
a. EBIT at Financial Breakeven (i.e. EBIT at which EPS = 0)
D
0
EBIT
=I+
= 2000 +
=$
(1 T)
(1 0.4)
Re-creating Income Statement
EBIT
Interest
Earnings before taxes
Taxes
Net Income
EPS

$2,000
(2,000)
0
0
0
0

b. DFL
DFL = EBIT / (EBIT I) = 2,500 / (2,500 2,000)
DFL = 5
c. With preferred dividend of $600
D
600
EBIT
=I+
= 2000 +
=$
(1 T)
(1 0.4)
Re-creating Income Statement
EBIT
Interest
Earnings before taxes
Taxes
Net Income
Preferred Dividends
Net Income to Common Shareholder
EPS

$3,000
(2,000)
1,000
(400)
600
(600)
0
0

Solution
a. Balance Sheet after asset increase
Grimm Manuf.

Total assets

Debt
Equity
$600,000 Total Liabilities & equity

400,000
200,000
$600,000

Debt Ratio = 400,000/600,000 = 66.67%

Wright Mills

Total assets

Debt
Equity
$400,000 Total Liabilities & equity

200,000
200,000
$400,000

Debt Ratio = 200,000/400,000 = 50%

b. Balance Sheet after lease has been capitalized
Wright Mills

Total assets

Debt
Equity
$600,000 Total Liabilities & equity

400,000
200,000
$600,000

Debt Ratio = 400,000/600,000 = 66.67%

c. ROA and ROE is higher in case of operating lease and lower in case of capital lease. Because in case of operating lease
assets or equity remained unchanged and in capital lease the assets are increased.

Solution
IRR = 20%
r = 12%
Loom price = $250,000
Loan option
Four year amortization loan at interest rate 10%
Maintenance fee = $20,000
MACRS 5 years
T = 40%
Lease option
Lease payments = $70,000
Book value after 4 years = $42,500
a. Purchase or lease option selection
Loan installments
1
1
(1 + r)
PV = PMT
r

here r = 10% x (1 - 40%) = 6%

1
1
(1 + 0.06)
250,000 = PMT
0.06
PMT = 72,147.87
Cost of owning
Y0
Loan installments with tax savings
Maintenance cost net off tax
MACRS 5 years
Tax savings on depreciation
Salvage value
Present Value
NPV
Cost of leasing
Lease Payments with tax savings
Present Value
NPV

(185,111.59)

Y1
(72,147.87)
(12,000.00)
20%
20,000.00
(64,147.87)
(60,516.86)

Y2
(72,147.87)
(12,000.00)
32%
32,000.00
(52,147.87)
(46,411.42)

Y3
(72,147.87)
(12,000.00)
19%
19,000.00
(65,147.87)
(54,699.41)

Y4
(72,147.87)
(12,000.00)
12%
12,000.00
42,500.00
(29,647.87)
(23,483.89)

(42,000.00)
(42,000.00) (42,000.00) (42,000.00) (42,000.00)
(42,000.00)
(39,622.64) (37,379.85) (35,264.01) (33,267.93)
(187,534.44)

Loom should be leased as it clearly shows that the NPV of leasing the loom is less than the NPV of owning.
b. If the salvage value is 15% then
Book value
Salvage value (15%)
Gain/(Loss)

42,500.00
37,500.00
(5,000.00)

Tax benefit on loss

Salvage value with tax benefit

(2,000.00)
39,500.00

With the above salvage value NPV comes out to be.

Y0
Y1
Y2
Y3
Y4
Loan installments with tax savings
- (72,147.87) (72,147.87) (72,147.87) (72,147.87)
Maintenance cost net off tax
- (12,000.00) (12,000.00) (12,000.00) (12,000.00)
MACRS 5 years
20%
32%
19%
12%
Tax savings on depreciation
20,000.00
32,000.00
19,000.00
12,000.00
Salvage value
39,500.00
- (64,147.87) (52,147.87) (65,147.87) (32,647.87)
Present Value
- (60,516.86) (46,411.42) (54,699.41) (25,860.17)
NPV
(187,487.87)
This again is somewhat greater than the leasing scenario. However, it may affect the decision to lease equipment if
there is further decrease in salvage value of equipment.
c. Cash outflow would be added in the analysis at the year 4 for the purchase of the asset equal to the book value of the
assets at that point in time.

Solution
Investment = $1.5 million
MACRS 3 years
Maintenance expense = $75,000 per year
T = 40%
Interest rate = 15% with amortization in 4 equal payments
Lease payments = $400,000 per year for 4 years (end-of-year)
Salvage value at the expiry of lease = $250,000
a. Purchase or lease option selection
Loan installments
1
1
(1 + r)
PV = PMT
r
here r = 15% x (1 - 40%) = 9%
1
1
(1 + 0.09)
1,500,000 = PMT
0.09
PMT = 463,002.99

Cost of owning
Y0
Loan installments with tax savings
Maintenance cost net off tax
MACRS 5 years
Tax savings on depreciation
Salvage value
Present Value
NPV

(704,864.30)

Y1
Y2
Y3
(463,002.99) (463,002.99) (463,002.99)
(45,000.00) (45,000.00) (45,000.00)
33%
45%
15%
198,000.00
270,000.00
90,000.00
(310,002.99)
31,997.01 (328,002.99)
(284,406.42)
26,931.24 (253,278.49)

Y4
(463,002.99)
(45,000.00)
7%
42,000.00
150,000.00
(274,002.99)
(194,110.63)

Cost of Leasing
Y0
Lease Payments net off tax
Salvage Value
Present Value
NPV

Y1
Y2
Y3
Y4
(240,000.00) (240,000.00) (240,000.00) (240,000.00)
(250,000.00)
(240,000.00) (240,000.00) (240,000.00) (490,000.00)
- (220,183.49) (202,003.20) (185,324.04) (170,022.05)
(777,532.77)

Clearly the NPV for leasing is lesser than the cost of owning, so leasing is preferred.