12-7A (Cost of preferred stock) (kps) Your firm is planning to issue preferred stock.

The stock sells for %115;

however, if new stock is issued, the company would receive only $98. The par value of the stock is $100 and
the dividend rate is 14%. What is the cost of capital for the stock to your firm?
Dividend D
kps = =
Net Price NPps
14% x $100 $14
= =
$98 $98
= 14.29%

12-9A (Cost of Equity) the common stock for Bestsold Corp. sells for $58. If a new issue is sold, the flotation
costs are estimated to be 8%. The company pays 50% of its earnings in dividends, and a $4 dividen was recently
paid. Earnings per share 5 years ago were $5. Earnings are expected to continue to grow at the same annual
rate in the future as during the past 5 years. The firms marginal tax rate is 34%. Calculate the cost (a) internal
common and (b) external common.
Answer: If the firm pays out 50 percent of its earnings in dividends, its recent earnings must have been $8 ($4
dividend divided by 0.5). Thus, earnings increased from $5 to $8 in five years. Using Appendix C and looking for
a table value of .625 ($5/$8), the annual growth rate is approximately ten percent.
a. Cost of internal common stock (kcs):
 D1 
kcs =   + g
 Pcs 
$4(1  .10) $4.40
= + 0.10 = + 0.10
$58 $58
= 0.1759 = 17.59%
b. Cost of external common (new common) stock, kncs
 D1 
kncs =   + g
 cs 
NP
$4.40
= + 0.10
$58(1  0.08)
$4.40
= + 0.10
$53.36
= 0.1825 = 18.25%

12-10A (Cost of Debt) Sincere Stationery Corp. needs to raise $500,000 to improve its manufacturing plant. It
has decided to issue a $1,000 par value bond with a 14% annual coupon rate and a 10-year maturity. The
investors require a 9% rate of return.
a. compute the market value of the bonds
10 $140 $1,000
Price (Pd) =  +
(1  0.09)
t 1
t
(1  0.09)10
= $140(6.418) + $1000(0.422)
= $1,320.52
b. what will the net price be if flotation costs are 10.5% of the market price?
NPd = $1,320.52(1 - 0.105) = $1,181.87
c. How many bonds will the firm have to issue to receive the needed funds?
$500,000
Number of Bonds = = 423.06 ≈ 424 Bonds
$1,181.87
d. What is the firm’s after-tax cost of debt if its average tax rate is 25% and its marginal tax rate is 34%?
Cost of debt:
10 $140 $1,000
$1,181.87 =  +
t 1 (1  k d ) t
(1  k d )10

Rate Value Value

For 10% $1,246.30 $1,246.30
kd% 1,181.87
11% ________ 1,176.46
$ 64.43 $ 69.84
 $64.43 
kd = 0.10 +    (0.01) = 0.1092 = 10.92%
 $69.84 
After tax
cost of debt = 10.92% (1 - 0.34) = 7.21%
e. Assume the coupon rate is 10%. What effects does changing the coupon rate have on the firm’s after-tax
cost of capital?
10 $100 $1,000
1. Price (Pd) =  +
t  1 (1  0.09) (1  0.09)10
t

= $100 (6.418) + $1,000 (0.422)

= $1,063.80
2. NPd = $1,063.80 (1 - 0.105)
= $952.10
$500,000
3. Number of Bonds =
$952.10
= 525.15 ≈ 526 Bonds
4. Cost of debt:
10 $100 $1,000
$952.10 =  +
t  1 (1  k d ) (1  k d )10
t

Rate Value Value

For: 10% $1,000.00 $1,000.00
kd% 952.10
11% ________ 940.90
$ 47.90 $ 59.10
 $47.90 
kd = 0.10 +    (0.01) = 0.1081 = 10.81%
 $59.10 
After tax
cost of debt = 10.81% (1 - 0.34) = 7.13%
f. Why is there a change?
There is a very slight decrease in the cost of debt because the flotation costs associated with the higher
coupon bond are higher ($138.65 in flotation costs for the 14 percent coupon bond versus $111.70 for the
10 percent coupon bond).

12-13A (Weighted Average Cost of Capital) Crypton Electronics has a capital structure consisting of 40%
common stock, and 60% debt. A debt issue of $1,000 par value 6% bonds, maturing in 15 years and paying
annual interest, will sell for $975. Flotation costs for the bonds will be $15 per bond. Common stock of the firm
is currently selling for $30 per share. The firm expect to pay a $2.25 dividend next year. Dividends have grown
at the rate of 5% per year and are expected to continue to do so for the foreseeable future. Flotation costs for
the stock issue are 5% of the market price. What is Crypton cost of capital where the firm’s tax rate is 30%?
Answer: Net price after flotation costs = $975 - $15
= $960.00
Cost of debt:
15
$60 $1,000
$960.00 = t 1 (1  k d ) t
+
(1  k d )15
Rate Value Value
For: 6% $1,000.00 $1,000.00
kd% 960.00
7% ________ 908.48
$ 40.00 $ 91.52
 $40.00 
kd = 0.06 +    (0.01) = .064 = 6.4%
 $91.52 
After tax
cost of debt = 6.4%(1 - 0.30) = 4.48%
Cost of common stock, kncs
 D1 
kncs =  + g
 NPcs 
$2.25
= + .05
$30(1  0.05)
= .129 = 12.9%
Source Capital Structure After-tax cost of capital Weighted cost
Debt 60% 4.48% 2.69%
Common Stock 40% 12.9% 5.16%
kwacc = 7.85%
13-2A (Free cash flow model valuation) the Bergman Corp. sold its shares to the general public in 2003. The
firm’s estimated free cash flows for the next 4 years. Bergman estimated that its free cash flow would form a
level perpetuity beginning in year 4. Furthermore, the firms investment banker conducted a study of the firms’
cost of capital and estimated the weighted average cost of capital to be approximately 12%.
a. What is the value of Bergman using the free cash flow valuation model?
b. Given that Bergmans invested capital in year 0 is $9,818.18, what is the market value added for Bergman?
c. If Bergman has $2,000 shares of common stock outstanding and liabilities valued at $4,000, what is the value
per share of its stock?
FREE CASH FLOWS:
Year 1 2 3 4
Sales $30,000.00 $33,000.00 $36,300.00 $36,300.00
Operating income (Earnings Before Interest 4,800.00 5,280.00 5,808.00 5,808.00
and Taxes)
Less cash tax payments (1,440.00) (1,584.00) (1,742.40) (1,742.40)
Net operating profits after taxes (NOPAT) $ 3,360.00 $ 3,696.00 $ 4,065.60 $ 4,065.60
Less investments:
Investment in Net Working Capital (354.55) (390.00) (429.00) -
Capital expenditures (CAPEX) (490.91) (540.00) (594.00) -
Total investments $ (845.46) $ (930.00) $ (1,023.00) $ -
Free cash flow $ 2,514.54 $ 2,766.00 $ 3,042.60 $ 4,065.60
PV of FCF 2,245.13 2,205.04 2,165.66 $24,115.11
Present value of free cash flows:
Planning horizon cash flows $ 6,615.83
Terminal value in year 4: 33,880.00
PV of terminal value $ 24,115.11
a) Firm value $ 30,730.94
Invested capital (year 0) $ 9,818.18
b) Market Value Added $ 20,912.76
Debt $ 4,000.00
Shareholder value ($30,730.94 – 4,000) $ 26,730.94
No. of shares 2,000.00
c) Value per share $ 13.37

13-3A (Calculating economic value added)

Sales growth for years 1-3 10%, Operating profit margin 16%, Net working capital to sales ratio 13%, Current
assets to sales ratio 18%, Property, plant, and equipment to sales ratio 18%, Beginning sales $27,272.73, Cash
tax rate 30%, Total liabilities $4,000, Cost of capital 12%, Number of shares 2,000.
year 0 1 2 3 4
Change in current assets $ 354.55 $ 390.00 $ 429.00 $ -
Current assets $ 4,909.09 $ 5,263.64 $ 5,653.64 $ 6,082.64 $ 6,082.64
Capital expenditures $ 490.91 $ 540.00 $ 594.00 $ -
Property, plant and equipment 4,909.09 $ 5,400.00 $ 5,940.00 $ 6,534.00 $ 6,534.00
Total Capital = Total Assets - Non- $ 9,818.18 $10,663.64 $11,593.64 $12,616.64 $12,616.64
interest liabilities

a) Calculation of EVA:
Year 0 1 2 3 4 and
beyond
Sales $30,000.00 $33,000.00 $36,300.00 $ 36,300.00
Operating income 4,800.00 5,280.00 5,808.00
$ 5,808.00
Less cash tax payments (1,440.00) (1,584.00) (1,742.40) (1,742.40)
Net operating profits after taxes $3,360.00 $ 3,696.00 $ 4,065.60 $ 4,065.60
(NOPAT)
Less capital charge (Invested Capital $(1,178.18) $(1,279.64) $(1,391.24) $ (1,514.00)
x Kwacc)
Economic Value Added $2,181.82 $2,416.36 $ 2,674.36 $ 2,551.60
Invested Capital $ 9,818.18 $10,663.64 $11,593.64 $12,616.64 $12,616.64
b) Return on Invested Capital
(NOPATt  ICt-1) 34.22% 34.66% 35.07% 32.22%
c) Market Value Added = PV(EVAs) $20,640.89
Plus Invested Capital (year 0) 9,818.18
Firm Value $31,459.07
a. The EVAs are positive each year, indicating Bergman is creating value for its shareholders.
b. The ROIC is greater than the cost of capital, so the firm is creating value for its shareholders. When the ROIC
is greater than the cost of capital, we should see positive EVAs.
c. The present value of the EVAs exceeds the market value added in Problem 13-2A.
13-4A (Incentive compensation)
Given:
Base pay $ 100,000.00
Incentive % 20.00%
Target EVA $
Performance 20,000,000.00

a. Unbounded incentive plan

Scenario A Scenario B Scenario C
Actual EVA $ 15,000,000 $ 20,000,000 $ 30,000,000
Performance

Plant Manager Compensation

Base pay $ 100,000.00 $ 100,000.00 $ 100,000.00
Incentive pay 15,000.00 20,000.00 30,000.00
Total compensation $ 115,000.00 $ 120,000.00 $ 130,000.00
b. Bounded incentive plan (80/120)
Scenario A Scenario B Scenario C
Actual EVA $15,000,000 $20,000,000 $30,000,000
Performance

Plant Manager Compensation

Base pay $ 100,000.00 $ 100,000.00 $ 100,000.00
Incentive pay - 20,000.00 24,000.00
Total compensation $ 100,000.00 $ 120,000.00 $ 124,000.00
This plan encourages employees to meet targets only within range of performance where payout varies with
performance (between floor and cap). Employees have no incentive to improve performance if below floor or
above cap.
14-1. Financial markets are institutions and procedures that facilitate transactions in all types of financial
claims. Financial markets perform the function of allocating savings in the economy to the ultimate
demander(s) of the savings. Without these financial markets, the total wealth of the economy would
be lessened. Financial markets aid the rate of capital formation in the economy.
14-2. A financial intermediary issues its own type of security which is called an indirect security. It does this
to attract funds. Once the funds are attracted, the intermediary purchases the financial claims of other
economic units in order to generate a return on the invested funds. A life insurance company, for
example, issues life insurance policies (its indirect security) and buys corporate bonds in large quantities.
14-3. The money market consists of all institutions and procedures that accomplish transactions in short-term
debt instruments issued by borrowers with (typically) high credit ratings. Examples of securities traded
in the money market include U.S. Treasury Bills, bankers’ acceptances, and commercial paper. Notice
that all of these are debt instruments. Equity securities are not traded in the money market. It is entirely
an over-the-counter market. On the other hand, the capital market provides for transactions in long-
term financial claims (those claims with maturity periods extending beyond one year). Trades in the
capital market can take place on organized security exchanges or over-the-counter markets.
14-4. Organized stock exchanges provide for:
(1) A continuous market. This means a series of continuous security prices is generated. Price
changes between trades are dampened, reducing price volatility, and enhancing the liquidity of
securities.
 (2) Establishing and publicizing fair security prices. Prices on an organized exchange are determined
in the manner of an auction. Moreover, the prices are published in widely available media like
newspapers.
(3) An aftermarket to aid businesses in the flotation of new security issues. The continuous pricing
mechanism provided by the exchanges facilitates the determination of offering prices in new
flotations. The initial buyer of the new issue has a ready market in which he can sell the security
should he need liquidity rather than a financial asset.
14-5. General categories examined by an organized exchange in determining whether an applicant firm’s
securities can be listed on it? The criteria for listing can be labeled as follows: (1) profitability; (2) size;
(3) market value; (4) public ownership.
14-6. Why do you think most secondary market trading in bonds takes place over-the-counter? Most bonds
are traded among very large financial institutions. Life insurance companies and pension funds are
typical examples. These institutions deal in large quantities (blocks) of securities. An over-the-counter
bond dealer can easily bring together a few buyers and sellers of these large quantities of bonds. By
comparison, common stocks are owned by millions of investors. The organized exchanges are necessary
to accomplish the "fragmented" trading in equities.
14-7. The investment banker is a middleman involved in the channeling of savings into long-term investment.
He performs the functions of: (1) underwriting; (2) distributing; (3) advising. By assuming underwriting
risk, the investment banker and his syndicate purchase the securities from the issuer and hope to sell
them at a higher price. Distributing the securities means getting those financial claims into the hands of
the ultimate investor. This is accomplished through the syndicate's selling group. Finally, the investment
banker can provide the corporate client with sound advice on which type of security to issue, when to
issue it, and how to price it.
14-8. In a negotiated purchase, the corporate security issuer and the managing investment banker negotiate
the price that the investment banker will pay the issuer for the new offering of securities. In a
competitive-bid situation, the price paid to the corporate security issuer is determined by competitive
(sealed) bids, which are submitted by several investment banking syndicates hoping to win the right to
underwrite the offering.
14-9. Investment banking syndicates are established for three key reasons: (1) the investment banker who
originates the business probably cannot afford to purchase the entire new issue himself; (2) to spread
the risk of loss among several underwriters; (3) to widen the distribution network.
14-10. Several positive benefits are associated with private placements. The first is speed. Funds can be
obtained quickly, primarily due to the absence of a required registration with the SEC. Second, flotation
costs are lower as compared to public offerings of the same dollar size. Third, greater financing flexibility
is associated with the private placement. All of the funds, for example, need not be borrowed at once.
They can be taken over a period of time. Elements of the debt contract can also be renegotiated during
the life of the loan.
14-11. As a percent of gross proceeds, flotation costs are inversely related to the dollar size of the new issue.
Additionally, common stock is more expensive to issue than preferred stock, which is more expensive to
issue than debt.
14-12. What type of financing vehicle (instrument or instruments) is most favored. The answer on this is clear.
The corporate debt markets dominate the corporate equity markets when new funds are raised. The
tax system of the U.S. economy favors debt financing by making interest expense deductible from
income when computing the firm's federal tax liability. Consider all corporate securities offered for cash
over the period 1999-2001. The percentage of the total represented by bonds and notes was 76.9
percent compared to 23.1 percent equity.
14-13. What is the major savings-surplus sector in the US economy. The household sector is the largest net
supplier of savings to the financial markets. Foreign financial investors have recently been net suppliers
 of savings to the financial markets. On the other hand, the nonfinancial corporate business sector is
most often a savings-deficit sector. The U.S. Government sector too is a deficit sector in most years.
14-14. Identify three distinct ways that savings are ultimately transferred to business firms in need of cash.
First, there may be a direct transfer of savings from the investor to the borrower. Second, there may be
an indirect transfer that used the services provided by an investment banker. Third, there may be an
indirect transfer that uses the services of a financial intermediary. Private pension funds and life
insurance companies are prominent examples of the latter case.
15-3B. (Break-even point and operating leverage) Avitar Corporation manufactures a line of computer memory
expansion boards used in microcomputers. The average selling price of its finished product is $175 per
unit. The variable cost for these same units is $115. Avitar incurs fixed costs of $650.000 per year.
a. What is the break-even point in units for the company?
b. What is the dollar sales volume the firm’s must achieve to reach the break-even point?
c. What would be the firm’s profit or loss at the following units of production sold: 10.000 units? 16.000
units? 20.000 units?
d. Find the degree of operating leverage for the production and sales levels given in part (c).
Answer:
F $650,000 $650,000
(a) QB = = = = 10,833 Units
PV $175  $115 $60
(b) S* = (10,833 units) × ($175) = $1,895,775

Alternatively,
F $650,000
S* = =
VC $115
1 1
S $175
$650,000 $650,000
= = = $1,895,596
1  0.6571 .3429
Note: $1,895,596 differs from $1,895,775 due to rounding.
(c) 10,000 16,000 20,000
units units units
Sales $1,750,000 $2,800,000 $3,500,000
Variable costs 1,150,000 1,840,000 2,300,000
Revenue before fixed costs 600,000 960,000 1,200,000
Fixed costs 650,000 650,000 650,000
EBIT -$50,000 $ 310,000 $ 550,000

(d) 10,000 units 16,000 units 20,000 units

$600,000 $960,000 $1,200,000

= -12 times = 3.1 times = 2.2 times
 $50,000 $310,000 $550,000
Notice that the degree of operating leverage decreases as the firm's sales level rises above the break-
even point.
15-4B. (Break-even point and operating leverage) Some financial data for each of three firms are as follows:
Durham Raleign Cabinets Charlotte Colonials
Furniture
Average selling price per unit $ 20.00 $ 435.00 $ 35.00
Average variable cost per unit $ 13.75 $ 240.00 $ 15.75
Units sold 80,000 4,500 15,000
Fixed costs $ 40,000 $ 150,000 $ 60,000
 a. What is the profit for each company at the indicated sales volume?
b. What is the break-even point in units for each company?
c. What is the degree of operating leverage for each company at the indicated sales volume?
d. If sales were to decline, which firm would suffer the largest relative decline in profitability?
Answer:
(a) Durham Raleigh Charlotte
Furniture Cabinets Colonials
Sales $1,600,000 $1,957,500 $525,000
Variable costs 1,100,000 1,080,000 236,250
Revenue before
fixed costs $500,000 $877,500 $288,750
Fixed costs 40,000 150,000 60,000
EBIT $460,000 $727,500 $228,750

Durham F $40,000 $40,000

(b) Furniture: QB = = = = 6,400 units
PV $20.00  $13.75 $6.25

Raleigh $150,000 $150,000

Cabinets: QB = = = 769 units
$435  $240 $195

Charlotte $60,000 $60,000

Colonials: QB = = = 3,117 units
$35.00  $15.75 $19.25
(c) Durham Raleigh Charlotte
Furniture Furniture Colonials
RBF $500,000 $877,500 $288,750
EBIT = = =
$460,000 $727,500 $228,750
= 1.09 times 1.21 times 1.26 times
(d) Charlotte Colonials, since its degree of operating leverage exceeds that of the other two
companies.
15-5B. (fixed costs and the break even point) Cypress Books expects to earn $55,000 next year after taxes. Sales
will be $400,008. The store is located near the shopping district surrounding Sheffield university. Its average
product sells for $28 a unit. The variable cost per unit is $18. The store experiences a 45 percent tax rate.
a. What are the store’s fixed costs expected to be next year?
b. Calculate the store’s break even point in both units and dollars.
Answer:
(a) {S - [VC + F]} (1 - T) = $55,000
   VC   
S  S    F  1  T  = $55,000
   S  
{$400,008 - [257,148 + F ]} (0.55) = $55,000
($142,860 - F) (0.55) = $55,000
F = $42,860
F $42,860 $42,860
(b) QB = = = = 4,286 units
PV $28.00  $18.00 $10.00
F $42,860
S* = = = $120,056
VC 1  0.643
1
S
15-6B. (break even point and profit margin) A recent graduate of Neeley University is planning to open a new
wholesaling operation. Her target operating profit margin is 28 percent. Her unit contribution margin will be 45
percent of sales. Average annual sales are forecast to be $3,750,000.
a. How large can fixed costs be for the wholesaling operation and still allow the 28 percent operating profit
margin to be achieved?
b. What is the break even point in dollars for the firm?
Answer:
(a) Find the EBIT level at the forecast sales volume:
EBIT
= .28
S
Therefore, EBIT = (0.28) ($3,750,000) = $1,050,000
Next, find total variable costs:
VC
= 0.55,
S
so: VC = (0.55) $3,750,000 = $2,062,500
Now, solve for total fixed costs:
S - (VC + F) = $1,050,000
$3,750,000 - ($1,687,500 + F) = $1,050,000
F = $637,500
$637,500
(b) S* = = $1,416,66
1  0.55
15-7B. (leverage analysis) you have developed the following analytical income statement for your corporation.
It represents the most recent year’s operations, which ended yesterday.
Sales $40,000,000
Variable costs 16,000,000
Revenue before fixed costs $24,000,000
Fixed costs 10,000,000
EBIT $14,000,000
Interest expense 1,150,000
Earnings before taxes $12,850,000
Taxes 3,750,000
Net income $ 9,100,000
Your supervisor in the controller’s office has just handed you a memorandum asking for written responses to
the following questions:
a. At this level of output, what is the degree of operating leverage?
b. What is the degree of financial leverage?
c. What is the degree of combined leverage?
d. What is the firm’s break even point in sales dollars?
e. If sales should increase by 20 percent, by what percent would earnings before taxes (and net income)
increase?
Answer:
Revenue before Fixed costs $24,000,000
(a) EBIT = = 1.71 times
$14,000,000
EBIT $14,000,000
(b) = = 1.09 times
EBIT  I $12,850,000
(c) DCL$40,000,000= (1.71) × (1.09) = 1.86 times
 F $10,000,000
(d) S* = =
VC $16m
1 1
S $40m
$10,000,000 $10,000,000
= = = $16,666,667
1  0 .4 0 .6
(e) (20%) × (1.86) = 37.2%
15-8B. (break-even point) you are a hard-working analyst in the office of financial operations for a
manufacturing firm that produces a single product. You have developed the following cost structure information
for this company. All of it pertains to an output level of 7 million units. Using this information, find the break
even point in units of output for the firm.
Return on operating assets = 25%
Operating asset turnover = 5 times
Operating assets =$18 million
Degree of operating leverage =6 times
Answer:
Step (1) Compute the operating profit margin:
(Operating Profit Margin) x (Operating Asset Turnover) = Return on Operating Assets
(M) x (5) = 0.25
M = .05
Step (2) Compute the sales level relative to the given output level:
Sales
= 5
$18,000,000
Sales = $90,000,000
Step (3) Compute EBIT:
(.05) ($90,000,000) = $4,500,000

Step (4) Compute revenue before fixed costs. Since the degree of operating leverage is 6 times,
revenue before fixed costs (RBF) is 6 times EBIT as follows:
RBF = (6)  ($4,500,000) = $27,000,000
Step (5) Compute total variable costs:
(Sales) - (Total variable costs) = $27,000,000
$90,000,000 - (Total variable costs) = $27,000,000
Total variable costs = $63,000,000
Step (6) Compute total fixed costs:
RBF - Fixed costs = $4,500,000
$27,000,000 - fixed costs = $4,500,000
Fixed costs = $22,500,000
Step (7) Find the selling price per unit, and the variable cost per unit:
$90,000,000
P = = $12.86
7,000,000
$63,000,000
V = = $9.00
7,000,000
Step (8) Compute the break-even point:
F $22,500,000
QB = =
PV ($12.86)  ($9)
$22,500,000
= = 5,829,016 units
$3.86
15-9B. (break even point and operating leverage) Matthew Electronics manufactures a complete line of radio
and communication equipment for law enforcement agencies. The average selling price of its finished product
is $175 per unit. The variable costs for these same units is $140. Matthew’s incurs fixed costs of $550,000 per
year.
a. What is the break even poit in units for the company?
b. What is the dollar sales volume the firm must achieve to reach the break even point?
c. What would be the firm’s profit or loss at the following units of production sold: 12,000 units? 15,000
units? 20,000 units?
d. Find the degree of operating leverage for the production and sales levels given in part (c).
Answer:
F $550,000 $550,000
(a) QB = = = = 15,714 units
PV $175  $140 $35
F $550,000
(b) S* = =
VC $140
1 1
S $175
$550,000 $550,000
= = = $2,750,000
1  0 .8 .2

(c) 12,000 15,000 20,000

Units Units Units
Sales $2,100,000 $2,625,000 $3,500,000
Variable costs 1,680,000 2,100,000 2,800,000
Revenue before fixed costs $ 420,000 $ 525,000 $700,000
Fixed costs 550,000 550,000 550,000
EBIT -$130,000 -$25,000 $ 150,000
(d) 12,000 units 15,000 units 20,000 units
$420,000 $525,000 $700,000
= -3.2 times = -21 times = 4.67 times
 $130,000  $25,000 $150,000