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End of Chapter Solutions

Modern Financial Management 8


th
edition
Ross, Westerfield, Jaffe, Jordan
CHAPTER 1
INTRODUCTION TO CORPORATE
FINANCE
Answers to Concept Questions
1. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders
elect the directors of the corporation, who in turn appoint the firms management. This separation of
ownership from control in the corporate form of organiation is what causes agenc! pro"lems to
e#ist. $anagement ma! act in its own or someone elses "est interests, rather than those of the
shareholders. If such e%ents occur, the! ma! contradict the goal of ma#imiing the share price of the
e&uit! of the firm.
2. Such organiations fre&uentl! pursue social or political missions, so man! different goals are
concei%a"le. 'ne goal that is often cited is re%enue minimiation( i.e., pro%ide whate%er goods and
ser%ices are offered at the lowest possi"le cost to societ!. ) "etter approach might "e to o"ser%e that
e%en a not*for*profit "usiness has e&uit!. Thus, one answer is that the appropriate goal is to
ma#imie the %alue of the e&uit!.
3. +resuma"l!, the current stoc, %alue reflects the ris,, timing, and magnitude of all future cash flows,
"oth short*term and long*term. If this is correct, then the statement is false.
4. )n argument can "e made either wa!. )t the one e#treme, we could argue that in a mar,et econom!,
all of these things are priced. There is thus an optimal le%el of, for e#ample, ethical and-or illegal
"eha%ior, and the framewor, of stoc, %aluation e#plicitl! includes these. )t the other e#treme, we
could argue that these are non*economic phenomena and are "est handled through the political
process. ) classic .and highl! rele%ant/ thought &uestion that illustrates this de"ate goes something
li,e this0 1) firm has estimated that the cost of impro%ing the safet! of one of its products is 234
million. 5owe%er, the firm "elie%es that impro%ing the safet! of the product will onl! sa%e 264
million in product lia"ilit! claims. What should the firm do78
5. The goal will "e the same, "ut the "est course of action toward that goal ma! "e different "ecause of
differing social, political, and economic institutions.
6. The goal of management should "e to ma#imie the share price for the current shareholders. If
management "elie%es that it can impro%e the profita"ilit! of the firm so that the share price will
e#ceed 239, then the! should fight the offer from the outside compan!. If management "elie%es that
this "idder or other unidentified "idders will actuall! pa! more than 239 per share to ac&uire the
compan!, then the! should still fight the offer. 5owe%er, if the current management cannot increase
the %alue of the firm "e!ond the "id price, and no other higher "ids come in, then management is not
acting in the interests of the shareholders "! fighting the offer. Since current managers often lose
their :o"s when the corporation is ac&uired, poorl! monitored managers ha%e an incenti%e to fight
corporate ta,eo%ers in situations such as this.
SOLUTIONS
7. We would e#pect agenc! pro"lems to "e less se%ere in other countries, primaril! due to the relati%el!
small percentage of indi%idual ownership. ;ewer indi%idual owners should reduce the num"er of
di%erse opinions concerning corporate goals. The high percentage of institutional ownership might
lead to a higher degree of agreement "etween owners and managers on decisions concerning ris,!
pro:ects. In addition, institutions ma! "e "etter a"le to implement effecti%e monitoring mechanisms
on managers than can indi%idual owners, "ased on the institutions deeper resources and e#periences
with their own management.
8. The increase in institutional ownership of stoc, in the <nited States and the growing acti%ism of
these large shareholder groups ma! lead to a reduction in agenc! pro"lems for <.S. corporations and
a more efficient mar,et for corporate control. 5owe%er, this ma! not alwa!s "e the case. If the
managers of the mutual fund or pension plan are not concerned with the interests of the in%estors, the
agenc! pro"lem could potentiall! remain the same, or e%en increase since there is the possi"ilit! of
agenc! pro"lems "etween the fund and its in%estors.
9. 5ow much is too much7 Who is worth more, Jac, Welch or Tiger Woods7 The simplest answer is
that there is a mar,et for e#ecuti%es :ust as there is for all t!pes of la"or. E#ecuti%e compensation is
the price that clears the mar,et. The same is true for athletes and performers. 5a%ing said that, one
aspect of e#ecuti%e compensation deser%es comment. ) primar! reason e#ecuti%e compensation has
grown so dramaticall! is that companies ha%e increasingl! mo%ed to stoc,*"ased compensation.
Such mo%ement is o"%iousl! consistent with the attempt to "etter align stoc,holder and management
interests. In recent !ears, stoc, prices ha%e soared, so management has cleaned up. It is sometimes
argued that much of this reward is simpl! due to rising stoc, prices in general, not managerial
performance. +erhaps in the future, e#ecuti%e compensation will "e designed to reward onl!
differential performance, i.e., stoc, price increases in e#cess of general mar,et increases.
10. $a#imiing the current share price is the same as ma#imiing the future share price at an! future
period. The %alue of a share of stoc, depends on all of the future cash flows of compan!. )nother
wa! to loo, at this is that, "arring large cash pa!ments to shareholders, the e#pected price of the
stoc, must "e higher in the future than it is toda!. Who would "u! a stoc, for =>44 toda! when the
share price in one !ear is e#pected to "e =847
B-2
CHAPTER 2
FINANCIAL STATEMENTS AND CASH
FLOW
Answers to Concepts Review and Critical !in"in# Questions
1. True. E%er! asset can "e con%erted to cash at some price. 5owe%er, when we are referring to a li&uid
asset, the added assumption that the asset can "e con%erted cash at or near mar,et %alue is important.
2. The recognition and matching principles in financial accounting call for re%enues, and the costs
associated with producing those re%enues, to "e 1"oo,ed8 when the re%enue process is essentiall!
complete, not necessaril! when the cash is collected or "ills are paid. ?ote that this wa! is not
necessaril! correct( its the wa! accountants ha%e chosen to do it.
3. The "ottom line num"er shows the change in the cash "alance on the "alance sheet. )s such, it is not
a useful num"er for anal!ing a compan!.
4. The ma:or difference is the treatment of interest e#pense. The accounting statement of cash flows
treats interest as an operating cash flow, while the financial cash flows treat interest as a financing
cash flow. The logic of the accounting statement of cash flows is that since interest appears on the
income statement, which shows the operations for the period, it is an operating cash flow. In realit!,
interest is a financing e#pense, which results from the compan!s choice of de"t and e&uit!. We will
ha%e more to sa! a"out this in a later chapter. When comparing the two cash flow statements, the
financial statement of cash flows is a more appropriate measure of the compan!s performance
"ecause of its treatment of interest.
5. $ar,et %alues can ne%er "e negati%e. Imagine a share of stoc, selling for @264. This would mean
that if !ou placed an order for >44 shares, !ou would get the stoc, along with a chec, for 26,444.
5ow man! shares do !ou want to "u!7 $ore generall!, "ecause of corporate and indi%idual
"an,ruptc! laws, net worth for a person or a corporation cannot "e negati%e, impl!ing that lia"ilities
cannot e#ceed assets in mar,et %alue.
6. ;or a successful compan! that is rapidl! e#panding, for e#ample, capital outla!s will "e large,
possi"l! leading to negati%e cash flow from assets. In general, what matters is whether the mone! is
spent wisel!, not whether cash flow from assets is positi%e or negati%e.
7. Its pro"a"l! not a good sign for an esta"lished compan! to ha%e negati%e cash flow from assets, "ut
it would "e fairl! ordinar! for a start*up, so it depends.
SOLUTIONS
8. ;or e#ample, if a compan! were to "ecome more efficient in in%entor! management, the amount of
in%entor! needed would decline. The same might "e true if the compan! "ecomes "etter at collecting
its recei%a"les. In general, an!thing that leads to a decline in ending ?WC relati%e to "eginning
would ha%e this effect. ?egati%e net capital spending would mean more long*li%ed assets were
li&uidated than purchased.
9. If a compan! raises more mone! from selling stoc, than it pa!s in di%idends in a particular period,
its cash flow to stoc,holders will "e negati%e. If a compan! "orrows more than it pa!s in interest and
principal, its cash flow to creditors will "e negati%e.
10. The ad:ustments discussed were purel! accounting changes( the! had no cash flow or mar,et %alue
conse&uences unless the new accounting information caused stoc,holders to re%alue the deri%ati%es.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. To find owners e&uit!, we must construct a "alance sheet as follows0
Aalance Sheet
C) B9,444 CC BD,344
?;) 63,444 CTE >3,>44
'E 77
T) B68,444 TC F 'E B68,444
We ,now that total lia"ilities and owners e&uit! .TC F 'E/ must e&ual total assets of B68,444. We
also ,now that TC F 'E is e&ual to current lia"ilities plus long*term de"t plus owners e&uit!, so
owners e&uit! is0
'E G B68,444 @>3,>44 @ D,344 G B>4,H44
?WC G C) @ CC G B9,444 @ D,344 G BI44
2. The income statement for the compan! is0
Income Statement
Sales =96I,444
Costs 684,444
Eepreciation 38,444
EAIT =64J,444
Interest >9,444
EAT =>JD,444
Ta#es .39K/ HI,J44
?et income =>6H,>44
B-4
CHAPTER 2 B-
'ne e&uation for net income is0
?et income G Ei%idends L )ddition to retained earnings
Rearranging, we get0
)ddition to retained earnings G ?et income @ Ei%idends
)ddition to retained earnings G =>6H,>44 @ DI,444
)ddition to retained earnings G =IJ,>44
3. To find the "oo, %alue of current assets, we use0 ?WC G C) @ CC. Rearranging to sol%e for current
assets, we get0
C) G ?WC L CC G 2J44M L 6.6$ G 23.>$
The mar,et %alue of current assets and fi#ed assets is gi%en, so0
Aoo, %alue C) G 23.>$ $ar,et %alue C) G 26.8$
Aoo, %alue ?;) G 2D.4$ $ar,et %alue ?;) G 23.6$
Aoo, %alue assets G 23.>$ L D.4$ G 2I.>$ $ar,et %alue assets G 26.8$ L 3.6$ G 2H.4$
4. Ta#es G 4.>9.294M/ L 4.69.269M/ L 4.3D.269M/ L 4.3J.26I3M @ >44M/
Ta#es G 28J,I64
The a%erage ta# rate is the total ta# paid di%ided "! net income, so0
)%erage ta# rate G 28J,I64 - 26I3,444
)%erage ta# rate G 36.8HK
The marginal ta# rate is the ta# rate on the ne#t 2> of earnings, so the marginal ta# rate G 3JK.
5. To calculate 'C;, we first need the income statement0
Income Statement
Sales =>3,944
Costs 9,D44
Eepreciation >,644
EAIT =H,J44
Interest H84
Ta#a"le income =H,664
Ta#es .34K/ >,8HH
?et income =D,39D
'C; G EAIT L Eepreciation @ Ta#es
'C; G =H,J44 L >,644 @ >,8HH
'C; G =H,63D
6. ?et capital spending G ?;)end

@ ?;)"eg L Eepreciation
?et capital spending G D,I44,444 @ D,644,444 L J69,444
?et capital spending G >,D69,444
5
SOLUTIONS
7. The long*term de"t account will increase "! B8 million, the amount of the new long*term de"t issue.
Since the compan! sold >4 million new shares of stoc, with a B> par %alue, the common stoc,
account will increase "! B>4 million. The capital surplus account will increase "! B>H million, the
%alue of the new stoc, sold a"o%e its par %alue. Since the compan! had a net income of BI million,
and paid BD million in di%idends, the addition to retained earnings was B3 million, which will
increase the accumulated retained earnings account. So, the new long*term de"t and stoc,holders
e&uit! portion of the "alance sheet will "e0
Cong*term de"t B H8,444,444
Total long*term de"t B H8,444,444

Shareholders e&uit!
+referred stoc, B >8,444,444
Common stoc, .B> par %alue/ 39,444,444
)ccumulated retained earnings J6,444,444
Capital surplus H9,444,444
Total e&uit! B 6>4,444,444

Total Cia"ilities F E&uit! B 6I8,444,444
8. Cash flow to creditors G Interest paid @ ?et new "orrowing
Cash flow to creditors G Rs.3D4,444 @ .CTEend @ CTE"eg/
Cash flow to creditors G Rs.3D4,444 @ .Rs.3,>44,444 @ 6,844,444/
Cash flow to creditors G Rs.3D4,444 @ 344,444
Cash flow to creditors G Rs.D4,444
9. Cash flow to stoc,holders G Ei%idends paid @ ?et new e&uit!
Cash flow to stoc,holders G Rs.H44,444 @ N.Commonend L )+ISend/ @ .Common"eg L )+IS"eg/O
Cash flow to stoc,holders G Rs.H44,444 @ N.Rs.899,444 L I,H44,444/ @ .Rs.864,444 L H,844,444/O
Cash flow to stoc,holders G Rs.H44,444 @ .Rs.8,D99,444 @ I,H64,444/
Cash flow to stoc,holders G @Rs.639,444
?ote, )+IS is the additional paid*in surplus.
10. Cash flow from assets G Cash flow to creditors L Cash flow to stoc,holders
G Rs.D4,444 @ 639,444
G @Rs.>J9,444
Cash flow from assets G @Rs.>J9,444 G 'C; @ Change in ?WC @ ?et capital spending
@Rs.>J9,444 G 'C; @ .@Rs.>H9,444/ @ IH4,444

'perating cash flow G @Rs.>J9,444 L >H9,444 L IH4,444
'perating cash flow G Rs.I34,444
B-6
CHAPTER 2 B-
&ntermediate
11. a. The accounting statement of cash flows e#plains the change in cash during the !ear. The
accounting statement of cash flows will "e0
Statement of cash flows
Operations
?et income =>69
Eepreciation I9
Changes in other current assets .69/
Total cash flow from operations =>I9

&nvesting activities
)c&uisition of fi#ed assets =.>I9/
Total cash flow from in%esting acti%ities =.>I9/

Financing activities
+roceeds of long*term de"t =J4
Current lia"ilities >4
Ei%idends .H9/
Total cash flow from financing acti%ities =39

Change in cash .on "alance sheet/ =39
b. Change in ?WC G ?WCend @ ?WC"eg
G .C)end @ CCend/ @ .C)"eg @ CC"eg/
G N.=D9 L >D9/ @ I4O @ N.=>4 L >64/ @ H4/
G =>64 @ I4
G =94
c. To find the cash flow generated "! the firms assets, we need the operating cash flow, and the
capital spending. So, calculating each of these, we find0
Operating cash flow
?et income =>69
Eepreciation I9
'perating cash flow =644
?ote that we can calculate 'C; in this manner since there are no ta#es.
7
SOLUTIONS
'apital spending
Ending fi#ed assets =694
Aeginning fi#ed assets .>94/
Eepreciation I9
Capital spending =>I9
?ow we can calculate the cash flow generated "! the firms assets, which is0

'ash flow from assets
'perating cash flow =644
Capital spending .>I9/
Change in ?WC .94/
Cash flow from assets =.69/
?otice that the accounting statement of cash flows shows a positi%e cash flow, "ut the financial
cash flows show a negati%e cash flow. The cash flow generated "! the firms assets is a "etter
num"er for anal!ing the firms performance.
12. With the information pro%ided, the cash flows from the firm are the capital spending and the change
in net wor,ing capital, so0
'ash flows from the firm
Capital spending B.3,444/
)dditions to ?WC .>,444/
Cash flows from the firm B.D,444/
)nd the cash flows to the in%estors of the firm are0
'ash flows to investors of the firm
Sale of short*term de"t B.I,444/
Sale of long*term de"t .>8,444/
Sale of common stoc, .6,444/
Ei%idends paid 63,444
Cash flows to in%estors of the firm B.D,444/
B-8
CHAPTER 2 B-
13. a. The interest e#pense for the compan! is the amount of de"t times the interest rate on the de"t.
So, the income statement for the compan! is0
Income Statement
Sales 2>,444,444
Cost of goods sold 344,444
Selling costs 644,444
Eepreciation >44,444
EAIT 2D44,444
Interest >44,444
Ta#a"le income 2344,444
Ta#es .39K/ >49,444
?et income 2>J9,444
b. )nd the operating cash flow is0
'C; G EAIT L Eepreciation @ Ta#es
'C; G 2D44,444 L >44,444 @ >49,444
'C; G 23J9,444
14. To find the 'C;, we first calculate net income.
Income Statement
Sales P>D9,444
Costs 8H,444
Eepreciation I,444
'ther e#penses D,J44
EAIT PDI,>44
Interest >9,444
Ta#a"le income P36,>44
Ta#es .D4K/ >6,8D4
?et income P>J,6H4

Ei%idends P8,I44
)dditions to RE P>4,9H4
a. 'C; G EAIT L Eepreciation @ Ta#es
'C; G PDI,>44 L I,444 @ >6,8D4
'C; G PD>,6H4
b. C;C G Interest @ ?et new CTE
C;C G P>9,444 @ .@PH,944/
C;C G P6>,944

?ote that the net new long*term de"t is negati%e "ecause the compan! repaid part of its long*
term de"t.
c. C;S G Ei%idends @ ?et new e&uit!
C;S G P8,I44 @ H,D94
C;S G P6,694
9
SOLUTIONS
d. We ,now that C;) G C;C L C;S, so0
C;) G P6>,944 L 6,694 G P63,I94

C;) is also e&ual to 'C; @ ?et capital spending @ Change in ?WC. We alread! ,now 'C;.
?et capital spending is e&ual to0

?et capital spending G Increase in ?;) L Eepreciation
?et capital spending G P9,444 L I,444
?et capital spending G P>6,444
?ow we can use0
C;) G 'C; @ ?et capital spending @ Change in ?WC
P63,I94 G PD>,6H4 @ >6,444 @ Change in ?WC.

Sol%ing for the change in ?WC gi%es P9,9>4, meaning the compan! increased its ?WC "!
P9,9>4.
15. The solution to this &uestion wor,s the income statement "ac,wards. Starting at the "ottom0

?et income G Ei%idends L )ddition to ret. earnings
?et income G 2J44 L D,944
?et income G 29,D44
?ow, loo,ing at the income statement0
EAT @ .EAT Q Ta# rate/ G ?et income
Recognie that EAT Q ta# rate is simpl! the calculation for ta#es. Sol%ing this for EAT !ields0
EAT G ?I - .>@ Ta# rate/
EAT G 29,D44 - 4.H9
EAT G 28,348
?ow we can calculate0
EAIT G EAT L Interest
EAIT G 28,348 L >,H44
EAIT G 2J,J48
The last step is to use0
EAIT G Sales @ Costs @ Eepreciation
2J,J48 G 26J,444 @ >3,444 @ Eepreciation
Eepreciation G 2H,4J6
Sol%ing for depreciation, we find that depreciation G 2H,4J6

B-10
CHAPTER 2 B-
16. The "alance sheet for the compan! loo,s li,e this0
Aalance Sheet
Cash 2>I9,444 )ccounts pa!a"le 2D34,444
)ccounts recei%a"le >D4,444 ?otes pa!a"le >84,444
In%entor! 6H9,444 Current lia"ilities 2H>4,444
Current assets 2984,444 Cong*term de"t >,D34,444
Total lia"ilities 26,4D4,444
Tangi"le net fi#ed assets 6,J44,444
Intangi"le net fi#ed assets I64,444 Common stoc, 77
)ccumulated ret. earnings >,6D4,444
Total assets 2D,644,444 Total lia". F owners e&uit! 2D,644,444
Total lia"ilities and owners e&uit! is0
TC F 'E G CC L CTE L Common stoc,
Sol%ing for this e&uation for e&uit! gi%es us0
Common stoc, G 2D,644,444 @ >,6D4,444 @ 6,4D4,444
Common stoc, G 2J64,444
17. The mar,et %alue of shareholders e&uit! cannot "e ero. ) negati%e mar,et %alue in this case would
impl! that the compan! would pa! !ou to own the stoc,. The mar,et %alue of shareholders e&uit!
can "e stated as0 Shareholders e&uit! G $a# N.T) @ TC/, 4O. So, if T) is DD4,444, e&uit! is e&ual
to D4,444, and if T) is 334,444, e&uit! is e&ual to 4. We should note here that while the
mar,et %alue of e&uit! cannot "e negati%e, the "oo, %alue of shareholders e&uit! can "e negati%e.
18. a. Ta#es Rrowth G 4.>9.294M/ L 4.69.269M/ L 4.3D.2>4M/ G 2>I,>94
Ta#es Income G 4.>9.294M/ L 4.69.269M/ L 4.3D.269M/ L 4.3J.2639M/ L 4.3D.28.>H9$/
G 26,8J4,444
b. Each firm has a marginal ta# rate of 3DK on the ne#t 2>4,444 of ta#a"le income, despite their
different a%erage ta# rates, so "oth firms will pa! an additional 23,D44 in ta#es.
19. Income Statement
Sales =894,444
C'RS H34,444
)FS e#penses >64,444
Eepreciation >34,444
EAIT .=34,444/
Interest 89,444
Ta#a"le income .=>>9,444/
Ta#es .39K/ 4
a. ?et income .=>>9,444/
11
SOLUTIONS
b. 'C; G EAIT L Eepreciation @ Ta#es
'C; G .=34,444/ L >34,444 @ 4
'C; G =>44,444
c. ?et income was negati%e "ecause of the ta# deducti"ilit! of depreciation and interest e#pense.
5owe%er, the actual cash flow from operations was positi%e "ecause depreciation is a non*cash
e#pense and interest is a financing e#pense, not an operating e#pense.
20. ) firm can still pa! out di%idends if net income is negati%e( it :ust has to "e sure there is sufficient
cash flow to ma,e the di%idend pa!ments.
Change in ?WC G ?et capital spending G ?et new e&uit! G 4. .Ri%en/
Cash flow from assets G 'C; @ Change in ?WC @ ?et capital spending
Cash flow from assets G =>44,444 @ 4 @ 4 G =>44,444
Cash flow to stoc,holders G Ei%idends @ ?et new e&uit!
Cash flow to stoc,holders G =34,444 @ 4 G =34,444
Cash flow to creditors G Cash flow from assets @ Cash flow to stoc,holders
Cash flow to creditors G =>44,444 @ 34,444
Cash flow to creditors G =I4,444
Cash flow to creditors is also0
Cash flow to creditors G Interest @ ?et new CTE
So0
?et new CTE G Interest @ Cash flow to creditors
?et new CTE G =89,444 @ I4,444
?et new CTE G =>9,444
21. a. The income statement is0
Income Statement
Sales B>6,844
Cost of good sold >4,D44
Eepreciation >,J44
EAIT B 944
Interest D94
Ta#a"le income B 94
Ta#es .3DK/ >I
?et income B33
b. 'C; G EAIT L Eepreciation @ Ta#es
'C; G B944 L >,J44 @ >I
'C; G B6,383
B-12
CHAPTER 2 B-
c. Change in ?WC G ?WCend @ ?WC"eg
G .C)end @ CCend/ @ .C)"eg @ CC"eg/
G .B3,894 @ 6,>44/ @ .B3,644 @ >,844/
G B>,I94 @ >,D44 G B394
?et capital spending G ?;)end @ ?;)"eg L Eepreciation
G BJ,I44 @ J,>44 L >,J44
G B6,944
C;) G 'C; @ Change in ?WC @ ?et capital spending
G B6,383 @ 394 @ 6,944
G @BDHI
The cash flow from assets can "e positi%e or negati%e, since it represents whether the firm raised
funds or distri"uted funds on a net "asis. In this pro"lem, e%en though net income and 'C; are
positi%e, the firm in%ested hea%il! in "oth fi#ed assets and net wor,ing capital( it had to raise a net
BDHI in funds from its stoc,holders and creditors to ma,e these in%estments.
d. Cash flow to creditorsG Interest @ ?et new CTE
G BD94 @ 4
G BD94
Cash flow to stoc,holders G Cash flow from assets @ Cash flow to creditors
G @BDHI @ D94
G @BJ>I
We can also calculate the cash flow to stoc,holders as0
Cash flow to stoc,holders G Ei%idends @ ?et new e&uit!
Sol%ing for net new e&uit!, we get0
?et new e&uit! G B944 @ .@J>I/
G B>,D>I
The firm had positi%e earnings in an accounting sense .?I S 4/ and had positi%e cash flow from
operations. The firm in%ested B394 in new net wor,ing capital and B6,944 in new fi#ed assets. The
firm had to raise BDHI from its sta,eholders to support this new in%estment. It accomplished this "!
raising B>,D>I in the form of new e&uit!. )fter pa!ing out B944 of this in the form of di%idends to
shareholders and BD94 in the form of interest to creditors, BDHI was left to meet the firms cash
flow needs for in%estment.
22. a. Total assets 644H G =H94 L 6,J44 G =3,994
Total lia"ilities 644H G =6H9 L >,944 G =>,IH9
'wners e&uit! 644H G =3,994 @ >,IH9 G =>,I89
Total assets 644I G =I49 L 3,D44 G =D,>49
Total lia"ilities 644I G =6J4 L >,I64 G =6,4>4
'wners e&uit! 644I G =D,>49 @ 6,4>4 G =6,4J9
13
SOLUTIONS
b. ?WC 644H G C)4H @ CC4H G =H94 @ 6H9 G =389
?WC 644I G C)4I @ CC4I G =I49 @ 6J4 G =D>9
Change in ?WC G ?WC4I @ ?WC4H9 G =D>9 @ 389 G =34
c. We can calculate net capital spending as0
?et capital spending G ?et fi#ed assets 644I @ ?et fi#ed assets 644H L Eepreciation
?et capital spending G =3,D44 @ 6,J44 L 844
?et capital spending G =>,344
So, the compan! had a net capital spending cash flow of =>,344. We also ,now that net capital
spending is0
?et capital spending G ;i#ed assets "ought @ ;i#ed assets sold
=>,344 G =>,944 @ ;i#ed assets sold
;i#ed assets sold G =>,944 @ >,344 G =644
To calculate the cash flow from assets, we must first calculate the operating cash flow. The
operating cash flow is calculated as follows .!ou can also prepare a traditional income
statement/0
EAIT G Sales @ Costs @ Eepreciation
EAIT G =8,H44 @ D,>94 @ 844
EAIT G =3,H94
EAT G EAIT @ Interest
EAT G =3,H94 @ 6>H
EAT G =3,D3D

Ta#es G EAT .39
Ta#es G =3,D3D .39
Ta#es G =>,646
'C; G EAIT L Eepreciation @ Ta#es
'C; G =3,H94 L 844 @ >,646
'C; G =3,6D8
Cash flow from assets G 'C; @ Change in ?WC @ ?et capital spending.
Cash flow from assets G =3,6D8 @ 34 @ >,344
Cash flow from assets G =>,J>8
d. ?et new "orrowing G CTE4I @ CTE4H
?et new "orrowing G =>,I64 @ >,944
?et new "orrowing G =664
Cash flow to creditors G Interest @ ?et new CTE
Cash flow to creditors G =6>H @ 664
Cash flow to creditors G @=D
?et new "orrowing G =664 G Ee"t issued @ Ee"t retired
Ee"t retired G =344 @ 664 G =84
B-14
CHAPTER 2 B-
23.
Aalance sheet as of Eec. 3>, 644H
Cash 26,>4I )ccounts pa!a"le 26,6>3
)ccounts recei%a"le 6,I8J ?otes pa!a"le D4I
In%entor! D,J9J Current lia"ilities 26,H64
Current assets 2J,899
Cong*term de"t 2I,49H
?et fi#ed assets 2>I,HHJ 'wnersT e&uit! 2>I,8D8
Total assets 26I,96D Total lia". F e&uit! 26I,96D
Aalance sheet as of Eec. 3>, 644I
Cash 26,>99 )ccounts pa!a"le 26,>DH
)ccounts recei%a"le 3,>D6 ?otes pa!a"le 386
In%entor! 9,4JH Current lia"ilities 26,968
Current assets 2>4,3J3
Cong*term de"t 28,636
?et fi#ed assets 2>8,4J> 'wnersT e&uit! 2>I,I6D
Total assets 268,D8D Total lia". F e&uit! 268,D8D
644H Income Statement 644I Income Statement
Sales 2D,4>8.44 Sales 2D,3>6.44
C'RS >,386.44 C'RS >,9HJ.44
'ther e#penses 368.44 'ther e#penses 6ID.44
Eepreciation 9II.44 Eepreciation 9I8.44
EAIT 2>,I3>.44 EAIT 2>,8J>.44
Interest 6HJ.44 Interest 34J.44
EAT 2>,DH6.44 EAT 2>,986.44
Ta#es .3DK/ DJI.48 Ta#es .3DK/ 93I.88
?et income 2 JHD.J6 ?et income 2>,4DD.>6
Ei%idends 2D88.44 Ei%idends 2936.44
)dditions to RE 2DIH.J6 )dditions to RE 29>6.>6
24. 'C; G EAIT L Eepreciation @ Ta#es
'C; G 2>,8J> L 9I8 @ 93I.88
'C; G 2>,J3>.>6
Change in ?WC G ?WCend @ ?WC"eg G .C) @ CC/ end

@ .C) @ CC/ "eg
Change in ?WC G .2>4,3J3 @ 6,968/ @ .2J,899 @ 6,H64/
Change in ?WC G 2I,8H9 @ I,639 G 2H34
?et capital spending G ?;)end @ ?;)"eg L Eepreciation
?et capital spending G 2>8,4J> @ >I,HHJ L 9I8
?et capital spending G 2>,444
15
SOLUTIONS
Cash flow from assets G 'C; @ Change in ?WC @ ?et capital spending
Cash flow from assets G 2>,J3>.>6 @ H34 @ >,444
Cash flow from assets G 234>.>6
Cash flow to creditors G Interest @ ?et new CTE
?et new CTE G CTEend @ CTE"eg
Cash flow to creditors G 234J @ .28,636 @ I,49H/
Cash flow to creditors G @28HI
?et new e&uit! G Common stoc,end @ Common stoc,"eg
Common stoc, L Retained earnings G Total owners e&uit!
?et new e&uit! G .'E @ RE/ end @ .'E @ RE/ "eg
?et new e&uit! G 'Eend

@ 'E"eg L RE"eg @ REend
REend G RE"eg L )dditions to RE
?et new e&uit! G 'Eend @ 'E"eg L RE"eg

@ .RE"eg L )dditions to RE/
G 'Eend @ 'E"eg @ )dditions to RE
?et new e&uit! G 2>I,I6D @ >I,8D8 @ 9>6.>6 G @2H3H.>6
Cash flow to stoc,holders G Ei%idends @ ?et new e&uit!
Cash flow to stoc,holders G 2936 @ .@2H3H.>6/
Cash flow to stoc,holders G 2>,>H8.>6
)s a chec,, cash flow from assets is 234>.>6.
Cash flow from assets G Cash flow from creditors L Cash flow to stoc,holders
Cash flow from assets G @28HI L >,>H8.>6
Cash flow from assets G 234>.>6
'hallenge
25. We will "egin "! calculating the operating cash flow. ;irst, we need the EAIT, which can "e
calculated as0
EAIT G ?et income L Current ta#es L Eeferred ta#es L Interest
EAIT G >J6 L >>4 L 6> L 9I
EAIT G 384
?ow we can calculate the operating cash flow as0
Operating cash flow
Earnings "efore interest and ta#es 384
Eepreciation >49
Current ta#es .>>4/
'perating cash flow 3I9
B-16
CHAPTER 2 B-
The cash flow from assets is found in the in%esting acti%ities portion of the accounting statement of
cash flows, so0
'ash flow from assets
)c&uisition of fi#ed assets >J8
Sale of fi#ed assets .69/
Capital spending >I3
The net wor,ing capital cash flows are all found in the operations cash flow section of the
accounting statement of cash flows. 5owe%er, instead of calculating the net wor,ing capital cash
flows as the change in net wor,ing capital, we must calculate each item indi%iduall!. Eoing so, we
find0
Net wor(ing capital cash flow
Cash >D4
)ccounts recei%a"le 3>
In%entories .6D/
)ccounts pa!a"le .>J/
)ccrued e#penses >4
?otes pa!a"le .H/
'ther .6/
?WC cash flow >34
E#cept for the interest e#pense and notes pa!a"le, the cash flow to creditors is found in the financing
acti%ities of the accounting statement of cash flows. The interest e#pense from the income statement
is gi%en, so0
'ash flow to creditors
Interest 9I
Retirement of de"t 8D
Ee"t ser%ice >D>
+roceeds from sale of long*term de"t .>6J/
Total >6
)nd we can find the cash flow to stoc,holders in the financing section of the accounting statement
of cash flows. The cash flow to stoc,holders was0
'ash flow to stoc(holders
Ei%idends JD
Repurchase of stoc, >9
Cash to stoc,holders >4J
+roceeds from new stoc, issue .DJ/
Total H4
17
SOLUTIONS
26. ?et capital spending G ?;)end @ ?;)"eg L Eepreciation
G .?;)end @ ?;)"eg/ L .Eepreciation L )E"eg/ @ )E"eg
G .?;)end @ ?;)"eg/L )Eend @ )E"eg
G .?;)end L )Eend/ @ .?;)"eg L )E"eg/ G ;)end

@ ;)"eg
27. a. The ta# "u""le causes a%erage ta# rates to catch up to marginal ta# rates, thus eliminating the
ta# ad%antage of low marginal rates for high income corporations.
b. )ssuming a ta#a"le income of 2>44,444, the ta#es will "e0
Ta#es G 4.>9.294M/ L 4.69.269M/ L 4.3D.269M/ L 4.3J.2639M/ G 2>>3.JM
)%erage ta# rate G 2>>3.JM - 2339M G 3DK
The marginal ta# rate on the ne#t dollar of income is 3D percent.
;or corporate ta#a"le income le%els of 2339M to 2>4$, a%erage ta# rates are e&ual to marginal
ta# rates.
Ta#es G 4.3D.2>4$/ L 4.39.29$/ L 4.38.23.333$/ G 2H,D>H,HHI
)%erage ta# rate G 2H,D>H,HHI - 2>8,333,33D G 39K
The marginal ta# rate on the ne#t dollar of income is 39 percent. ;or corporate ta#a"le income
le%els o%er 2>8,333,33D, a%erage ta# rates are again e&ual to marginal ta# rates.
c. Ta#es G 4.3D.2644M/ G 2H8M G 4.>9.294M/ L 4.69.269M/ L 4.3D.269M/ L U.2>44M/(
U.2>44M/ G 2H8M @ 66.69M G 2D9.I9M
U G 2D9.I9M - 2>44M
U G D9.I9K
B-18
CHAPTER 3
FINANCIAL STATEMENTS ANALYSIS
AND LONG-TERM PLANNING
Answers to Concepts Review and Critical !in"in# Questions
1. Time trend anal!sis gi%es a picture of changes in the compan!s financial situation o%er time.
Comparing a firm to itself o%er time allows the financial manager to e%aluate whether some aspects
of the firms operations, finances, or in%estment acti%ities ha%e changed. +eer group anal!sis
in%ol%es comparing the financial ratios and operating performance of a particular firm to a set of
peer group firms in the same industr! or line of "usiness. Comparing a firm to its peers allows the
financial manager to e%aluate whether some aspects of the firms operations, finances, or in%estment
acti%ities are out of line with the norm, there"! pro%iding some guidance on appropriate actions to
ta,e to ad:ust these ratios if appropriate. Aoth allow an in%estigation into what is different a"out a
compan! from a financial perspecti%e, "ut neither method gi%es an indication of whether the
difference is positi%e or negati%e. ;or e#ample, suppose a compan!s current ratio is increasing o%er
time. It could mean that the compan! had "een facing li&uidit! pro"lems in the past and is rectif!ing
those pro"lems, or it could mean the compan! has "ecome less efficient in managing its current
accounts. Similar arguments could "e made for a peer group comparison. ) compan! with a current
ratio lower than its peers could "e more efficient at managing its current accounts, or it could "e
facing li&uidit! pro"lems. ?either anal!sis method tells us whether a ratio is good or "ad, "oth
simpl! show that something is different, and tells us where to loo,.
2. If a compan! is growing "! opening new stores, then presuma"l! total re%enues would "e rising.
Comparing total sales at two different points in time might "e misleading. Same*store sales control
for this "! onl! loo,ing at re%enues of stores open within a specific period.
3. The reason is that, ultimatel!, sales are the dri%ing force "ehind a "usiness. ) firms assets,
emplo!ees, and, in fact, :ust a"out e%er! aspect of its operations and financing e#ist to directl! or
indirectl! support sales. +ut differentl!, a firms future need for things li,e capital assets, emplo!ees,
in%entor!, and financing are determined "! its future sales le%el.
4. Two assumptions of the sustaina"le growth formula are that the compan! does not want to sell new
e&uit!, and that financial polic! is fi#ed. If the compan! raises outside e&uit!, or increases its de"t*
e&uit! ratio, it can grow at a higher rate than the sustaina"le growth rate. 'f course, the compan!
could also grow faster than its profit margin increases, if it changes its di%idend polic! "! increasing
the retention ratio, or its total asset turno%er increases.
SOLUTIONS
5. The sustaina"le growth rate is greater than 64 percent, "ecause at a 64 percent growth rate the
negati%e E;? indicates that there is e#cess financing still a%aila"le. If the firm is >44 percent e&uit!
financed, then the sustaina"le and internal growth rates are e&ual and the internal growth rate would
"e greater than 64 percent. 5owe%er, when the firm has some de"t, the internal growth rate is alwa!s
less than the sustaina"le growth rate, so it is am"iguous whether the internal growth rate would "e
greater than or less than 64 percent. If the retention ratio is increased, the firm will ha%e more internal
funding sources a%aila"le, and it will ha%e to ta,e on more de"t to ,eep the de"t-e&uit! ratio constant,
so the E;? will decline. Con%ersel!, if the retention ratio is decreased, the E;? will rise. If the
retention rate is ero, "oth the internal and sustaina"le growth rates are ero, and the E;? will rise to
the change in total assets.
6. Common*sie financial statements pro%ide the financial manager with a ratio anal!sis of the
compan!. The common*sie income statement can show, for e#ample, that cost of goods sold as a
percentage of sales is increasing. The common*sie "alance sheet can show a firms increasing
reliance on de"t as a form of financing. Common*sie statements of cash flows are not calculated for
a simple reason0 There is no possi"le denominator.
7. It would reduce the e#ternal funds needed. If the compan! is not operating at full capacit!, it would
"e a"le to increase sales without a commensurate increase in fi#ed assets.
8. R'E is a "etter measure of the compan!s performance. R'E shows the percentage return for the
!ear earned on shareholder in%estment. Since the goal of a compan! is to ma#imie shareholder
wealth, this ratio shows the compan!s performance in achie%ing this goal o%er the period.
9. The EAITE-)ssets ratio shows the compan!s operating performance "efore interest, ta#es, and
depreciation. This ratio would show how a compan! has controlled costs. While ta#es are a cost, and
depreciation and amortiation can "e considered costs, the! are not as easil! controlled "! compan!
management. Con%ersel!, depreciation and amortiation can "e altered "! accounting choices. This
ratio onl! uses costs directl! related to operations in the numerator. )s such, it gi%es a "etter metric
to measure management performance o%er a period than does R').
10. Cong*term lia"ilities and e&uit! are in%estments made "! in%estors in the compan!, either in the
form of a loan or ownership. Return on in%estment is intended to measure the return the compan!
earned from these in%estments. Return on in%estment will "e higher than the return on assets for a
compan! with current lia"ilities. To see this, realie that total assets must e&ual total de"t and e&uit!,
and total de"t and e&uit! is e&ual to current lia"ilities plus long*term lia"ilities plus e&uit!. So, return
on in%estment could "e calculated as net income di%ided "! total assets minus current lia"ilities.
11. +resuma"l! not, "ut, of course, if the product had "een much less popular, then a similar fate would
ha%e awaited due to lac, of sales.
12. Since customers did not pa! until shipment, recei%a"les rose. The firms ?WC, "ut not its cash,
increased. )t the same time, costs were rising faster than cash re%enues, so operating cash flow
declined. The firms capital spending was also rising. Thus, all three components of cash flow from
assets were negati%el! impacted.
13. ;inancing possi"l! could ha%e "een arranged if the compan! had ta,en &uic, enough action.
Sometimes it "ecomes apparent that help is needed onl! when it is too late, again emphasiing the
need for planning.
B-20
CHAPTER 3 B-
14. )ll three were important, "ut the lac, of cash or, more generall!, financial resources ultimatel!
spelled doom. )n inade&uate cash resource is usuall! cited as the most common cause of small
"usiness failure.
15. Eemanding cash upfront, increasing prices, su"contracting production, and impro%ing financial
resources %ia new owners or new sources of credit are some of the options. When orders e#ceed
capacit!, price increases ma! "e especiall! "eneficial.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. R'E G .+$/.T)T/.E$/
R'E G ..486/.>.34/.>.I9/ G >8.HHK
2. The e&uit! multiplier is0
E$ G > L E-E
E$ G > L >.34 G 6.34
'ne formula to calculate return on e&uit! is0
R'E G .R')/.E$/
R'E G .48I.6.34/ G 64.4>K
R'E can also "e calculated as0
R'E G ?I - TE
So, net income is0
?I G R'E.TE/
?I G ..644>/.2964,444/ G 2>4D,496
3. This is a multi*step pro"lem in%ol%ing se%eral ratios. The ratios gi%en are all part of the Eu +ont
Identit!. The onl! Eu +ont Identit! ratio not gi%en is the profit margin. If we ,now the profit margin,
we can find the net income since sales are gi%en. So, we "egin with the Eu +ont Identit!0
R'E G 4.>H G .+$/.T)T/.E$/ G .+$/.S - T)/.> L E-E/
Sol%ing the Eu +ont Identit! for profit margin, we get0
+$ G N.R'E/.T)/O - N.> L E-E/.S/O
+$ G N.4.>H/.B>,>89/O - N.> L >/. B6,I44/O G .439>
21
SOLUTIONS
?ow that we ha%e the profit margin, we can use this num"er and the gi%en sales figure to sol%e for
net income0
+$ G .439> G ?I - S
?I G .439>.B6,I44/ G BJD.84
4. )n increase of sales to =63,4D4 is an increase of0
Sales increase G .=63,4D4 @ >J,644/ - =>J,644
Sales increase G .64 or 64K
)ssuming costs and assets increase proportionall!, the pro forma financial statements will loo, li,e
this0
+ro forma income statement +ro forma "alance sheet
Sales =63,4D4.44 )ssets = >>>,H44 Ee"t = 64,D44.44
Costs >8,HH4.44 E&uit! ID,33D.D8
EAIT D,384.44 Total = >>>,H44 Total = JD,I3D.D8
Ta#es .3DK/ >,D8J.64
?et income = 6,8J4.84
The pa!out ratio is constant, so the di%idends paid this !ear is the pa!out ratio from last !ear times
net income, or0
Ei%idends G .=JH3.H4 - =6,D4J/.=6,8J4.84/
Ei%idends G =>,>9H.36
The addition to retained earnings is0
)ddition to retained earnings G =6,8J4.84 @ >,>9H.36
)ddition to retained earnings G =>,I3D.D8
)nd the new e&uit! "alance is0
E&uit! G =I6,H44 L >,I3D.D8
E&uit! G =ID,33D.D8
So the E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G =>>>,H44 @ JD,I3D.D8
E;? G =>H,8H9.96
B-22
CHAPTER 3 B-
5. The ma#imum percentage sales increase is the sustaina"le growth rate. To calculate the sustaina"le
growth rate, we first need to calculate the R'E, which is0
R'E G ?I - TE
R'E G V>6,HI6,444 - VI3,444,444
R'E G .>I3H
The plow"ac, ratio, b, is one minus the pa!out ratio, so0
b G > @ .34
b G .I4
?ow we can use the sustaina"le growth rate e&uation to get0
Sustaina"le growth rate G .R'E Q "/ - N> @ .R'E Q "/O
Sustaina"le growth rate G N.>I3H..I4/O - N> @ .>I3H..I4/O
Sustaina"le growth rate G .>383 or >3.83K
So, the ma#imum !en increase in sales is0
$a#imum increase in sales G V9D,444,444..>383/
$a#imum increase in sales G VI,DHJ,6ID.I6
6. We need to calculate the retention ratio to calculate the sustaina"le growth rate. The retention ratio
is0
b G > @ .34
b G .I4
?ow we can use the sustaina"le growth rate e&uation to get0
Sustaina"le growth rate G .R'E Q b/ - N> @ .R'E Q b/O
Sustaina"le growth rate G N.>J..I4/O - N> @ .>J..I4/O
Sustaina"le growth rate G .>93D or >9.3DK
7. We must first calculate the R'E using the Eu +ont ratio to calculate the sustaina"le growth rate. The
R'E is0
R'E G .+$/.T)T/.E$/
R'E G ..4IH/.>.D4/.>.94/
R'E G >9.JHK
The plow"ac, ratio is one minus the di%idend pa!out ratio, so0
b G > @ .D4
b G .H4
23
SOLUTIONS
?ow, we can use the sustaina"le growth rate e&uation to get0
Sustaina"le growth rate G .R'E Q b/ - N> @ .R'E Q b/O
Sustaina"le growth rate G N.>9JH..H4/O - N> @ .>9JH..H4/O
Sustaina"le growth rate G >4.9JK
8. )n increase of sales to 29,>J6 is an increase of0
Sales increase G .29,>J6 @ D,D44/ - 2D,D44
Sales increase G .>8 or >8K
)ssuming costs and assets increase proportionall!, the pro forma financial statements will loo, li,e
this0
+ro forma income statement +ro forma "alance sheet
Sales 2 9,>J6 )ssets 2 >9,8>6 Ee"t 2 J,>44
Costs 3,>H8 E&uit! H,36D
?et income 2 6,46D Total 2 >9,8>6 Total 2 >9,D6D
If no di%idends are paid, the e&uit! account will increase "! the net income, so0
E&uit! G 2D,344 L 6,46D
E&uit! G 2H,36D
So the E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G 2>9,8>6 @ >9,D6D G 2388
9. a. ;irst, we need to calculate the current sales and change in sales. The current sales are ne#t
!ears sales di%ided "! one plus the growth rate, so0
Current sales G ?e#t !ears sales - .> L g/
Current sales G Rs.DD4,444,444 - .> L .>4/
Current sales G Rs.D44,444,444
)nd the change in sales is0
Change in sales G Rs.DD4,444,444 @ D44,444,444
Change in sales G Rs.D4,444,444
B-24
CHAPTER 3 B-
We can now complete the current "alance sheet. The current assets, fi#ed assets, and short*term
de"t are calculated as a percentage of current sales. The long*term de"t and par %alue of stoc,
are gi%en. The plug %aria"le is the additions to retained earnings. So0
)ssets Cia"ilities and e&uit!
Current assets Rs.84,444,444 Short*term de"t Rs.H4,444,444
Cong*term de"t Rs.>D9,444,444

;i#ed assets 9H4,444,444 Common stoc, Rs.94,444,444
)ccumulated retained earnings 389,444,444
Total e&uit! Rs.D39,444,444

Total assets Rs.HD4,444,444 Total lia"ilities and e&uit! Rs.HD4,444,444
b. We can use the e&uation from the te#t to answer this &uestion. The assets-sales and de"t-sales
are the percentages gi%en in the pro"lem, so0
E;? G
,
_

Sales
)ssets
Q WSales @
,
_

Sales
Ee"t
Q WSales @ .p Q +ro:ected sales/ Q .> @ d/
E;? G ..64 L >.D4/ Q Rs.D4,444,444 @ ..>9 Q Rs.D4,444,444/ @ N..>6 Q Rs.DD4,444,444/ Q .> @ .
D4/O
E;? G Rs.6H,364,444
c. The current assets, fi#ed assets, and short*term de"t will all increase at the same percentage as
sales. The long*term de"t and common stoc, will remain constant. The accumulated retained
earnings will increase "! the addition to retained earnings for the !ear. We can calculate the
addition to retained earnings for the !ear as0
?et income G +rofit margin Q Sales
?et income G .>6.Rs.DD4,444,444/
?et income G Rs.96,844,444
The addition to retained earnings for the !ear will "e the net income times one minus the
di%idend pa!out ratio, which is0
)ddition to retained earnings G ?et income.> @ d/
)ddition to retained earnings G Rs.96,844,444.> @ .D4/
)ddition to retained earnings G Rs.3>,H84,444
So, the new accumulated retained earnings will "e0
)ccumulated retained earnings G Rs.3I9,444,444 L 3>,H84,444
)ccumulated retained earnings G Rs.D4H,H84,444
25
SOLUTIONS
The pro forma "alance sheet will "e0
)ssets Cia"ilities and e&uit!
Current assets Rs.88,444,444 Short*term de"t Rs.HH,444,444
Cong*term de"t Rs.>D9,444,444

;i#ed assets H>H,444,444 Common stoc, Rs.94,444,444
)ccumulated retained earnings D>H,H84,444
Total e&uit! Rs.DHH,H84,444

Total assets Rs.I4D,444,444 Total lia"ilities and e&uit! Rs.HII,H84,444
The E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G Rs.I4D,444,444 @ HII,H84,444
E;? G Rs.6H,364,444
10. a. The sustaina"le growth is0
Sustaina"le growth rate G
b
b
R'E * >
R'E

where0
b G Retention ratio G > @ +a!out ratio G .H9
So0
Sustaina"le growth rate G
.H9 .4894 * >
.H9 .4894

Sustaina"le growth rate G .4989 or 9.89K


b. It is possi"le for the sustaina"le growth rate and the actual growth rate to differ. If an! of the
actual parameters in the sustaina"le growth rate e&uation differs from those used to compute
the sustaina"le growth rate, the actual growth rate will differ from the sustaina"le growth rate.
Since the sustaina"le growth rate includes R'E in the calculation, this also implies that changes
in the profit margin, total asset turno%er, or e&uit! multiplier will affect the sustaina"le growth
rate.
c. The compan! can increase its growth rate "! doing an! of the following0
* Increase the de"t*to*e&uit! ratio "! selling more de"t or repurchasing stoc,
* Increase the profit margin, most li,el! "! "etter controlling costs.
* Eecrease its total assets-sales ratio( in other words, utilie its assets more efficientl!.
* Reduce the di%idend pa!out ratio.
B-26
CHAPTER 3 B-
&ntermediate
11. The solution re&uires su"stituting two ratios into a third ratio. Rearranging E-T)0
;irm ) ;irm A
E - T) G .H4 E - T) G .D4
.T) @ E/ - T) G .H4 .T) @ E/ - T) G .D4
.T) - T)/ @ .E - T)/ G .H4 .T) - T)/ @ .E - T)/ G .D4
> @ .E - T)/ G .H4 > @ .E - T)/ G .D4
E - T) G .D4 E - T) G .H4
E G .D4.T)/ E G .H4.T)/
Rearranging R'), we find0
?I - T) G .64 ?I - T) G .34
?I G .64.T)/ ?I G .34.T)/
Since R'E G ?I - E, we can su"stitute the a"o%e e&uations into the R'E formula, which !ields0
R'E G .64.T)/ - .D4.T)/ G .64 - .D4 G 94K R'E G .34.T)/ - .H4 .T)/ G .34 - .H4 G 94K
12. +$ G ?I - S G @=>3,>9H - =>DI,3>8 G @8.J3K
)s long as "oth net income and sales are measured in the same currenc!, there is no pro"lem( in fact,
e#cept for some mar,et %alue ratios li,e E+S and AX+S, none of the financial ratios discussed in the
te#t are measured in terms of currenc!. This is one reason wh! financial ratio anal!sis is widel! used
in international finance to compare the "usiness operations of firms and-or di%isions across national
economic "orders. The net income in dollars is0
?I G +$ Q Sales
?I G @4.48J3.26HI,HH>/ G @263,J43
13. a. The e&uation for e#ternal funds needed is0
E;? G
,
_

Sales
)ssets
Q WSales @
,
_

Sales
Ee"t
Q WSales @ .+$ Q +ro:ected sales/ Q .> @ d/
where0
)ssets-Sales G V3>,444,444-V38,444,444 G 4.86
WSales G Current sales Q Sales growth rate G V38,444,444..64/ G VI,H44,444
Ee"t-Sales G V8,444,444-V38,444,444 G .6>49
p G ?et income-Sales G V6,JJ4,444-V38,444,444 G .4I8I
+ro:ected sales G Current sales Q .> L Sales growth rate/ G V38,444,444.> L .64/ G VD9,H44,444
d G Ei%idends-?et income G V>,>JH,444-V6,JJ4,444 G .D4
so0
E;? G ..86 Q VI,H44,444/ @ ..6>49 Q VI,H44,444/ @ ..4I8I Q VD9,H44,444/ Q .> @ .D4/
E;? G V6,DDI,644
27
SOLUTIONS
b. The current assets, fi#ed assets, and short*term de"t will all increase at the same percentage as
sales. The long*term de"t and common stoc, will remain constant. The accumulated retained
earnings will increase "! the addition to retained earnings for the !ear. We can calculate the
addition to retained earnings for the !ear as0
?et income G +rofit margin Q Sales
?et income G .4I8I.VD9,H44,444/
?et income G V3,988,444
The addition to retained earnings for the !ear will "e the net income times one minus the
di%idend pa!out ratio, which is0
)ddition to retained earnings G ?et income.> @ d/
)ddition to retained earnings G V3,988,444.> @ .D4/
)ddition to retained earnings G V6,>96,844
So, the new accumulated retained earnings will "e0
)ccumulated retained earnings G V>3,444,444 L 6,>96,844
)ccumulated retained earnings G V>9,>96,844
The pro forma "alance sheet will "e0
)ssets Cia"ilities and e&uit!
Current assets V>4,844,444 Short*term de"t VJ,H44,444
Cong*term de"t VH,444,444

;i#ed assets 6H,D44,444 Common stoc, VD,444,444
)ccumulated retained earnings >9,>96,844
Total e&uit! V>J,>96,844

Total assets V3I,644,444 Total lia"ilities and e&uit! V3D,I96,844
The E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G V3I,644,444 @ 3D,I96,844
E;? G V6,DDI,644
B-28
CHAPTER 3 B-
c. The sustaina"le growth is0
Sustaina"le growth rate G
b
b
R'E * >
R'E

where0
R'E G ?et income-Total e&uit! G V6,JJ4,444-V>I,444,444 G .>I9J
b G Retention ratio G Retained earnings-?et income G V>,IJD,444-V6,JJ4,444 G .H4
So0
Sustaina"le growth rate G
.H4 .>I9J * >
.H4 .>I9J

Sustaina"le growth rate G .>>84 or >>.84K


d. The compan! cannot :ust cut its di%idends to achie%e the forecast growth rate. )s shown "elow,
e%en with a ero di%idend polic!, the E;? will still "e V>,4>6,444.
)ssets Cia"ilities and e&uit!
Current assets V>4,844,444 Short*term de"t VJ,H44,444
Cong*term de"t VH,444,444

;i#ed assets 6H,D44,444 Common stoc, VD,444,444
)ccumulated retained earnings >H,988,444
Total e&uit! V64,988,444

Total assets V3I,644,444 Total lia"ilities and e&uit! V3H,>88,444
The E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G V3I,644,444 @ 3H,>88,444
E;? G V>,4>6,444
The compan! does ha%e se%eral alternati%es. It can increase its asset utiliation and-or its profit
margin. The compan! could also increase the de"t in its capital structure. This will decrease the
e&uit! account, there"! increasing R'E.
14. This is a multi*step pro"lem in%ol%ing se%eral ratios. It is often easier to loo, "ac,ward to determine
where to start. We need recei%a"les turno%er to find da!s sales in recei%a"les. To calculate
recei%a"les turno%er, we need credit sales, and to find credit sales, we need total sales. Since we are
gi%en the profit margin and net income, we can use these to calculate total sales as0
+$ G 4.48H G ?I - Sales G 2>I3,444 - Sales( Sales G 26,4>>,H68
Credit sales are I4 percent of total sales, so0
Credit sales G 26,4>>,H68.4.I4/ G 2>,D48,>D4
29
SOLUTIONS
?ow we can find recei%a"les turno%er "!0
Recei%a"les turno%er G Sales - )ccounts recei%a"le G 2>,D48,>D4 - 2>D3,644 G J.83 times
Ea!s sales in recei%a"les G 3H9 da!s - Recei%a"les turno%er G 3H9 - J.83 G 3I.>6 da!s
15. The solution to this pro"lem re&uires a num"er of steps. ;irst, remem"er that C) L ?;) G T). So,
if we find the C) and the T), we can sol%e for ?;). <sing the num"ers gi%en for the current ratio
and the current lia"ilities, we sol%e for C)0
CR G C) - CC
C) G CR.CC/ G >.64.2894/ G 2>,464
To find the total assets, we must first find the total de"t and e&uit! from the information gi%en. So,
we find the net income using the profit margin0
+$ G ?I - Sales
?I G +rofit margin Q Sales G .4J9.2D,3>4/ G 2D4J.D9
We now use the net income figure as an input into R'E to find the total e&uit!0
R'E G ?I - TE
TE G ?I - R'E G 2D4J.D9 - .6>9 G 2>,J4D.D6
?e#t, we need to find the long*term de"t. The long*term de"t ratio is0
Cong*term de"t ratio G 4.I4 G CTE - .CTE L TE/
In%erting "oth sides gi%es0
> - 4.I4 G .CTE L TE/ - CTE G > L .TE - CTE/
Su"stituting the total e&uit! into the e&uation and sol%ing for long*term de"t gi%es the following0
> L 2>,J4D.D6 - CTE G >.D6J
CTE G 2>,J4D.D6 - .D6J G 2D,DD3.HD
?ow, we can find the total de"t of the compan!0
TE G CC L CTE G 2894 L D,DD3.HD G 29,6J3.HD
)nd, with the total de"t, we can find the TEFE, which is e&ual to T)0
T) G TE L TE G 29,6J3.HD L >,J4D.D6 G 2I,>J8.4H
)nd finall!, we are read! to sol%e the "alance sheet identit! as0
?;) G T) @ C) G 2I,>J8.4H @ >,464 G 2H,>I8.4H
B-30
CHAPTER 3 B-
16. This pro"lem re&uires !ou to wor, "ac,ward through the income statement. ;irst, recognie that
?et income G .> @ tC/EAT. +lugging in the num"ers gi%en and sol%ing for EAT, we get0
EAT G 2I,894 - 4.H4 G 2>3,483.33
?ow, we can add interest to EAIT to get EAIT as follows0
EAIT G EAT L Interest paid G 2>3,483.33 L 6,>48 G 2>9,>J>.33
To get EAITE .earnings "efore interest, ta#es, and depreciation/, the numerator in the cash co%erage
ratio, add depreciation to EAIT0
EAITE G EAIT L Eepreciation G 2>9,>J>.33 L >,H8I G 2>H,8I8.33
?ow, simpl! plug the num"ers into the cash co%erage ratio and calculate0
Cash co%erage ratio G EAITE - Interest G 2>H,8I8.33 - 26,>48 G 8.4> times
17. The onl! ratio gi%en which includes cost of goods sold is the in%entor! turno%er ratio, so it is the last
ratio used. Since current lia"ilities are gi%en, we start with the current ratio0
Current ratio G 3.3 G C) - CC G C) - B3D4,444
C) G B>,>66,444
<sing the &uic, ratio, we sol%e for in%entor!0
Yuic, ratio G >.8 G .C) @ In%entor!/ - CC G .B>,>66,444 @ In%entor!/ - B3D4,444
In%entor! G C) @ .Yuic, ratio Q CC/
In%entor! G B>,>66,444 @ .>.8 Q B3D4,444/
In%entor! G B9>4,444
In%entor! turno%er G D.6 G C'RS - In%entor! G C'RS - B9>4,444
C'RS G B6,>D6,444
31
SOLUTIONS
18. Common Common Common*
6449 sie 644H sie "ase !ear
)ssets
Current assets
Cash = >4,>H8 6.9DK = >4,H83 6.3IK >.494H
)ccounts recei%a"le 6I,>D9 H.IIK 68,H>3 H.3DK >.49D>
In%entor! 9J,36D >D.84K HD,893 >D.3IK >.4J36
Total = JH,H3I 6D.>>K =>4D,D>J 63.48K >.4III
;i#ed assets
?et plant and e&uipment 34D,>H9 I9.8JK 3DI,>H8 IH.J6K >.>D>D
Total assets = D44,846 >44K = D9>,3>I >44K >.>6H4
Cia"ilities and 'wners E&uit!
Current lia"ilities
)ccounts pa!a"le = I3,>89 >8.6HK = 9J,34J >3.>DK 4.8>4D
?otes pa!a"le 3J,>69 J.IHK D8,>H8 >4.HIK >.63>>
Total =>>6,3>4 68.46K =>4I,DII 63.8>K 4.J9I4
Cong*term de"t = 94,444 >6.DIK = H6,444 >3.IDK >.6D44
'wners e&uit!
Common stoc, F paid*in surplus = 84,444 >J.JHK = 84,444 >I.I3K >.4444
)ccumulated retained earnings >98,DJ6 3J.9DK 64>,8D4 DD.I6K >.6I39
Total = 638,DJ6 9J.94K = 68>,8D4 H6.D9K >.>8>8
Total lia"ilities and owners e&uit! = D44,846 >44K = D9>,3>I >44K >.>6H4
The common*sie "alance sheet answers are found "! di%iding each categor! "! total assets. ;or
e#ample, the cash percentage for 6449 is0
=>4,>H8 - =D44,846 G .469D or 6.9DK
This means that cash is 6.9DK of total assets.
The common*"ase !ear answers are found "! di%iding each categor! %alue for 644H "! the same
categor! %alue for 6449. ;or e#ample, the cash common*"ase !ear num"er is found "!0
=>4,H83 - =>4,>H8 G >.494H
19. To determine full capacit! sales, we di%ide the current sales "! the capacit! the compan! is currentl!
using, so0
;ull capacit! sales G Ca2DI8,444 - .89
;ull capacit! sales G Ca29H6,393
So, the dollar growth rate in sales is0
Sales growth G Ca29H6,393 @ DI8,444
Sales growth G Ca28D,393
B-32
CHAPTER 3 B-
20. To find the new le%el of fi#ed assets, we need to find the current percentage of fi#ed assets to full
capacit! sales. Eoing so, we find0
;i#ed assets - ;ull capacit! sales G Ca2D>9,444 - Ca29H6,393
;i#ed assets - ;ull capacit! sales G .I384

?e#t, we calculate the total dollar amount of fi#ed assets needed at the new sales figure.
Total fi#ed assets G .I384.Ca2H84,444/
Total fi#ed assets G Ca294>,864
The new fi#ed assets necessar! is the total fi#ed assets at the new sales figure minus the current le%el
of fi#ed assets.
?ew fi#ed assets G Ca294>,864 @ D>9,444
?ew fi#ed assets G Ca28H,864
21. )ssuming costs %ar! with sales and a 64 percent increase in sales, the pro forma income statement
will loo, li,e this0
T)I +' ST)TI'?ERS
+ro ;orma Income Statement
Sales 2 >,48H,444
Costs 896,444
'ther e#penses >D,D44
EAIT 2 6>J,H44
Interest >J,I44
Ta#a"le income 2 >JJ,J44
Ta#es.39K/ HJ,JH9
?et income 2 >6J,J39
The pa!out ratio is constant, so the di%idends paid this !ear is the pa!out ratio from last !ear times
net income, or0
Ei%idends G .2D6,D98-2>4H,>D9/.2>6J,J39/
Ei%idends G 29>,JID
)nd the addition to retained earnings will "e0
)ddition to retained earnings G 2>6J,J39 @ 9>,JID
)ddition to retained earnings G 2II,JH>
The new accumulated retained earnings on the pro forma "alance sheet will "e0
?ew accumulated retained earnings G 269I,444 L II,JH>
?ew accumulated retained earnings G 233D,JH>
33
SOLUTIONS
The pro forma "alance sheet will loo, li,e this0
T)I +' ST)TI'?ERS
+ro ;orma Aalance Sheet
)ssets Cia"ilities and 'wners E&uit!
Current assets Current lia"ilities
Cash 2 34,444 )ccounts pa!a"le 2 I8,444
)ccounts recei%a"le 9>,H44 ?otes pa!a"le J,444
In%entor! J>,644 Total 2 8I,444
Total 2 >I6,844 Cong*term de"t >9H,444
;i#ed assets
?et plant and 'wners e&uit!
e&uipment D3H,844 Common stoc, and
paid*in surplus 2 6>,444
Retained earnings 33D,JH>
Total 2 399,JH>
Total lia"ilities and owners
Total assets 2 H4J,H44 e&uit! 2 9J8,JH>
So, the E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G 2H4J,H44 @ 9J8,JH>
E;? G 2>4,H3J
22. ;irst, we need to calculate full capacit! sales, which is0
;ull capacit! sales G 2J49,444 - .84
;ull capacit! sales G 2>,>3>,694
The capital intensit! ratio at full capacit! sales is0
Capital intensit! ratio G ;i#ed assets - ;ull capacit! sales
Capital intensit! ratio G 23HD,444 - 2>,>3>,694
Capital intensit! ratio G .36>II
The fi#ed assets re&uired at full capacit! sales is the capital intensit! ratio times the pro:ected sales
le%el0
Total fi#ed assets G .36>II.2>,48H,444/ G 23DJ,DD4
So, E;? is0
E;? G .2>I6,844 L 3DJ,DD4/ @ 29J8,JH> G @2IH,I6>
?ote that this solution assumes that fi#ed assets are decreased .sold/ so the compan! has a >44
percent fi#ed asset utiliation. If we assume fi#ed assets are not sold, the answer "ecomes0
E;? G .2>I6,844 L 3HD,444/ @ 29J8,JH> G @2H6,>H>
B-34
CHAPTER 3 B-
23. The E-E ratio of the compan! is0
E-E G .2>9H,444 L ID,444/ - 26I8,444
E-E G .86I3D
So the new total de"t amount will "e0
?ew total de"t G .86I3D.2399,JH>/
?ew total de"t G 26JD,944.>>
So, the E;? is0
E;? G 2H4J,H44 @ .26JD,944.>> L 399,JH>/ G @2D4,8H>.>>
)n interpretation of the answer is not that the compan! has a negati%e E;?. Coo,ing "ac, at
+ro"lem 6>, we see that for the same sales growth, the E;? is 2>4,H3J. The negati%e num"er in this
case means the compan! has too much capital. There are two possi"le solutions. ;irst, the compan!
can put the e#cess funds in cash, which has the effect of changing the current asset growth rate.
Second, the compan! can use the e#cess funds to repurchase de"t and e&uit!. To maintain the
current capital structure, the repurchase must "e in the same proportion as the current capital
structure.
'hallenge
24. The pro forma income statements for all three growth rates will "e0
T)I +' ST)TI'?ERS
+ro ;orma Income Statement
)* + ,ales
-rowth
./+ ,ales
-rowth
.*+ ,ales
-rowth
Sales 2>,4D4,I94 2>,48H,444 2>,>3>,694
Costs 8>H,944 896,444 88I,944
'ther e#penses >3,844 >D,D44 >9,444
EAIT 2 6>4,D94 2 6>J,H44 2 668,I94
Interest >J,I44 >J,I44 >J,I44
Ta#a"le income 2 >J4,I94 2 >JJ,J44 2 64J,494
Ta#es .39K/ HH,IH3 HJ,JH9 I3,>H8
?et income 2 >63,J88 2 >6J,J39 2 >39,883

Ei%idends 2 DJ,9J9 2 9>,JID 2 9D,393
)dd to RE ID,3J3 II,JH> 8>,934
We will calculate the E;? for the >9 percent growth rate first. )ssuming the pa!out ratio is constant,
the di%idends paid will "e0
Ei%idends G .2D6,D98-2>4H,>D9/.2>63,J88/
Ei%idends G 2DJ,9J9
35
SOLUTIONS
)nd the addition to retained earnings will "e0
)ddition to retained earnings G 2>63,J88 @ DJ,9J9
)ddition to retained earnings G 2ID,3J3
The new accumulated retained earnings on the pro forma "alance sheet will "e0
?ew accumulated retained earnings G 269I,444 L ID,3J3
?ew accumulated retained earnings G 233>,3J3
The pro forma "alance sheet will loo, li,e this0
)*+ ,ales -rowth0
T)I +' ST)TI'?ERS
+ro ;orma Aalance Sheet
)ssets Cia"ilities and 'wners E&uit!
Current assets Current lia"ilities
Cash 2 68,I94 )ccounts pa!a"le 2 ID,I94
)ccounts recei%a"le DJ,D94 ?otes pa!a"le J,444
In%entor! 8I,D44 Total 2 83,I94
Total 2 >H9,H44 Cong*term de"t >9H,444
;i#ed assets
?et plant and 'wners e&uit!
e&uipment D>8,H44 Common stoc, and
paid*in surplus 2 6>,444
Retained earnings 33>,3J3
Total 2 396,3J3
Total lia"ilities and owners
Total assets 2 98D,644 e&uit! 2 9J6,>D3
So, the E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G 298D,644 @ 9J6,>D3
E;? G @2I,JD3
)t a 64 percent growth rate, and assuming the pa!out ratio is constant, the di%idends paid will "e0
Ei%idends G .2D6,D98-2>4H,>D9/.2>6J,J39/
Ei%idends G 29>,JID
)nd the addition to retained earnings will "e0
)ddition to retained earnings G 2>6J,J39 @ 9>,JID
)ddition to retained earnings G 2II,JH>
B-36
CHAPTER 3 B-
The new accumulated retained earnings on the pro forma "alance sheet will "e0
?ew accumulated retained earnings G 269I,444 L II,JH>
?ew accumulated retained earnings G 233D,JH>
The pro forma "alance sheet will loo, li,e this0
./+ ,ales -rowth0
T)I +' ST)TI'?ERS
+ro ;orma Aalance Sheet
)ssets Cia"ilities and 'wners E&uit!
Current assets Current lia"ilities
Cash 2 34,444 )ccounts pa!a"le 2 I8,444
)ccounts recei%a"le 9>,H44 ?otes pa!a"le J,444
In%entor! J>,644 Total 2 8I,444
Total 2 >I6,844 Cong*term de"t >9H,444
;i#ed assets
?et plant and 'wners e&uit!
e&uipment D3H,844 Common stoc, and
paid*in surplus 2 6>,444
Retained earnings 33D,JH>
Total 2 399,JH>
Total lia"ilities and owners
Total assets 2 H4J,H44 e&uit! 2 9J8,JH>
So, the E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G 2H4J,H44 @ 9J8,JH>
E;? G 2>4,H3J
)t a 69 percent growth rate, and assuming the pa!out ratio is constant, the di%idends paid will "e0
Ei%idends G .2D6,D98-2>4H,>D9/.2>39,883/
Ei%idends G 29D,393
)nd the addition to retained earnings will "e0
)ddition to retained earnings G 2>39,883 @ 9D,393
)ddition to retained earnings G 28>,934
The new accumulated retained earnings on the pro forma "alance sheet will "e0
?ew accumulated retained earnings G 269I,444 L 8>,934
?ew accumulated retained earnings G 2338,934
37
SOLUTIONS
The pro forma "alance sheet will loo, li,e this0
.*+ ,ales -rowth0
T)I +' ST)TI'?ERS
+ro ;orma Aalance Sheet
)ssets Cia"ilities and 'wners E&uit!
Current assets Current lia"ilities
Cash 2 3>,694 )ccounts pa!a"le 2 8>,694
)ccounts recei%a"le 93,I94 ?otes pa!a"le J,444
In%entor! J9,444 Total 2 J4,694
Total 2 >84,444 Cong*term de"t >9H,444
;i#ed assets
?et plant and 'wners e&uit!
e&uipment D99,444 Common stoc, and
paid*in surplus 2 6>,444
Retained earnings 338,934
Total 2 39J,934
Total lia"ilities and owners
Total assets 2 H39,444 e&uit! 2 H49,I84
So, the E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G 2H39,444 @ H49,I84
E;? G 26J,66>
25. The pro forma income statements for all three growth rates will "e0
T)I +' ST)TI'?ERS
+ro ;orma Income Statement
./+ ,ales
-rowth
0/+ ,ales
-rowth
0*+ ,ales
-rowth
Sales 2>,48H,444 2>,>IH,944 2>,66>,I94
Costs 896,444 J63,444 J98,944
'ther e#penses >D,D44 >9,H44 >H,644
EAIT 2 6>J,H44 2 63I,J44 2 6DI,494
Interest >J,I44 >J,I44 >J,I44
Ta#a"le income 2 >JJ,J44 2 6>8,644 2 66I,394
Ta#es .39K/ HJ,JH9 IH,3I4 IJ,9I3
?et income 2 >6J,J39 2 >D>,834 2 >DI,II8

Ei%idends 2 9>,JID 2 9H,I36 2 9J,>>>
)dd to RE II,JH> 89,4J8 88,HHI
B-38
CHAPTER 3 B-
<nder the sustaina"le growth rate assumption, the compan! maintains a constant de"t*e&uit! ratio.
The E-E ratio of the compan! is0
E-E G .2>9H,444 L ID,444/ - 26I8,444
E-E G .86I3D
)t a 64 percent growth rate, and assuming the pa!out ratio is constant, the di%idends paid will "e0
Ei%idends G .2D6,D98-2>4H,>D9/.2>6J,J39/
Ei%idends G 29>,JID
)nd the addition to retained earnings will "e0
)ddition to retained earnings G 2>6J,J39 @ 9>,JID
)ddition to retained earnings G 2II,JH>
The total e&uit! on the pro forma "alance sheet will "e0
?ew total e&uit! G 26>,444 L 69I,444 L II,JH>
?ew total e&uit! G 2399,JH>
The new total de"t will "e0
?ew total de"t G .86I3D.2399,JH>/
?ew total de"t G 26JD,944
So, the new long*term de"t will "e the new total de"t minus the new short*term de"t, or0
?ew long*term de"t G 26JD,944 @ 8I,444
?ew long*term de"t G 264I,944
39
SOLUTIONS
The pro forma "alance sheet will loo, li,e this0
,ales growth rate 1 ./+ and "ebt2E!uit ratio 1 .3.405:
T)I +' ST)TI'?ERS
+ro ;orma Aalance Sheet
)ssets Cia"ilities and 'wners E&uit!
Current assets Current lia"ilities
Cash 2 34,444 )ccounts pa!a"le 2 I8,444
)ccounts recei%a"le 9>,H44 ?otes pa!a"le J,444
In%entor! J>,644 Total 2 8I,444
Total 2 >I6,844 Cong*term de"t 64I,944
;i#ed assets
?et plant and 'wners e&uit!
e&uipment D3H,844 Common stoc, and
paid*in surplus 2 6>,444
Retained earnings 33D,JH>
Total 2 399,JH>
Total lia"ilities and owners
Total assets 2 H4J,H44 e&uit! 2 H94,DH>
So, the E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G 2H4J,H44 @ H94,DH>
E;? G @2D4,8H>
)t a 34 percent growth rate, and assuming the pa!out ratio is constant, the di%idends paid will "e0
Ei%idends G .2D6,D98-2>4H,>D9/.2>D>,834/
Ei%idends G 29H,I36
)nd the addition to retained earnings will "e0
)ddition to retained earnings G 2>D>,834 @ 9H,I36
)ddition to retained earnings G 289,4J8
The new total e&uit! on the pro forma "alance sheet will "e0
?ew total e&uit! G 26>,444 L 69I,444 L 89,4J8
?ew total e&uit! G 23H3,4J8
The new total de"t will "e0
?ew total de"t G .86I3D.23H3,4J8/
?ew total de"t G 2344,D49
B-40
CHAPTER 3 B-
So, the new long*term de"t will "e the new total de"t minus the new short*term de"t, or0
?ew long*term de"t G 2344,D49 @ J3,944
?ew long*term de"t G 264H,J49
,ales growth rate 1 0/+ and debt2e!uit ratio 1 .3.405:
T)I +' ST)TI'?ERS
+ro ;orma Aalance Sheet
)ssets Cia"ilities and 'wners E&uit!
Current assets Current lia"ilities
Cash 2 36,944 )ccounts pa!a"le 2 8D,944
)ccounts recei%a"le 99,J44 ?otes pa!a"le J,444
In%entor! J8,844 Total 2 J3,944
Total 2 >8I,644 Cong*term de"t 64H,J49
;i#ed assets
?et plant and 'wners e&uit!
e&uipment DI3,644 Common stoc, and
paid*in surplus 2 6>,444
Retained earnings 3D6,4J8
Total 2 3H3,4J8
Total lia"ilities and owners
Total assets 2 HH4,D44 e&uit! 2 HH3,943
So, the E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G 2HH4,D44 @ HH3,943
E;? G @23,>43
)t a 39 percent growth rate, and assuming the pa!out ratio is constant, the di%idends paid will "e0
Ei%idends G .2D6,D98-2>4H,>D9/.2>DI,II8/
Ei%idends G 29J,>>>
)nd the addition to retained earnings will "e0
)ddition to retained earnings G 2>DI,II8 @ 9J,>>>
)ddition to retained earnings G 288,HHI
The new total e&uit! on the pro forma "alance sheet will "e0
?ew total e&uit! G 26>,444 L 69I,444 L 88,HHI
?ew total e&uit! G 23HH,HHI
41
SOLUTIONS
The new total de"t will "e0
?ew total de"t G .86I3D.23HH,HHI/
?ew total de"t G 2343,39I
So, the new long*term de"t will "e the new total de"t minus the new short*term de"t, or0
?ew long*term de"t G 2343,39I @ JH,I94
?ew long*term de"t G 264H,H4I
,ales growth rate 1 0*+ and debt2e!uit ratio 1 .3.405:
T)I +' ST)TI'?ERS
+ro ;orma Aalance Sheet
)ssets Cia"ilities and 'wners E&uit!
Current assets Current lia"ilities
Cash 2 33,I94 )ccounts pa!a"le 2 8I,I94
)ccounts recei%a"le 98,494 ?otes pa!a"le J,444
In%entor! >46,H44 Total 2 JH,I94
Total 2 >JD,D44 Cong*term de"t 64H,H4I
;i#ed assets
?et plant and 'wners e&uit!
e&uipment DJ>,D44 Common stoc, and
paid*in surplus 2 6>,444
Retained earnings 3D9,HHI
Total 2 3HH,HHI
Total lia"ilities and owners
Total assets 2 H89,844 e&uit! 2 HI4,46D
So the E;? is0
E;? G Total assets @ Total lia"ilities and e&uit!
E;? G 2H89,844 @ HI4,46D
E;? G 2>9,IIH
26. We must need the R'E to calculate the sustaina"le growth rate. The R'E is0
R'E G .+$/.T)T/.E$/
R'E G ..4H6/.> - >.99/.> L 4.3/
R'E G .4964 or 9.64K
?ow, we can use the sustaina"le growth rate e&uation to find the retention ratio as0
Sustaina"le growth rate G .R'E Q b/ - N> @ .R'E Q b/O
Sustaina"le growth rate G .>D G N.4964."/O - N> @ .4964."/O
b G 6.3H
B-42
CHAPTER 3 B-
This implies the pa!out ratio is0
+a!out ratio G > @ b
+a!out ratio G > @ 6.3H
+a!out ratio G @>.3H
This is a negati%e di%idend pa!out ratio of >3H percent, which is impossi"le. The growth rate is not
consistent with the other constraints. The lowest possi"le pa!out rate is 4, which corresponds to
retention ratio of >, or total earnings retention.
The ma#imum sustaina"le growth rate for this compan! is0
$a#imum sustaina"le growth rate G .R'E Q b/ - N> @ .R'E Q b/O
$a#imum sustaina"le growth rate G N.4964.>/O - N> @ .4964.>/O
$a#imum sustaina"le growth rate G .49DJ or 9.DJK
27. We ,now that E;? is0
E;? G Increase in assets @ )ddition to retained earnings
The increase in assets is the "eginning assets times the growth rate, so0
Increase in assets G ) g
The addition to retained earnings ne#t !ear is the current net income times the retention ratio, times
one plus the growth rate, so0
)ddition to retained earnings G .?I b/.> L g/
)nd rearranging the profit margin to sol%e for net income, we get0
?I G +$.S/
Su"stituting the last three e&uations into the E;? e&uation we started with and rearranging, we get0
E;? G ).g/ @ +$.S/b.> L g/
E;? G ).g/ @ +$.S/b @ N+$.S/bOg
E;? G @ +$.S/b L N) @ +$.S/bOg
28. We start with the E;? e&uation we deri%ed in +ro"lem 6I and set it e&ual to ero0
E;? G 4 G @ +$.S/b L N) @ +$.S/bOg
Su"stituting the rearranged profit margin e&uation into the internal growth rate e&uation, we ha%e0
Internal growth rate G N+$.S/b O - N) @ +$.S/bO
43
SOLUTIONS
Since0
R') G ?I - )
R') G +$.S/ - )
We can su"stitute this into the internal growth rate e&uation and di%ide "oth the numerator and
denominator "! ). This gi%es0
Internal growth rate G ZN+$.S/bO - )[ - ZN) @ +$.S/bO - )[
Internal growth rate G b.R')/ - N> @ b.R')/O
To deri%e the sustaina"le growth rate, we must realie that to maintain a constant E-E ratio with no
e#ternal e&uit! financing, E;? must e&ual the addition to retained earnings times the E-E ratio0
E;? G .E-E/N+$.S/b.> L g/O
E;? G ).g/ @ +$.S/b.> L g/
Sol%ing for g and then di%iding numerator and denominator "! )0
Sustaina"le growth rate G +$.S/b.> L E-E/ - N) @ +$.S/b.> L E-E /O
Sustaina"le growth rate G NR').> L E-E /bO - N> @ R').> L E-E /bO
Sustaina"le growth rate G b.R'E/ - N> @ b.R'E/O
29. In the following deri%ations, the su"script 1E8 refers to end of period num"ers, and the su"script 1A8
refers to "eginning of period num"ers. TE is total e&uit! and T) is total assets.
;or the sustaina"le growth rate:
Sustaina"le growth rate G .R'EE Q b/ - .> @ R'EE Q b/
Sustaina"le growth rate G .?I-TEE Q b/ - .> @ ?I-TEE Q b/
We multipl! this e&uation "!0
.TEE - TEE/
Sustaina"le growth rate G .?I - TEE Q b/ - .> @ ?I - TEE Q b/ Q .TEE - TEE/
Sustaina"le growth rate G .?I Q b/ - .TEE @ ?I Q b/
Recognie that the denominator is e&ual to "eginning of period e&uit!, that is0
.TEE @ ?I Q b/ G TEA
Su"stituting this into the pre%ious e&uation, we get0
Sustaina"le rate G .?I Q b/ - TEA
B-44
CHAPTER 3 B-
Which is e&ui%alent to0
Sustaina"le rate G .?I - TEA/ Q b
Since R'EA G ?I - TEA
The sustaina"le growth rate e&uation is0
Sustaina"le growth rate G R'EA Q b
;or the internal growth rate0
Internal growth rate G .R')E Q b/ - .> @ R')E Q b/
Internal growth rate G .?I - T)E Q b/ - .> @ ?I - T)E Q b/
We multipl! this e&uation "!0
.T)E - T)E/
Internal growth rate G .?I - T)E Q b/ - N.> @ ?I - T)E Q b/ Q .T)E - T)E/O
Internal growth rate G .?I Q b/ - .T)E @ ?I Q b/
Recognie that the denominator is e&ual to "eginning of period assets, that is0
.T)E @ ?I Q b/ G T)A
Su"stituting this into the pre%ious e&uation, we get0
Internal growth rate G .?I Q b/ - T)A
Which is e&ui%alent to0
Internal growth rate G .?I - T)A/ Q b
Since R')A G ?I - T)A
The internal growth rate e&uation is0
Internal growth rate G R')A Q b
30. Since the compan! issued no new e&uit!, shareholders e&uit! increased "! retained earnings.
Retained earnings for the !ear were0
Retained earnings G ?I @ Ei%idends
Retained earnings G =84,444 @ DJ,444
Retained earnings G =3>,444
45
SOLUTIONS
So, the e&uit! at the end of the !ear was0
Ending e&uit! G =>H9,444 L 3>,444
Ending e&uit! G =>JH,444
The R'E "ased on the end of period e&uit! is0
R'E G =84,444 - =>JH,444
R'E G D4.86K
The plow"ac, ratio is0
+low"ac, ratio G )ddition to retained earnings-?I
+low"ac, ratio G =3>,444 - =84,444
+low"ac, ratio G .38I9 or G 38.I9K
<sing the e&uation presented in the te#t for the sustaina"le growth rate, we get0
Sustaina"le growth rate G .R'E Q b/ - N> @ .R'E Q b/O
Sustaina"le growth rate G N.D486..38I9/O - N> @ .D486..38I9/O
Sustaina"le growth rate G .>8IJ or >8.IJK
The R'E "ased on the "eginning of period e&uit! is
R'E G =84,444 - =>H9,444
R'E G .D8D8 or D8.D8K
<sing the shortened e&uation for the sustaina"le growth rate and the "eginning of period R'E, we
get0
Sustaina"le growth rate G R'E Q b
Sustaina"le growth rate G .D8D8 Q .38I9
Sustaina"le growth rate G .>8IJ or >8.IJK
<sing the shortened e&uation for the sustaina"le growth rate and the end of period R'E, we get0
Sustaina"le growth rate G R'E Q b
Sustaina"le growth rate G .D486 Q .38I9
Sustaina"le growth rate G .>986 or >9.86K
<sing the end of period R'E in the shortened sustaina"le growth rate results in a growth rate that is
too low. This will alwa!s occur whene%er the e&uit! increases. If e&uit! increases, the R'E "ased on
end of period e&uit! is lower than the R'E "ased on the "eginning of period e&uit!. The R'E .and
sustaina"le growth rate/ in the a""re%iated e&uation is "ased on e&uit! that did not e#ist when the net
income was earned.
B-46
CHAPTER 4
DISCOUNTED CASH FLOW VALUATION
Answers to Concepts Review and Critical !in"in# Questions
1. )ssuming positi%e cash flows and interest rates, the future %alue increases and the present %alue
decreases.
2. )ssuming positi%e cash flows and interest rates, the present %alue will fall and the future %alue will
rise.
3. The "etter deal is the one with e&ual installments.
4. \es, the! should. )+Rs generall! dont pro%ide the rele%ant rate. The onl! ad%antage is that the! are
easier to compute, "ut, with modern computing e&uipment, that ad%antage is not %er! important.
5. ) freshman does. The reason is that the freshman gets to use the mone! for much longer "efore
interest starts to accrue.
6. Its a reflection of the time %alue of mone!. R$)C gets to use the 2944 immediatel!. If R$)C uses
it wisel!, it will "e worth more than 2>4,444 in thirt! !ears.
7. 'ddl! enough, it actuall! ma,es it more desira"le since R$)C onl! has the right to pa! the full
2>4,444 "efore it is due. This is an e#ample of a 1call8 feature. Such features are discussed at length
in a later chapter.
8. The ,e! considerations would "e0 .>/ Is the rate of return implicit in the offer attracti%e relati%e to
other, similar ris, in%estments7 and .6/ 5ow ris,! is the in%estment( i.e., how certain are we that we
will actuall! get the =>4,4447 Thus, our answer does depend on who is ma,ing the promise to repa!.
9. The Treasur! securit! would ha%e a somewhat higher price "ecause the Treasur! is the strongest of
all "orrowers.
10. The price would "e higher "ecause, as time passes, the price of the securit! will tend to rise toward
2>4,444. This rise is :ust a reflection of the time %alue of mone!. )s time passes, the time until
receipt of the 2>4,444 grows shorter, and the present %alue rises. In 64>4, the price will pro"a"l! "e
higher for the same reason. We cannot "e sure, howe%er, "ecause interest rates could "e much
higher, or R$)Cs financial position could deteriorate. Either e%ent would tend to depress the
securit!s price.
SOLUTIONS
$olutions to Questions and %ro&le's
NOTE: All-end-of chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. The simple interest per !ear is0
29,444 Q .4I G 2394
So, after 9 !ears, !ou will ha%e0
2394 Q 9 G 2>,I94 in interest.
The total "alance will "e 29,444 L >,I94 G 2H,I94
With compound interest, we use the future %alue formula0
;X G +X.> Lr/
t

;X G 29,444.>.4I/
9
G 2I,4>6.IH
The difference is0
2I,4>6.IH @ H,I94 G 26H6.IH
2. To find the ;X of a lump sum, we use0
;X G +X.> L r/
t
a. ;X G B>,444.>.4H/
>4
G B>,IJ4.89
b. ;X G B>,444.>.4I/
>4
G B>,JHI.>9
c. ;X G B>,444.>.4H/
64
G B3,64I.>D
d. Aecause interest compounds on the interest alread! earned, the future %alue in part c is more
than twice the future %alue in part a. With compound interest, future %alues grow e#ponentiall!.
3. To find the +X of a lump sum, we use0
+X G ;X - .> L r6
t
+X G =>9,D9> - .>.49/
H
G =>>,96J.II
+X G =9>,99I - .>.>>/
J
G =64,>9D.J>
+X G =88H,4I3 - .>.>H/
>8
G =H>,6HH.8I
+X G =994,>HD - .>.>J/
63
G =>4,4HI.68
B-48
CHAPTER 4 B-
4. To answer this &uestion, we can use either the ;X or the +X formula. Aoth will gi%e the same answer
since the! are the in%erse of each other. We will use the ;X formula, that is0
;X G +X.> L r/
t
Sol%ing for r, we get0
r G .;X - +X/
> - t
@ >
;X G 234I G 26H9.> L r/
6
( r G .234I - 26H9/
>-6
@ > G I.H3K
;X G 28JH G 23H4.> L r/
J
( r G .28JH - 23H4/
>-J
@ > G >4.HHK
;X G 2>H6,>8> G 23J,444.> L r/
>9
( r G .2>H6,>8> - 23J,444/
>->9
@ > G J.JIK
;X G 2D83,944 G 2DH,963.> L r/
34
( r G .2D83,944 - 2DH,963/
>-34
@ > G 8.>6K
5. To answer this &uestion, we can use either the ;X or the +X formula. Aoth will gi%e the same answer
since the! are the in%erse of each other. We will use the ;X formula, that is0
;X G +X.> L r/
t
Sol%ing for t, we get0
t G ln.;X - +X/ - ln.> L r/
;X G V>,68D,444 G VH69,444 .>.4J/
t
( t G ln.V>,68D,444- VH69,444/ - ln >.4J G 8.39 !rs
;X G VD,3D>,444 G V8>4,444 .>.4I/
t
( t G ln.VD,3D>,444- V8>4,444/ - ln >.4I G 6D.8> !rs
;X G VD46,HH6,444 G V>8,D44,444 .>.6>/
t
( t G ln.VD46,HH6,444 - V>8,D44,444/ - ln >.6> G >H.>J !rs
;X G V>I3,D3J,444 G V6>,944,444 .>.6J/
t
( t G ln.V>I3,D3J,444 - V6>,944,444/ - ln >.6J G 8.64 !rs
6. To find the length of time for mone! to dou"le, triple, etc., the present %alue and future %alue are
irrele%ant as long as the future %alue is twice the present %alue for dou"ling, three times as large for
tripling, etc. To answer this &uestion, we can use either the ;X or the +X formula. Aoth will gi%e the
same answer since the! are the in%erse of each other. We will use the ;X formula, that is0
;X G +X.> L r/
t
Sol%ing for t, we get0
t G ln.;X - +X/ - ln.> L r/
The length of time to dou"le !our mone! is0
;X G 26 G 2>.>.4H/
t
t G ln 6 - ln >.4H G >>.J4 !ears
The length of time to &uadruple !our mone! is0
;X G 2D G 2>.>.4H/
t

t G ln D - ln >.4H G 63.IJ !ears
49
SOLUTIONS
?otice that the length of time to &uadruple !our mone! is twice as long as the time needed to dou"le
!our mone! .the difference in these answers is due to rounding/. This is an important concept of
time %alue of mone!.
7. To find the +X of a lump sum, we use0
+X G ;X - .> L r6
t
+X G 2844,444,444 - .>.4J9/
64
G 2>34,698,J9J.>6
8. To answer this &uestion, we can use either the ;X or the +X formula. Aoth will gi%e the same answer
since the! are the in%erse of each other. We will use the ;X formula, that is0
;X G +X.> L r/
t
Sol%ing for r, we get0
r G .;X - +X/
> - t
@ >
r G .2>4,3>>,944 - 2>6,3II,944/
>-D
@ > G @ D.DHK
?otice that the interest rate is negati%e. This occurs when the ;X is less than the +X.
9. ) consol is a perpetuit!. To find the +X of a perpetuit!, we use the e&uation0
+X G ' - r
+X G =>64 - .>9
+X G =844.44
10. To find the future %alue with continuous compounding, we use the e&uation0
;X G +Xe
Rt
a. ;X G 2>,444e
.>6.9/
G 2>,866.>6
b. ;X G 2>,444e
.>4.3/
G 2>,3DJ.8H
c. ;X G 2>,444e
.49.>4/
G 2>,HD8.I6
d. ;X 1 2>,444e
.4I.8/
G 2>,I94.HI
11. To sol%e this pro"lem, we must find the +X of each cash flow and add them. To find the +X of a
lump sum, we use0
+X G ;X - .> L r6
t
+X]>4K G =>,644 - >.>4 L =H44 - >.>4
6
L =899 - >.>4
3
L =>,D84 - >.>4
D
G =3,6D4.4>
+X]>8K G =>,644 - >.>8 L =H44 - >.>8
6
L =899 - >.>8
3
L =>,D84 - >.>8
D
G =6,I3>.H>
+X]6DK G =>,644 - >.6D L =H44 - >.6D
6
L =899 - >.6D
3
L =>,D84 - >.6D
D
G =6,D36.D4
B-50
CHAPTER 4 B-
12. To find the +X), we use the e&uation0
+X) G '.Z> @ N>-.> L r6O
t
[ - r /
)t a 9 percent interest rate0
U]9K0 +X) G D,444ZN> @ .>->.49/
J
O - .49 [ G 68,D3>.6J
\]9K0 +X) G H,444ZN> @ .>->.49/
9
O - .49 [ G 69,JIH.8H
)nd at a 66 percent interest rate0
U]66K0 +X) G D,444ZN> @ .>->.66/
J
O - .66 [ G >9,>D9.>D
\]66K0 +X) G H,444ZN> @ .>->.66/
9
O - .66 [ G >I,>8>.8D
?otice that the +X of Cash flow U has a greater +X at a 9 percent interest rate, "ut a lower +X at a
66 percent interest rate. The reason is that U has greater total cash flows. )t a lower interest rate, the
total cash flow is more important since the cost of waiting .the interest rate/ is not as great. )t a
higher interest rate, \ is more %alua"le since it has larger cash flows. )t a higher interest rate, these
"igger cash flows earl! are more important since the cost of waiting .the interest rate/ is so much
greater.
13. To find the +X), we use the e&uation0
+X) G '.Z> @ N>-.> L r6O
t
[ - r /
+X)]>9 !rs0 +X) G Rs.3,H44ZN> @ .>->.>4/
>9
O - .>4[ G Rs.6I,38>.8J
+X)]D4 !rs0 +X) G Rs.3,H44ZN> @ .>->.>4/
D4
O - .>4[ G Rs.39,64D.98
+X)]I9 !rs0 +X) G Rs.3,H44ZN> @ .>->.>4/
I9
O - .>4[ G Rs.39,JI>.I4
To find the +X of a perpetuit!, we use the e&uation0
+X G ' - r
+X G Rs.3,H44 - .>4
+X G Rs.3H,444.44
?otice that as the length of the annuit! pa!ments increases, the present %alue of the annuit!
approaches the present %alue of the perpetuit!. The present %alue of the I9*!ear annuit! and the
present %alue of the perpetuit! impl! that the %alue toda! of all perpetuit! pa!ments "e!ond I9 !ears
is onl! Rs.68.34.
14. This cash flow is a perpetuit!. To find the +X of a perpetuit!, we use the e&uation0
+X G ' - r
+X G 2>9,444 - .48 G 2>8I,944.44
51
SOLUTIONS
To find the interest rate that e&uates the perpetuit! cash flows with the +X of the cash flows. <sing
the +X of a perpetuit! e&uation0
+X G ' - r
2>J9,444 G 2>9,444 - r
We can now sol%e for the interest rate as follows0
r G 2>9,444 - 2>J9,444 G I.HJK
15. ;or discrete compounding, to find the E)R, we use the e&uation0
E)R G N> L .)+R - m/O
m
@ >
E)R G N> L ..>> - D/O
D
@ > G >>.DHK
E)R G N> L ..4I - >6/O
>6
@ > G I.63K
E)R G N> L ..4J - 3H9/O
3H9
@ > G J.D6K
To find the E)R with continuous compounding, we use the e&uation0
E)R G e
&
@ >
E)R G e
.>I
@ > G >8.93K
16. 5ere, we are gi%en the E)R and need to find the )+R. <sing the e&uation for discrete
compounding0
E)R G N> L .)+R - m/O
m
@ >
We can now sol%e for the )+R. Eoing so, we get0
)+R G mN.> L E)R/
>-m
@ >O
E)R G .48> G N> L .)+R - 6/O
6
@ > )+R G 6N.>.48>/
>-6
@ >O G I.JDK
E)R G .4IH G N> L .)+R - >6/O
>6
@ > )+R G >6N.>.4IH/
>->6
@ >O G I.39K
E)R G .>H8 G N> L .)+R - 96/O
96
@ > )+R G 96N.>.>H8/
>-96
@ >O G >9.99K
Sol%ing the continuous compounding E)R e&uation0
E)R G e
&
@ >
We get0
)+R G ln.> L E)R/
)+R G ln.> L .6H6/
)+R G 63.6IK
B-52
CHAPTER 4 B-
17. ;or discrete compounding, to find the E)R, we use the e&uation0
E)R G N> L .)+R - m/O
m
@ >
So, for each "an,, the E)R is0
;irst ?ational0 E)R G N> L ..>66 - >6/O
>6
@ > G >6.J>K
;irst <nited0 E)R G N> L ..>69 - 6/O
6
@ > G >6.8JK
?otice that the higher )+R does not necessaril! mean the higher E)R. The num"er of compounding
periods within a !ear will also affect the E)R.
18. The cost of a case of wine is >4 percent less than the cost of >6 indi%idual "ottles, so the cost of a
case will "e0
Cost of case G .>6/.B>4/.> @ .>4/
Cost of case G B>48
?ow, we need to find the interest rate. The cash flows are an annuit! due, so0
+X) G .> L r6 '.Z> @ N>-.> L r/O
t
[ - r/
B>48 G .> L r/ B>4.Z> @ N> - .> L r/
>6
O - r /
Sol%ing for the interest rate, we get0
r G .4>J8 or >.J8K per wee,
So, the )+R of this in%estment is0
)+R G .4>J8.96/
)+R G >.46II or >46.IIK
)nd the E)R is0
E)R G .> L .4>J8/
96
@ >
E)R G >.IHH8 or >IH.H8K
The anal!sis appears to "e correct. 5e reall! can earn a"out >II percent "u!ing wine "! the case.
The onl! &uestion left is this0 Can !ou reall! find a fine "ottle of Aordeau# for B>47
19. 5ere, we need to find the length of an annuit!. We ,now the interest rate, the +X, and the pa!ments.
<sing the +X) e&uation0
+X) G '.Z> @ N>-.> L r/O
t
[ - r/
>H,944 G 944Z N> @ .>->.44J/
t
O - .44J[
53
SOLUTIONS
?ow, we sol%e for t0
>->.44J
t
G > @ N.>H,944/..44J/ - .944/O
>.44J
t
G >-.4.I43/ G >.D66
t G ln >.D66 - ln >.44J G 3J.33 months
20. 5ere, we are tr!ing to find the interest rate when we ,now the +X and ;X. <sing the ;X e&uation0
;X G +X.> L r/
2D G 23.> L r/
r G D-3 @ > G 33.33K per wee,
The interest rate is 33.33K per wee,. To find the )+R, we multipl! this rate "! the num"er of wee,s
in a !ear, so0
)+R G .96/33.33K G >,I33.33K
)nd using the e&uation to find the E)R0
E)R G N> L .)+R - m/O
m
@ >
E)R G N> L .3333O
96
@ > G 3>3,J>H,9>9.HJK
&ntermediate
21. To find the ;X of a lump sum with discrete compounding, we use0
;X G +X.> L r/
t
a. ;X G 2>,444.>.48/
3
G 2>,69J.I>
b. ;X G 2>,444.> L .48-6/
H
G 2>,6H9.36
c. ;X G 2>,444.> L .48->6/
3H
G 2>,6I4.6D
To find the future %alue with continuous compounding, we use the e&uation0
;X G +Xe
Rt
d. ;X G 2>,444e
.48.3/
G 2>,6I>.69
e. The future %alue increases when the compounding period is shorter "ecause interest is earned
on pre%iousl! accrued interest. The shorter the compounding period, the more fre&uentl!
interest is earned, and the greater the future %alue, assuming the same stated interest rate.
22. The total interest paid "! ;irst Simple Aan, is the interest rate per period times the num"er of
periods. In other words, the interest "! ;irst Simple Aan, paid o%er >4 !ears will "e0
.48.>4/ G .8
B-54
CHAPTER 4 B-
;irst Comple# Aan, pa!s compound interest, so the interest paid "! this "an, will "e the ;X factor
of 2>, or0
.> L r/
>4
Setting the two e&ual, we get0
..48/.>4/ G .> L r/
>4
@ >
r G >.8
>->4
@ > G H.49K
23. We need to find the annuit! pa!ment in retirement. 'ur retirement sa%ings ends at the same time the
retirement withdrawals "egin, so the +X of the retirement withdrawals will "e the ;X of the
retirement sa%ings. So, we find the ;X of the stoc, account and the ;X of the "ond account and add
the two ;Xs.
Stoc, account0 ;X) G Rs.I44NZN> L ..>>->6/ O
3H4
@ >[ - ..>>->6/O G Rs.>,JH3,>H3.86
Aond account0 ;X) G Rs.344NZN> L ..4I->6/ O
3H4
@ >[ - ..4I->6/O G Rs.3H9,JJ>.34
So, the total amount sa%ed at retirement is0
Rs.>,JH3,>H3.86 L 3H9,JJ>.34 G Rs.6,36J,>99.>>
Sol%ing for the withdrawal amount in retirement using the +X) e&uation gi%es us0
+X) G Rs.6,36J,>99.>> G 'N> @ Z> - N> L ..4J->6/O
344
[ - ..4J->6/O
' G Rs.6,36J,>99.>> - >>J.>H>H G Rs.>J,9DH.>J withdrawal per month
24. Since we are loo,ing to &uardruple our mone!, the +X and ;X are irrele%ant as long as the ;X is
four times as large as the +X. The num"er of periods is four, the num"er of &uarters per !ear. So0
;X G 2D G 2>.> L r/
.>6-3/

r G D>.D6K
25. 5ere, we need to find the interest rate for two possi"le in%estments. Each in%estment is a lump sum,
so0
R0 +X G =94,444 G =89,444 - .> L r/
9

.> L r/
9
G =89,444 - =94,444
r G .>.I4/
>-9
@ > G >>.64K
50 +X G =94,444 G =>I9,444 - .> L r/
>4

.> L r/
>4
G =>I9,444 - =94,444
r G .3.94/
>->4
@ > G >3.39K
55
SOLUTIONS
26. This is a growing perpetuit!. The present %alue of a growing perpetuit! is0
+X G C - .r @ g/
+X G Rs.644,444 - ..>4 @ .49/
+X G Rs.D,444,444
It is important to recognie that when dealing with annuities or perpetuities, the present %alue
e&uation calculates the present %alue one period "efore the first pa!ment. In this case, since the first
pa!ment is in two !ears, we ha%e calculated the present %alue one !ear from now. To find the %alue
toda!, we simpl! discount this %alue as a lump sum. Eoing so, we find the %alue of the cash flow
stream toda! is0
+X G ;X - .> L r/
t
+X G Rs.D,444,444 - .> L .>4/
>
+X G Rs.3,H3H,3H3.HD
27. The di%idend pa!ments are made &uarterl!, so we must use the &uarterl! interest rate. The &uarterl!
interest rate is0
Yuarterl! rate G Stated rate - D
Yuarterl! rate G .>6 - D
Yuarterl! rate G .43
<sing the present %alue e&uation for a perpetuit!, we find the %alue toda! of the di%idends paid must
"e0
+X G C - r
+X G V>,444 - .43
+X G V33,333.33
28. We can use the +X) annuit! e&uation to answer this &uestion. The annuit! has 64 pa!ments, not >J
pa!ments. Since there is a pa!ment made in \ear 3, the annuit! actuall! "egins in \ear 6. So, the
%alue of the annuit! in \ear 6 is0
+X) G '.Z> @ N>-.> L r6O
t
[ - r /
+X) G 26,444.Z> @ N>-.> L .48/O
64
[ - .48/
+X) G 2>J,H3H.6J
This is the %alue of the annuit! one period "efore the first pa!ment, or \ear 6. So, the %alue of the
cash flows toda! is0
+X G ;X-.> L r/
t
+X G 2>J,H3H.6J-.> L .48/
6
+X G 2>H,83D.JH
29. We need to find the present %alue of an annuit!. <sing the +X) e&uation, and the >9 percent interest
rate, we get0
+X) G '.Z> @ N>-.> L r6O
t
[ - r /
+X) G 2944.Z> @ N>-.> L .>9/O
>9
[ - .>9/
+X) G 26,J63.HJ
B-56
CHAPTER 4 B-
This is the %alue of the annuit! in \ear 9, one period "efore the first pa!ment. ;inding the %alue of
this amount toda!, we find0
+X G ;X-.> L r/
t
+X G 26,J63.HJ-.> L .>6/
9
+X G 2>,H98.J8
30. The amount "orrowed is the %alue of the home times one minus the down pa!ment, or0
)mount "orrowed G D4,444,444.> @ .64/
)mount "orrowed G 36,444,444
The monthl! pa!ments with a "alloon pa!ment loan are calculated assuming a longer amortiation
schedule, in this case, 34 !ears. The pa!ments "ased on a 34*!ear repa!ment schedule would "e0
+X) G 36,444,444 G '.Z> @ N> - .> L .48->6/O
3H4
[ - ..48->6//
' G 63D,849
?ow, at time G 8, we need to find the +X of the pa!ments which ha%e not "een made. The "alloon
pa!ment will "e0
+X) G 63D,849.Z> @ N> - .> L .48->6/O
66.>6/
[ - ..48->6//
+X) G 6J,>69,HH3
31. 5ere, we need to find the ;X of a lump sum, with a changing interest rate. We must do this pro"lem
in two parts. )fter the first si# months, the "alance will "e0
;X G =D,444 N> L ..4>J->6/O
H
G =D,438.>9
This is the "alance in si# months. The ;X in another si# months will "e0
;X G =D,438.>9 N> L ..>H->6/O
H
G =D,3I6.>H
The pro"lem as,s for the interest accrued, so, to find the interest, we su"tract the "eginning "alance
from the ;X. The interest accrued is0
Interest G =D,3I6.>H @ D,444.44 G =3I6.>H
32. The compan! would "e indifferent at the interest rate that ma,es the present %alue of the cash flows
e&ual to the cost toda!. Since the cash flows are a perpetuit!, we can use the +X of a perpetuit!
e&uation. Eoing so, we find0
+X G ' - r
6D4,444 G 6>,444 - r
r G 6>,444 - 6D4,444
r G .48I9 or 8.I9K
57
SOLUTIONS
33. The compan! will accept the pro:ect if the present %alue of the increased cash flows is greater than
the cost. The cash flows are a growing perpetuit!, so the present %alue is0
+X G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[
+X G 2>6,444ZN>-..>> @ .4H/O @ N>-..>> @ .4H/O Q N.> L .4H/-.> L .>>/O
9
[
+X G 2DJ,3J8.I8
The compan! should not accept the pro:ect since the cost is greater than the increased cash flows.
34. Since !our salar! grows at D percent per !ear, !our salar! ne#t !ear will "e0
?e#t !ears salar! G S)RD44,444 .> L .4D/
?e#t !ears salar! G S)RD>H,444
This means !our deposit ne#t !ear will "e0
?e#t !ears deposit G S)RD44,444..46/
?e#t !ears deposit G S)R8,364
Since !our salar! grows at D percent, !ou deposit will also grow at D percent. We can use the present
%alue of a growing perpetuit! e&uation to find the %alue of !our deposits toda!. Eoing so, we find0
+X G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[
+X G S)R8,364ZN>-..48 @ .4D/O @ N>-..48 @ .4D/O Q N.> L .4D/-.> L .48/O
D4
[
+X G S)R>H6,436.JD
?ow, we can find the future %alue of this lump sum in D4 !ears. We find0
;X G +X.> L r/
t
;X G S)R>H6,436.JD .> L .48/
D4
;X G S)R3,964,488.>8
This is the %alue of !our sa%ings in D4 !ears.
35. The relationship "etween the +X) and the interest rate is0
+X) falls as r increases, and +X) rises as r decreases
;X) rises as r increases, and ;X) falls as r decreases
The present %alues of ^9,444 per !ear for >4 !ears at the %arious interest rates gi%en are0
+X)]>4K G ^9,444ZN> @ .>->.>4/
>4
O - .>4[ G ^34,I66.8D
+X)]9K G ^9,444ZN> @ .>->.49/
>4
O - .49[ G ^38,H48.HI
+X)]>9K G ^9,444ZN> @ .>->.>9/
>4
O - .>9[ G ^69,4J3.8D
B-58
CHAPTER 4 B-
36. 5ere, we are gi%en the ;X), the interest rate, and the amount of the annuit!. We need to sol%e for
the num"er of pa!ments. <sing the ;X) e&uation0
;X) G B>9,444 G B>44NZN> L ..>4->6/O
t
@ > [ - ..>4->6/O
Sol%ing for t, we get0
>.44833
t
G > L N.B>9,444/..>4->6/ - >44O
t G ln 6.69 - ln >.44833 G JI.I6 pa!ments
37. 5ere, we are gi%en the +X), num"er of periods, and the amount of the annuit!. We need to sol%e for
the interest rate. <sing the +X) e&uation0
+X) G 2D9,444 G 2J94NZ> @ N> - .> L r/O
H4
[- rO
To find the interest rate, we need to sol%e this e&uation on a financial calculator, using a spreadsheet,
or "! trial and error. If !ou use trial and error, remem"er that increasing the interest rate lowers the
+X), and increasing the interest rate decreases the +X). <sing a spreadsheet, we find0
r G 4.8>4K
The )+R is the periodic interest rate times the num"er of periods in the !ear, so0
)+R G >6.4.8>4/ G J.I6K

38. The amount of principal paid on the loan is the +X of the monthl! pa!ments !ou ma,e. So, the
present %alue of the 2>,444 monthl! pa!ments is0
+X) G 2>,444N.> @ Z> - N> L ..4H8->6/O[
3H4
/ - ..4H8->6/O G 2>93,3J>.83
The monthl! pa!ments of 2>,444 will amount to a principal pa!ment of 2>93,3J>.83. The amount of
principal !ou will still owe is0
2644,444 @ >93,3J>.83 G 2DH,H48.>I
This remaining principal amount will increase at the interest rate on the loan until the end of the loan
period. So the "alloon pa!ment in 34 !ears, which is the ;X of the remaining principal will "e0
Aalloon pa!ment G 2DH,H48.>I N> L ..4H8->6/O
3H4
G 239H,38I.>4
39. We are gi%en the total +X of all four cash flows. If we find the +X of the three cash flows we ,now, and
su"tract them from the total +X, the amount left o%er must "e the +X of the missing cash flow. So, the
+X of the cash flows we ,now are0
+X of \ear > C;0 +5+>,444 - >.>4 G +5+J4J.4J
+X of \ear 3 C;0 +5+6,444 - >.>4
3
G +5+>,946.H3
+X of \ear D C;0 +5+6,444 - >.>4
D
G +5+>,3HH.43
59
SOLUTIONS
So, the +X of the missing C; is0
+5+9,JIJ @ J4J.4J @ >,946.H3 @ >,3HH.43 G +5+6,64>.69
The &uestion as,s for the %alue of the cash flow in \ear 6, so we must find the future %alue of this
amount. The %alue of the missing C; is0
+5+6,64>.69.>.>4/
6
G +5+6,HH3.96
40. To sol%e this pro"lem, we simpl! need to find the +X of each lump sum and add them together. It is
important to note that the first cash flow of V> million occurs toda!, so we do not need to discount
that cash flow. The +X of the lotter! winnings is0
(>,444,444 L V>,D44,444->.>6 L V>,844,444->.>6
6
L V6,644,444->.>6
3
L V6,H44,444->.>6
D
L
V3,444,444->.>6
9
L V3,D44,444->.>6
H
L V3,844,444->.>6
I
L VD,644,444->.>6
8
L
VD,H44,444->.>6
J
L V9,444,444->.>6
>4
G V>I,4>>,JDI.I8
41. 5ere, we are finding interest rate for an annuit! cash flow. We are gi%en the +X), num"er of
periods, and the amount of the annuit!. We need to sol%e for the num"er of pa!ments. We should
also note that the +X of the annuit! is not the amount "orrowed since we are ma,ing a down
pa!ment on the warehouse. The amount "orrowed is0
)mount "orrowed G 4.84.=>,H44,444/ G =>,684,444
<sing the +X) e&uation0
+X) G =>,684,444 G =>4,444NZ> @ N> - .> L r/O
3H4
[- rO
<nfortunatel!, this e&uation cannot "e sol%ed to find the interest rate using alge"ra. To find the
interest rate, we need to sol%e this e&uation on a financial calculator, using a spreadsheet, or "! trial
and error. If !ou use trial and error, remem"er that increasing the interest rate decreases the +X),
and decreasing the interest rate increases the +X). <sing a spreadsheet, we find0
r G 4.I668K
The )+R is the monthl! interest rate times the num"er of months in the !ear, so0
)+R G >6.4.I668/ G 8.HIK
)nd the E)R is0
E)R G .> L .44I668/
>6
@ > G J.43K
42. The profit the firm earns is :ust the +X of the sales price minus the cost to produce the asset. We find
the +X of the sales price as the +X of a lump sum0
+X G 2>>9,444 - >.>3
3
G 2IJ,I44.II
B-60
CHAPTER 4 B-
)nd the firms profit is0
+rofit G 2IJ,I44.II @ I6,444.44 G 2I,I44.II
To find the interest rate at which the firm will "rea, e%en, we need to find the interest rate using the
+X .or ;X/ of a lump sum. <sing the +X e&uation for a lump sum, we get0
2I6,444 G 2>>9,444 - . > L r/
3

r G .2>>9,444 - 2I6,444/
>-3
@ > G >H.8JK
43. We want to find the %alue of the cash flows toda!, so we will find the +X of the annuit!, and then
"ring the lump sum +X "ac, to toda!. The annuit! has >I pa!ments, so the +X of the annuit! is0
+X) G 26,444ZN> @ .>->.>4/
>I
O - .>4[ G 2>H,4D3.>>
Since this is an ordinar! annuit! e&uation, this is the +X one period "efore the first pa!ment, so it is
the +X at t G 8. To find the %alue toda!, we find the +X of this lump sum. The %alue toda! is0
+X G 2>H,4D3.>> - >.>4
8
G 2I,D8D.63
44. This &uestion is as,ing for the present %alue of an annuit!, "ut the interest rate changes during the
life of the annuit!. We need to find the present %alue of the cash flows for the last eight !ears first.
The +X of these cash flows is0
+X)6 G P>,944 NZ> @ > - N> L ..>6->6/O
JH
[ - ..>6->6/O G PJ6,6J>.99
?ote that this is the +X of this annuit! e#actl! se%en !ears from toda!. ?ow, we can discount this
lump sum to toda!. The %alue of this cash flow toda! is0
+X G PJ6,6J>.99 - N> L ..>9->6/O
8D
G P36,94I.>8
?ow, we need to find the +X of the annuit! for the first se%en !ears. The %alue of these cash flows
toda! is0
+X)> G P>,944 NZ> @ > - N> L ..>9->6/O
8D
[ - ..>9->6/O G PII,I33.68
The %alue of the cash flows toda! is the sum of these two cash flows, so0
+X G PII,I33.68 L 36,94I.>8 G P>>4,6D4.DH
45. 5ere, we are tr!ing to find the dollar amount in%ested toda! that will e&ual the ;X) with a ,nown
interest rate, and pa!ments. ;irst, we need to determine how much we would ha%e in the annuit!
account. ;inding the ;X of the annuit!, we get0
;X) G B>,444 NZN > L ..>49->6/O
>84
@ >[ - ..>49->6/O G BD3D,46J.8>
?ow, we need to find the +X of a lump sum that will gi%e us the same ;X. So, using the ;X of a
lump sum with continuous compounding, we get0
;X G BD3D,46J.8> G +Xe
.4J.>9/

+X G BD3D,46J.8> e
7>.39
G B>>6,9>8.44
61
SOLUTIONS
46. To find the %alue of the perpetuit! at t G I, we first need to use the +X of a perpetuit! e&uation.
<sing this e&uation we find0
+X G 23,444 - .4H9 G 2DH,>93.89
Remem"er that the +X of a perpetuit! .and annuit!/ e&uations gi%e the +X one period "efore the first
pa!ment, so, this is the %alue of the perpetuit! at t G >D. To find the %alue at t G I, we find the +X of
this lump sum as0
+X G 2DH,>93.89 - >.4H9
I
G 26J,I44.6J
47. To find the )+R and E)R, we need to use the actual cash flows of the loan. In other words, the
interest rate &uoted in the pro"lem is onl! rele%ant to determine the total interest under the terms
gi%en. The interest rate for the cash flows of the loan is0
+X) G =64,444 G =>,J44Z.> @ N> - .> L r/O
>6
/ - r [
)gain, we cannot sol%e this e&uation for r, so we need to sol%e this e&uation on a financial
calculator, using a spreadsheet, or "! trial and error. <sing a spreadsheet, we find0
r G 6.4IHK per month
So the )+R is0
)+R G >6.6.4IHK/ G 6D.J>K
)nd the E)R is0
E)R G .>.46IH/
>6
@ > G 6I.JHK
48. The cash flows in this pro"lem are semiannual, so we need the effecti%e semiannual rate. The
interest rate gi%en is the )+R, so the monthl! interest rate is0
$onthl! rate G .>6 - >6 G .4>
To get the semiannual interest rate, we can use the E)R e&uation, "ut instead of using >6 months as
the e#ponent, we will use H months. The effecti%e semiannual rate is0
Semiannual rate G .>.4>/
H
@ > G H.>9K
We can now use this rate to find the +X of the annuit!. The +X of the annuit! is0
+X) ] t G J0 Ca2>4,444ZN> @ .> - >.4H>9/
>4
O - .4H>9[ G Ca2I3,4I3.H8
?ote, that this is the %alue one period .si# months/ "efore the first pa!ment, so it is the %alue at t G J.
So, the %alue at the %arious times the &uestions as,ed for uses this %alue J !ears from now.
+X ] t G 90 Ca2I3,4I3.H8 - >.4H>9
8
G Ca2D9,36D.I>
B-62
CHAPTER 4 B-
?ote, that !ou can also calculate this present %alue .as well as the remaining present %alues/ using
the num"er of !ears. To do this, !ou need the E)R. The E)R is0
E)R G .> L .4>/
>6
@ > G >6.H8K
So, we can find the +X at t G 9 using the following method as well0
+X ] t G 90 Ca2I3,4I3.H8 - >.>6H8
D
G Ca2D9,36D.I>
The %alue of the annuit! at the other times in the pro"lem is0
+X ] t G 30 Ca2I3,4I3.H8 - >.4H>9
>6
G Ca239,HJH.6>
+X ] t G 30 Ca2I3,4I3.H8 - >.>6H8
H
G Ca239,HJH.6>
+X ] t G 40 Ca2I3,4I3.H8 - >.4H>9
>8
G Ca26D,JD8.JI
+X ] t G 40 Ca2I3,4I3.H8 - >.>6H8
J
G Ca26D,JD8.JI
49. a. Calculating the +X of an ordinar! annuit!, we get0
+X) G 969ZN> @ .>->.4J9/
H
O - .4J9[ G 6,364.D>
b. To calculate the +X) due, we calculate the +X of an ordinar! annuit! for t @ > pa!ments, and
add the pa!ment that occurs toda!. So, the +X of the annuit! due is0
+X) G 969 L 969ZN> @ .>->.4J9/
9
O - .4J9[ G 6,9D4.89
50. We need to use the +X) due e&uation, that is0
+X)due G .> L r/ +X)
<sing this e&uation0
+X)due G )u29H,444 G N> L ..48>9->6/O Q 'NZ> @ > - N> L ..48>9->6/O
D8
[ - ..48>9->6/
)u299,H66.63 G 'Z> @ N> - .> L .48>9->6/
D8
O[ - ..48>9->6/
' G )u2>,3H>.86
?otice, that when we find the pa!ment for the +X) due, we simpl! discount the +X of the annuit!
due "ac, one period. We then use this %alue as the +X of an ordinar! annuit!.
'hallenge
51. The monthl! interest rate is the annual interest rate di%ided "! >6, or0
$onthl! interest rate G .>6 - >6
$onthl! interest rate G .4>
63
SOLUTIONS
?ow we can set the present %alue of the lease pa!ments e&ual to the cost of the e&uipment, or
2D,444. The lease pa!ments are in the form of an annuit! due, so0
+X)due G .> L r/ '.Z> @ N>-.> L r6O
t
[ - r /
2D,444 G .> L .4>/ '.Z> @ N>-.> L .4>6O
6D
[ - .4> /
' G 2>8H.D3
52. ;irst, we will calculate the present %alue if the college e#penses for each child. The e#penses are an
annuit!, so the present %alue of the college e#penses is0
+X) G '.Z> @ N>-.> L r/O
t
[ - r /
+X) G 263,444.Z> @ N>-.> L .499/O
D
[ - .499/
+X) G 284,H>8.D9
This is the cost of each childs college e#penses one !ear "efore the! enter college. So, the cost of
the oldest childs college e#penses toda! will "e0
+X G ;X-.> L r/
t
+X G 284,H>8.D9-.> L .499/
>D
+X G 238,4JI.8>
)nd the cost of the !oungest childs college e#penses toda! will "e0
+X G ;X-.> L r/
t
+X G 284,H>8.D9-.> L .499/
>H
+X G 23D,66J.4I
Therefore, the total cost toda! of !our childrens college e#penses is0
Cost toda! G 238,4JI.8> L 3D,66J.4I
Cost toda! G 2I6,36H.88
This is the present %alue of !our annual sa%ings, which are an annuit!. So, the amount !ou must sa%e
each !ear will "e0
+X) G '.Z> @ N>-.> L r/O
t
[ - r /
2I6,36H.88 G '.Z> @ N>-.> L .499/O
>9
[ - .499/
' G 2I,649.H>
53. The salar! is a growing annuit!, so using the e&uation for the present %alue of a growing annuit!.
The salar! growth rate is D percent and the discount rate is >6 percent, so the %alue of the salar! offer
toda! is0
+X G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[
+X G ^I9,444ZN>-..>6 @ .4D/O @ N>-..>6 @ .4D/O Q N.> L .4D/-.> L .>6/O
69
[
+X G ^IJ4,D8I.96
The !earl! "onuses are >4 percent of the annual salar!. This means that ne#t !ears "onus will "e0
?e#t !ears "onus G .>4.^I9,444/
?e#t !ears "onus G ^I,944
B-64
CHAPTER 4 B-
Since the salar! grows at D percent, the "onus will grow at D percent as well. <sing the growing
annuit! e&uation, with a D percent growth rate and a >6 percent discount rate, the present %alue of the
annual "onuses is0
+X G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[
+X G ^I,944ZN>-..>6 @ .4D/O @ N>-..>6 @ .4D/O Q N.> L .4D/-.> L .>6/O
69
[
+X G ^IJ,4D8.I9
?otice the present %alue of the "onus is >4 percent of the present %alue of the salar!. The present
%alue of the "onus will alwa!s "e the same percentage of the present %alue of the salar! as the "onus
percentage. So, the total %alue of the offer is0
+X G +X.Salar!/ L +X.Aonus/ L Aonus paid toda!
+X G ^IJ4,D8I.96L IJ,4D8.I9 L >4,444
+X G ^8IJ,93H.68
54. 5ere, we need to compare to options. In order to do so, we must get the %alue of the two cash flow
streams to the same time, so we will find the %alue of each toda!. We must also ma,e sure to use the
afterta# cash flows, since it is more rele%ant. ;or 'ption ), the afterta# cash flows are0
)fterta# cash flows G +reta# cash flows.> @ ta# rate/
)fterta# cash flows G 2>H4,444.> @ .68/
)fterta# cash flows G 2>>9,644
The afterta# cash flows from 'ption ) are in the form of an annuit! due, so the present %alue of the
cash flow toda! is0
+X)due G .> L r/ '.Z> @ N>-.> L r6O
t
[ - r /
+X)due G .> L .>4/ 2>>9,644.Z> @ N>-.> L .>46O
3>
[ - .>4 /
+X)due G 2>,64>,>84.99
;or 'ption A, the afterta# cash flows are0
)fterta# cash flows G +reta# cash flows.> @ ta# rate/
)fterta# cash flows G 2>4>,499.> @ .68/
)fterta# cash flows G 2I6,I9J.H4
The afterta# cash flows from 'ption A are an ordinar! annuit!, plus the cash flow toda!, so the
present %alue0
+X G '.Z> @ N>-.> L r6O
t
[ - r / L C;4
+X G 2I6,I9J.H4.Z> @ N>-.> L .>46O
34
[ - .>4 / L 2DDH,444
+X G 2>,>3>,8J8.93
\ou should choose 'ption ) "ecause it has a higher present %alue on an afterta# "asis.
65
SOLUTIONS
55. We need to find the first pa!ment into the retirement account. The present %alue of the desired
amount at retirement is0
+X G ;X-.> L r/
t
+X G Rs.>,444,444-.> L .>4/
34
+X G Rs.9I,348.99
This is the %alue toda!. Since the sa%ings are in the form of a growing annuit!, we can use the
growing annuit! e&uation and sol%e for the pa!ment. Eoing so, we get0
+X G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[
Rs.9I,348.99 G 'ZN>-..>4 @ .43/O @ N>-..>4 @ .43/O Q N.> L .43/-.> L .>4/O
34
[
' G Rs.D,H9J.IJ
This is the amount !ou need to sa%e ne#t !ear. So, the percentage of !our salar! is0
+ercentage of salar! G Rs.D,H9J.IJ-Rs.99,444
+ercentage of salar! G .48DI or 8.DIK
?ote that this is the percentage of !our salar! !ou must sa%e each !ear. Since !our salar! is
increasing at 3 percent, and the sa%ings are increasing at 3 percent, the percentage of salar! will
remain constant.
56. Since she put >,444 down, the amount "orrowed will "e0
)mount "orrowed G >9,444 @ >,444
)mount "orrowed G >D,444
So, the monthl! pa!ments will "e0
+X) G '.Z> @ N>-.> L r/O
t
[ - r /
>D,444 G 'NZ> @ N>-.> L .4JH->6/O
H4
[ - ..4JH->6/O
' G 6JD.I>
The amount remaining on the loan is the present %alue of the remaining pa!ments. Since the first
pa!ment was made on 'cto"er >, 644D, and she made a pa!ment on 'cto"er >, 644H, there are 39
pa!ments remaining, with the first pa!ment due immediatel!. So, we can find the present %alue of
the remaining 3D pa!ments after ?o%em"er >, 644H, and add the pa!ment made on this date. So the
remaining principal owed on the loan is0
+X G '.Z> @ N>-.> L r/O
t
[ - r / L C4
+X G 6JD.I>NZ> @ N>-.> L .4JH->6/O
3D
[ - ..4JH->6/O L 6JD.I>
' G J,43I.33
She must also pa! a one percent prepa!ment penalt!, so the total amount of the pa!ment is0
Total pa!ment G )mount due.> L +repa!ment penalt!/
Total pa!ment G J,43I.33.> L .4>/
Total pa!ment G J,>6I.I>
B-66
CHAPTER 4 B-
57. The cash flows for this pro"lem occur monthl!, and the interest rate gi%en is the E)R. Since the cash
flows occur monthl!, we must get the effecti%e monthl! rate. 'ne wa! to do this is to find the )+R
"ased on monthl! compounding, and then di%ide "! >6. So, the pre*retirement )+R is0
E)R G .>4>> G N> L .)+R - >6/O
>6
@ >( )+R G >6N.>.>>/
>->6
@ >O G >4.D8K
)nd the post*retirement )+R is0
E)R G .48 G N> L .)+R - >6/O
>6
@ >( )+R G >6N.>.48/
>->6
@ >O G I.I6K
;irst, we will calculate how much he needs at retirement. The amount needed at retirement is the +X
of the monthl! spending plus the +X of the inheritance. The +X of these two cash flows is0
+X) G B69,444Z> @ N> - .> L .4II6->6/
>6.64/
O[ - ..4II6->6/ G B3,49>,JD3.6H
+X G BI94,444 - N> L ..4II6->6/O
6D4
G B>H4,J>>.>H
So, at retirement, he needs0
B3,49>,JD3.6H L >H4,J>>.>H G B3,6>6,89D.D6
5e will "e sa%ing B6,>44 per month for the ne#t >4 !ears until he purchases the ca"in. The %alue of
his sa%ings after >4 !ears will "e0
;X) G B6,>44NZN > L ..>4D8->6/O
>6.>4/
@ >[ - ..>4D8->6/O G BDD6,63J.HJ
)fter he purchases the ca"in, the amount he will ha%e left is0
BDD6,63J.HJ @ 394,444 G BJ6,63J.HJ
5e still has 64 !ears until retirement. When he is read! to retire, this amount will ha%e grown to0
;X G BJ6,63J.HJN> L ..>4D8->6/O
>6.64/
G BID3,HH9.>6
So, when he is read! to retire, "ased on his current sa%ings, he will "e short0
B3,6>6,89D.D> @ ID3,HH9.>6 G B6,DHJ,>8J.6J
This amount is the ;X of the monthl! sa%ings he must ma,e "etween !ears >4 and 34. So, finding
the annuit! pa!ment using the ;X) e&uation, we find his monthl! sa%ings will need to "e0
;X) G B6,DHJ,>8J.6J G 'NZN > L ..>4D8->6/O
>6.64/
@ >[ - ..>4D8->6/O
' G B3,493.8I
58. To answer this &uestion, we should find the +X of "oth options, and compare them. Since we are
purchasing the car, the lowest +X is the "est option. The +X of the leasing is simpl! the +X of the
lease pa!ments, plus the =>. The interest rate we would use for the leasing option is the same as the
interest rate of the loan. The +X of leasing is0
+X G => L =D94Z> @ N> - .> L .48->6/
>6.3/
O[ - ..48->6/ G =>D,3H>.3>
67
SOLUTIONS
The +X of purchasing the car is the current price of the car minus the +X of the resale price. The +X
of the resale price is0
+X G =63,444 - N> L ..48->6/O
>6.3/
G =>8,>4H.8H
The +X of the decision to purchase is0
=39,444 @ =>8,>4H.8H G =>H,8J3.>D
In this case, it is cheaper to lease the car than "u! it since the +X of the leasing cash flows is lower.
To find the "rea,e%en resale price, we need to find the resale price that ma,es the +X of the two
options the same. In other words, the +X of the decision to "u! should "e0
=39,444 @ +X of resale price G =>D,3H>.3>
+X of resale price G =64,H38.HJ
The resale price that would ma,e the +X of the lease %ersus "u! decision is the ;X of this %alue, so0
Area,e%en resale price G =64,H38.HJN> L ..48->6/O
>6.3/
G =6H,6>H.43
59. To find the &uarterl! salar! for the pla!er, we first need to find the +X of the current contract. The
cash flows for the contract are annual, and we are gi%en a dail! interest rate. We need to find the
E)R so the interest compounding is the same as the timing of the cash flows. The E)R is0
E)R G N> L ..4D9-3H9/O
3H9
@ > G D.H4K
The +X of the current contract offer is the sum of the +X of the cash flows. So, the +X is0
+X G 28,444,444 L 2D,444,444->.4DH L 2D,844,444->.4DH
6
L 29,I44,444->.4DH
3
L 2H,D44,444->.4DH
D

L 2I,444,444->.4DH
9
L 2I,944,444->.4DH
H

+X G 23I,896,43I.J>
The pla!er wants the contract increased in %alue "! 2I94,444, so the +X of the new contract will "e0
+X G 23I,896,43I.J> L I94,444 G 238,H46,43I.J>
The pla!er has also re&uested a signing "onus pa!a"le toda! in the amount of 2J million. We can
simpl! su"tract this amount from the +X of the new contract. The remaining amount will "e the +X
of the future &uarterl! pa!chec,s.
238,H46,43I.J> @ J,444,444 G 26J,H46,43I.J>
To find the &uarterl! pa!ments, first realie that the interest rate we need is the effecti%e &uarterl!
rate. <sing the dail! interest rate, we can find the &uarterl! interest rate using the E)R e&uation,
with the num"er of da!s "eing J>.69, the num"er of da!s in a &uarter .3H9 - D/. The effecti%e
&uarterl! rate is0
Effecti%e &uarterl! rate G N> L ..4D9-3H9/O
J>.69
@ > G >.>3>K
?ow, we ha%e the interest rate, the length of the annuit!, and the +X. <sing the +X) e&uation and
sol%ing for the pa!ment, we get0
B-68
CHAPTER 4 B-
+X) G 26J,H46,43I.J> G 'ZN> @ .>->.4>>3>/
6D
O - .4>>3>[
' G 2>,D>9,3D8.3I
60. To find the )+R and E)R, we need to use the actual cash flows of the loan. In other words, the
interest rate &uoted in the pro"lem is onl! rele%ant to determine the total interest under the terms
gi%en. The cash flows of the loan are the =64,444 !ou must repa! in one !ear, and the =>I,H44 !ou
"orrow toda!. The interest rate of the loan is0
=64,444 G =>I,H44.> L r/
r G .=64,444 - >I,H44/ @ > G >3.HDK
Aecause of the discount, !ou onl! get the use of =>I,H44, and the interest !ou pa! on that amount is
>3.HDK, not >6K.
61. 5ere, we ha%e cash flows that would ha%e occurred in the past and cash flows that would occur in
the future. We need to "ring "oth cash flows to toda!. Aefore we calculate the %alue of the cash
flows toda!, we must ad:ust the interest rate, so we ha%e the effecti%e monthl! interest rate. ;inding
the )+R with monthl! compounding and di%iding "! >6 will gi%e us the effecti%e monthl! rate. The
)+R with monthl! compounding is0
)+R G >6N.>.4J/
>->6
@ >O G 8.H9K
To find the %alue toda! of the "ac, pa! from two !ears ago, we will find the ;X of the annuit!, and
then find the ;X of the lump sum. Eoing so gi%es us0
;X) G .2D4,444->6/ NZN > L ..48H9->6/O
>6
@ >[ - ..48H9->6/O G 2D>,H6D.33
;X G 2D>,H6D.33.>.4J/ G 2D9,3I4.96
?otice we found the ;X of the annuit! with the effecti%e monthl! rate, and then found the ;X of the
lump sum with the E)R. )lternati%el!, we could ha%e found the ;X of the lump sum with the
effecti%e monthl! rate as long as we used >6 periods. The answer would "e the same either wa!.
?ow, we need to find the %alue toda! of last !ears "ac, pa!0
;X) G .2D3,444->6/ NZN > L ..48H9->6/O
>6
@ >[ - ..48H9->6/O G 2DD,IDH.>9
?e#t, we find the %alue toda! of the fi%e !ears future salar!0
+X) G .2D9,444->6/ZNZ> @ Z> - N> L ..48H9->6/O
>6.9/
[O - ..48H9->6/[G 2>86,>D6.>D
The %alue toda! of the :ur! award is the sum of salaries, plus the compensation for pain and
suffering, and court costs. The award should "e for the amount of0
)ward G 2D9,3I4.96 L DD,IDH.>9 L >86,>D6.>D L >44,444 L 64,444
)ward G 23J6,698.8>
69
SOLUTIONS
)s the plaintiff, !ou would prefer a lower interest rate. In this pro"lem, we are calculating "oth the
+X and ;X of annuities. ) lower interest rate will decrease the ;X), "ut increase the +X). So, "! a
lower interest rate, we are lowering the %alue of the "ac, pa!. Aut, we are also increasing the +X of
the future salar!. Since the future salar! is larger and has a longer time, this is the more important
cash flow to the plaintiff.
62. )gain, to find the interest rate of a loan, we need to loo, at the cash flows of the loan. Since this loan
is in the form of a lump sum, the amount !ou will repa! is the ;X of the principal amount, which
will "e0
Coan repa!ment amount G +5+>4,444.>.>4/ G +5+>>,444
The amount !ou will recei%e toda! is the principal amount of the loan times one minus the points.
)mount recei%ed G +5+>4,444.> @ .43/ G +5+J,I44
?ow, we simpl! find the interest rate for this +X and ;X.
+5+>>,444 G +5+J,I44.> L r/
r G .+5+>>,444 - +5+J,I44/ @ > G >3.D4K
With a >3 percent &uoted interest rate loan and two points, the E)R is0
Coan repa!ment amount G +5+>4,444.>.>3/ G +5+>>,344
)mount recei%ed G +5+>4,444.> @ .46/ G +5+J,844
+5+>>,344 G +5+J,844.> L r/
r G .+5+>>,344 - +5+J,844/ @ > G >9.3>K
The effecti%e rate is not affected "! the loan amount, since it drops out when sol%ing for r.
63. ;irst, we will find the )+R and E)R for the loan with the refunda"le fee. Remem"er, we need to use
the actual cash flows of the loan to find the interest rate. With the B>,944 application fee, !ou will
need to "orrow B64>,944 to ha%e B644,444 after deducting the fee. Sol%ing for the pa!ment under
these circumstances, we get0
+X) G B64>,944 G ' ZN> @ >-.>.44H69/
3H4
O-.44H69[ where .44H69 G .4I9->6
' G B>,D48.J6
We can now use this amount in the +X) e&uation with the original amount we wished to "orrow,
B644,444. Sol%ing for r, we find0
+X) G B644,444 G B>,D48.J6NZ> @ N> - .> L r/O
3H4
[- rO
B-70
CHAPTER 4 B-
Sol%ing for r with a spreadsheet, on a financial calculator, or "! trial and error, gi%es0
r G 4.H3>DK per month
)+R G >6.4.H3>DK/ G I.98K
E)R G .> L .44H3>D/
>6
@ > G I.89K
With the nonrefunda"le fee, the )+R of the loan is simpl! the &uoted )+R since the fee is not
considered part of the loan. So0
)+R G I.94K
E)R G N> L ..4I9->6/O
>6
@ > G I.IHK
64. Ae careful of interest rate &uotations. The actual interest rate of a loan is determined "! the cash
flows. 5ere, we are told that the +X of the loan is >,444, and the pa!ments are D6.69 per month
for three !ears, so the interest rate on the loan is0
+X) G >,444 G D6.69N Z> @ N> - .> L r/O
3H
[ - r O
Sol%ing for r with a spreadsheet, on a financial calculator, or "! trial and error, gi%es0
r G 6.DIK per month
)+R G >6.6.DIK/ G 6J.H3K
E)R G .> L .46DI/
>6
@ > G 3D.44K
Its called add*on interest "ecause the interest amount of the loan is added to the principal amount of
the loan "efore the loan pa!ments are calculated.
H9. 5ere, we are sol%ing a two*step time %alue of mone! pro"lem. Each &uestion as,s for a different
possi"le cash flow to fund the same retirement plan. Each sa%ings possi"ilit! has the same ;X, that
is, the +X of the retirement spending when !our friend is read! to retire. The amount needed when
!our friend is read! to retire is0

+X) G =J4,444ZN> @ .>->.48/
>9
O - .48[ G =II4,393.48
This amount is the same for all three parts of this &uestion.
a. If !our friend ma,es e&ual annual deposits into the account, this is an annuit! with the ;X) e&ual
to the amount needed in retirement. The re&uired sa%ings each !ear will "e0
;X) G =II4,393.48 G 'N.>.48
34
@ >/ - .48O
' G =H,844.6D
b. 5ere we need to find a lump sum sa%ings amount. <sing the ;X for a lump sum e&uation, we get0
;X G =II4,393.48 G +X.>.48/
34

+X G =IH,999.H3
71
SOLUTIONS
c. In this pro"lem, we ha%e a lump sum sa%ings in addition to an annual deposit. Since we alread!
,now the %alue needed at retirement, we can su"tract the %alue of the lump sum sa%ings at
retirement to find out how much !our friend is short. Eoing so gi%es us0
;X of trust fund deposit G =69,444.>.48/
>4
G =93,JI3.>6
So, the amount !our friend still needs at retirement is0
;X G =II4,393.48 @ 93,JI3.>6 G =I>H,3IJ.JH
<sing the ;X) e&uation, and sol%ing for the pa!ment, we get0
=I>H,3IJ.JH G 'N.>.48
34
@ >/ - .48O
' G =H,363.84
This is the total annual contri"ution, "ut !our friends emplo!er will contri"ute =>,944 per !ear,
so !our friend must contri"ute0
;riendTs contri"ution G =H,363.84 @ >,944 G =D,863.84
HH. We will calculate the num"er of periods necessar! to repa! the "alance with no fee first. We simpl!
need to use the +X) e&uation and sol%e for the num"er of pa!ments.
Without fee and annual rate G >J.64K0
+X) G B>4,444 G B644ZN> @ .>->.4>H/
t
O - .4>H [ where .4>H G .>J6->6
Sol%ing for t, we get0
t G lnZ> - N> @ .B>4,444-B644/..4>H/O[ - ln.>.4>H/
t G ln 9 - ln >.4>H
t G >4>.3J months
Without fee and annual rate G J.64K0
+X) G B>4,444 G B644ZN> @ .>->.44IHHHI/
t
O - .44IHHHI [ where .44IHHHI G .4J6->6
Sol%ing for t, we get0
t G lnZ> - N> @ .B>4,444-B644/..44IHHHI/O[ - ln.>.44IHHHI/
t G ln >.H6>H - ln >.44IHHHI
t G H3.34 months
?ote that we do not need to calculate the time necessar! to repa! !our current credit card with a fee
since no fee will "e incurred. The time to repa! the new card with a transfer fee is0
B-72
CHAPTER 4 B-
With fee and annual rate G J.64K0
+X) G B>4,644 G B644Z N> @ .>->.44IHHHI/
t
O - .44IHHHI [ where .44IHHHI G .4J6->6
Sol%ing for t, we get0
t G lnZ> - N> @ .B>4,644-B644/..44IHHHI/O[ - ln.>.44IHHHI/
t G ln >.HD64 - ln >.44IHHHI
t G HD.JD months
67. We need to find the ;X of the premiums to compare with the cash pa!ment promised at age H9. We
ha%e to find the %alue of the premiums at !ear H first since the interest rate changes at that time. So0

;X> G 2I94.>.>>/
9
G 2>,6H3.IJ
;X6 G 2I94.>.>>/
D
G 2>,>38.99
;X3 G 2894.>.>>/
3
G 2>,>H6.DJ
;XD G 2894.>.>>/
6
G 2>,4DI.6J
;X9 G 2J94.>.>>/
>
G 2>,49D.94
Xalue at !ear si# G 2>,6H3.IJ L >,>38.99 L >,>H6.DJ L >,4DI.6J L >,49D.94 L J94.44 G 2H,H>H.H6
;inding the ;X of this lump sum at the childs H9
th
"irthda!0
;X G 2H,H>H.H6.>.4I/
9J
G 2398,36H.94
The polic! is not worth "u!ing( the future %alue of the polic! is 2398,36H.94, "ut the polic! contract
will pa! off 2694,444. The premiums are worth 2>48,36H.94 more than the polic! pa!off.
?ote, we could also compare the +X of the two cash flows. The +X of the premiums is0
+X G 2I94->.>> L 2I94->.>>
6
L 2894->.>>
3
L 2894->.>>
D
L 2J94->.>>
9
L 2J94->.>>
H
G 23,93I.9>
)nd the %alue toda! of the 2694,444 at age H9 is0
+X G 2694,444->.4I
9J
G 2D,H>H.33
+X G 2D,H>H.33->.>>
H
G 26,DH8.48
The premiums still ha%e the higher cash flow. )t time ero, the difference is 26,>D8.69. Whene%er
!ou are comparing two or more cash flow streams, the cash flow with the highest %alue at one time
will ha%e the highest %alue at an! other time.
5ere is a &uestion for !ou0 Suppose !ou in%est 26,>D8.69, the difference in the cash flows at time
ero, for si# !ears at an >> percent interest rate, and then for 9J !ears at a se%en percent interest rate.
5ow much will it "e worth7 Without doing calculations, !ou ,now it will "e worth 2>48,36H.94, the
difference in the cash flows at time H9_
73
SOLUTIONS
H8. Since the pa!ments occur at si# month inter%als, we need to get the effecti%e si#*month interest rate.
We can calculate the dail! interest rate since we ha%e an )+R compounded dail!, so the effecti%e
si#*month interest rate is0
Effecti%e si#*month rate G .> L Eail! rate/
>84
@ >
Effecti%e si#*month rate G .> L .4J-3H9/
>84
@ >
Effecti%e si#*month rate G .4D9D or D.9DK
?ow, we can use the +X) e&uation to find the present %alue of the semi*annual pa!ments. Eoing so,
we find0
+X) G '.Z> @ N>-.> L r/O
t
[ - r /
+X) G =944,444.Z> @ N>-.> L .4D9DO
D4
[ - .4D9D/
+X) G =J,>9>,D>8.H>
This is the %alue si# months from toda!, which is one period .si# months/ prior to the first pa!ment.
So, the %alue toda! is0
+X G =J,>9>,D>8.H> - .> L .4D9D/
+X G =8,I9D,>I9.IH
This means the total %alue of the lotter! winnings toda! is0
Xalue of winnings toda! G =8,I9D,>I9.IH L >,444,444
Xalue of winnings toda! G =J,I9D,>I9.IH
\ou should ta,e the offer since the %alue of the offer is greater than the present %alue of the
pa!ments.
69. 5ere, we need to find the interest rate that ma,es the +X), the college costs, e&ual to the ;X), the
sa%ings. The +X of the college costs are0
+X) G 264,444NZ> @ N> - .> L r/O
D
[ - r O
)nd the ;X of the sa%ings is0
;X) G 28,444ZN.> L r/
H
@ > O - r [
Setting these two e&uations e&ual to each other, we get0
264,444NZ> @ N> - .> L r/O
D
[ - r O G 28,444ZN .> L r/
H
@ > O - r [
Reducing the e&uation gi%es us0
.> L r/
>4
@ D.44.> L r/
D
L D4.44 G 4
?ow, we need to find the roots of this e&uation. We can sol%e using trial and error, a root*sol%ing
calculator routine, or a spreadsheet. <sing a spreadsheet, we find0
r G >4.9IK
B-74
CHAPTER 4 B-
I4. 5ere, we need to find the interest rate that ma,es us indifferent "etween an annuit! and a perpetuit!.
To sol%e this pro"lem, we need to find the +X of the two options and set them e&ual to each other.
The +X of the perpetuit! is0
+X G Ca2>4,444 - r
)nd the +X of the annuit! is0
+X) G Ca266,444NZ> @ N> - .> L r/O
>4
[ - r O
Setting them e&ual and sol%ing for r, we get0
Ca2>4,444 - r 1 Ca266,444NZ> @ N> - .> L r/O
>4
[ - r O
Ca2>4,444 - Ca266,444 G > @ N> - .> L r/O
>4

.9D99
>->4
G > - .> L r/
r G > - .9D99
>->4
@ >
r G .4H69 or H.69K
71. The cash flows in this pro"lem occur e%er! two !ears, so we need to find the effecti%e two !ear rate.
'ne wa! to find the effecti%e two !ear rate is to use an e&uation similar to the E)R, e#cept use the
num"er of da!s in two !ears as the e#ponent. .We use the num"er of da!s in two !ears since it is
dail! compounding( if monthl! compounding was assumed, we would use the num"er of months in
two !ears./ So, the effecti%e two*!ear interest rate is0
Effecti%e 6*!ear rate G N> L ..>3-3H9/O
3H9.6/
@ > G 6J.HJK
We can use this interest rate to find the +X of the perpetuit!. Eoing so, we find0
+X G )u2H,I44 -.6JHJ G )u266,9H8.84
This is an important point0 Remem"er that the +X e&uation for a perpetuit! .and an ordinar!
annuit!/ tells !ou the +X one period "efore the first cash flow. In this pro"lem, since the cash flows
are two !ears apart, we ha%e found the %alue of the perpetuit! one period .two !ears/ "efore the first
pa!ment, which is one !ear ago. We need to compound this %alue for one !ear to find the %alue
toda!. The %alue of the cash flows toda! is0
+X G )u266,9H8.84.> L .>3-3H9/
3H9
G )u269,I4>.3J
The second part of the &uestion assumes the perpetuit! cash flows "egin in four !ears. In this case,
when we use the +X of a perpetuit! e&uation, we find the %alue of the perpetuit! two !ears from
toda!. So, the %alue of these cash flows toda! is0
+X G )u266,9H8.84 - .> L .>3-3H9/
6.3H9/
G )u2>I,D46.9>
75
SOLUTIONS
72. To sol%e for the +X) due0
+X) G

/ .>
....
/ .> / .>
6 t
r
'
r
'
r
'
+
+ +
+
+
+
+X)due G

/ .>
....
/ .>
> * t
r
'
r
'
'
+
+ +
+
+
+X)due G

/ .>
....
/ .> / .>
/ .>
6

,
_

+
+ +
+
+
+
+
t
r
'
r
'
r
'
r
+X)due G .> L r/ +X)
)nd the ;X) due is0
;X) G ' L C.> L r/ L '.> L r/
6
L `. L '.> L r/
t @ >
;X)due G '.> L r/ L C.> L r/
6
L `. L '.> L r/
t
;X)due G .> L r/N' L C.> L r/ L `. L '.> L r/
t @ >
O
;X)due G .> L r/;X)
73. a. The )+R is the interest rate per wee, times 96 wee,s in a !ear, so0
)+R G 96.>4K/ G 964K
E)R G .> L .>4/
96
@ > G >D,>4D.6JK
b. In a discount loan, the amount !ou recei%e is lowered "! the discount, and !ou repa! the full
principal. With a >4 percent discount, !ou would recei%e BJ for e%er! B>4 in principal, so the
wee,l! interest rate would "e0
B>4 G BJ.> L r/
r G .B>4 - BJ/ @ > G >>.>>K
?ote the dollar amount we use is irrele%ant. In other words, we could use B4.J4 and B>, BJ4 and
B>44, or an! other com"ination and we would get the same interest rate. ?ow we can find the
)+R and the E)R0
)+R G 96.>>.>>K/ G 9II.I8K
E)R G .> L .>>>>/
96
@ > G 63,89D.H3K
B-76
CHAPTER 4 B-
c. <sing the cash flows from the loan, we ha%e the +X) and the annuit! pa!ments and need to find
the interest rate, so0
+X) G B98.8D G B69NZ> @ N> - .> L r/O
D
[- r O
<sing a spreadsheet, trial and error, or a financial calculator, we find0
r G 69.>JK per wee,
)+R G 96.69.>JK/ G >,34J.J6K
E)R G >.69>8
96
@ > G >>,89>,94>.JDK
74. To answer this, we can diagram the perpetuit! cash flows, which are0 .?ote, the su"scripts are onl!
to differentiate when the cash flows "egin. The cash flows are all the same amount./
`..
'3
'6 '6
'> '> '>
Thus, each of the increased cash flows is a perpetuit! in itself. So, we can write the cash flows
stream as0
'>-R '6-R '3-R 'D-R `.
So, we can write the cash flows as the present %alue of a perpetuit! with a perpetuit! pa!ment of0
'6-R '3-R 'D-R `.
The present %alue of this perpetuit! is0
+X G .'-R/ - R G '-R
6
So, the present %alue e&uation of a perpetuit! that increases "! ' each period is0
+X G '-R L '-R
6
77
SOLUTIONS
75. Since it is onl! an appro#imation, we ,now the Rule of I6 is e#act for onl! one interest rate. <sing
the "asic future %alue e&uation for an amount that dou"les in %alue and sol%ing for t, we find0
;X G +X.> L R/
t
26 G 2>.> L R/
t
ln.6/ G t ln.> L R/
t G ln.6/ - ln.> L R/
We also ,now the Rule of I6 appro#imation is0
t G I6 - R
We can set these two e&uations e&ual to each other and sol%e for R. We also need to remem"er that
the e#act future %alue e&uation uses decimals, so the e&uation "ecomes0
.I6 - R G ln.6/ - ln.> L R/
4 G ..I6 - R/ - N ln.6/ - ln.> L R/O
It is not possi"le to sol%e this e&uation directl! for R, "ut using Sol%er, we find the interest rate for
which the Rule of I6 is e#act is I.8DH8JD percent.
76. We are onl! concerned with the time it ta,es mone! to dou"le, so the dollar amounts are irrele%ant.
So, we can write the future %alue of a lump sum with continuousl! compounded interest as0
26 G 2>e
Rt
6 G e
Rt
Rt G ln.6/
Rt G .HJ3>DI
t G .HJ>3DI - R
Since we are using percentage interest rates while the e&uation uses decimal form, to ma,e the
e&uation correct with percentages, we can multipl! "! >440
t G HJ.>3DI - R
B-78
CHAPTER 4 B-
Calculator $olutions
1.
Enter 9 IK 29,444
) *+, %- %. /-
Sol%e for 2I,4>6.IH
2I,4>6.IH @ H,I94 G 26H6.IH
2.
Enter >4 HK B>,444
) *+, %- %. /-
Sol%e for B>,IJ4.89
Enter >4 IK B>,444
) *+, %- %. /-
Sol%e for B>,JHI.>9
Enter 64 HK B>,444
) *+, %- %. /-
Sol%e for B3,64I.>D
3.
Enter H 9K =>9,D9>
) *+, %- %. /-
Sol%e for =>>,96J.II
Enter J >>K =9>,99I
) *+, %- %. /-
Sol%e for =64,>9D.J>
Enter 63 >HK =88H,4I3
) *+, %- %. /-
Sol%e for =6J,>HJ.J9
Enter >8 >JK =994,>HD
) *+, %- %. /-
Sol%e for =6D,46D.4J
4.
Enter 6 26H9
t 234I
) *+, %- %. /-
Sol%e for I.H3K
79
SOLUTIONS
Enter J 23H4
t 28JH
) *+, %- %. /-
Sol%e for >4.HHK
Enter >9 23J,444
t 2>H6,>8>
) *+, %- %. /-
Sol%e for J.JIK
Enter 34 2DH,963
t 2D83,944
) *+, %- %. /-
Sol%e for 8.>6K
5.
Enter JK VH69,444
t V>,68D,444
) *+, %- %. /-
Sol%e for 8.39
Enter IK V8>4,444
t VD,3D>,444
) *+, %- %. /-
Sol%e for 6D.8>
Enter 6>K V>8,D44,444
t VD46,HH6,444
) *+, %- %. /-
Sol%e for >H.>J
Enter 6JK V6>,944,444
t V>I3,D3J,444
) *+, %- %. /-
Sol%e for 8.64
6.
Enter HK 2>
t 26
) *+, %- %. /-
Sol%e for >>.J4
Enter HK 2>
t 2D
) *+, %- %. /-
Sol%e for 63.IJ
7.
Enter 64 J.9K 2844,444,444
) *+, %- %. /-
Sol%e for 2>34,698,J9J.>6
B-80
CHAPTER 4 B-
8.
Enter D
t 2>6,3II,944
2>4,3>>,944
) *+, %- %. /-
Sol%e for @D.DHK
11.
C/o =4 C/o =4 C/o =4
C01 =>,644 C01 =>,644 C01 =>,644
/01 > /01 > /01 >
C02 =H44 C02 =H44 C02 =H44
/02 > /02 > /02 >
C03 =899 C03 =899 C03 =899
/03 > /03 > /03 >
C04 =>,D84 C04 =>,D84 C04 =>,D84
/04 > /04 > /04 >
I G >4 I G >8 I G 6D
?+X C+T ?+X C+T ?+X C+T
=3,6D4.4> =6,I3>.H> =6,D36.D4
12.
Enter J 9K D,444
) *+, %- %. /-
Sol%e for 68,D3>.6J
Enter 9 9K H,444
) *+, %- %. /-
Sol%e for 69,JIH.8H
Enter J 66K D,444
) *+, %- %. /-
Sol%e for >9,>D9.>D
Enter 9 66K H,444
) *+, %- %. /-
Sol%e for >I,>8>.8D
13.
Enter >9 >4K Rs.3,H44
) *+, %- %. /-
Sol%e for Rs.6I,38>.8J
Enter D4 >4K Rs.3,H44
) *+, %- %. /-
Sol%e for Rs.39,64D.98
81
SOLUTIONS
Enter I9 >4K Rs.3,H44
) *+, %- %. /-
Sol%e for Rs.39,JI>.I4
15.
Enter >>K D
)0. 1// C+,
Sol%e for >>.DHK
Enter IK >6
)0. 1// C+,
Sol%e for I.63K
Enter JK 3H9
)0. 1// C+,
Sol%e for J.D6K
16.
Enter 8.>K 6
)0. 1// C+,
Sol%e for I.JDK
Enter I.HK >6
)0. 1// C+,
Sol%e for I.39K
Enter >H.8K 96
)0. 1// C+,
Sol%e for >9.99K
17.
Enter >6.6K >6
)0. 1// C+,
Sol%e for >6.J>K
Enter >6.9K 6
)0. 1// C+,
Sol%e for >6.8JK
18. 2
nd
23) 2
nd
$1
Enter >6 B>48
t B>4
) *+, %- %. /-
Sol%e for >.J8K
)+R G >.J8K Q 96 G >46.IIK
B-82
CHAPTER 4 B-
Enter >46.IIK 96
)0. 1// C+,
Sol%e for >IH.H8K
19.
Enter 4.JK >H,944
t 944
) *+, %- %. /-
Sol%e for 3J.33
20.
Enter >,I33.33K 96
)0. 1// C+,
Sol%e for 3>3,J>H,9>9.HJK
21.
Enter 3 8K 2>,444
) *+, %- %. /-
Sol%e for 2>,69J.I>
Enter 3 Q 6 8K-6 2>,444
) *+, %- %. /-
Sol%e for 2>,6H9.36
Enter 3 Q >6 8K->6 2>,444
) *+, %- %. /-
Sol%e for 2>,6I4.6D
23. Stoc, account0
Enter 3H4 >>K - >6 Rs.I44
) *+, %- %. /-
Sol%e for Rs.>,JH3,>H3.86
Aond account0
Enter 3H4 IK - >6 Rs.344
) *+, %- %. /-
Sol%e for Rs.3H9,JJ>.34
Sa%ings at retirement G Rs.>,JH3,>H3.86 L 3H9,JJ>.34 G Rs.6,36J,>99.>>
Enter 344 JK - >6 Rs.6,36J,>99.>>
) *+, %- %. /-
Sol%e for Rs.>J,9DH.>J
83
SOLUTIONS
24.
Enter >6 - 3
t 2>
2D
) *+, %- %. /-
Sol%e for D>.D6K
25.
Enter 9
t =94,444
=89,444
) *+, %- %. /-
Sol%e for >>.64K
Enter >4
t =94,444
=>I9,444
) *+, %- %. /-
Sol%e for >3.39K
28.
Enter 64 8K 26,444
) *+, %- %. /-
Sol%e for 2>J,H3H.6J
Enter 6 8K 2>J,H3H.6J
) *+, %- %. /-
Sol%e for 2>H,83D.JH
29.
Enter >9 >9K 2944
) *+, %- %. /-
Sol%e for 26,J63.HH
Enter 9 >6K 26,J63.HH
) *+, %- %. /-
Sol%e for 2>,H98.J8
30.
Enter 3H4 8K->6 .84.
D4,444,444/
) *+, %- %. /-
Sol%e for 63D,849
Enter 66 Q >6 8K->6 63D,849
) *+, %- %. /-
Sol%e for 6J,>69,HH3
31.
Enter H >.J4K - >6 =D,444
) *+, %- %. /-
B-84
CHAPTER 4 B-
Sol%e for =D,438.>9
Enter H >HK - >6 =D,438.>9
) *+, %- %. /-
Sol%e for =D,3I6.>H
=D,3I6.>H @ D,444 G =3I6.>H
35.
Enter >4 >4K ^9,444
) *+, %- %. /-
Sol%e for ^34,I66.8D
Enter >4 9K ^9,444
) *+, %- %. /-
Sol%e for ^38,H48.HI
Enter >4 >9K ^9,444
) *+, %- %. /-
Sol%e for ^69,4J3.8D
36.
Enter >4K - >6
t B>44
B>9,444
) *+, %- %. /-
Sol%e for JI.I6
37.
Enter H4 2D9,444
t 2J94
) *+, %- %. /-
Sol%e for 4.8>4K
4.8>4K >6 G J.I6K
38.
Enter 3H4 H.8K - >6 2>,444
) *+, %- %. /-
Sol%e for 2>93,3J>.83
2644,444 @ >93,3J>.83 G 2DH,H48.>I
Enter 3H4 H.8K - >6 2DH,H48.>I
) *+, %- %. /-
Sol%e for 239H,38I.>4
85
SOLUTIONS
39.
C/o +5+4
C01 +5+>,444
/01 >
C02 +5+4
/02 >
C03 +5+6,444
/03 >
C04 +5+6,444
/04 >
I G >4K
?+X C+T
+5+3,III.I9
+X of missing C; G +5+9,JIJ @ 3,III.I9 G +5+6,64>.69
Xalue of missing C;0
Enter 6 >4K +5+6,64>.69
) *+, %- %. /-
Sol%e for +5+6,HH3.96
40.
C/o V>,444,444
C01 V>,D44,444
/01 >
C02 V>,844,444
/02 >
C03 V6,644,444
/03 >
C04 V6,H44,444
/04 >
C05 V3,444,444
/05 >
C06 V3,D44,444
/06 >
C07 V3,844,444
/07 >
C08 VD,644,444
/08 >
C09 VD,H44,444
/09 >
C010 V9,444,444
I G >6K
?+X C+T
V>I,4>>,JDI.I8
B-86
CHAPTER 4 B-
41.
Enter 3H4 .84.=>,H44,444/
t =>4,444
) *+, %- %. /-
Sol%e for 4.I668K
)+R G 4.I668K >6 G 8.HIK
Enter 8.HIK >6
)0. 1// C+,
Sol%e for J.43K
42.
Enter 3 >3K 2>>9,444
) *+, %- %. /-
Sol%e for 2IJ,I44.II
+rofit G 2IJ,I44.II @ I6,444 G 2I,I44.II
Enter 3
t 2I6,444
2>>9,444
) *+, %- %. /-
Sol%e for >H.8JK
43.
Enter >I >4K 26,444
) *+, %- %. /-
Sol%e for 2>H,4D3.>>
Enter 8 >4K 2>H,4D3.>>
) *+, %- %. /-
Sol%e for 2I,D8D.63
44.
Enter 8D >9K - >6 P>,944
) *+, %- %. /-
Sol%e for PII,I33.68
Enter JH >6K - >6 P>,944
) *+, %- %. /-
Sol%e for PJ6,6J>.99
Enter 8D >9K - >6 PJ6,6J>.99
) *+, %- %. /-
Sol%e for P36,94I.>8
PII,I33.68 L 36,94I.>8 G P>>4,6D4.DH
87
SOLUTIONS
45.
Enter >9 Q >6 >4.9K->6 B>,444
) *+, %- %. /-
Sol%e for BD3D,46J.8>
;X G BD3D,46J.8> G +X e
.4J.>9/
( +X G BD3D,46J.8> e
7>.39
G B>>6,9>8.44
46. +X] t G >D0 23,444 - 4.4H9 G 2DH,>93.89
Enter I H.9K 2DH,>93.89
) *+, %- %. /-
Sol%e for 26J,I44.6J
47.
Enter >6 =64,444
t =>,J44
) *+, %- %. /-
Sol%e for 6.4IHK
)+R G 6.4IHK >6 G 6D.J>K
Enter 6D.J>K >6
)0. 1// C+,
Sol%e for 6I.JHK
48. $onthl! rate G .>6 - >6 G .4>( semiannual rate G .>.4>/
H
@ > G H.>9K
Enter >4 H.>9K Ca2>4,444
) *+, %- %. /-
Sol%e for Ca2D3,8DD.6>
Enter 8 H.>9K Ca2D3,8DD.6>
) *+, %- %. /-
Sol%e for Ca26I,>JD.83
Enter >6 H.>9K Ca2D3,8DD.6>
) *+, %- %. /-
Sol%e for Ca26>,D>I.I6
Enter >8 H.>9K Ca2D3,8DD.6>
) *+, %- %. /-
Sol%e for Ca2>D,JHJ.38
B-88
CHAPTER 4 B-
49.
a.
Enter H J.9K 969
) *+, %- %. /-
Sol%e for 6,364.D>
b. 6
nd
AR? 6
nd
SET
Enter H J.9K 969
) *+, %- %. /-
Sol%e for 6,9D4.89
50. 2
nd
23) 2
nd
$1
Enter D8 8.>9K - >6 )u29H,444
) *+, %- %. /-
Sol%e for )u2>,3H>.86
51. 6
nd
AR? 6
nd
SET
Enter 6 Q >6 >6K - >6 2D,444
) *+, %- %. /-
Sol%e for 2>8H.D3
52. +X of college e#penses0
Enter D 9.9K 263,444
) *+, %- %. /-
Sol%e for 284,H>8.D9
Cost toda! of oldest childs e#penses0
Enter >D 9.9K 284,H>8.D9
) *+, %- %. /-
Sol%e for 238,4JI.8>
Cost toda! of !oungest childs e#penses0
Enter >H 9.9K 284,H>8.D9
) *+, %- %. /-
Sol%e for 23D,66J.4I
Total cost toda! G 238,4JI.8> L 3D,66J.4I G 2I6,36H.8H
Enter >9 9.9K 2I6,36H.8H
) *+, %- %. /-
Sol%e for 2I,649.H>
89
SOLUTIONS
54. 'ption )0
)fterta# cash flows G +reta# cash flows.> @ ta# rate/
)fterta# cash flows G 2>H4,444.> @ .68/
)fterta# cash flows G 2>>9,644
6
?E
AR? 6
nd
SET
Enter 3> >4K 2>>9,644
) *+, %- %. /-
Sol%e for 2>,64>,>84.99
'ption A0
)fterta# cash flows G +reta# cash flows.> @ ta# rate/
)fterta# cash flows G 2>4>,499.> @ .68/
)fterta# cash flows G 2I6,I9J.H4
6
?E
AR? 6
nd
SET
Enter 34 >4K 2DDH,444 2I6,I9J.H4
) *+, %- %. /-
Sol%e for 2>,>3>,8J8.93
56.
Enter 9 Q >6 J.HK - >6 >D,444
) *+, %- %. /-
Sol%e for 6JD.I>
6
nd
AR? 6
nd
SET
Enter 39 J.HK - >6 6JD.I>
) *+, %- %. /-
Sol%e for J,4I3.33
Total pa!ment G )mount due.> L +repa!ment penalt!/
Total pa!ment G J,4I3.33.> L .4>/
Total pa!ment G J,>6I.I>
57. +re*retirement )+R0
Enter >>K >6
)0. 1// C+,
Sol%e for >4.D8K
+ost*retirement )+R0
Enter 8K >6
)0. 1// C+,
Sol%e for I.I6K
B-90
CHAPTER 4 B-
)t retirement, he needs0
Enter 6D4 I.I6K - >6 B69,444 BI94,444
) *+, %- %. /-
Sol%e for B3,36>6,89D.D>
In >4 !ears, his sa%ings will "e worth0
Enter >64 >4.D8K - >6 B6,>44
) *+, %- %. /-
Sol%e for BDD6,63J.HJ
)fter purchasing the ca"in, he will ha%e0 BDD6,63J.HJ @ 394,444 G BJ6,63J.HJ
Each month "etween !ears >4 and 34, he needs to sa%e0
Enter 6D4 >4.D8K - >6 BJ6,63J.HJ B3,6>6,89D.D6
) *+, %- %. /-
Sol%e for B3,493.8I
58. +X of purchase0
Enter 3H 8K - >6 =63,444
) *+, %- %. /-
Sol%e for =>8,>4H.8H
=39,444 @ >8,>4H.8H G =>H,8J3.>D
+X of lease0
Enter 3H 8K - >6 =D94
) *+, %- %. /-
Sol%e for =>D,3H4.3>
=>D,3H4.3> L > G =>D,3H>.3>
Cease the car.
\ou would "e indifferent when the +X of the two cash flows are e&ual. The present %alue of the
purchase decision must "e =>D,3H>.3>. Since the difference in the two cash flows is =39,444 @
>D,3H>.3> G =64,H38.HJ, this must "e the present %alue of the future resale price of the car. The
"rea,*e%en resale price of the car is0
Enter 3H 8K - >6 =64,H38.HJ
) *+, %- %. /-
Sol%e for =6H,6>H.43
59.
Enter D.94K 3H9
)0. 1// C+,
Sol%e for D.H4K
91
SOLUTIONS
C/o 28,444,444
C01 2D,444,444
/01 >
C02 2D,844,444
/02 >
C03 29,I44,444
/03 >
C04 2H,D44,444
/04 >
C05 2I,444,444
/05 >
C06 2I,944,444
/06 >
I G D.H4K
?+X C+T
23I,896,43I.J>
?ew contract %alue G 23I,896,43I.J> L I94,444 G 238,H46,43I.J>
+X of pa!ments G 238,H46,43I.J> @ J,444,444 G 26J,H46,43I.J>
Effecti%e &uarterl! rate G N> L ..4D9-3H9/O
J>.69
@ > G >.>3>K
Enter 6D >.>3>K 26J,H46,43I.J>
) *+, %- %. /-
Sol%e for 2>,D>9,3D8.3I
60.
Enter > =>I,H44
t =64,444
) *+, %- %. /-
Sol%e for >3.HDK
61.
Enter JK >6
)0. 1// C+,
Sol%e for 8.H9K
Enter >6 8.H9K - >6 2D4,444 - >6
) *+, %- %. /-
Sol%e for 2D>,H6D.33
Enter > JK 2D>,H6D.33
) *+, %- %. /-
Sol%e for 2D9,3I4.96
B-92
CHAPTER 4 B-
Enter >6 8.H9K - >6 2D3,444 - >6
) *+, %- %. /-
Sol%e for 2DD,IDH.>9
Enter H4 8.H9K - >6 2D9,444 - >6
) *+, %- %. /-
Sol%e for 2>86,>D6.>D
)ward G 2D9,3I4.96 L DD,IDH.>9 L >86,>D6.>D L >44,444 L 64,444 G 23J6,698.8>
62.
Enter > +5+J,I44
t +5+>>,444
) *+, %- %. /-
Sol%e for >3.D4K
Enter > +5+J,844
t +5+>>,344
) *+, %- %. /-
Sol%e for >9.3>K
63. Refunda"le fee0 With the B>,944 application fee, !ou will need to "orrow B64>,944 to ha%e
B644,444 after deducting the fee. Sol%e for the pa!ment under these circumstances.
Enter
34 >6
I.94K - >6 B64>,944
) *+, %- %. /-
Sol%e for B>,D48.J6
Enter
34 >6
B644,444
t B>,D48.J6
) *+, %- %. /-
Sol%e for 4.H3>DK
)+R G 4.H3>DK >6 G I.98K
Enter I.98K >6
)0. 1// C+,
Sol%e for I.89K
Without refunda"le fee0 )+R G I.94K
Enter I.94K >6
)0. 1// C+,
Sol%e for I.IHK
93
SOLUTIONS
64.
Enter 3H >,444
t D6.69
) *+, %- %. /-
Sol%e for 6.DIK
)+R G 6.DIK >6 G 6J.H3K
Enter 6J.H3K >6
)0. 1// C+,
Sol%e for 3D.44K
65. What she needs at age H90
Enter >9 8K =J4,444
) *+, %- %. /-
Sol%e for =II4,393.48
a.
Enter 34 8K =II4,393.48
) *+, %- %. /-
Sol%e for =H,844.6D
b.
Enter 34 8K =II4,393.48
) *+, %- %. /-
Sol%e for =IH,999.H3
c.
Enter >4 8K =69,444
) *+, %- %. /-
Sol%e for =93,JI3.>6
)t H9, she is short0 =II4,393.48 @ 93,JI3.>6 G =I>H,3IJ.JH
Enter 34 8K a=I>H,3IJ.JH
) *+, %- %. /-
Sol%e for =H,363.84
5er emplo!er will contri"ute =>,944 per !ear, so she must contri"ute0
=H,363.84 @ >,944 G =D,863.84 per !ear
66. Without fee0
Enter >J.6K - >6 B>4,444
t B644
) *+, %- %. /-
Sol%e for >4>.3J
B-94
CHAPTER 4 B-
Enter J.6K - >6 B>4,444
t B644
) *+, %- %. /-
Sol%e for H3.34
With fee0
Enter J.6K - >6 B>4,644
t B644
) *+, %- %. /-
Sol%e for HD.JD
67. Xalue at \ear H0
Enter 9 >>K 2I94
) *+, %- %. /-
Sol%e for 2>,6H3.IJ
Enter D >>K 2I94
) *+, %- %. /-
Sol%e for 2>,>38.99
Enter 3 >>K 2894
) *+, %- %. /-
Sol%e for 2>,>H6.DJ
Enter 6 >>K 2894
) *+, %- %. /-
Sol%e for 2>,4DI.6J
Enter > >>K 2J94
) *+, %- %. /-
Sol%e for 2>,49D.94
So, at \ear 9, the %alue is0 2>,6H3.IJ L >,>38.99 L >,>H6.DJ L >,4DI.6J L >,49D.94
L J94 G 2H,H>6.H6
)t \ear H9, the %alue is0
Enter 9J IK 2H,H>6.H6
) *+, %- %. /-
Sol%e for 2398,36H.94
The polic! is not worth "u!ing( the future %alue of the polic! is 2398M, "ut the polic! contract
will pa! off 2694M.
95
SOLUTIONS
68. Effecti%e si#*month rate G .> L Eail! rate/
>84
@ >
Effecti%e si#*month rate G .> L .4J-3H9/
>84
@ >
Effecti%e si#*month rate G .4D9D or D.9DK
Enter D4 D.9DK =944,444
) *+, %- %. /-
Sol%e for =J,>9>,D>8.H>
Enter > D.9DK =J,48J,J6J.39
) *+, %- %. /-
Sol%e for =8,I9D,>I9.IH
Xalue of winnings toda! G =8,I9D,>I9.IH L >,444,444
Xalue of winnings toda! G =J,I9D,>I9.IH
69.
C/o
t 28,444
C01
t 28,444
/01 9
C02 264,444
/02 D
IRR C+T
>4.9IK
73.
a. A%R 4 105 52 4 5205
Enter 964K 96
)0. 1// C+,
Sol%e for >D,>4D.6JK
b.
Enter > BJ.44
t B>4.44
) *+, %- %. /-
Sol%e for >>.>>K
)+R G >>.>>K 96 G 9II.I8K
Enter 9II.I8K 96
)0. 1// C+,
Sol%e for 63,89D.H3K
c.
Enter D B98.8D
t B69
) *+, %- %. /-
Sol%e for 69.>JK
B-96
CHAPTER 4 B-
)+R G 69.>JK 96 G >,34J.J6K
Enter >,34J.J6 K 96
)0. 1// C+,
Sol%e for >>,89>,94>.JDK
97
CHAPTER 4, APPENDIX
NET PRESENT VALUE: FIRST
PRINCIPLES OF FINANCE
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
1. The potential consumption for a "orrower ne#t !ear is the salar! during the !ear, minus the
repa!ment of the loan and interest to fund the current consumption. The amount that must "e
"orrowed to fund this !ears consumption is0
)mount to "orrow G 2>44,444 @ 84,444 G 264,444
Interest will "e charged the amount "orrowed, so the repa!ment of this loan ne#t !ear will "e0
Coan repa!ment G 264,444.>.>4/ G 266,444
So, the consumption potential ne#t !ear is the salar! minus the loan repa!ment, or0
Consumption potential G 2J4,444 @ 66,444 G 2H8,444
2. The potential consumption for a sa%er ne#t !ear is the salar! during the !ear, plus the sa%ings from
the current !ear and the interest earned. The amount sa%ed this !ear is0
)mount sa%ed G 294,444 @ 39,444 G 2>9,444
The sa%er will earn interest o%er the !ear, so the %alue of the sa%ings ne#t !ear will "e0
Sa%ings %alue in one !ear G 2>9,444.>.>6/ G 2>H,844
So, the consumption potential ne#t !ear is the salar! plus the %alue of the sa%ings, or0
Consumption potential G 2H4,444 @ >H,844 G 2IH,844
3. ;inancial mar,ets arise to facilitate "orrowing and lending "etween indi%iduals. A! "orrowing and
lending, people can ad:ust their pattern of consumption o%er time to fit their particular preferences.
This allows corporations to accept all positi%e ?+X pro:ects, regardless of the inter*temporal
consumption preferences of the shareholders.
CHAPTER 4 APPENDIX B-99
SOLUTIONS
4. a. The present %alue of la"or income is the total of the ma#imum current consumption. So,
sol%ing for the interest rate, we find0
28H G 2D4 L 294-.> L R/
R G .48I4 or 8.I4K
b. The ?+X of the in%estment is the difference "etween the new ma#imum current consumption
minus the old ma#imum current consumption, or0
?+X G 2J8 @ 8H G 2>6
c. The total ma#imum current consumption amount must "e the present %alue of the e&ual annual
consumption amount. If C is the e&ual annual consumption amount, we find0
2J8 G C L C-.> L R/
2J8 G C L C-.>.48I4/
C G 29>.4D
5. a. The mar,et interest rate must "e the increase in the ma#imum current consumption to the
ma#imum consumption ne#t !ear, which is0
$ar,et interest rate G 2J4,444-284,444 @ > G 4.>694 or >6.94K
b. 5arr! will in%est 2>4,444 in financial assets and 234,444 in producti%e assets toda!.
c. ?+X G @234,444 L 29H,694->.>69
?+X G 264,444
B-100
CHAPTER 5
HOW TO VALUE BONDS AND STOCKS
Answers to Concepts Review and Critical !in"in# Questions
1. Aond issuers loo, at outstanding "onds of similar maturit! and ris,. The !ields on such "onds are
used to esta"lish the coupon rate necessar! for a particular issue to initiall! sell for par %alue. Aond
issuers also simpl! as, potential purchasers what coupon rate would "e necessar! to attract them.
The coupon rate is fi#ed and simpl! determines what the "onds coupon pa!ments will "e. The
re&uired return is what in%estors actuall! demand on the issue, and it will fluctuate through time. The
coupon rate and re&uired return are e&ual onl! if the "ond sells e#actl! at par.
2. Cac, of transparenc! means that a "u!er or seller cant see recent transactions, so it is much harder
to determine what the "est price is at an! point in time.
3. The %alue of an! in%estment depends on the present %alue of its cash flows( i.e., what in%estors will
actuall! recei%e. The cash flows from a share of stoc, are the di%idends.
4. In%estors "elie%e the compan! will e%entuall! start pa!ing di%idends .or "e sold to another
compan!/.
5. In general, companies that need the cash will often forgo di%idends since di%idends are a cash
e#pense. \oung, growing companies with profita"le in%estment opportunities are one e#ample(
another e#ample is a compan! in financial distress. This &uestion is e#amined in depth in a later
chapter.
6. The general method for %aluing a share of stoc, is to find the present %alue of all e#pected future
di%idends. The di%idend growth model presented in the te#t is onl! %alid .i/ if di%idends are e#pected
to occur fore%er( that is, the stoc, pro%ides di%idends in perpetuit!, and .ii/ if a constant growth rate
of di%idends occurs fore%er. ) %iolation of the first assumption might "e a compan! that is e#pected
to cease operations and dissol%e itself some finite num"er of !ears from now. The stoc, of such a
compan! would "e %alued "! appl!ing the general method of %aluation e#plained in this chapter. )
%iolation of the second assumption might "e a start*up firm that isnt currentl! pa!ing an! di%idends,
"ut is e#pected to e%entuall! start ma,ing di%idend pa!ments some num"er of !ears from now. This
stoc, would also "e %alued "! the general di%idend %aluation method e#plained in this chapter.
7. The common stoc, pro"a"l! has a higher price "ecause the di%idend can grow, whereas it is fi#ed on
the preferred. 5owe%er, the preferred is less ris,! "ecause of the di%idend and li&uidation
preference, so it is possi"le the preferred could "e worth more, depending on the circumstances.
8. \es. If the di%idend grows at a stead! rate, so does the stoc, price. In other words, the di%idend
growth rate and the capital gains !ield are the same.
SOLUTIONS
9. The three factors are0 >/ The compan!s future growth opportunities. 6/ The compan!s le%el of ris,,
which determines the interest rate used to discount cash flows. 3/ The accounting method used.
B-102
CHAPTER 5 B-
10. +resuma"l!, the current stoc, %alue reflects the ris,, timing and magnitude of all future cash flows,
"oth short*term and long*term. If this is correct, then the statement is false.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
NOTE: Most problems do not e8plicitl list a par value for bonds. Even though a bond can have an par
value# in general# corporate bonds in the 9nited ,tates will have a par value of :)#///. ;e will use this
par value in all problems unless a different par value is e8plicitl stated.
%asic
1. The price of a pure discount .ero coupon/ "ond is the present %alue of the par. E%en though the
"ond ma,es no coupon pa!ments, the present %alue is found using semiannual compounding periods,
consistent with coupon "onds. This is a "ond pricing con%ention. So, the price of the "ond for each
\T$ is0
a. + G 2>,444-.> L .469/
64
G 2H>4.6I
b. + G 2>,444-.> L .49/
64
G 23IH.8J
c. + G 2>,444-.> L .>4/
64
G 2>H>.9>
2. The price of an! "ond is the +X of the interest pa!ment, plus the +X of the par %alue. ?otice this
pro"lem assumes an annual coupon. The price of the "ond at each \T$ will "e0
a. + G =D4.Z> @ N>-.> L .4D/O
D4
[ - .4D/ L =>,444N> - .> L .4D/
D4
O
+ G =>,444.44
When the \T$ and the coupon rate are e&ual, the "ond will sell at par.
b. + G =D4.Z> @ N>-.> L .49/O
D4
[ - .49/ L =>,444N> - .> L .49/
D4
O
+ G =868.D>
When the \T$ is greater than the coupon rate, the "ond will sell at a discount.
c. + G =D4.Z> @ N>-.> L .43/O
D4
[ - .43/ L =>,444N> - .> L .43/
D4
O
+ G =>,63>.>9
When the \T$ is less than the coupon rate, the "ond will sell at a premium.
103
SOLUTIONS
We would li,e to introduce shorthand notation here. Rather than write .or t!pe, as the case ma! "e/
the entire e&uation for the +X of a lump sum, or the +X) e&uation, it is common to a""re%iate the
e&uations as0
+XI;<#t G > - .> L r6
t
which stands for +resent Xalue Interest ;actor, and0
+XI;)<#t G .Z> @ N>-.> L r6O
t
[ - r /
which stands for +resent Xalue Interest ;actor of an )nnuit!
These a""re%iations are short hand notation for the e&uations in which the interest rate and the
num"er of periods are su"stituted into the e&uation and sol%ed. We will use this shorthand notation
in the remainder of the solutions ,e!.
3. 5ere we are finding the \T$ of a semiannual coupon "ond. The "ond price e&uation is0
+ G 2JI4 G 2D3.+XI;)<+,64/ L 2>,444.+XI;<+,64/
Since we cannot sol%e the e&uation directl! for <, using a spreadsheet, a financial calculator, or trial
and error, we find0
< G D.93>K
Since the coupon pa!ments are semiannual, this is the semiannual interest rate. The \T$ is the )+R
of the "ond, so0
\T$ G 6 D.93>K G J.4HK
4. The constant di%idend growth model is0
+t G Et Q .> L g/ - .< @ g/
So, the price of the stoc, toda! is0
+4 G E4

.> L g/ - .< @ g/ G B>.D4 .>.4H/ - ..>9 @ .4H/ G B>H.DJ
The di%idend at !ear D is the di%idend toda! times the ;XI; for the growth rate in di%idends and four
!ears, so0
+3 G E3

.> L g/ - .< @ g/ G E4

.> L g/
D

- .< @ g/ G B>.D4 .>.4H/
D

- ..>9 @ .4H/ G B>J.HD
We can do the same thing to find the di%idend in \ear >>, which gi%es us the price in \ear >4, so0
+>4 G E>4

.> L g/ - .< @ g/ G E4

.> L g/
>>

- .< @ g/ G B>.D4 .>.4H/
>>

- ..>9 @ .4H/ G B6J.93
B-104
CHAPTER 5 B-
There is another feature of the constant di%idend growth model0 The stoc, price grows at the
di%idend growth rate. So, if we ,now the stoc, price toda!, we can find the future %alue for an! time
in the future we want to calculate the stoc, price. In this pro"lem, we want to ,now the stoc, price in
three !ears, and we ha%e alread! calculated the stoc, price toda!. The stoc, price in three !ears will
"e0
+3 G +4.> L g/
3
G B>H.DJ.> L .4H/
3
G B>J.HD
)nd the stoc, price in >4 !ears will "e0
+>4 G +4.> L g/
>4
G B>H.DJ.> L .4H/
>4
G B6J.93
5. We need to find the re&uired return of the stoc,. <sing the constant growth model, we can sol%e the
e&uation for <. Eoing so, we find0
< G .E> - +4/ L g G .23.>4 - 2D8.44/ L .49 G >>.DHK
6. <sing the constant growth model, we find the price of the stoc, toda! is0
+4 G E> - .< @ g/ G Rs.3.H4 - ..>3 @ .4D9/ G Rs.D6.39
7. We ,now the stoc, has a re&uired return of >6 percent, and the di%idend and capital gains !ield are
e&ual, so0
Ei%idend !ield G >-6..>6/ G .4H G Capital gains !ield
?ow we ,now "oth the di%idend !ield and capital gains !ield. The di%idend is simpl! the stoc, price
times the di%idend !ield, so0
E> G .4H.V>>,444/ G VHH4
This is the di%idend ne#t !ear. The &uestion as,s for the di%idend this !ear. <sing the relationship
"etween the di%idend this !ear and the di%idend ne#t !ear0
E> G E4.> L g/
We can sol%e for the di%idend that was :ust paid0
VHH4 G E4 .> L .4H/
E4 G VHH4 - >.4H G VH66.HD
8. The price of an! financial instrument is the +X of the future cash flows. The future di%idends of this
stoc, are an annuit! for eight !ears, so the price of the stoc, is the +X), which will "e0
+4 G 2>6.44.+XI;)>4K,8/ G 2HD.46
105
SOLUTIONS
9. The growth rate of earnings is the return on e&uit! times the retention ratio, so0
g G R'E Q b
g G .>D..H4/
g G .48D or 8.D4K
To find ne#t !ears earnings, we simpl! multipl! the current earnings times one plus the growth rate,
so0
?e#t !ears earnings G Current earnings.> L g/
?e#t !ears earnings G 264,444,444.> L .48D/
?e#t !ears earnings G 26>,H84,444
&ntermediate
10. 5ere we are finding the \T$ of semiannual coupon "onds for %arious maturit! lengths. The "ond
price e&uation is0
P = C(PVIFAR%,t) + $1,000(PVIFR%,t)
$ir!ang ;oods "ond0
+4 G 2D4.+XI;)3K,6H/ L 2>,444.+XI;3K,6H/ G 2>,>I8.II
+> G 2D4.+XI;)3K,6D/ L 2>,444.+XI;3K,6D/ G 2>,>HJ.3H
+3 G 2D4.+XI;)3K,64/ L 2>,444.+XI;3K,64/ G 2>,>D8.II
+8 G 2D4.+XI;)3K,>4/ L 2>,444.+XI;3K,>4/ G 2>,489.34
+>6 G 2D4.+XI;)3K,6/ L 2>,444.+XI;3K,6/ G 2>,4>J.>3
+>3 G 2>,444
\eosu ;ishing "ond0
\0 +4 G 234.+XI;)DK,6H/ L 2>,444.+XI;DK,6H/ G 28D4.>I
+> G 234.+XI;)DK,6D/ L 2>,444.+XI;DK,6D/ G 28DI.93
+3 G 234.+XI;)DK,64/ L 2>,444.+XI;DK,64/ G 28HD.>4
+8 G 234.+XI;)DK,>4/ L 2>,444.+XI;DK,>4/ G 2J>8.8J
+>6 G 234.+XI;)DK,6/ L 2>,444.+XI;DK,6/ G 2J8>.>D
+>3 G 2>,444
)ll else held e&ual, the premium o%er par %alue for a premium "ond declines as maturit! approaches,
and the discount from par %alue for a discount "ond declines as maturit! approaches. This is called
1pull to par.8 In "oth cases, the largest percentage price changes occur at the shortest maturit!
lengths.
)lso, notice that the price of each "ond when no time is left to maturit! is the par %alue, e%en though
the purchaser would recei%e the par %alue plus the coupon pa!ment immediatel!. This is "ecause we
calculate the clean price of the "ond.
B-106
CHAPTER 5 B-
11. The "ond price e&uation for this "ond is0
+4 G 2>,4D4 G 2D6.+XI;)<+,>8/ L 2>,444.+XI;<+,>8/
<sing a spreadsheet, financial calculator, or trial and error we find0
< G 3.88IK
This is the semiannual interest rate, so the \T$ is0
\T$ G 6 3.88IK G I.IIK
The current !ield is0
Current !ield G )nnual coupon pa!ment - +rice G 28D - 2>,4D4 G 8.48K
The effecti%e annual !ield is the same as the E)R, so using the E)R e&uation from the pre%ious
chapter0
Effecti%e annual !ield G .> L 4.4388I/
6
@ > G I.J6K
12. The compan! should set the coupon rate on its new "onds e&ual to the re&uired return. The re&uired
return can "e o"ser%ed in the mar,et "! finding the \T$ on outstanding "onds of the compan!. So,
the \T$ on the "onds currentl! sold in the mar,et is0
+ G 2>,4J9 G 2D4.+XI;)<+,D4/ L 2>,444.+XI;<+,D4/
<sing a spreadsheet, financial calculator, or trial and error we find0
< G 3.99K
This is the semiannual interest rate, so the \T$ is0
\T$ G 6 3.99K G I.>4K
13. This stoc, has a constant growth rate of di%idends, "ut the re&uired return changes twice. To find the
%alue of the stoc, toda!, we will "egin "! finding the price of the stoc, at \ear H, when "oth the
di%idend growth rate and the re&uired return are sta"le fore%er. The price of the stoc, in \ear H will
"e the di%idend in \ear I, di%ided "! the re&uired return minus the growth rate in di%idends. So0
+H G EH

.> L g/ - .< @ g/ G E4

.> L g/
I

- .< @ g/ G =3.44 .>.49/
I

- ..>> @ .49/ G =I4.3H
?ow we can find the price of the stoc, in \ear 3. We need to find the price here since the re&uired
return changes at that time. The price of the stoc, in \ear 3 is the +X of the di%idends in \ears D, 9,
and H, plus the +X of the stoc, price in \ear H. The price of the stoc, in \ear 3 is0
+3

G =3.44.>.49/
D
- >.>D L =3.44.>.49/
9
- >.>D
6
L =3.44.>.49/
H
- >.>D
3
L =I4.3H - >.>D
3

+3 G =9H.39
107
SOLUTIONS
;inall!, we can find the price of the stoc, toda!. The price toda! will "e the +X of the di%idends in
\ears >, 6, and 3, plus the +X of the stoc, in \ear 3. The price of the stoc, toda! is0
+4 G =3.44.>.49/ - >.>H L =3.44.>.49/
6
- .>.>H/
6
L =3.44.>.49/
3
- .>.>H/
3
L =9H.39 - .>.>H/
3

G =D3.94
14. 5ere we ha%e a stoc, that pa!s no di%idends for >4 !ears. 'nce the stoc, "egins pa!ing di%idends, it
will ha%e a constant growth rate of di%idends. We can use the constant growth model at that point. It
is important to remem"er that general form of the constant di%idend growth formula is0
+t G NEt Q .> L g/O - .< @ g/
This means that since we will use the di%idend in \ear >4, we will "e finding the stoc, price in \ear
J. The di%idend growth model is similar to the +X) and the +X of a perpetuit!0 The e&uation gi%es
!ou the +X one period "efore the first pa!ment. So, the price of the stoc, in \ear J will "e0
+J G E>4

- .< @ g/ G 8.44 - ..>9 @ .4H/ G 88.8J
The price of the stoc, toda! is simpl! the +X of the stoc, price in the future. We simpl! discount the
future stoc, price at the re&uired return. The price of the stoc, toda! will "e0
+4 G 88.8J - >.>9
J
G 69.6I
15. The price of a stoc, is the +X of the future di%idends. This stoc, is pa!ing four di%idends, so the
price of the stoc, is the +X of these di%idends using the re&uired return. The price of the stoc, is0
+4 G B>6 - >.>> L B>9 - >.>>
6
L B>8 - >.>>
3
L B6> - >.>>
D
G BDJ.J8
16. With supernormal di%idends, we find the price of the stoc, when the di%idends le%el off at a constant
growth rate, and then find the +X of the future stoc, price, plus the +X of all di%idends during the
supernormal growth period. The stoc, "egins constant growth in \ear 9, so we can find the price of
the stoc, in \ear D, one !ear "efore the constant di%idend growth "egins, as0
+D G ED

.> L g/ - .< @ g/ G 6.44.>.49/ - ..>3 @ .49/ G 6H.69
The price of the stoc, toda! is the +X of the first four di%idends, plus the +X of the \ear D stoc,
price. So, the price of the stoc, toda! will "e0
+4 G 8.44 - >.>3 L H.44 - >.>3
6
L 3.44 - >.>3
3
L 6.44 - >.>3
D
L 6H.69 - >.>3
D
G 3>.>8
17. With supernormal di%idends, we find the price of the stoc, when the di%idends le%el off at a constant
growth rate, and then find the +X of the future stoc, price, plus the +X of all di%idends during the
supernormal growth period. The stoc, "egins constant growth in \ear D, so we can find the price of
the stoc, in \ear 3, one !ear "efore the constant di%idend growth "egins as0
+3 G E3

.> L g/ - .< @ g/ G E4

.> L g)/
3

.> L g./ - .< @ g./ G P6.84.>.69/
3
.>.4I/ - ..>3 @ .4I/ G PJI.93
B-108
CHAPTER 5 B-
The price of the stoc, toda! is the +X of the first three di%idends, plus the +X of the \ear 3 stoc,
price. The price of the stoc, toda! will "e0
+4 G 6.84.>.69/ - >.>3 L P6.84.>.69/
6
- >.>3
6
L P6.84.>.69/
3
- >.>3
3
L PJI.93 - >.>3
3

+4 G PII.J4
18. 5ere we need to find the di%idend ne#t !ear for a stoc, e#periencing supernormal growth. We ,now
the stoc, price, the di%idend growth rates, and the re&uired return, "ut not the di%idend. ;irst, we
need to realie that the di%idend in \ear 3 is the current di%idend times the ;XI;. The di%idend in
\ear 3 will "e0
E3 G E4

.>.34/
3

)nd the di%idend in \ear D will "e the di%idend in \ear 3 times one plus the growth rate, or0
ED G E4

.>.34/
3
.>.>8/
The stoc, "egins constant growth in \ear D, so we can find the price of the stoc, in \ear D as the
di%idend in \ear 9, di%ided "! the re&uired return minus the growth rate. The e&uation for the price
of the stoc, in \ear D is0
+D G ED

.> L g/ - .< @ g/
?ow we can su"stitute the pre%ious di%idend in \ear D into this e&uation as follows0
+D G E4

.> L g)/
3

.> L g./ .> L g0/ - .< @ g0/
+D G E4

.>.34/
3

.>.>8/ .>.48/ - ..>D @ .48/ G DH.HHE4
When we sol%e this e&uation, we find that the stoc, price in \ear D is DH.HH times as large as the
di%idend toda!. ?ow we need to find the e&uation for the stoc, price toda!. The stoc, price toda! is
the +X of the di%idends in \ears >, 6, 3, and D, plus the +X of the \ear D price. So0
+4 G E4.>.34/->.>D L E4.>.34/
6
->.>D
6
L E4.>.34/
3
->.>D
3
L E4.>.34/
3
.>.>8/->.>D
D
L DH.HHE4->.>D
D
We can factor out E4 in the e&uation, and com"ine the last two terms. Eoing so, we get0
+4 G Rs.I4.44 G E4Z>.34->.>D L >.34
6
->.>D
6
L >.34
3
->.>D
3
L N.>.34/
3
.>.>8/ L DH.HHO - >.>D
D
[
Reducing the e&uation e%en further "! sol%ing all of the terms in the "races, we get0
Rs.I4 G Rs.33.4DE4
E4 G Rs.I4.44 - Rs.33.4D G Rs.6.>6
This is the di%idend toda!, so the pro:ected di%idend for the ne#t !ear will "e0
E> G Rs.6.>6.>.34/ G Rs.6.I9
109
SOLUTIONS
19. We are gi%en the stoc, price, the di%idend growth rate, and the re&uired return, and are as,ed to find
the di%idend. <sing the constant di%idend growth model, we get0
+4 G 294 G E4

.> L g/ - .< @ g/
Sol%ing this e&uation for the di%idend gi%es us0
E4 G 294..>D @ .48/ - .>.48/ G 26.I8
20. The price of a share of preferred stoc, is the di%idend pa!ment di%ided "! the re&uired return. We
,now the di%idend pa!ment in \ear H, so we can find the price of the stoc, in \ear 9, one !ear
"efore the first di%idend pa!ment. Eoing so, we get0
+9 G BJ.44 - .4I G B>68.9I
The price of the stoc, toda! is the +X of the stoc, price in the future, so the price toda! will "e0
+4 G B>68.9I - .>.4I/
9
G BJ>.HI
21. If the compan!s earnings are declining at a constant rate, the di%idends will decline at the same rate
since the di%idends are assumed to "e a constant percentage of income. The di%idend ne#t !ear will
"e less than this !ears di%idend, so
+4 G E4

.> L g/ - .< @ g/ G 9.44.> @ .>4/ - N..>D @ .@.>4/O G >8.I9
22. 5ere we ha%e a stoc, pa!ing a constant di%idend for a fi#ed period, and an increasing di%idend
thereafter. We need to find the present %alue of the two different cash flows using the appropriate
&uarterl! interest rate. The constant di%idend is an annuit!, so the present %alue of these di%idends is0
+X) G '.+XI;)<#t/
+X) G V>,444.+XI;)6.9K,>6/
+X) G V>4,69I.IH
?ow we can find the present %alue of the di%idends "e!ond the constant di%idend phase. <sing the
present %alue of a growing annuit! e&uation, we find0
+>6 G E>3 - .< @ g/
+>6 G V>,444 .> L .449/ - ..469 @ .449/
+>6 G V94,694
This is the price of the stoc, immediatel! after it has paid the last constant di%idend. So, the present
%alue of the future price is0
+X G V94,694 - .> L .469/
>6
+X G V3I,3H3.H8
The price toda! is the sum of the present %alue of the two cash flows, so0
+4 G V>4,69I.IH L 3I,3H3.H8
+4 G VDI,H6>.D9
B-110
CHAPTER 5 B-
23. We can find the price of the stoc, in \ear D when it "egins a constant increase in di%idends using the
growing perpetuit! e&uation. So, the price of the stoc, in \ear D, immediatel! after the di%idend
pa!ment, is0
+D G ED.> L g/ - .< @ g/
+D G 26.> L .4H/ - ..>H @ .4H/
+D G 26>.64
The stoc, price toda! is the sum of the present %alue of the two fi#ed di%idends plus the present
%alue of the future price, so0
+4 G 26 - .> L .>H/
3
L 26 - .> L .>H/
D
L 26>.64 - .> L .>H/
D
+4 G 2>D.4J
24. 5ere we need to find the di%idend ne#t !ear for a stoc, with nonconstant growth. We ,now the stoc,
price, the di%idend growth rates, and the re&uired return, "ut not the di%idend. ;irst, we need to
realie that the di%idend in \ear 3 is the constant di%idend times the ;XI;. The di%idend in \ear 3
will "e0
E3 G E.>.4D/
The e&uation for the stoc, price will "e the present %alue of the constant di%idends, plus the present
%alue of the future stoc, price, or0
+4 G E - >.>3 L E ->.>3
6
L E.>.4D/-..>3 @ .4D/->.>3
6
=34 G E - >.>3 L E ->.>3
6
L E.>.4D/-..>3 @ .4D/->.>3
6
We can factor out E4 in the e&uation, and com"ine the last two terms. Eoing so, we get0
=34 G EZ>->.>3 L >->.>3
6
L N.>.4D/-..>3 @ .4D/O - >.>3
6
[
Reducing the e&uation e%en further "! sol%ing all of the terms in the "races, we get0
=34 G E.>4.I>I8/
E G =34 - >4.I>I8 G =6.84
25. The re&uired return of a stoc, consists of two components, the capital gains !ield and the di%idend
!ield. In the constant di%idend growth model .growing perpetuit! e&uation/, the capital gains !ield is
the same as the di%idend growth rate, or alge"raicall!0
< G E>-+4 L g
111
SOLUTIONS
We can find the di%idend growth rate "! the growth rate e&uation, or0
g G R'E Q b
g G .>> Q .I9
g G .4869 or 8.69K
This is also the growth rate in di%idends. To find the current di%idend, we can use the information
pro%ided a"out the net income, shares outstanding, and pa!out ratio. The total di%idends paid is the
net income times the pa!out ratio. To find the di%idend per share, we can di%ide the total di%idends
paid "! the num"er of shares outstanding. So0
Ei%idend per share G .?et income Q +a!out ratio/ - Shares outstanding
Ei%idend per share G .V>4,444,444 Q .69/ - >,694,444
Ei%idend per share G V6.44
?ow we can use the initial e&uation for the re&uired return. We must remem"er that the e&uation
uses the di%idend in one !ear, so0
< G E>-+4 L g
< G V6.> L .4869/-VD4 L .4869
< G .>3HH or >3.HHK
26. ;irst, we need to find the annual di%idend growth rate o%er the past four !ears. To do this, we can
use the future %alue of a lump sum e&uation, and sol%e for the interest rate. Eoing so, we find the
di%idend growth rate o%er the past four !ears was0
;X G +X.> L </
t
R>.HH G R4.J4.> L </
D
< G .R>.HH - R4.J4/
>-D
@ >
< G .>H9D or >H.9DK
We ,now the di%idend will grow at this rate for fi%e !ears "efore slowing to a constant rate
indefinitel!. So, the di%idend amount in se%en !ears will "e0
EI G E4.> L g>/
9
.> L g6/
6
EI G R>.HH.> L .>H9D/
9
.> L .48/
6
EI G RD.>H
27. a. We can find the price of the all the outstanding compan! stoc, "! using the di%idends the same
wa! we would %alue an indi%idual share. Since earnings are e&ual to di%idends, and there is no
growth, the %alue of the compan!s stoc, toda! is the present %alue of a perpetuit!, so0
+ G E - <
+ G 2844,444 - .>9
+ G 29,333,333.33
B-112
CHAPTER 5 B-
The price*earnings ratio is the stoc, price di%ided "! the current earnings, so the price*earnings
ratio of each compan! with no growth is0
+-E G +rice - Earnings
+-E G 29,333,333.33 - 2844,444
+-E G H.HI times
b. Since the earnings ha%e increased, the price of the stoc, will increase. The new price of the all
the outstanding compan! stoc, is0
+ G E - <
+ G .2844,444 L >44,444/ - .>9
+ G 2H,444,444.44
The price*earnings ratio is the stoc, price di%ided "! the current earnings, so the price*earnings
with the increased earnings is0
+-E G +rice - Earnings
+-E G 2H,444,444 - 2844,444
+-E G I.94 times
c. Since the earnings ha%e increased, the price of the stoc, will increase. The new price of the all
the outstanding compan! stoc, is0
+ G E - <
+ G .2844,444 L 644,444/ - .>9
+ G 2H,HHH,HHH.HI
The price*earnings ratio is the stoc, price di%ided "! the current earnings, so the price*earnings
with the increased earnings is0
+-E G +rice - Earnings
+-E G 2H,HHH,HHH.HI - 2844,444
+-E G 8.33 times
28. a. If the compan! does not ma,e an! new in%estments, the stoc, price will "e the present %alue of
the constant perpetual di%idends. In this case, all earnings are paid di%idends, so, appl!ing the
perpetuit! e&uation, we get0
+ G Ei%idend - R
+ G Ca2I - .>6
+ G Ca298.33
b. The in%estment is a one*time in%estment that creates an increase in E+S for two !ears. To
calculate the new stoc, price, we need the cash cow price plus the ?+XR'. In this case, the
?+XR' is simpl! the present %alue of the in%estment plus the present %alue of the increases in
E+S. S', the ?+XR' will "e0
?+XR' G C> - .> L R/ L C6 - .> L R/
6
L C3 - .> L R/
3
?+XR' G @Ca2>.I9 - >.>6 L Ca2>.J4 - >.>6
6
L Ca26.>4 - >.>6
3
?+XR' G Ca2>.D9
113
SOLUTIONS
So, the price of the stoc, if the compan! underta,es the in%estment opportunit! will "e0
+ G Ca298.33 L >.D9
+ G Ca29J.I8
c. )fter the pro:ect is o%er, and the earnings increase no longer e#ists, the price of the stoc, will
re%ert "ac, to Ca298.33, the %alue of the compan! as a cash cow.
29. a. The price of the stoc, is the present %alue of the di%idends. Since earnings are e&ual to
di%idends, we can find the present %alue of the earnings to calculate the stoc, price. )lso, since
we are e#cluding ta#es, the earnings will "e the re%enues minus the costs. We simpl! need to
find the present %alue of all future earnings to find the price of the stoc,. The present %alue of
the re%enues is0
+XRe%enue G '> - .< @ g/
+XRe%enue G )u23,444,444.> L .49/ - ..>9 @ .49/
+XRe%enue G )u23>,944,444
)nd the present %alue of the costs will "e0
+XCosts G '> - .< @ g/
+XCosts G )u2>,944,444.> L .49/ - ..>9 @ .49/
+XCosts G )u2>9,I94,444
So, the present %alue of the compan!s earnings and di%idends will "e0
+XEi%idends G )u23>,944,444 @ >9,I94,444
+XEi%idends G )u2>9,I94,444
?ote that since re%enues and costs increase at the same rate, we could ha%e found the present
%alue of future di%idends as the present %alue of current di%idends. Eoing so, we find0
E4 G Re%enue4 @ Costs4
E4 G )u23,444,444 @ >,944,444
E4 G )u2>,944,444
?ow, appl!ing the growing perpetuit! e&uation, we find0
+XEi%idends G '> - .< @ g/
+XEi%idends G )u2>,944,444.> L .49/ - ..>9 @ .49/
+XEi%idends G )u2>9,I94,444
This is the same answer we found pre%iousl!. The price per share of stoc, is the total %alue of
the compan!s stoc, di%ided "! the shares outstanding, or0
+ G Xalue of all stoc, - Shares outstanding
+ G )u2>9,I94,444 - >,444,444
+ G )u2>9.I9
B-114
CHAPTER 5 B-
b. The %alue of a share of stoc, in a compan! is the present %alue of its current operations, plus
the present %alue of growth opportunities. To find the present %alue of the growth opportunities,
we need to discount the cash outla! in \ear > "ac, to the present, and find the %alue toda! of
the increase in earnings. The increase in earnings is a perpetuit!, which we must discount "ac,
to toda!. So, the %alue of the growth opportunit! is0
?+XR' G C4 L C> - .> L </ L .C6 - </ - .> L </
?+XR' G @)u2>9,444,444 @ )u29,444,444 - .> L .>9/ L .)u2H,444,444 - .>9/ - .> L .>9/
?+XR' G )u2>9,D3D,I86.H>
To find the %alue of the growth opportunit! on a per share "asis, we must di%ide this amount "!
the num"er of shares outstanding, which gi%es us0
?+XR'+er share G )u2>9,D3D,I86.H> - )u2>,444,444
?+XR'+er share G )u2>9.D3
The stoc, price will increase "! )u2>9.D3 per share. The new stoc, price will "e0
?ew stoc, price G )u2>9.I9 L >9.D3
?ew stoc, price G )u23>.>8
30. a. If the compan! continues its current operations, it will not grow, so we can %alue the compan!
as a cash cow. The total %alue of the compan! as a cash cow is the present %alue of the future
earnings, which are a perpetuit!, so0
Cash cow %alue of compan! G ' - <
Cash cow %alue of compan! G >>4,444,444 - .>9
Cash cow %alue of compan! G I33,333,333.33
The %alue per share is the total %alue of the compan! di%ided "! the shares outstanding, so0
Share price G I33,333,333.33 - 64,444,444
Share price G 3H.HI
b. To find the %alue of the in%estment, we need to find the ?+X of the growth opportunities. The
initial cash flow occurs toda!, so it does not need to "e discounted. The earnings growth is a
perpetuit!. <sing the present %alue of a perpetuit! e&uation will gi%e us the %alue of the
earnings growth one period from toda!, so we need to discount this "ac, to toda!. The ?+XR'
of the in%estment opportunit! is0
?+XR' G C4 L C> L .C6 - R/ - .> L R/
?+XR' G @>6,444,444 @ I,444,444 L .>4,444,444 - .>9/ - .> L .>9/
?+XR' G 3J,88D,49I.JI
115
SOLUTIONS
c. The price of a share of stoc, is the cash cow %alue plus the ?+XR'. We ha%e alread!
calculated the ?+XR' for the entire pro:ect, so we need to find the ?+XR' on a per share
"asis. The ?+XR' on a per share "asis is the ?+XR' of the pro:ect di%ided "! the shares
outstanding, which is0
?+XR' per share G 3J,88D,49I.JI - 64,444,444
?+XR' per share G >.JJ
This means the per share stoc, price if the compan! underta,es the pro:ect is0
Share price G Cash cow price L ?+XR' per share
Share price G 3H.HI L >.JJ
Share price G 38.HH
31. a. If the compan! does not ma,e an! new in%estments, the stoc, price will "e the present %alue of
the constant perpetual di%idends. In this case, all earnings are paid as di%idends, so, appl!ing
the perpetuit! e&uation, we get0
+ G Ei%idend - R
+ G =9 - .>D
+ G =39.I>
b. The in%estment occurs e%er! !ear in the growth opportunit!, so the opportunit! is a growing
perpetuit!. So, we first need to find the growth rate. The growth rate is0
g G Retention Ratio Return on Retained Earnings
g G 4.69 Q 4.D4
g G 4.>4 or >4K
?e#t, we need to calculate the ?+X of the in%estment. Euring !ear 3, twent!*fi%e percent of
the earnings will "e rein%ested. Therefore, =>.69 is in%ested .=9 .69/. 'ne !ear later, the
shareholders recei%e a D4 percent return on the in%estment, or =4.94 .=>.69 Q .D4/, in
perpetuit!. The perpetuit! formula %alues that stream as of !ear 3. Since the in%estment
opportunit! will continue indefinitel! and grows at >4 percent, appl! the growing perpetuit!
formula to calculate the ?+X of the in%estment as of !ear 6. Eiscount that %alue "ac, two
!ears to toda!.
?+XR' G N.In%estment L Return - </ - .< @ g/O - .> L </
6
?+XR' G N.@=>.69 L =4.94 - .>D/ - .4.>D @ 4.>/O - .>.>D/
6
?+XR' G =DD.HH
The %alue of the stoc, is the +X of the firm without ma,ing the in%estment plus the ?+X of the
in%estment, or0
+ G +X.E+S/ L ?+XR'
+ G =39.I> L =DD.HH
+ G =84.3I
B-116
CHAPTER 5 B-
'hallenge
32. To find the capital gains !ield and the current !ield, we need to find the price of the "ond. The
current price of Aond + and the price of Aond + in one !ear is0
+0 +4 G 2>44.+XI;)8K,9/ L 2>,444.+XI;8K,9/ G 2>,4IJ.89
+> G 2>44.+XI;)8K,D/ L 2>,444.+XI;8K,D/ G 2>,4HH.6D
Current !ield G 2>44 - 2>,4IJ.89 G J.6HK
The capital gains !ield is0
Capital gains !ield G .?ew price @ 'riginal price/ - 'riginal price
Capital gains !ield G .2>,4HH.6D @ >,4IJ.89/ - 2>,4IJ.89 G @>.6HK
The current price of Aond E and the price of Aond E in one !ear is0
E0 +4 G 2H4.+XI;)8K,9/ L 2>,444.+XI;8K,9/ G 2J64.>9
+> G 2H4.+XI;)8K,D/ L 2>,444.+XI;8K,D/ G 2J33.IH
Current !ield G 2H4 - 2J64.>9 G H.96K
Capital gains !ield G .2J33.IH @ J64.>9/ - 2J64.>9 G L>.D8K
)ll else held constant, premium "onds pa! high current income while ha%ing price depreciation as
maturit! nears( discount "onds do not pa! high current income "ut ha%e price appreciation as
maturit! nears. ;or either "ond, the total return is still 8K, "ut this return is distri"uted differentl!
"etween current income and capital gains.
33. a. The rate of return !ou e#pect to earn if !ou purchase a "ond and hold it until maturit! is the
\T$. The "ond price e&uation for this "ond is0
+4 G V>,>94 G V84.+XI;)<+,>4/ L V>,444.+XI; <+,>4/
<sing a spreadsheet, financial calculator, or trial and error we find0
< G \T$ G 9.JIK
b. To find our 5+\, we need to find the price of the "ond in two !ears. The price of the "ond in
two !ears, at the new interest rate, will "e0
+6 G V84.+XI;)D.JIK,8/ L V>,444.+XI;D.JIK,8/ G V>,>JH.D>
117
SOLUTIONS
To calculate the 5+\, we need to find the interest rate that e&uates the price we paid for the
"ond with the cash flows we recei%ed. The cash flows we recei%ed were V84 each !ear for two
!ears, and the price of the "ond when we sold it. The e&uation to find our 5+\ is0
+4 G V>,>94 G V84.+XI;)<+,6/ L V>,>JH.D>.+XI;<+,6/
Sol%ing for <, we get0
< G 5+\ G 8.8JK
The realied 5+\ is greater than the e#pected \T$ when the "ond was "ought "ecause interest
rates dropped "! > percent( "ond prices rise when !ields fall.
34. The price of an! "ond .or financial instrument/ is the +X of the future cash flows. E%en though Aond
$ ma,es different coupons pa!ments, to find the price of the "ond, we :ust find the +X of the cash
flows. The +X of the cash flows for Aond $ is0
+$ G B>,644.+XI;)9K,>H/.+XI;9K,>6/ L B>,944.+XI;)9K,>6/.+XI;9K,68/ L B64,444.+XI;9K,D4/
+$ G B>3,DID.64
?otice that for the coupon pa!ments of B>,944, we found the +X) for the coupon pa!ments, and
then discounted the lump sum "ac, to toda!.
Aond ? is a ero coupon "ond with a B64,444 par %alue( therefore, the price of the "ond is the +X of
the par, or0
+? G B64,444.+XI;9K,D4/ G B6,8D4.J>
35. We are as,ed to find the di%idend !ield and capital gains !ield for each of the stoc,s. )ll of the
stoc,s ha%e a >9 percent re&uired return, which is the sum of the di%idend !ield and the capital gains
!ield. To find the components of the total return, we need to find the stoc, price for each stoc,.
<sing this stoc, price and the di%idend, we can calculate the di%idend !ield. The capital gains !ield
for the stoc, will "e the total return .re&uired return/ minus the di%idend !ield.
W0 +4 G E4.> L g/ - .< @ g/ G 2D.94.>.>4/-..>9 @ .>4/ G 2JJ.44
Ei%idend !ield G E>-+4 G D.94.>.>4/-JJ.44 G 9K
Capital gains !ield G .>9 @ .49 G >4K
U0 +4 G E4.> L g/ - .< @ g/ G 2D.94-..>9 @ 4/ G 234.44
Ei%idend !ield G E>-+4 G D.94-34.44 G >9K
Capital gains !ield G .>9 @ .>9 G 4K
\0 +4 G E4.> L g/ - .< @ g/ G 2D.94.> @ .49/-..>9 L .49/ G 26>.38
Ei%idend !ield G E>-+4 G D.94.4.J9/-6>.38 G 64K
Capital gains !ield G .>9 @ .64 G @ 9K
B-118
CHAPTER 5 B-
b0 +6 G E6.> L g/ - .< @ g/ G E4.> L g)/
6
.> L g./-.< @ g/ G 2D.94.>.64/
6
.>.>6/-..>9 @ .>6/ G 26D>.J6
+4 G 2D.94 .>.64/ - .>.>9/ L 2D.94 .>.64/
6
- .>.>9/
6
L 26D>.J6 - .>.>9/
6
G 2>J6.96
Ei%idend !ield G E>-+4 G 2D.94.>.64/-2>J6.96 G 6.8K
Capital gains !ield G .>9 @ .468 G >6.6K
In all cases, the re&uired return is >9K, "ut the return is distri"uted differentl! "etween current
income and capital gains. 5igh*growth stoc,s ha%e an apprecia"le capital gains component "ut a
relati%el! small current income !ield( con%ersel!, mature, negati%e*growth stoc,s pro%ide a high
current income "ut also price depreciation o%er time.
36. a. <sing the constant growth model, the price of the stoc, pa!ing annual di%idends will "e0
+4 G E4.> L g/ - .< @ g/ G =3.44.>.4H/-..>D @ .4H/ G =3J.I9
b. If the compan! pa!s &uarterl! di%idends instead of annual di%idends, the &uarterl! di%idend
will "e one*fourth of annual di%idend, or0
Yuarterl! di%idend0 =3.44.>.4H/-D G =4.IJ9
To find the e&ui%alent annual di%idend, we must assume that the &uarterl! di%idends are
rein%ested at the re&uired return. We can then use this interest rate to find the e&ui%alent annual
di%idend. In other words, when we recei%e the &uarterl! di%idend, we rein%est it at the re&uired
return on the stoc,. So, the effecti%e &uarterl! rate is0
Effecti%e &uarterl! rate0 >.>D
.69
@ > G .4333
The effecti%e annual di%idend will "e the ;X) of the &uarterl! di%idend pa!ments at the
effecti%e &uarterl! re&uired return. In this case, the effecti%e annual di%idend will "e0
Effecti%e E> G =4.IJ9.;XI;)3.33K,D/ G =3.3D
?ow, we can use the constant growth model to find the current stoc, price as0
+4 G =3.3D-..>D @ .4H/ G =D>.I8
?ote that we can not simpl! find the &uarterl! effecti%e re&uired return and growth rate to find
the %alue of the stoc,. This would assume the di%idends increased each &uarter, not each !ear.
37. a. If the compan! does not ma,e an! new in%estments, the stoc, price will "e the present %alue of
the constant perpetual di%idends. In this case, all earnings are paid di%idends, so, appl!ing the
perpetuit! e&uation, we get0
+ G Ei%idend - R
+ G Ca2H - .>D
+ G Ca2D6.8H
119
SOLUTIONS
b. The in%estment occurs e%er! !ear in the growth opportunit!, so the opportunit! is a growing
perpetuit!. So, we first need to find the growth rate. The growth rate is0
g G Retention Ratio Return on Retained Earnings
g G 4.34 Q 4.>6
g G 4.43H or 3.H4K
?e#t, we need to calculate the ?+X of the in%estment. Euring !ear 3, 34 percent of the
earnings will "e rein%ested. Therefore, Ca2>.84 is in%ested .Ca2H .34/. 'ne !ear later, the
shareholders recei%e a >6 percent return on the in%estment, or Ca24.6>H .Ca2>.84 Q .>6/, in
perpetuit!. The perpetuit! formula %alues that stream as of !ear 3. Since the in%estment
opportunit! will continue indefinitel! and grows at 3.H percent, appl! the growing perpetuit!
formula to calculate the ?+X of the in%estment as of !ear 6. Eiscount that %alue "ac, two
!ears to toda!.
?+XR' G N.In%estment L Return - R/ - .R @ g/O - .> L R/
6
?+XR' G N.@Ca2>.84 L Ca24.6>H - .>D/ - .4.>D @ 4.43H/O - .>.>D/
6
?+XR' G @Ca2>.J4
The %alue of the stoc, is the +X of the firm without ma,ing the in%estment plus the ?+X of the
in%estment, or0
+ G +X.E+S/ L ?+XR'
+ G Ca2D6.8H @ >.J4
+ G Ca2D4.J9
c. bero percent_ There is no retention ratio which would ma,e the pro:ect profita"le for the
compan!. If the compan! retains more earnings, the growth rate of the earnings on the
in%estment will increase, "ut the pro:ect will still not "e profita"le. Since the return of the
pro:ect is less than the re&uired return on the compan! stoc,, the pro:ect is ne%er worthwhile. In
fact, the more the compan! retains and in%ests in the pro:ect, the less %alua"le the stoc,
"ecomes.
38. 5ere we ha%e a stoc, with supernormal growth "ut the di%idend growth changes e%er! !ear for the
first four !ears. We can find the price of the stoc, in \ear 3 since the di%idend growth rate is
constant after the third di%idend. The price of the stoc, in \ear 3 will "e the di%idend in \ear D,
di%ided "! the re&uired return minus the constant di%idend growth rate. So, the price in \ear 3 will
"e0
+3 G )u23.94.>.64/.>.>9/.>.>4/.>.49/ - ..>3 @ .49/ G )u2HJ.I3
The price of the stoc, toda! will "e the +X of the first three di%idends, plus the +X of the stoc, price
in \ear 3, so0
+4 G )u23.94.>.64/-.>.>3/ L )u23.94.>.64/.>.>9/->.>3
6
L )u23.94.>.64/.>.>9/.>.>4/->.>3
3
L
)u2HJ.I3->.>3
3

+4 G )u29J.9>
B-120
CHAPTER 5 B-
39. 5ere we want to find the re&uired return that ma,es the +X of the di%idends e&ual to the current
stoc, price. The e&uation for the stoc, price is0
+ G )u23.94.>.64/-.> L </ L )u23.94.>.64/.>.>9/-.> L </
6
L )u23.94.>.64/.>.>9/.>.>4/-.> L </
3
L N)u23.94.>.64/.>.>9/.>.>4/.>.49/-.< @ .49/O-.> L </
3
G )u2J8.H9
We need to find the roots of this e&uation. <sing spreadsheet, trial and error, or a calculator with a
root sol%ing function, we find that0
< G J.89K
40. In this pro"lem, growth is occurring from two different sources0 The learning cur%e and the new
pro:ect. We need to separatel! compute the %alue from the two difference sources. ;irst, we will
compute the %alue from the learning cur%e, which will increase at 9 percent. )ll earnings are paid
out as di%idends, so we find the earnings per share are0
E+S G Earnings-total num"er of outstanding shares
E+S G .>4,444,444 Q >.49/ - >4,444,444
E+S G >.49
;rom the ?+XR' mode0
+ G E-., @ g/ L ?+XR'
+ G >.49-.4.>4 @ 4.49/ L ?+XR'
+ G 6> L ?+XR'
?ow we can compute the ?+XR' of the new pro:ect to "e launched two !ears from now. The
earnings per share two !ears from now will "e0
E+S6 G >.44.> L .49/
6

E+S6 G >.>469
Therefore, the initial in%estment in the new pro:ect will "e0
Initial in%estment G .64.>.>469/
Initial in%estment G 4.66
The earnings per share of the new pro:ect is a perpetuit!, with an annual cash flow of0
Increased E+S from pro:ect G 9,444,444 - >4,444,444 shares
Increased E+S from pro:ect G 4.94
So, the %alue of all future earnings in !ear 6, one !ear "efore the compan! realies the earnings, is0
+X G 4.94 - .>4
+X G 9.44
?ow, we can find the ?+XR' per share of the in%estment opportunit! in !ear 6, which will "e0
?+XR'6 G @4.66 L 9.44
?+XR'6 G D.I8
121
SOLUTIONS
The %alue of the ?+XR' toda! will "e0
?+XR' G D.I8 - .> L .>4/
6
?+XR' G 3.J9
+lugging in the ?+XR' model we get(
+ G 6> L 3.J9
+ G 6D.J9
?ote that !ou could also %alue the compan! and the pro:ect with the %alues gi%en, and then di%ide
the final answer "! the shares outstanding. The final answer would "e the same.
B-122
CHAPTER 5, APPENDIX
THE TERM STRUCTURE OF INTEREST
RATES, SPOT RATES, AND YIELD TO
MATURITY
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
1. a. The present %alue of an! coupon "ond is the present %alue of its coupon pa!ments and face
%alue. $atch each cash flow with the appropriate spot rate. ;or the cash flow that occurs at the
end of the first !ear, use the one*!ear spot rate. ;or the cash flow that occurs at the end of the
second !ear, use the two*!ear spot rate. Eoing so, we find the price of the "ond is0
+ G C> - .> L r>/ L .C6 L ;/ - .> L r6/
6

+ G 2H4 - .>.48/ L .2H4 L >,444/ - .>.>4/
6
+ G 2J3>.9J
b. The !ield to the maturit! is the discount rate, , which sets the cash flows e&ual to the price of
the "ond. So, the \T$ is0
+ G C> - .> L / L .C6 L ;/ - .> L /
6

2J3>.9J G 2H4 - .> L / L .2H4 L >,444/ - .> L /
6
G .4JJD or J.JDK
2. The present %alue of an! coupon "ond is the present %alue of its coupon pa!ments and face %alue.
$atch each cash flow with the appropriate spot rate.
+ G C> - .> L r>/ L .C6 L ;/ - .> L r6/
6

+ G 294 - .>.>>/ L .294 L >,444/ - .>.48/
6
+ G 2JD9.69
3. )ppl! the forward rate formula to calculate the one*!ear rate o%er the second !ear.
.> L r>/.> L f6/ G .> L r6/
6
.>.4I/.> L f6/ G .>.489/
6
f6 G .>446 or >4.46K
SOLUTIONS
4. a. We appl! the forward rate formula to calculate the one*!ear forward rate o%er the second !ear.
Eoing so, we find0
.> L r>/.> L f6/ G .> L r6/
6
.>.4D/.> L f6/ G .>.499/
6
f6 G .4I46 or I.46K
b. We appl! the forward rate formula to calculate the one*!ear forward rate o%er the third !ear.
Eoing so, we find0
.> L r6/
6
.> L f3/ G .> L r3/
3
.>.499/
6
.> L f3/ G .>.4H9/
3
f3 G .4893 or 8.93K
5. The spot rate for !ear > is the same as forward rate for !ear >, or D.9 percent. To find the two !ear
spot rate, we can use the forward rate e&uation0
.> L r>/.> L f6/ G .> L r6/
6
r6 G N.> L r>/.> L f6/O
>-6
@ >
r6 G N.>.4D9/.>.4H/O
>-6
@ >
r6 G .4969 or 9.69K
6. Aased upon the e#pectation h!potheses, strateg! > and strateg! 6 will "e in e&uili"rium at0
.> L f>/ .> L f6/ G .> L r6/
6
That is, if the e#pected spot rate for 6 !ears is e&ual to the product of successi%e one !ear forward
rates. If the spot rate in !ear 6 is higher than implied "! f6 then strateg! > is "est. If the spot rate in
!ear 6 is lower than implied "! f6, strateg! > is "est.
B-124
CHAPTER 6
)1 %R1$1) -A671 A)8 091R
*)-1$.1) R761$
Answers to Concepts Review and Critical !in"in# Questions
1. )ssuming con%entional cash flows, a pa!"ac, period less than the pro:ects life means that the ?+X
is positi%e for a ero discount rate, "ut nothing more definiti%e can "e said. ;or discount rates greater
than ero, the pa!"ac, period will still "e less than the pro:ects life, "ut the ?+X ma! "e positi%e,
ero, or negati%e, depending on whether the discount rate is less than, e&ual to, or greater than the
IRR. The discounted pa!"ac, includes the effect of the rele%ant discount rate. If a pro:ects
discounted pa!"ac, period is less than the pro:ects life, it must "e the case that ?+X is positi%e.
2. )ssuming con%entional cash flows, if a pro:ect has a positi%e ?+X for a certain discount rate, then it
will also ha%e a positi%e ?+X for a ero discount rate( thus, the pa!"ac, period must "e less than the
pro:ect life. Since discounted pa!"ac, is calculated at the same discount rate as is ?+X, if ?+X is
positi%e, the discounted pa!"ac, period must "e less than the pro:ects life. If ?+X is positi%e, then
the present %alue of future cash inflows is greater than the initial in%estment cost( thus, +I must "e
greater than >. If ?+X is positi%e for a certain discount rate <, then it will "e ero for some larger
discount rate <c( thus, the IRR must "e greater than the re&uired return.
3. a. +a!"ac, period is simpl! the accounting "rea,*e%en point of a series of cash flows. To actuall!
compute the pa!"ac, period, it is assumed that an! cash flow occurring during a gi%en period is
realied continuousl! throughout the period, and not at a single point in time. The pa!"ac, is
then the point in time for the series of cash flows when the initial cash outla!s are full!
reco%ered. Ri%en some predetermined cutoff for the pa!"ac, period, the decision rule is to
accept pro:ects that pa! "ac, "efore this cutoff, and re:ect pro:ects that ta,e longer to pa! "ac,.
The worst pro"lem associated with the pa!"ac, period is that it ignores the time %alue of
mone!. In addition, the selection of a hurdle point for the pa!"ac, period is an ar"itrar!
e#ercise that lac,s an! steadfast rule or method. The pa!"ac, period is "iased towards short*
term pro:ects( it full! ignores an! cash flows that occur after the cutoff point.
b. The a%erage accounting return is interpreted as an a%erage measure of the accounting
performance of a pro:ect o%er time, computed as some a%erage profit measure attri"uta"le to
the pro:ect di%ided "! some a%erage "alance sheet %alue for the pro:ect. This te#t computes
))R as a%erage net income with respect to a%erage .total/ "oo, %alue. Ri%en some
predetermined cutoff for ))R, the decision rule is to accept pro:ects with an ))R in e#cess of
the target measure, and re:ect all other pro:ects. ))R is not a measure of cash flows or mar,et
%alue, "ut is rather a measure of financial statement accounts that often "ear little resem"lance
to the rele%ant %alue of a pro:ect. In addition, the selection of a cutoff is ar"itrar!, and the time
%alue of mone! is ignored. ;or a financial manager, "oth the reliance on accounting num"ers
rather than rele%ant mar,et data and the e#clusion of time %alue of mone! considerations are
trou"ling. Eespite these pro"lems, ))R continues to "e used in practice "ecause .>/ the
accounting information is usuall! a%aila"le, .6/ anal!sts often use accounting ratios to anal!e
SOLUTIONS
firm performance, and .3/ managerial compensation is often tied to the attainment of target
accounting ratio goals.
c. The IRR is the discount rate that causes the ?+X of a series of cash flows to "e identicall! ero.
IRR can thus "e interpreted as a financial "rea,*e%en rate of return( at the IRR discount rate,
the net %alue of the pro:ect is ero. The acceptance and re:ection criteria are0
If C4 d 4 and all future cash flows are positi%e, accept the pro:ect if the internal rate of
return is greater than or e&ual to the discount rate.
If C4 d 4 and all future cash flows are positi%e, re:ect the pro:ect if the internal rate of
return is less than the discount rate.
If C4 S 4 and all future cash flows are negati%e, accept the pro:ect if the internal rate of
return is less than or e&ual to the discount rate.
If C4 S 4 and all future cash flows are negati%e, re:ect the pro:ect if the internal rate of
return is greater than the discount rate.
IRR is the discount rate that causes ?+X for a series of cash flows to "e ero. ?+X is preferred
in all situations to IRR( IRR can lead to am"iguous results if there are non*con%entional cash
flows, and it also ma! am"iguousl! ran, some mutuall! e#clusi%e pro:ects. 5owe%er, for stand*
alone pro:ects with con%entional cash flows, IRR and ?+X are interchangea"le techni&ues.
d. The profita"ilit! inde# is the present %alue of cash inflows relati%e to the pro:ect cost. )s such,
it is a "enefit-cost ratio, pro%iding a measure of the relati%e profita"ilit! of a pro:ect. The
profita"ilit! inde# decision rule is to accept pro:ects with a +I greater than one, and to re:ect
pro:ects with a +I less than one. The profita"ilit! inde# can "e e#pressed as0 +I G .?+X L
cost/-cost G > L .?+X-cost/. If a firm has a "as,et of positi%e ?+X pro:ects and is su":ect to
capital rationing, +I ma! pro%ide a good ran,ing measure of the pro:ects, indicating the 1"ang
for the "uc,8 of each particular pro:ect.
e. ?+X is simpl! the present %alue of a pro:ects cash flows, including the initial outla!. ?+X
specificall! measures, after considering the time %alue of mone!, the net increase or decrease in
firm wealth due to the pro:ect. The decision rule is to accept pro:ects that ha%e a positi%e ?+X,
and re:ect pro:ects with a negati%e ?+X. ?+X is superior to the other methods of anal!sis
presented in the te#t "ecause it has no serious flaws. The method unam"iguousl! ran,s
mutuall! e#clusi%e pro:ects, and it can differentiate "etween pro:ects of different scale and time
horion. The onl! draw"ac, to ?+X is that it relies on cash flow and discount rate %alues that
are often estimates and thus not certain, "ut this is a pro"lem shared "! the other performance
criteria as well. ) pro:ect with ?+X G 26,944 implies that the total shareholder wealth of the
firm will increase "! 26,944 if the pro:ect is accepted.
4. ;or a pro:ect with future cash flows that are an annuit!0
+a!"ac, G I - C
)nd the IRR is0
4 G @ I L C - IRR
B-126
CHAPTER 6 B-
Sol%ing the IRR e&uation for IRR, we get0
IRR G C - I
?otice this is :ust the reciprocal of the pa!"ac,. So0
IRR G > - +A
;or long*li%ed pro:ects with relati%el! constant cash flows, the sooner the pro:ect pa!s "ac,, the
greater is the IRR, and the IRR is appro#imatel! e&ual to the reciprocal of the pa!"ac, period.
5. There are a num"er of reasons. Two of the most important ha%e to do with transportation costs and
e#change rates. $anufacturing in the <.S. places the finished product much closer to the point of
sale, resulting in significant sa%ings in transportation costs. It also reduces in%entories "ecause goods
spend less time in transit. 5igher la"or costs tend to offset these sa%ings to some degree, at least
compared to other possi"le manufacturing locations. 'f great importance is the fact that
manufacturing in the <.S. means that a much higher proportion of the costs are paid in dollars. Since
sales are in dollars, the net effect is to immunie profits to a large e#tent against fluctuations in
e#change rates. This issue is discussed in greater detail in the chapter on international finance.
6. The single "iggest difficult!, "! far, is coming up with relia"le cash flow estimates. Eetermining an
appropriate discount rate is also not a simple tas,. These issues are discussed in greater depth in the
ne#t se%eral chapters. The pa!"ac, approach is pro"a"l! the simplest, followed "! the ))R, "ut
e%en these re&uire re%enue and cost pro:ections. The discounted cash flow measures .discounted
pa!"ac,, ?+X, IRR, and profita"ilit! inde#/ are reall! onl! slightl! more difficult in practice.
7. \es, the! are. Such entities generall! need to allocate a%aila"le capital efficientl!, :ust as for*profits
do. 5owe%er, it is fre&uentl! the case that the 1re%enues8 from not*for*profit %entures are not
tangi"le. ;or e#ample, charita"le gi%ing has real opportunit! costs, "ut the "enefits are generall!
hard to measure. To the e#tent that "enefits are measura"le, the &uestion of an appropriate re&uired
return remains. +a!"ac, rules are commonl! used in such cases. ;inall!, realistic cost-"enefit
anal!sis along the lines indicated should definitel! "e used "! the <.S. go%ernment and would go a
long wa! toward "alancing the "udget_
8. The statement is false. If the cash flows of +ro:ect A occur earl! and the cash flows of +ro:ect )
occur late, then for a low discount rate the ?+X of ) can e#ceed the ?+X of A. '"ser%e the
following e#ample.
C4 C> C6 IRR ?+X ] 4K
+ro:ect ) @B>,444,444 B4 B>,DD4,444 64K BDD4,444
+ro:ect A @B6,444,444 B6,D44,444 B4 64K D44,444
5owe%er, in one particular case, the statement is true for e&uall! ris,! pro:ects. If the li%es of the
two pro:ects are e&ual and the cash flows of +ro:ect A are twice the cash flows of +ro:ect ) in e%er!
time period, the ?+X of +ro:ect A will "e twice the ?+X of +ro:ect ).
9. )lthough the profita"ilit! inde# .+I/ is higher for +ro:ect A than for +ro:ect ), +ro:ect ) should "e
chosen "ecause it has the greater ?+X. Confusion arises "ecause +ro:ect A re&uires a smaller
in%estment than +ro:ect ). Since the denominator of the +I ratio is lower for +ro:ect A than for
+ro:ect ), A can ha%e a higher +I !et ha%e a lower ?+X. 'nl! in the case of capital rationing could
the compan!s decision ha%e "een incorrect.
127
SOLUTIONS
10. a. +ro:ect ) would ha%e a higher IRR since initial in%estment for +ro:ect ) is less than that of
+ro:ect A, if the cash flows for the two pro:ects are identical.
b. \es, since "oth the cash flows as well as the initial in%estment are twice that of +ro:ect A.
11. +ro:ect As ?+X would "e more sensiti%e to changes in the discount rate. The reason is the time
%alue of mone!. Cash flows that occur further out in the future are alwa!s more sensiti%e to changes
in the interest rate. This sensiti%it! is similar to the interest rate ris, of a "ond.
12. The $IRR is calculated "! finding the present %alue of all cash outflows, the future %alue of all cash
inflows to the end of the pro:ect, and then calculating the IRR of the two cash flows. )s a result, the
cash flows ha%e "een discounted or compounded "! one interest rate .the re&uired return/, and then
the interest rate "etween the two remaining cash flows is calculated. )s such, the $IRR is not a true
interest rate. In contrast, consider the IRR. If !ou ta,e the initial in%estment, and calculate the future
%alue at the IRR, !ou can replicate the future cash flows of the pro:ect e#actl!.
13. The statement is incorrect. It is true that if !ou calculate the future %alue of all intermediate cash
flows to the end of the pro:ect at the re&uired return, then calculate the ?+X of this future %alue and
the initial in%estment, !ou will get the same ?+X. 5owe%er, ?+X sa!s nothing a"out rein%estment
of intermediate cash flows. The ?+X is the present %alue of the pro:ect cash flows. What is actuall!
done with those cash flows once the! are generated is not rele%ant. +ut differentl!, the %alue of a
pro:ect depends on the cash flows generated "! the pro:ect, not on the future %alue of those cash
flows. The fact that the rein%estment 1wor,s8 onl! if !ou use the re&uired return as the rein%estment
rate is also irrele%ant simpl! "ecause rein%estment is not rele%ant in the first place to the %alue of the
pro:ect.
'ne ca%eat0 'ur discussion here assumes that the cash flows are trul! a%aila"le once the! are
generated, meaning that it is up to firm management to decide what to do with the cash flows. In
certain cases, there ma! "e a re&uirement that the cash flows "e rein%ested. ;or e#ample, in
international in%esting, a compan! ma! "e re&uired to rein%est the cash flows in the countr! in
which the! are generated and not 1repatriate8 the mone!. Such funds are said to "e 1"loc,ed8 and
rein%estment "ecomes rele%ant "ecause the cash flows are not trul! a%aila"le.
14. The statement is incorrect. It is true that if !ou calculate the future %alue of all intermediate cash
flows to the end of the pro:ect at the IRR, then calculate the IRR of this future %alue and the initial
in%estment, !ou will get the same IRR. 5owe%er, as in the pre%ious &uestion, what is done with the
cash flows once the! are generated does not affect the IRR. Consider the following e#ample0
C4 C> C6 IRR
+ro:ect ) @2>44 2>4 2>>4 >4K
Suppose this 2>44 is a deposit into a "an, account. The IRR of the cash flows is >4 percent. Eoes
the IRR change if the \ear > cash flow is rein%ested in the account, or if it is withdrawn and spent on
pia7 ?o. ;inall!, consider the !ield to maturit! calculation on a "ond. If !ou thin, a"out it, the
\T$ is the IRR on the "ond, "ut no mention of a rein%estment assumption for the "ond coupons is
suggested. The reason is that rein%estment is irrele%ant to the \T$ calculation( in the same wa!,
rein%estment is irrele%ant in the IRR calculation. 'ur ca%eat a"out "loc,ed funds applies here as
well.
B-128
CHAPTER 6 B-
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. The pa!"ac, period is the time that it ta,es for the cumulati%e undiscounted cash inflows to
e&ual the initial in%estment.
+ro:ect )0
Cumulati%e cash flows \ear > G =D,444 G =D,444
Cumulati%e cash flows \ear 6 G =D,444 L3,944 G =I,944
+a!"ac, period G 6 !ears
+ro:ect A0
Cumulati%e cash flows \ear > G =6,944 G =6,944
Cumulati%e cash flows \ear 6 G =6,944 L >,644 G =3,I44
Cumulati%e cash flows \ear 3 G =6,944 L >,644 L 3,444 G =H,I44
Companies can calculate a more precise %alue using fractional !ears. To calculate the fractional
pa!"ac, period, find the fraction of !ear 3s cash flows that is needed for the compan! to ha%e
cumulati%e undiscounted cash flows of =9,444. Ei%ide the difference "etween the initial
in%estment and the cumulati%e undiscounted cash flows as of !ear 6 "! the undiscounted cash
flow of !ear 3.
+a!"ac, period G 6 L .=9,444 @ =3,I44/ - =3,444
+a!"ac, period G 6.D3
Since pro:ect ) has a shorter pa!"ac, period than pro:ect A has, the compan! should choose
pro:ect ).
b. Eiscount each pro:ects cash flows at >9 percent. Choose the pro:ect with the highest ?+X.
+ro:ect )0
?+X G @=I,944 L =D,444 - >.>9 L =3,944 - >.>9
6
L =>,944 - >.>9
3
?+X G @=388.JH
+ro:ect A0
?+X G @=9,444 L =6,944 - >.>9 L =>,644 - >.>9
6
L =3,444 - >.>9
3
?+X G =93.83
The firm should choose +ro:ect A since it has a higher ?+X than +ro:ect ) has.
129
SOLUTIONS
2. To calculate the pa!"ac, period, we need to find the time that the pro:ect has reco%ered its initial
in%estment. The cash flows in this pro"lem are an annuit!, so the calculation is simpler. If the initial
cost is =3,444, the pa!"ac, period is0
+a!"ac, G 3 L .=D84 - =8D4/ G 3.9I !ears
There is a shortcut to calculate the pa!"ac, period if the future cash flows are an annuit!. Just di%ide
the initial cost "! the annual cash flow. ;or the =3,444 cost, the pa!"ac, period is0
+a!"ac, G =3,444 - =8D4 G 3.9I !ears
;or an initial cost of =9,444, the pa!"ac, period is0
+a!"ac, G 9 L .=844 - =8D4/ G 9.J9 !ears
The pa!"ac, period for an initial cost of =I,644 is a little tric,ier. ?otice that the total cash inflows
after eight !ears will "e0
Total cash inflows G 8.=8D4/ G =H,I64
If the initial cost is =I,644, the pro:ect ne%er pa!s "ac,. ?otice that if !ou use the shortcut for
annuit! cash flows, !ou get0
+a!"ac, G =I,644 - =8D4 G 8.9I !ears.
This answer does not ma,e sense since the cash flows stop after eight !ears, so there is no pa!"ac,
period.
3. When we use discounted pa!"ac,, we need to find the %alue of all cash flows toda!. The %alue toda!
of the pro:ect cash flows for the first four !ears is0
Xalue toda! of \ear > cash flow G 2I,444->.>D G 2H,>D4.39
Xalue toda! of \ear 6 cash flow G 2I,944->.>D
6
G 29,II>.4>
Xalue toda! of \ear 3 cash flow G 28,444->.>D
3
G 29,3JJ.II
Xalue toda! of \ear D cash flow G 28,944->.>D
D
G 29,436.H8
To find the discounted pa!"ac,, we use these %alues to find the pa!"ac, period. The discounted first
!ear cash flow is 2H,>D4.39, so the discounted pa!"ac, for an 28,444 initial cost is0
Eiscounted pa!"ac, G > L .28,444 @ H,>D4.39/-29,II>.4> G >.36 !ears
;or an initial cost of 2>3,444, the discounted pa!"ac, is0
Eiscounted pa!"ac, G 6 L .2>3,444 @ H,>D4.39 @ 9,II>.4>/-29,3JJ.II G 6.64 !ears
?otice the calculation of discounted pa!"ac,. We ,now the pa!"ac, period is "etween two and three
!ears, so we su"tract the discounted %alues of the \ear > and \ear 6 cash flows from the initial cost.
This is the numerator, which is the discounted amount we still need to ma,e to reco%er our initial
in%estment. We di%ide this amount "! the discounted amount we will earn in \ear 3 to get the
fractional portion of the discounted pa!"ac,.
B-130
CHAPTER 6 B-
If the initial cost is 2>I,944, the discounted pa!"ac, is0
Eiscounted pa!"ac, G 3 L .2>I,944 @ H,>D4.39 @ 9,II>.4> @ 9,3JJ.II/ - 29,436.H8 G 3.4D !ears
4. To calculate the discounted pa!"ac,, discount all future cash flows "ac, to the present, and use these
discounted cash flows to calculate the pa!"ac, period. Eoing so, we find0
R G 4K0 V>,444,444 - V6>4,444 G D.IH !ears
Eiscounted pa!"ac, G Regular pa!"ac, G D.IH !ears
R G 9K0 V6>4,444->.49 L V6>4,444->.49
6
L V6>4,444->.49
3
L V6>4,444->.49
D
L V6>4,444->.49
9

G VJ4J,>J4.>4
V6>4,444->.49
H
G V>9H,I49.63
Eiscounted pa!"ac, G 9 L .V>,444,444 @ J4J,>J4.>4/ - V>9H,I49.63 G 9.98 !ears
R G >9K0 V6>4,444->.>9 L V6>4,444->.>9
6
L V6>4,444->.>9
3
L V6>4,444->.>9
D
L V6>4,444->.>9
9
L
V6>4,444->.>9
H
G VIJD,ID>.3I( The pro:ect ne%er pa!s "ac,.
5. a. The a%erage accounting return is the a%erage pro:ect earnings after ta#es, di%ided "! the
a%erage "oo, %alue, or a%erage net in%estment, of the machine during its life. The "oo, %alue
of the machine is the gross in%estment minus the accumulated depreciation.
)%erage "oo, %alue G .Aoo, %alue4 L Aoo, %alue> L Aoo, %alue6 L Aoo, %alue3 L
Aoo, %alueD L Aoo, %alue9/ - .Economic life/
)%erage "oo, %alue G .B>H,444 L >6,444 L 8,444 L D,444 L 4/ - .9 !ears/
)%erage "oo, %alue G B8,444
)%erage pro:ect earnings G BD,944
To find the a%erage accounting return, we di%ide the a%erage pro:ect earnings "! the a%erage
"oo, %alue of the machine to calculate the a%erage accounting return. Eoing so, we find0
)%erage accounting return G )%erage pro:ect earnings - )%erage "oo, %alue
)%erage accounting return G BD,944 - B8,444
)%erage accounting return G 4.9H69 or 9H.69K
6. ;irst, we need to determine the a%erage "oo, %alue of the pro:ect. The "oo, %alue is the gross
in%estment minus accumulated depreciation.
+urchase Eate \ear > \ear 6 \ear 3
Rross In%estment 8,444
8,444

8,444

8,444
Cess0 )ccumulated depreciation 4 D,444 H,944 8,444
?et In%estment 8,444
D,444

>,944
4
?ow, we can calculate the a%erage "oo, %alue as0
)%erage "oo, %alue G .8,444 L D,444 L >,944 L 4/ - .D !ears/
)%erage "oo, %alue G 3,3I9
131
SOLUTIONS
To calculate the a%erage accounting return, we must remem"er to use the afterta# a%erage net
income when calculating the a%erage accounting return. So, the a%erage afterta# net income is0
)%erage afterta# net income G .> @ tc/ )nnual preta# net income
)%erage afterta# net income G .> @ 4.34/ 6,444
)%erage afterta# net income G >,D44
The a%erage accounting return is the a%erage after*ta# net income di%ided "! the a%erage "oo, %alue,
which is0
)%erage accounting return G >,D44 - 3,3I9
)%erage accounting return G 4.D>D8 or D>.D8K
7. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero. So, the e&uation that defines
the IRR for this pro:ect is0
4 G C4 L C> - .> L IRR/ L C6 - .> L IRR/
6
L C3 - .> L IRR/
3
4 G @28,444 L 2D,444-.> L IRR/ L 23,444-.> L IRR/
6
L 26,444-.> L IRR/
3

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we find that0
IRR G H.J3K
Since the IRR is less than the re&uired return we would re:ect the pro:ect.
8. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero. So, the e&uation that defines
the IRR for this +ro:ect ) is0
4 G C4 L C> - .> L IRR/ L C6 - .> L IRR/
6
L C3 - .> L IRR/
3
4 G @ =6,444 L =>,444-.> L IRR/ L =>,944-.> L IRR/
6
L =6,444-.> L IRR/
3

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we find that0
IRR G DI.>9K
)nd the IRR for +ro:ect A is0
4 G C4 L C> - .> L IRR/ L C6 - .> L IRR/
6
L C3 - .> L IRR/
3
4 G @ =>,944 L =944-.> L IRR/ L =>,444-.> L IRR/
6
L =>,I94-.> L IRR/
3

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we find that0
IRR G D4.66K
9. The profita"ilit! inde# is defined as the +X of the cash inflows di%ided "! the +X of the cash
outflows. The cash flows from this pro:ect are an annuit!, so the e&uation for the profita"ilit! inde#
is0
+I G C.+XI;)R,t/ - C4
+I G Rs.D4,444.+XI;)>9K,I/ - Rs.>H4,444
+I G >.4D4>
B-132
CHAPTER 6 B-
10. a. The profita"ilit! inde# is the present %alue of the future cash flows di%ided "! the initial cost.
So, for +ro:ect )lpha, the profita"ilit! inde# is0
+I)lpha G N344 - >.>4 L I44 - >.>4
6
L H44 - >.>4
3
O - 944 G 6.H4D
)nd for +ro:ect Aeta the profita"ilit! inde# is0
+IAeta G N344 - >.>4 L >,844 - >.>4
6
L >,I44 - >.>4
3
O - 6,444 G >.9>J
b. )ccording to the profita"ilit! inde#, !ou would accept +ro:ect )lpha. 5owe%er, remem"er the
profita"ilit! inde# rule can lead to an incorrect decision when ran,ing mutuall! e#clusi%e
pro:ects.
&ntermediate
11. a. To ha%e a pa!"ac, e&ual to the pro:ects life, gi%en ' is a constant cash flow for ? !ears0
' G I-?
b. To ha%e a positi%e ?+X, I d ' .+XI;)<K, N/. Thus, ' S I - .+XI;)<K, N/.
c. Aenefits G ' .+XI;)<+# N/ G 6 Q costs G 6I
' G 6I - .+XI;)<+# N/
12. a. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero. So, the e&uation
that defines the IRR for this pro:ect is0
4 G C4 L C> - .> L IRR/ L C6 - .> L IRR/
6
L C3 - .> L IRR/
3
L CD - .> L IRR/
D
4 G B9,444 @ B6,944 - .> L IRR/ @ B6,344 - .> L IRR/
6
@ B>,444 - .> L IRR/
3

@ B>,444 - .> LIRR/
D
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR G >H.HJK
b. This pro"lem differs from pre%ious ones "ecause the initial cash flow is positi%e and all future
cash flows are negati%e. In other words, this is a financing*t!pe pro:ect, while pre%ious pro:ects
were in%esting*t!pe pro:ects. ;or financing situations, accept the pro:ect when the IRR is less
than the discount rate. Re:ect the pro:ect when the IRR is greater than the discount rate.
IRR G >H.HJK
Eiscount Rate G >9K
IRR S Eiscount Rate
Re:ect the offer when the discount rate is less than the IRR.
133
SOLUTIONS
c. <sing the same reason as part b., we would accept the pro:ect if the discount rate is 64 percent.
IRR G >H.HJK
Eiscount Rate G 64K
IRR d Eiscount Rate
)ccept the offer when the discount rate is greater than the IRR.
d. The ?+X is the sum of the present %alue of all cash flows, so the ?+X of the pro:ect if the
discount rate is >4 percent will "e0
?+X G B9,444 @ B6,944 - >.>9 @ B6,344 - >.>9
6
@ B>,444 - >.>9
3
@ B>,444 - >.>9
D
?+X G @B>D6.3>
When the discount rate is >9 percent, the ?+X of the offer is @B>D6.3>. Re:ect the offer.
)nd the ?+X of the pro:ect is the discount rate is 64 percent will "e0
?+X G B9,444 @ B6,944 - >.6 @ B6,344 - >.6
6
@ B>,444 - >.6
3
@ B>,444 - >.6
D
?+X G B698.DJ
When the discount rate is 64 percent, the ?+X of the offer is B698.DJ. )ccept the offer.
e. \es, the decisions under the ?+X rule are consistent with the choices made under the IRR rule
since the signs of the cash flows change onl! once.
13. a. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero. So, the IRR for
each pro:ect is0
Eeepwater ;ishing IRR0
4 G C4 L C> - .> L IRR/ L C6 - .> L IRR/
6
L C3 - .> L IRR/
3
4 G @Rs.H44,444 L Rs.6I4,444 - .> L IRR/ L Rs.394,444 - .> L IRR/
6
L Rs.344,444 - .> L IRR/
3
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR G 6D.34K
Su"marine Ride IRR0
4 G C4 L C> - .> L IRR/ L C6 - .> L IRR/
6
L C3 - .> L IRR/
3
4 G @Rs.>,844,444 L Rs.>,444,444 - .> L IRR/ L Rs.I44,444 - .> L IRR/
6
L Rs.J44,444 - .> L
IRR/
3
B-134
CHAPTER 6 B-
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR G 6>.DHK
Aased on the IRR rule, the deepwater fishing pro:ect should "e chosen "ecause it has the higher
IRR.
b. To calculate the incremental IRR, we su"tract the smaller pro:ects cash flows from the larger
pro:ects cash flows. In this case, we su"tract the deepwater fishing cash flows from the
su"marine ride cash flows. The incremental IRR is the IRR of these incremental cash flows. So,
the incremental cash flows of the su"marine ride are0
\ear 4 \ear > \ear 6 \ear 3
Su"marine Ride @
Rs.>,844,444
Rs.>,444,444 Rs.I44,444 Rs.J44,444
Eeepwater ;ishing @H44,444 6I4,444 394,444 344,444
Su"marine @ ;ishing @
Rs.>,644,444
Rs.I34,444 Rs.394,444 Rs.H44,444
Setting the present %alue of these incremental cash flows e&ual to ero, we find the incremental
IRR is0
4 G C4 L C> - .> L IRR/ L C6 - .> L IRR/
6
L C3 - .> L IRR/
3
4 G @Rs.>,644,444 L Rs.I34,444 - .> L IRR/ L Rs.394,444 - .> L IRR/
6
L Rs.H44,444 - .> L
IRR/
3
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
Incremental IRR G >J.J6K
;or in%esting*t!pe pro:ects, accept the larger pro:ect when the incremental IRR is greater than
the discount rate. Since the incremental IRR, >J.J6K, is greater than the re&uired rate of return
of >9 percent, choose the su"marine ride pro:ect. ?ote that this is the choice when e%aluating
onl! the IRR of each pro:ect. The IRR decision rule is flawed "ecause there is a scale pro"lem.
That is, the su"marine ride has a greater initial in%estment than does the deepwater fishing
pro:ect. This pro"lem is corrected "! calculating the IRR of the incremental cash flows, or "!
e%aluating the ?+X of each pro:ect.
c. The ?+X is the sum of the present %alue of the cash flows from the pro:ect, so the ?+X of each
pro:ect will "e0
Eeepwater fishing0
?+X G @Rs.H44,444 L Rs.6I4,444 - >.>9 L Rs.394,444 - >.>9
6
L Rs.344,444 - >.>9
3
?+X G Rs.JH,H8I.IH
135
SOLUTIONS
Su"marine ride0
?+X G @Rs.>,844,444 L Rs.>,444,444 - >.>9 L Rs.I44,444 - >.>9
6
L Rs.J44,444 - >.>9
3
?+X G Rs.>J4,H34.3J
Since the ?+X of the su"marine ride pro:ect is greater than the ?+X of the deepwater fishing
pro:ect, choose the su"marine ride pro:ect. The incremental IRR rule is alwa!s consistent with
the ?+X rule.
14. a. The profita"ilit! inde# is the +X of the future cash flows di%ided "! the initial in%estment. The
cash flows for "oth pro:ects are an annuit!, so0
+II G Ca2>9,444.+XI;)>4K,3 / - Ca234,444 G >.6D3
+III G Ca26,844.+XI;)>4K,3/ - Ca29,444 G >.3J3
The profita"ilit! inde# decision rule implies that we accept pro:ect II, since +III is greater than
the +II.
b. The ?+X of each pro:ect is0
?+XI G @ Ca234,444 L Ca2>9,444.+XI;)>4K,3/ G Ca2I,346.I8
?+XII G @ Ca29,444 L Ca26,844.+XI;)>4K,3/ G Ca2>,JH3.>J
The ?+X decision rule implies accepting +ro:ect I, since the ?+XI is greater than the ?+XII.
c. <sing the profita"ilit! inde# to compare mutuall! e#clusi%e pro:ects can "e am"iguous when
the magnitudes of the cash flows for the two pro:ects are of different scale. In this pro"lem,
pro:ect I is roughl! 3 times as large as pro:ect II and produces a larger ?+X, !et the profit*
a"ilit! inde# criterion implies that pro:ect II is more accepta"le.
15. a. The e&uation for the ?+X of the pro:ect is0
?+X G @ V68,444,444 L V93,444,444->.>6 @ V8,444,444->.>6
6
G V>6,JD3,8II.99
The ?+X is greater than 4, so we would accept the pro:ect.
b. The e&uation for the IRR of the pro:ect is0
4 G @V68,444,444 L V93,444,444-.>LIRR/ @ V8,444,444-.>LIRR/
6

;rom Eescartes rule of signs, we ,now there are two IRRs since the cash flows change signs
twice. ;rom trial and error, the two IRRs are0
IRR G I6.I9K, @83.DHK
When there are multiple IRRs, the IRR decision rule is am"iguous. Aoth IRRs are correct( that
is, "oth interest rates ma,e the ?+X of the pro:ect e&ual to ero. If we are e%aluating whether or
not to accept this pro:ect, we would not want to use the IRR to ma,e our decision.
B-136
CHAPTER 6 B-
16. a. The pa!"ac, period is the time that it ta,es for the cumulati%e undiscounted cash inflows to
e&ual the initial in%estment.
Aoard game0
Cumulati%e cash flows \ear > G BD44 G BD44
+a!"ac, period G B344 - BD44 G .I9 !ears
CE*R'$0
Cumulati%e cash flows \ear > G B>,>44 G B>,>44
Cumulati%e cash flows \ear 6 G B>,>44 L 844 G B>,J44
+a!"ac, period G > L .B>,944 @ B>,>44/ - B844
+a!"ac, period G >.94 !ears
Since the "oard game has a shorter pa!"ac, period than the CE*R'$ pro:ect, the compan!
should choose the "oard game.
b. The ?+X is the sum of the present %alue of the cash flows from the pro:ect, so the ?+X of each
pro:ect will "e0
Aoard game0
?+X G @B344 L BD44 - >.>4 L B>44 - >.>4
6
L B>44 - >.>4
3
?+X G B66>.D>
CE*R'$0
?+X G @B>,944 L B>,>44 - >.>4 L B844 - >.>4
6
L BD44 - >.>4
3
?+X G BDH>.H8
Since the ?+X of the CE*R'$ is greater than the ?+X of the "oard game, choose the CE*
R'$.
c. The IRR is the interest rate that ma,es the ?+X of a pro:ect e&ual to ero. So, the IRR of each
pro:ect is0
Aoard game0
4 G @B344 L BD44 - .> L IRR/ L B>44 - .> L IRR/
6
L B>44 - .> L IRR/
3
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR G H9.H>K
137
SOLUTIONS
CE*R'$0
4 G @B>,944 L B>,>44 - .> L IRR/ L B844 - .> L IRR/
6
L BD44 - .> L IRR/
3
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR G 34.4JK
Since the IRR of the "oard game is greater than the IRR of the CE*R'$, IRR implies we
choose the "oard game.
d. To calculate the incremental IRR, we su"tract the smaller pro:ects cash flows from the larger
pro:ects cash flows. In this case, we su"tract the "oard game cash flows from the CE*R'$
cash flows. The incremental IRR is the IRR of these incremental cash flows. So, the
incremental cash flows of the su"marine ride are0
\ear 4 \ear > \ear 6 \ear 3
CE*R'$ @B>,944 B>,>44 B844 BD44
Aoard game @344 D44 >44 >44
CE*R'$ @ Aoard game @B>,644 BI44 BI44 B344
Setting the present %alue of these incremental cash flows e&ual to ero, we find the incremental
IRR is0
4 G C4 L C> - .> L IRR/ L C6 - .> L IRR/
6
L C3 - .> L IRR/
3
4 G @B>,644 L BI44 - .> L IRR/ L BI44 - .> L IRR/
6
L B344 - .> L IRR/
3
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
Incremental IRR G 66.9IK
;or in%esting*t!pe pro:ects, accept the larger pro:ect when the incremental IRR is greater than
the discount rate. Since the incremental IRR, 66.9IK, is greater than the re&uired rate of return
of >4 percent, choose the CE*R'$ pro:ect. ?ote that this is the choice when e%aluating onl!
the IRR of each pro:ect. The IRR decision rule is flawed "ecause there is a scale pro"lem. That
is, the CE*R'$ has a greater initial in%estment than does the "oard game. This pro"lem is
corrected "! calculating the IRR of the incremental cash flows, or "! e%aluating the ?+X of
each pro:ect.
B-138
CHAPTER 6 B-
17. a. The profita"ilit! inde# is the +X of the future cash flows di%ided "! the initial in%estment. The
profita"ilit! inde# for each pro:ect is0
+ICE$) G N69,444,444 - >.>4 L >9,444,444 - >.>4
6
L 9,444,444 - >.>4
3
O - >4,444,444 G
3.8J
+IRD G N64,444,444 - >.>4 L 94,444,444 - >.>4
6
L D4,444,444 - >.>4
3
O - 64,444,444 G
D.D8
+IWi*;i G N64,444,444 - >.>4 L D4,444,444 - >.>4
6
L >44,444,444 - >.>4
3
O - 34,444,444 G
D.6>
The profita"ilit! inde# implies we accept the RD pro:ect. Remem"er this is not necessaril! correct
"ecause the profita"ilit! inde# does not necessaril! ran, pro:ects with different initial in%estments
correctl!.
b. The ?+X of each pro:ect is0
?+XCE$) G @>4,444,444 L 69,444,444 - >.>4 L >9,444,444 - >.>4
6
L 9,444,444 - >.>4
3

?+XCE$) G 68,884,9D4.J9
?+XRD G @64,444,444 L 64,444,444 - >.>4 L 94,444,444 - >.>4
6
L D4,444,444 - >.>4
3
?+XRD G HJ,99H,I6D.6I
+IWi*;i G @34,444,444 L 64,444,444 - >.>4 L D4,444,444 - >.>4
6
L >44,444,444 - >.>4
3
+IWi*;i G JH,3I>,>DJ.9>
?+X implies we accept the Wi*;i pro:ect since it has the highest ?+X. This is the correct
decision if the pro:ects are mutuall! e#clusi%e.
c. We would li,e to in%est in all three pro:ects since each has a positi%e ?+X. If the "udget is
limited to 34 million, we can onl! accept the CE$) pro:ect and the RD pro:ect, or the Wi*
;i pro:ect. ?+X is additi%e across pro:ects and the compan!. The total ?+X of the CE$)
pro:ect and the RD pro:ect is0
?+XCE$) and RD G 68,884,9D4.J9 L HJ,99H,I6D.6I
?+XCE$) and RD G J8,D3I,6H9.6>
This is greater than the Wi*;i pro:ect, so we should accept the CE$) pro:ect and the RD
pro:ect.
18. a. The pa!"ac, period is the time that it ta,es for the cumulati%e undiscounted cash inflows to
e&ual the initial in%estment.
)b$ $ini*S<X0
Cumulati%e cash flows \ear > G 644,444 G 644,444
+a!"ac, period G 644,444 - 644,444 G > !ear
)b; ;ull*S<X0
139
SOLUTIONS
Cumulati%e cash flows \ear > G 644,444 G 644,444
Cumulati%e cash flows \ear 6 G 644,444 L 344,444 G 944,444
+a!"ac, period G 6 !ears
Since the )b$ has a shorter pa!"ac, period than the )b;, the compan! should choose the
)b;. Remem"er the pa!"ac, period does not necessaril! ran, pro:ects correctl!.
b. The ?+X of each pro:ect is0
?+X)b$ G @644,444 L 644,444 - >.>4 L >94,444 - >.>4
6
L >94,444 - >.>4
3

?+X)b$ G 6>8,D86.3D
?+X)b; G @944,444 L 644,444 - >.>4 L 344,444 - >.>4
6
L 344,444 - >.>4
3
?+X)b; G >99,>DH.9>
The ?+X criteria implies we accept the )b$ "ecause it has the highest ?+X.
c. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero. So, the IRR of each
)b$ is0
4 G @644,444 L 644,444 - .> L IRR/ L >94,444 - .> L IRR/
6
L >94,444 - .> L IRR/
3

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR)b$ G I4.4DK
)nd the IRR of the )b; is0
4 G @944,444 L 644,444 - .> L IRR/ L 344,444 - .> L IRR/
6
L 344,444 - .> L IRR/
3
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR)b; G 69.I4K
The IRR criteria implies we accept the )b$ "ecause it has the highest ?+X. Remem"er the
IRR does not necessaril! ran, pro:ects correctl!.
d. Incremental IRR anal!sis is not necessar!. The )b$ has the smallest initial in%estment, and
the largest ?+X, so it should "e accepted.
B-140
CHAPTER 6 B-
19. a. The profita"ilit! inde# is the +X of the future cash flows di%ided "! the initial in%estment. The
profita"ilit! inde# for each pro:ect is0
+I) G NI4,444 - >.>6 L I4,444 - >.>6
6
O - >44,444 G >.>8
+IA G N>34,444 - >.>6 L >34,444 - >.>6
6
O - 644,444 G >.>4
+IC G NI9,444 - >.>6 L H4,444 - >.>6
6
O - >44,444 G >.>9
b. The ?+X of each pro:ect is0
?+X) G @>44,444 L I4,444 - >.>6 L I4,444 - >.>6
6
?+X) G >8,343.9I
?+XA G @644,444 L >34,444 - >.>6 L >34,444 - >.>6
6
?+XA G >J,I4H.H3
?+XC G @>44,444 L I9,444 - >.>6 L H4,444 - >.>6
6
?+XC G >D,IJ9.J6
c. )ccept pro:ects ), A, and C. Since the pro:ects are independent, accept all three pro:ects
"ecause the respecti%e profita"ilit! inde# of each is greater than one.
d. )ccept +ro:ect A. Since the +ro:ects are mutuall! e#clusi%e, choose the +ro:ect with the highest
+I, while ta,ing into account the scale of the +ro:ect. Aecause +ro:ects ) and C ha%e the same
initial in%estment, the pro"lem of scale does not arise when comparing the profita"ilit! indices.
Aased on the profita"ilit! inde# rule, +ro:ect C can "e eliminated "ecause its +I is less than the
+I of +ro:ect ). Aecause of the pro"lem of scale, we cannot compare the +Is of +ro:ects ) and
A. 5owe%er, we can calculate the +I of the incremental cash flows of the two pro:ects, which
are0
+ro:ect C4 C> C6
A @ ) @>44,444 H4,444 H4,444
When calculating incremental cash flows, remem"er to su"tract the cash flows of the pro:ect
with the smaller initial cash outflow from those of the pro:ect with the larger initial cash
outflow. This procedure insures that the incremental initial cash outflow will "e negati%e. The
incremental +I calculation is0
+I.A @ )/ G NH4,444 - >.>6 L H4,444 - >.>6
6
O - >44,444
+I.A @ )/ G >.4>D
The compan! should accept +ro:ect A since the +I of the incremental cash flows is greater than
one.
e. Remem"er that the ?+X is additi%e across pro:ects. Since we can spend 344,444, we could
ta,e two of the pro:ects. In this case, we should ta,e the two pro:ects with the highest ?+Xs,
which are +ro:ect A and +ro:ect ).
141
SOLUTIONS
20. a. The pa!"ac, period is the time that it ta,es for the cumulati%e undiscounted cash inflows to
e&ual the initial in%estment.
Er! +repeg0
Cumulati%e cash flows \ear > G VH44,444,444 G VH44,444,444
Cumulati%e cash flows \ear 6 G VH44,444,444 L D44,444,444 G V>,444,444,444
+a!"ac, period G 6 !ears
Sol%ent +repeg0
Cumulati%e cash flows \ear > G V344,444,444 G V344,444,444
Cumulati%e cash flows \ear 6 G V344,444,444 L 944,444,444 G V844,444,444
+a!"ac, period G > L .V644,444,444-V944,444,444/ G >.D !ears
Since the sol%ent prepeg has a shorter pa!"ac, period than the dr! prepeg, the compan! should
choose the sol%ent prepeg. Remem"er the pa!"ac, period does not necessaril! ran, pro:ects
correctl!.
b. The ?+X of each pro:ect is0
?+XEr! prepeg G @V>,444,444,444L VH44,444,444 - >.>4 L VD44,444,444 - >.>4
6
L V>,444,444,444 -
>.>4
3

?+XEr! prepeg G VH6I,3DI,898.I9
?+XRD G @V944,444,444 L V344,444,444 - >.>4 L V944,444,444 - >.>4
6
L V>44,444,444 - >.>4
3
?+XRD G V6H>,48>,8J3.J>
The ?+X criteria implies accepting the dr! prepeg "ecause it has the highest ?+X.
c. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero. So, the IRR of each
dr! prepeg is0
4 G @V>,444,444,444 L VH44,444,444 - .> L IRR/ L VD44,444,444 - .> L IRR/
6
L V>,444,444,444 -
.> L IRR/
3

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRREr! prepeg G 3J.IJK
)nd the IRR of the sol%ent prepeg is0
4 G @V944,444,444 L V344,444,444 - .> L IRR/ L V944,444,444 - .> L IRR/
6
L V>44,444,444 - .>
L IRR/
3
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
B-142
CHAPTER 6 B-
IRRSol%ent prepeg G D4.JJK
The IRR criteria implies accepting the sol%ent prepeg "ecause it has the highest ?+X. Remem"er the
IRR does not necessaril! ran, pro:ects correctl!.
d. Incremental IRR anal!sis is necessar!. The sol%ent prepeg has a higher IRR, "ut is relati%el!
smaller in terms of in%estment and ?+X. In calculating the incremental cash flows, we su"tract
the cash flows from the pro:ect with the smaller initial in%estment from the cash flows of the
pro:ect with the large initial in%estment, so the incremental cash flows are0
\ear 4 \ear > \ear 6 \ear 3
Er! prepeg @V>,444,444,444 VH44,444,44
4
VD44,444,444 V>,444,444,44
4
Sol%ent prepeg @944,444,444 344,444,444 944,444,444 >44,444,444
Er! prepeg @ Sol%ent
prepeg
@V944,444,444 V344,444,44
4
@V>44,444,444 VJ44,444,444
Setting the present %alue of these incremental cash flows e&ual to ero, we find the incremental
IRR is0
4 G @V944,444,444 L V344,444,444 - .> L IRR/ @ V>44,444,444 - .> L IRR/
6
L VJ44,444,444 -
.> L IRR/
3
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
Incremental IRR G 38.J4K
;or in%esting*t!pe pro:ects, we accept the larger pro:ect when the incremental IRR is greater
than the discount rate. Since the incremental IRR, 38.J4K, is greater than the re&uired rate of
return of >4 percent, we choose the dr! prepeg. ?ote that this is the choice when e%aluating
onl! the IRR of each pro:ect. The IRR decision rule is flawed "ecause there is a scale pro"lem.
That is, the dr! prepeg has a greater initial in%estment than does the sol%ent prepeg. This
pro"lem is corrected "! calculating the IRR of the incremental cash flows, or "! e%aluating the
?+X of each pro:ect.
A! the wa!, as an aside0 The cash flows for the incremental IRR change signs three times, so
we would e#pect up to three real IRRs. In this particular case, howe%er, two of the IRRs are not
real num"ers. ;or the record, the other IRRs are0
IRR G N>-.@.34DD6 L .486D4i/O @ >
IRR G N>-.@.34DD6 @ .486D4i/O @ >
21. a. The ?+X of each pro:ect is0
?+X?+*34 G @2>44,444 L 2D4,444ZN> @ .>->.>9/
9
O - .>9 [
?+X?+*34 G 23D,48H.64
?+X?U*64 G @234,444 L 264,444 - >.>9 L 263,444 - >.>9
6
L 26H,D94 - >.>9
3
L 234,D>8 - >.>9
D
L 23D,J84 - >.>9
9
?+X?U*64 G 29H,J9H.I9
143
SOLUTIONS
The ?+X criteria implies accepting the ?U*64.
b. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero, so the IRR of each
pro:ect is0
?+*340
4 G @2>44,444 L 2D4,444.Z> @ N>-.> L IRR/
9
O[ - IRR/
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR?+*34 G 68.H9K
)nd the IRR of the ?U*64 is0
4 G @234,444 L 264,444 - .> L IRR/ L 263,444 - .> L IRR/
6
L 26H,D94 - .> L IRR/
3

L 234,D>8 - .> L IRR/
D
L 23D,J84 - .> L IRR/
9
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR?U*64 G I3.46K
The IRR criteria implies accepting the ?U*64.
c. Incremental IRR anal!sis is not necessar!. The ?U*64 has a higher IRR, and "ut is relati%el!
smaller in terms of in%estment, with a larger ?+X. ?onetheless, we will calculate the
incremental IRR. In calculating the incremental cash flows, we su"tract the cash flows from the
pro:ect with the smaller initial in%estment from the cash flows of the pro:ect with the large
initial in%estment, so the incremental cash flows are0
\ear
Incremental
cash flow
4 @2I4,444
> 64,444
6 >I,444
3 >3,994
D J,986
9 9,464
Setting the present %alue of these incremental cash flows e&ual to ero, we find the incremental
IRR is0
4 G @2I4,444 L 264,444 - .> L IRR/ L 2>I,444 - .> L IRR/
6
L 2>3,994 - .> L IRR/
3

L 2J,986 - .> L IRR/
D
L 29,464 - .> L IRR/
9
B-144
CHAPTER 6 B-
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
Incremental IRR G @6.8JK
;or in%esting*t!pe pro:ects, accept the larger pro:ect when the incremental IRR is greater than
the discount rate. Since the incremental IRR, @6.8JK, is less than the re&uired rate of return of
>9 percent, choose the ?U*64.
d. The profita"ilit! inde# is the present %alue of all su"se&uent cash flows, di%ided "! the initial
in%estment, so the profita"ilit! inde# of each pro:ect is0
+I?+*34 G .2D4,444ZN> @ .>->.>9/
9
O - .>9 [/ - 2>44,444
+I?+*34 G >.3D>
+I?U*64 G N264,444 - >.>9 L 263,444 - >.>9
6
L 26H,D94 - >.>9
3
L 234,D>8 - >.>9
D

L 23D,J84 - >.>9
9
O - 234,444
+I?U*64 G 6.8JJ
The +I criteria implies accepting the ?U*64.
22. a. The ?+X of each pro:ect is0
?+X) G @=>44,444 L =94,444 - >.>9 L =94,444 - >.>9
6
L =D4,444 - >.>9
3
L =34,444 - >.>9
D
L =64,444 - >.>9
9
?+X) G =3D,H86.63
?+XA G @=644,444 L =H4,444 - >.>9 L =H4,444 - >.>9
6
L =H4,444 - >.>9
3
L =>44,444 - >.>9
D
L =644,444 - >.>9
9
?+XA G =J3,H4D.>8
The ?+X criteria implies accepting +ro:ect A.
b. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero, so the IRR of each
pro:ect is0
+ro:ect )0
4 G @=>44,444 L =94,444 - .> L IRR/ L =94,444 - .> L IRR/
6
L =D4,444 - .> L IRR/
3

L =34,444 - .> L IRR/
D
L =64,444 - .> L IRR/
9
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR) G 3>.68K
)nd the IRR of the +ro:ect A is0
4 G @=644,444 L =H4,444 - .> L IRR/ L =H4,444 - .> L IRR/
6
L =H4,444 - .> L IRR/
3

L =>44,444 - .> L IRR/
D
L =644,444 - .> L IRR/
9
145
SOLUTIONS
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRRA G 6J.9DK
The IRR criteria implies accepting +ro:ect ).
c. Incremental IRR anal!sis is not necessar!. The ?U*64 has a higher IRR, and is relati%el!
smaller in terms of in%estment, with a larger ?+X. ?onetheless, we will calculate the
incremental IRR. In calculating the incremental cash flows, we su"tract the cash flows from the
pro:ect with the smaller initial in%estment from the cash flows of the pro:ect with the large
initial in%estment, so the incremental cash flows are0
\ear
Incremental
cash flow
4 @=>44,444
> >4,444
6 >4,444
3 64,444
D I4,444
9 >84,444
Setting the present %alue of these incremental cash flows e&ual to ero, we find the incremental
IRR is0
4 G @=>44,444 L =>4,444 - .> L IRR/ L =>4,444 - .> L IRR/
6
L =64,444 - .> L IRR/
3

L =I4,444 - .> L IRR/
D
L =>84,444 - .> L IRR/
9
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
Incremental IRR G 68.H4K
;or in%esting*t!pe pro:ects, accept the larger pro:ect when the incremental IRR is greater than
the discount rate. Since the incremental IRR, 68.H4K, is greater than the re&uired rate of return
of >9 percent, choose the +ro:ect A.
d. The profita"ilit! inde# is the present %alue of all su"se&uent cash flows, di%ided "! the initial
in%estment, so the profita"ilit! inde# of each pro:ect is0
+I) G N94,444 - >.>9 L =94,444 - >.>9
6
L =D4,444 - >.>9
3
L =34,444 - >.>9
D

L =64,444 - >.>9
9
O - =>44,444
+I) G >.3DI
+IA G N=H4,444 - >.>9 L =H4,444 - >.>9
6
L =H4,444 - >.>9
3
L =>44,444 - >.>9
D
L =644,444 - >.>9
9
O - =644,444
+IA G >.DH8
The +I criteria implies accepting +ro:ect A.
B-146
CHAPTER 6 B-
23. a. The pa!"ac, period is the time that it ta,es for the cumulati%e undiscounted cash inflows to
e&ual the initial in%estment.
+ro:ect )0
Cumulati%e cash flows \ear > G 94,444 G 94,444
Cumulati%e cash flows \ear 6 G 94,444 L >44,444 G >94,444
+a!"ac, period G 6 !ears
+ro:ect A0
Cumulati%e cash flows \ear > G 644,444 G 644,444
+a!"ac, period G > !ear
+ro:ect C0
Cumulati%e cash flows \ear > G >44,444 G >44,444
+a!"ac, period G > !ear
+ro:ect A and +ro:ect C ha%e the same pa!"ac, period, so the pro:ects cannot "e ran,ed.
Regardless, the pa!"ac, period does not necessaril! ran, pro:ects correctl!.
b. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero, so the IRR of each
pro:ect is0
+ro:ect )0
4 G @>94,444 L 94,444 - .> L IRR/ L >44,444 - .> L IRR/
6

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR) G 4.44K
)nd the IRR of the +ro:ect A is0
4 G @644,444 L 644,444 - .> L IRR/ L >>>,444 - .> L IRR/
6

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRRA G 3J.I6K
147
SOLUTIONS
)nd the IRR of the +ro:ect C is0
4 G @>44,444 L >44,444 - .> L IRR/ L >44,444 - .> L IRR/
6

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRRC G H>.84K
The IRR criteria implies accepting +ro:ect C.
c. +ro:ect ) can "e e#cluded from the incremental IRR anal!sis. Since the pro:ect has a negati%e
?+X, and an IRR less than its re&uired return, the pro:ect is re:ected. We need to calculate the
incremental IRR "etween +ro:ect A and +ro:ect C. In calculating the incremental cash flows,
we su"tract the cash flows from the pro:ect with the smaller initial in%estment from the cash
flows of the pro:ect with the large initial in%estment, so the incremental cash flows are0
\ear
Incremental
cash flow
4 @>44,444
> >44,444
6 >>,444
Setting the present %alue of these incremental cash flows e&ual to ero, we find the incremental
IRR is0
4 G @>44,444 L >44,444 - .> L IRR/ L >>,444 - .> L IRR/
6

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
Incremental IRR G >4.44K
;or in%esting*t!pe pro:ects, accept the larger pro:ect when the incremental IRR is greater than
the discount rate. Since the incremental IRR, >4.44 percent, is less than the re&uired rate of
return of 64 percent, choose the +ro:ect C.
d. The profita"ilit! inde# is the present %alue of all su"se&uent cash flows, di%ided "! the initial
in%estment. We need to discount the cash flows of each pro:ect "! the re&uired return of each
pro:ect. The profita"ilit! inde# of each pro:ect is0
+I) G N94,444 - >.>4 L >44,444 - >.>4
6
O - >94,444
+I) G 4.89
+IA G N644,444 - >.64 L >>>,444 - >.64
6
O - 644,444
+IA G >.66
+IC G N>44,444 - >.64 L >44,444 - >.64
6
O - >44,444
+IC G >.93
The +I criteria implies accepting +ro:ect C.
B-148
CHAPTER 6 B-
e. We need to discount the cash flows of each pro:ect "! the re&uired return of each pro:ect. The
?+X of each pro:ect is0
?+X) G @>94,444 L 94,444 - >.>4 L >44,444 - >.>4
6

?+X) G @6>,J44.83
?+XA G @644,444 L 644,444 - >.64 L >>>,444 - >.64
6
?+XA G D3,I94.44
?+XC G @>44,444 L >44,444 - >.64 L >44,444 - >.64
6
?+XC G 96,III.I8
The ?+X criteria implies accepting +ro:ect C.
'hallenge
24. Ri%en the se%en*!ear pa!"ac,, the worst case is that the pa!"ac, occurs at the end of the se%enth
!ear. Thus, the worst case0
?+X G @+5+9,464 L +5+9,464->.>6
I
G @+5+6,IDJ.6>
The "est case has infinite cash flows "e!ond the pa!"ac, point. Thus, the "est*case ?+X is infinite.
25. The e&uation for the IRR of the pro:ect is0
4 G @=94D L =6,8H6-.> L IRR/ @ =H,4I4-.> L IRR/
6
L =9,I44-.> L IRR/
3
@ =6,444-.> L IRR/
D
<sing Eescartes rule of signs, from loo,ing at the cash flows we ,now there are four IRRs for this
pro:ect. E%en with most computer spreadsheets, we ha%e to do some trial and error. ;rom trial and
error, IRRs of 69K, 33.33K, D6.8HK, and HH.HIK are found.
We would accept the pro:ect when the ?+X is greater than ero. See for !ourself that the ?+X is
greater than ero for re&uired returns "etween 69K and 33.33K or "etween D6.8HK and HH.HIK.
26. a. 5ere the cash inflows of the pro:ect go on fore%er, which is a perpetuit!. <nli,e ordinar!
perpetuit! cash flows, the cash flows here grow at a constant rate fore%er, which is a growing
perpetuit!. If !ou remem"er "ac, to the chapter on stoc, %aluation, we presented a formula for
%aluing a stoc, with constant growth in di%idends. This formula is actuall! the formula for a
growing perpetuit!, so we can use it here. The +X of the future cash flows from the pro:ect is0
+X of cash inflows G ')-.< @ g/
+X of cash inflows G 94,444-..>3 @ .4H/ G I>D,689.I>
?+X is the +X of the outflows minus "! the +X of the inflows, so the ?+X is0
?+X of the pro:ect G @I84,444 L I>D,689.I> G @H9,I>D.6J
The ?+X is negati%e, so we would re:ect the pro:ect.
149
SOLUTIONS
b. 5ere we want to ,now the minimum growth rate in cash flows necessar! to accept the pro:ect.
The minimum growth rate is the growth rate at which we would ha%e a ero ?+X. The e&uation
for a ero ?+X, using the e&uation for the +X of a growing perpetuit! is0
4 G @ I84,444 L 94,444-..>3 @ g/
Sol%ing for g, we get0
g G H.9JK
27. a. The pro:ect in%ol%es three cash flows0 the initial in%estment, the annual cash inflows, and the
a"andonment costs. The mine will generate cash inflows o%er its >>*!ear economic life. To
e#press the +X of the annual cash inflows, appl! the growing annuit! formula, discounted at
the IRR and growing at eight percent.
+X.Cash Inflows/ G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[
+X.Cash Inflows/ G 2>44,444ZN>-.IRR @ .48/O @ N>-.IRR @ .48/O Q N.> L .48/-.> L IRR/O
>>
[
)t the end of >> !ears, the <tah $ining Corporate will a"andon the mine, incurring a 294,444
charge. Eiscounting the a"andonment costs "ac, >> !ears at the IRR to e#press its present
%alue, we get0
+X.)"andonment/ G C>> - .> L IRR/
>>
+X.)"andonment/ G @294,444 - .>LIRR/
>>


So, the IRR e&uation for this pro:ect is0
4 G @2H44,444 L 2>44,444ZN>-.IRR @ .48/O @ N>-.IRR @ .48/O Q N.> L .48/-.> L IRR/O
>>
[
@294,444 - .>LIRR/
>>

<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR G >8.9HK
b. \es. Since the mines IRR e#ceeds the re&uired return of >4 percent, the mine should "e
opened. The correct decision rule for an in%estment*t!pe pro:ect is to accept the pro:ect if the
discount rate is a"o%e the IRR. )lthough it appears there is a sign change at the end of the
pro:ect "ecause of the a"andonment costs, the last cash flow is actuall! positi%e "ecause the
operating cash in the last !ear.
28. a. We can appl! the growing perpetuit! formula to find the +X of stream A. The perpetuit!
formula %alues the stream as of one !ear "efore the first pa!ment. Therefore, the growing
perpetuit! formula %alues the stream of cash flows as of !ear 6. ?e#t, discount the +X as of the
end of !ear 6 "ac, two !ears to find the +X as of toda!, !ear 4. Eoing so, we find0
+X.)/ G NC3 - .R @ g/O - .> L R/
6
+X.)/ G N29,444 - .4.>6 @ 4.4D/O - .>.>6/
6
+X.)/ G 2DJ,86D.H6
B-150
CHAPTER 6 B-
We can appl! the perpetuit! formula to find the +X of stream %. The perpetuit! formula
discounts the stream "ac, to !ear >, one period prior to the first cash flow. Eiscount the +X as
of the end of !ear > "ac, one !ear to find the +X as of toda!, !ear 4. Eoing so, we find0
+X.%/ G NC6 - RO - .> L R/
+X.A/ G N@2H,444 - 4.>6O - .>.>6/
+X.A/ G @2DD,HD6.8H
b. If we com"ine the cash flow streams to form +ro:ect C, we get0
+ro:ect ) G NC3 - .R @ R/O - .> L R/
6

+ro:ect A G NC6 - RO - .> L R/
+ro:ect C G +ro:ect A L +ro:ect %
+ro:ect C G NC3 - .R @ g/O - .> L R/
6
L NC6 - RO - .> LR/
4 G N29,444 - .IRR @ .4D/O - .> L IRR/
6
L N@2H,444 - IRRO - .> L IRR/
<sing a spreadsheet, financial calculator, or trial and error to find the root of the e&uation, we
find that0
IRR G >D.H9K
c. The correct decision rule for an in%esting*t!pe pro:ect is to accept the pro:ect if the discount
rate is "elow the IRR. Since there is one IRR, a decision can "e made. )t a point in the future,
the cash flows from stream A will "e greater than those from stream %. Therefore, although
there are man! cash flows, there will "e onl! one change in sign. When the sign of the cash
flows change more than once o%er the life of the pro:ect, there ma! "e multiple internal rates of
return. In such cases, there is no correct decision rule for accepting and re:ecting pro:ects using
the internal rate of return.
29. To answer this &uestion, we need to e#amine the incremental cash flows. To ma,e the pro:ects
e&uall! attracti%e, +ro:ect Crore must ha%e a larger initial in%estment. We ,now this "ecause the
su"se&uent cash flows from +ro:ect Crore are larger than the su"se&uent cash flows from +ro:ect
Ca,h. So, su"tracting the +ro:ect Ca,h cash flows from the +ro:ect Crore cash flows, we find the
incremental cash flows are0
Incremental
\ear cash flows
4 @Io L Rs.>,944
> 344
6 344
3 944
?ow we can find the present %alue of the su"se&uent incremental cash flows at the discount rate, >6
percent. The present %alue of the incremental cash flows is0
+X G Rs.>,944 L Rs.344 - >.>6 L Rs.344 - >.>6
6
L Rs.944 - >.>6
3
+X G Rs.6,3H6.J>
151
SOLUTIONS
So, if I4 is greater than Rs.6,3H6.J>, the incremental cash flows will "e negati%e. Since we are
su"tracting +ro:ect Ca,h from +ro:ect Crore, this implies that for an! %alue o%er Rs.6,3H6.J> the
?+X of +ro:ect Crore will "e less than that of +ro:ect Ca,h, so I4 must "e less than Rs.6,3H6.J>.
30. The IRR is the interest rate that ma,es the ?+X of the pro:ect e&ual to ero. So, the IRR of the
pro:ect is0
4 G B64,444 @ B6H,444 - .> L IRR/ L B>3,444 - .> L IRR/
6

E%en though it appears there are two IRRs, a spreadsheet, financial calculator, or trial and error will
not gi%e an answer. The reason is that there is no real IRR for this set of cash flows. If !ou e#amine
the IRR e&uation, what we are reall! doing is sol%ing for the roots of the e&uation. Roing "ac, to
high school alge"ra, in this pro"lem we are sol%ing a &uadratic e&uation. In case !ou dont
remem"er, the &uadratic e&uation is0
# G
a
ac b b
6
D
6
t
In this case, the e&uation is0
# G
/ 444 6H . 6
/ 444 >3 /. 444 64 . D / 444 6H . / 444 6H .
6
#
# # # # t
The s&uare root term wor,s out to "e0
HIH,444,444 @ >,4D4,444,444 G @3HD,444,444
The s&uare root of a negati%e num"er is a comple# num"er, so there is no real num"er solution,
meaning the pro:ect has no real IRR.
B-152
CHAPTER 6 B-
Calculator $olutions
1. b. =ro>ect A
C/o @=I,944 C/o @=9,444
C01 =D,444 C01 =6,944
/01 > /01 >
C02 =3,944 C02 =>,644
/02 > /02 >
C03 =>,944 C03 =3,444
/03 > /03 >
I G >9K I G >9K
?+X C+T ?+X C+T
@=388.JH =93.83
7.
C/o @28,444
C01 2D,444
/01 >
C02 23,444
/02 >
C03 26,444
/03 >
IRR C+T
H.J3K
8. =ro>ect A =ro>ect %
C/o @=6,444 C/o @=>,944
C01 =>,444 C01 =944
/01 > /01 >
C02 =>,944 C02 =>,444
/02 > /02 >
C03 =6,444 C03 =>,I94
/03 > /03 >
IRR C+T IRR C+T
DI.>9K D4.66K
153
SOLUTIONS
9.
C/o 4
C01 Rs.D4,444
/01 I
I G >9K
?+X C+T
Rs.>HH,D>H.IJ
+I G 2>HH,D>H.IJ - 2>H4,444 G >.4D4>
12.
C/o B9,444
C01 @B6,944
/01 >
C02 @B6,344
/02 >
C03 @B>,444
/03 >
C04 @B>,444
/04 >
IRR C+T
>H.HJK
C/o B9,444 C/o B9,444
C01 @B6,944 C01 @B6,944
/01 > /01 >
C02 @B6,344 C02 @B6,344
/02 > /02 >
C03 @B>,444 C03 @B>,444
/03 > /03 >
C04 @B>,444 C04 @B>,444
/04 > /04 >
I G >9K I G 64K
?+X C+T ?+X C+T
@B>D6.3> B698.DJ
13. a. "eepwater fishing ,ubmarine ride
C/o @Rs.H44,444 C/o @
Rs.>,844,444
C01 Rs.6I4,444 C01 Rs.>,444,444
/01 > /01 >
C02 Rs.394,444 C02 Rs.I44,444
/02 > /02 >
C03 Rs.344,444 C03 Rs.J44,444
/03 > /03 >
IRR C+T IRR C+T
6D.34K 6>.DHK
B-154
CHAPTER 6 B-
b.
C/o @
Rs.>,644,444
C01 Rs.I34,444
/01 >
C02 Rs.394,444
/02 >
C03 Rs.H44,444
/03 >
IRR C+T
>J.J6K
c. "eepwater fishing ,ubmarine ride
C/o @Rs.H44,444 C/o @
Rs.>,844,444
C01 Rs.6I4,444 C01 Rs.>,444,444
/01 > /01 >
C02 Rs.394,444 C02 Rs.I44,444
/02 > /02 >
C03 Rs.344,444 C03 Rs.J44,444
/03 > /03 >
I G >9K I G >9K
?+X C+T ?+X C+T
Rs.JH,H8I.IH Rs.>J4,H34.3J
14. =ro>ect &
C/o Ca24 C/o @Ca234,444
C01 Ca2>9,444 C01 Ca2>9,444
/01 3 /01 3
I G >4K I G >4K
?+X C+T ?+X C+T
Ca23I,346.I8 Ca2I,346.I8
+I G Ca23I,346.I8 - Ca234,444 G >.6D3
=ro>ect &&
C/o Ca24 C/o @Ca29,444
C01 Ca26,844 C01 Ca26,844
/01 3 /01 3
I G >4K I G >4K
?+X C+T ?+X C+T
Ca2H,JH3.>J Ca2>,JH3.>J
+I G Ca2H,JH3.>J - Ca29,444 G >.3J3
155
SOLUTIONS
15.
C/o @V68,444,444 C/o @V68,444,444
C01 V93,444,444 C01 V93,444,444
/01 > /01 >
C02 @V8,444,444 C02 @V8,444,444
/02 > /02 >
I G >6K IRR C+T
?+X C+T I6.I9K
V>6,JD3,8II.99
Financial calculators will only give you one IRR, even if there are multiple IRRs. Using trial and
error, or a root solving calculator, the other IRR is 83.46%.
16. b. %oard game '"-<OM
C/o @B344 C/o @B>,944
C01 BD44 C01 B>,>44
/01 > /01 >
C02 B>44 C02 B844
/02 > /02 >
C03 B>44 C03 BD44
/03 > /03 >
I G >4K I G >4K
?+X C+T ?+X C+T
B66>.D> BDH>.H8
c. %oard game '"-<OM
C/o @B344 C/o @B>,944
C01 BD44 C01 B>,>44
/01 > /01 >
C02 B>44 C02 B844
/02 > /02 >
C03 B>44 C03 BD44
/03 > /03 >
IRR C+T IRR C+T
H9.H>K 34.4JK
c.
C/o @B>,644
C01 BI44
/01 >
C02 BI44
/02 >
C03 B344
/03 >
IRR C+T
66.9IK
B-156
CHAPTER 6 B-
17. a. '"MA -5 ;i-Fi
C/o 4 C/o 4 C/o 4
C01
69,444,444
C01
64,444,444
C01 64,444,444
/01 > /01 > /01 >
C02
>9,444,444
C02
94,444,444
C02 D4,444,444
/02 > /02 > /02 >
C03 9,444,444 C03
D4,444,444
C03
>44,444,444
/03 > /03 > /03 >
I G >4K I G >4K I G >4K
?+X C+T ?+X C+T ?+X C+T
38,884,9D4.J9 8J,99H,I6D.6I >6H,3I>,>DJ.9>
+ICE$) G 38,884,9D4.J9 - >4,444,444 G 3.8J
+IRD G 8J,99H,I6D.6I - 64,444,444 G D.D8
+IWi*;i G >6H,3I>,>DJ.9> - 34,444,444 G D.6>
b. '"MA -5 ;i-Fi
C/o @
>4,444,444
C/o @
64,444,444
C/o @
34,444,444
C01 69,444,444 C01 64,444,444 C01 64,444,444
/01 > /01 > /01 >
C02 >9,444,444 C02 94,444,444 C02 D4,444,444
/02 > /02 > /02 >
C03 9,444,444 C03 D4,444,444 C03
>44,444,444
/03 > /03 > /03 >
I G >4K I G >4K I G >4K
?+X C+T ?+X C+T ?+X C+T
68,884,9D4.J9 HJ,99H,I6D.6I JH,3I>,>DJ.9>
18. b. A?M A?F
C/o @644,444 C/o @944,444
C01 644,444 C01 644,444
/01 > /01 >
C02 >94,444 C02 344,444
/02 > /02 >
C03 >94,444 C03 344,4444
/03 > /03 >
I G >4K I G >4K
?+X C+T ?+X C+T
6>8,D86.3D >99,>DH.9>
c. A?M A?F
C/o @644,444 C/o @944,444
C01 644,444 C01 644,444
/01 > /01 >
157
SOLUTIONS
C02 >94,444 C02 344,444
/02 > /02 >
C03 >94,444 C03 344,444
/03 > /03 >
IRR C+T IRR C+T
I4.4DK 69.I4K
19. a. =ro>ect A =ro>ect % =ro>ect '
C/o 4 C/o 4 C/o 4
C01 I4,444 C01 >34,444 C01 I9,444
/01 > /01 > /01 >
C02 I4,444 C02 >34,444 C02 H4,444
/02 > /02 > /02 >
I G >6K I G >6K I G >6K
?+X C+T ?+X C+T ?+X C+T
>>8,343.9I 6>J,I4H.H3 >>D,IJ9.J6
+I) G >>8,343.9I - >44,444 G >.>8
+IA G 6>J,I4H.H3 - 644,444 G >.>4
+IC G >>D,IJ9.I6 - >44,444 G >.>9
b. =ro>ect A =ro>ect % =ro>ect '
C/o @>44,444 C/o @644,444 C/o @>44,444
C01 I4,444 C01 >34,444 C01 I9,444
/01 > /01 > /01 >
C02 >34,444 C02 >34,444 C02 H4,444
/02 > /02 > /02 >
I G >6K I G >6K I G >6K
?+X C+T ?+X C+T ?+X C+T
>8,343.9I >J,I4H.H3 >D,IJ9.J6
d. =ro>ect % 7 A
C/o @>44,444
C01 H4,444
/01 >
C02 H4,444
/02 >
I G >6K
?+X C+T
>4>,D43.4H
+I.A @ )/ G >4>,D43.4H - >44,444 G >.4>D
20. b. "r prepeg ,olvent prepeg
C/o @V>,444,444,444 C/o @
V944,444,444
C01 VH44,444,444 C01 V344,444,444
/01 > /01 >
C02 VD44,444,444 C02 V944,444,444
/02 > /02 >
B-158
CHAPTER 6 B-
C03 V>,444,444,444 C03 V>44,4444,44
4
/03 > /03 >
I G >4K I G >4K
?+X C+T ?+X C+T
VH6I,3DI.8H V6H>,48>.8J
c. "r prepeg ,olvent prepeg
C/o @V>,444,444,000 C/o @
V944,444,000
C01 VH44,444,444 C01 V344,444,444
/01 > /01 >
C02 VD44,444,444 C02 V944,444,444
/02 > /02 >
C03 V>,444,444,444 C03 V>44,4444,44
4
/03 > /03 >
IRR C+T IRR C+T
3J.IJK D4.JJK
d.
C/o @V944,444,000
C01 V344,444,444
/01 >
C02 @V>44,444,444
/02 >
C03 VJ44,444,444
/03 >
IRR C+T
38.J4K
21. a. N=-0/ N@-./
C/o @2>44,444 C/o @234,444
C01 2D4,444 C01 264,444
/01 9 /01 >
C02 C02 263,444
/02 /02 >
C03 C03 26H,D94
/03 /03 >
C04 C04 234,D>8
/04 /04 >
C05 C05 23D,8J4
/05 /05 >
I G >9K I G >9K
?+X C+T ?+X C+T
23D,48H.64 29H,J9H.I9
159
SOLUTIONS
b. N=-0/ N@-./
C/o @2>44,444 C/o @234,444
C01 2D4,444 C01 264,444
/01 9 /01 >
C02 C02 263,444
/02 /02 >
C03 C03 26H,D94
/03 /03 >
C04 C04 234,D>8
/04 /04 >
C05 C05 23D,8J4
/05 /05 >
IRR C+T IRR C+T
6H.89K I3.46K
c.
C/o @2I4,444
C01 264,444
/01 >
C02 2>I,444
/02 >
C03 2>3,994
/03 >
C04 2J,986
/04 >
C05 29,464
/05 >
IRR C+T
@6.8JK
d. N=-0/ N@-./
C/o 4 C/o 4
C01 2D4,444 C01 264,444
/01 9 /01 >
C02 C02 263,444
/02 /02 >
C03 C03 26H,D94
/03 /03 >
C04 C04 234,D>8
/04 /04 >
C05 C05 23D,8J4
/05 /05 >
I G >9K I G >9K
?+X C+T ?+X C+T
2>3D,48H.64 28H,J9H.I9
+I?+*34 G 2>3D,48H.64 - 2>44,444 G >.3D>
+I?U*64 G 28H,J9J.I9 - 234,444 G 6.8JJ
B-160
CHAPTER 6 B-
22. a. =ro>ect A =ro>ect %
C/o @=>44,444 C/o @=644,444
C01 =94,444 C01 =H4,444
/01 6 /01 3
C02 =D4,444 C02 =>44,444
/02 > /02 >
C03 =34,444 C03 =644,444
/03 > /03 >
C04 =64,444 C04
/04 > /04
I G >9K I G >9K
?+X C+T ?+X C+T
=3D,H86.63 =J3,H4D.>8
b. =ro>ect A =ro>ect %
C/o @=>44,444 C/o @=644,444
C01 =94,444 C01 =H4,444
/01 6 /01 3
C02 =D4,444 C02 =>44,444
/02 > /02 >
C03 =34,444 C03 =644,444
/03 > /03 >
C04 =64,444 C04
/04 > /04
IRR C+T I G >9K
3>.68K 6J.9DK
c.
C/o @=>44,444
C01 =>4,444
/01 6
C02 =64,444
/02 >
C03 =I4,444
/03 >
C04 =>84,444
/04 >
IRR C+T
68.H4K
161
SOLUTIONS
d. =ro>ect A =ro>ect %
C/o 4 C/o 4
C01 =94,444 C01 =H4,444
/01 6 /01 3
C02 =D4,444 C02 =>44,444
/02 > /02 >
C03 =34,444 C03 =644,444
/03 > /03 >
C04 =64,444 C04 =34,D>8
/04 > /04 >
I G >9K I G >9K
?+X C+T ?+X C+T
=>3D,H86.63 =6J3,H4D.>8
+I) G =>3D,H86.63 - =>44,444 G >.3DI
+IA G =6J3,H4D.>8 - =644,444 G >.DH8
23. b. =ro>ect A =ro>ect % =ro>ect '
C/o @>94,444 C/o @644,444 C/o @>44,444
C01 94,444 C01 644,444 C01 >44,444
/01 > /01 > /01 6
C02 >44,444 C02 >>>,444 C02
/02 > /02 > /02
IRR C+T IRR C+T IRR C+T
4.44K 3J.I6K H>.84K
c. =ro>ect % 7A
C/o @>44,444
C01 >44,444
/01 >
C02 >>,444
/02 >
IRR C+T
>4.44K
d. =ro>ect A =ro>ect % =ro>ect '
C/o 4 C/o 4 C/o 4
C01 94,444 C01 644,444 C01 >44,444
/01 > /01 > /01 6
C02 >44,444 C02 >>>,444 C02
/02 > /02 > /02
I G >4K I G 44K I G 44K
?+X C+T ?+X C+T ?+X C+T
>68,4JJ.>I 6D3,I94.44 >96,III.I8
+I) G >68,4JJ.>I - >94,444 G 4.89
+IA G 6D3,I94.44 - 644,444 G >.66
+IC G >96,III.I9 - >44,444 G >.93
e. =ro>ect A =ro>ect % =ro>ect '
B-162
CHAPTER 6 B-
C/o @>94,444 C/o @644,444 C/o @>44,444
C01 94,444 C01 644,444 C01 >44,444
/01 > /01 > /01 6
C02 >44,444 C02 >>>,444 C02
/02 > /02 > /02
I G >4K I G 64K I G 64K
?+X C+T ?+X C+T ?+X C+T
@6>,J44.83 D3,I94.44 96,III.I8
30.
C/o B64,444
C01 @B6H,444
/01 >
C02 B>3,444
/02 >
IRR C+T
ERR'R I
163
CHAPTER 7
.A:*)3 CA%*A6 *)-1$.1)
81C*$*0)$
Answers to Concepts Review and Critical !in"in# Questions
1. In this conte#t, an opportunit! cost refers to the %alue of an asset or other input that will "e used in a
pro:ect. The rele%ant cost is what the asset or input is actuall! worth toda!, not, for e#ample, what it
cost to ac&uire.
2. a. \es, the reduction in the sales of the compan!s other products, referred to as erosion, should
"e treated as an incremental cash flow. These lost sales are included "ecause the! are a cost .a
re%enue reduction/ that the firm must "ear if it chooses to produce the new product.
b. \es, e#penditures on plant and e&uipment should "e treated as incremental cash flows. These
are costs of the new product line. 5owe%er, if these e#penditures ha%e alread! occurred .and
cannot "e recaptured through a sale of the plant and e&uipment/, the! are sun, costs and are not
included as incremental cash flows.
c. ?o, the research and de%elopment costs should not "e treated as incremental cash flows. The
costs of research and de%elopment underta,en on the product during the past three !ears are
sun, costs and should not "e included in the e%aluation of the pro:ect. Eecisions made and
costs incurred in the past cannot "e changed. The! should not affect the decision to accept or
re:ect the pro:ect.
d. \es, the annual depreciation e#pense must "e ta,en into account when calculating the cash
flows related to a gi%en pro:ect. While depreciation is not a cash e#pense that directl! affects
cash flow, it decreases a firms net income and hence, lowers its ta# "ill for the !ear. Aecause
of this depreciation ta# shield, the firm has more cash on hand at the end of the !ear than it
would ha%e had without e#pensing depreciation.
e. ?o, di%idend pa!ments should not "e treated as incremental cash flows. ) firms decision to
pa! or not pa! di%idends is independent of the decision to accept or re:ect an! gi%en in%estment
pro:ect. ;or this reason, di%idends are not an incremental cash flow to a gi%en pro:ect. Ei%idend
polic! is discussed in more detail in later chapters.
f. \es, the resale %alue of plant and e&uipment at the end of a pro:ects life should "e treated as an
incremental cash flow. The price at which the firm sells the e&uipment is a cash inflow, and an!
difference "etween the "oo, %alue of the e&uipment and its sale price will create accounting
gains or losses that result in either a ta# credit or lia"ilit!.
g. \es, salar! and medical costs for production emplo!ees hired for a pro:ect should "e treated as
incremental cash flows. The salaries of all personnel connected to the pro:ect must "e included
as costs of that pro:ect.
CHAPTER 7 B-165
SOLUTIONS
3. Item I is a rele%ant cost "ecause the opportunit! to sell the land is lost if the new golf clu" is
produced. Item II is also rele%ant "ecause the firm must ta,e into account the erosion of sales of
e#isting products when a new product is introduced. If the firm produces the new clu", the earnings
from the e#isting clu"s will decrease, effecti%el! creating a cost that must "e included in the
decision. Item III is not rele%ant "ecause the costs of research and de%elopment are sun, costs.
Eecisions made in the past cannot "e changed. The! are not rele%ant to the production of the new
clu".
4. ;or ta# purposes, a firm would choose $)CRS "ecause it pro%ides for larger depreciation
deductions earlier. These larger deductions reduce ta#es, "ut ha%e no other cash conse&uences.
?otice that the choice "etween $)CRS and straight*line is purel! a time %alue issue( the total
depreciation is the same( onl! the timing differs.
5. Its pro"a"l! onl! a mild o%er*simplification. Current lia"ilities will all "e paid, presuma"l!. The
cash portion of current assets will "e retrie%ed. Some recei%a"les wont "e collected, and some
in%entor! will not "e sold, of course. Counter"alancing these losses is the fact that in%entor! sold
a"o%e cost .and not replaced at the end of the pro:ects life/ acts to increase wor,ing capital. These
effects tend to offset one another.
6. $anagements discretion to set the firms capital structure is applica"le at the firm le%el. Since an!
one particular pro:ect could "e financed entirel! with e&uit!, another pro:ect could "e financed with
de"t, and the firms o%erall capital structure would remain unchanged. ;inancing costs are not
rele%ant in the anal!sis of a pro:ects incremental cash flows according to the stand*alone principle.
7. The E)C approach is appropriate when comparing mutuall! e#clusi%e pro:ects with different li%es
that will "e replaced when the! wear out. This t!pe of anal!sis is necessar! so that the pro:ects ha%e
a common life span o%er which the! can "e compared. ;or e#ample, if one pro:ect has a three*!ear
life and the other has a fi%e*!ear life, then a >9*!ear horion is the minimum necessar! to place the
two pro:ects on an e&ual footing, impl!ing that one pro:ect will "e repeated fi%e times and the other
will "e repeated three times. ?ote the shortest common life ma! "e &uite long when there are more
than two alternati%es and-or the indi%idual pro:ect li%es are relati%el! long. )ssuming this t!pe of
anal!sis is %alid implies that the pro:ect cash flows remain the same o%er the common life, thus
ignoring the possi"le effects of, among other things0 .>/ inflation, .6/ changing economic conditions,
.3/ the increasing unrelia"ilit! of cash flow estimates that occur far into the future, and .D/ the
possi"le effects of future technolog! impro%ement that could alter the pro:ect cash flows.
8. Eepreciation is a non*cash e#pense, "ut it is ta#*deducti"le on the income statement. Thus
depreciation causes ta#es paid, an actual cash outflow, to "e reduced "! an amount e&ual to the
depreciation ta# shield, t
c
E. ) reduction in ta#es that would otherwise "e paid is the same thing as a
cash inflow, so the effects of the depreciation ta# shield must "e added in to get the total incremental
afterta# cash flows.
9. There are two particularl! important considerations. The first is erosion. Will the 1essentialied8
"oo, simpl! displace copies of the e#isting "oo, that would ha%e otherwise "een sold7 This is of
special concern gi%en the lower price. The second consideration is competition. Will other
pu"lishers step in and produce such a product7 If so, then an! erosion is much less rele%ant. )
particular concern to "oo, pu"lishers .and producers of a %ariet! of other product t!pes/ is that the
pu"lisher onl! ma,es mone! from the sale of new "oo,s. Thus, it is important to e#amine whether
the new "oo, would displace sales of used "oo,s .good from the pu"lishers perspecti%e/ or new
"oo,s .not good/. The concern arises an! time there is an acti%e mar,et for used product.
B-166
CHAPTER 7 B-
10. Eefinitel!. The damage to +orsches reputation is a factor the compan! needed to consider. If the
reputation was damaged, the compan! would ha%e lost sales of its e#isting car lines.
11. 'ne compan! ma! "e a"le to produce at lower incremental cost or mar,et "etter. )lso, of course,
one of the two ma! ha%e made a mista,e_
12. +orsche would recognie that the outsied profits would dwindle as more products come to mar,et
and competition "ecomes more intense.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. <sing the ta# shield approach to calculating 'C;, we get0
'C; G .Sales @ Costs/.> @ tC/ L tCEepreciation
'C; G N.29 Q 6,444/ @ .26 Q 6,444/O.> @ 4.3D/ L 4.3D.2>4,444-9/
'C; G 2D,HD4
So, the ?+X of the pro:ect is0
?+X G @2>4,444 L 2D,HD4.+XI;)>9K,9/
?+X G 29,99D
2. We will use the "ottom*up approach to calculate the operating cash flow for each !ear. We also must
"e sure to include the net wor,ing capital cash flows each !ear. So, the total cash flow each !ear will
"e0
\ear > \ear 6 \ear 3 \ear D
Sales 2I,444 2I,444 2I,444 2I,444
Costs 6,444 6,444 6,444 6,444
Eepreciation 6,944 6,944 6,944 6,944
EAT 26,944 26,944 26,944 26,944
Ta# 894 894 894 894
?et income 2>,H94 2>,H94 2>,H94 2>,H94

'C; 4 2D,>94 2D,>94 2D,>94 2D,>94
Capital spending @2>4,444 4 4 4 4
?WC @944 @694 @344 @644 >694
Incremental cash flow @2>4,944 23,J44 23,894 23,J94 29,D44
167
SOLUTIONS
The ?+X for the pro:ect is0
?+X G @2>4,944 L 23,J44 - >.>6 L 23,894 - >.>6
6
L 23,J94 - >.>6
3
L 29,D44 - >.>6
D
?+X G 26,6JD.HI

3. <sing the ta# shield approach to calculating 'C;, we get0
'C; G .Sales @ Costs/.> @ tC/ L tCEepreciation
'C; G .R6,D44,444 @ JH4,444/.> @ 4.39/ L 4.39.R6,I44,444-3/
'C; G R>,69>,444
So, the ?+X of the pro:ect is0
?+X G @R6,I44,444 L R>,69>,444.+XI;)>9K,3/
?+X G R>9H,3>D.H6
4. The cash outflow at the "eginning of the pro:ect will increase "ecause of the spending on ?WC. )t
the end of the pro:ect, the compan! will reco%er the ?WC, so it will "e a cash inflow. The sale of the
e&uipment will result in a cash inflow, "ut we also must account for the ta#es which will "e paid on
this sale. So, the cash flows for each !ear of the pro:ect will "e0
\ear Cash ;low
4 @ R3,444,444 G @R6.I$ @ 344M
> >,69>,444
6 >,69>,444
3 >,H8I,944 G R>,69>,444 L 344,444 L 6>4,444 L .4 @ 6>4,444/..39/
)nd the ?+X of the pro:ect is0
?+X G @R3,444,444 L R>,69>,444.+XI;)>9K,6/ L .R>,H8I,944 - >.>9
3
/
?+X G R>D3,364.DH
5. ;irst we will calculate the annual depreciation for the e&uipment necessar! for the pro:ect. The
depreciation amount each !ear will "e0
\ear > depreciation G R6.I$.4.3334/ G R8JJ,>44
\ear 6 depreciation G R6.I$.4.DDD4/ G R>,>J8,844
\ear 3 depreciation G R6.I$.4.>D84/ G R3JJ,H44
So, the "oo, %alue of the e&uipment at the end of three !ears, which will "e the initial in%estment
minus the accumulated depreciation, is0
Aoo, %alue in 3 !ears G R6.I$ @ .R8JJ,>44 L >,>J8,844 L 3JJ,H44/
Aoo, %alue in 3 !ears G R646,944
The asset is sold at a gain to "oo, %alue, so this gain is ta#a"le.
)fterta# sal%age %alue G R646,944 L .R6>4,444 @ 646,944/.4.39/
)fterta# sal%age %alue G R64I,3I9
B-168
CHAPTER 7 B-
To calculate the 'C;, we will use the ta# shield approach, so the cash flow each !ear is0
'C; G .Sales @ Costs/.> @ tC/ L tCEepreciation
\ear Cash ;low
4 @ R3,444,444 G @R6.I$ @ 344M
> >,694,H89.44 G .R>,DD4,444/..H9/ L 4.39.R8JJ,>44/
6 >,399,984.44 G .R>,DD4,444/..H9/ L 4.39.R>,>J8,844/
3 >,983,639.44 G .R>,DD4,444/..H9/ L 4.39.R3JJ,H44/ L R64I,3I9 L 344,444
Remem"er to include the ?WC cost in \ear 4, and the reco%er! of the ?WC at the end of the
pro:ect. The ?+X of the pro:ect with these assumptions is0
?+X G @ R3.4$ L .R>,694,H89->.>9/ L .R>,399,984->.>9
6
/ L .R>,983,639->.>9
3
/
NPV = R153,568.12
6. ;irst, we will calculate the annual depreciation of the new e&uipment. It will "e0
)nnual depreciation charge G =J69,444-9
)nnual depreciation charge G =>89,444
The afterta# sal%age %alue of the e&uipment is0
)fterta# sal%age %alue G =J4,444.> @ 4.39/
)fterta# sal%age %alue G =98,944
<sing the ta# shield approach, the 'C; is0
'C; G =3H4,444.> @ 4.39/ L 4.39.=>89,444/
'C; G =6J8,I94
?ow we can find the pro:ect IRR. There is an unusual feature that is a part of this pro:ect. )ccepting
this pro:ect means that we will reduce ?WC. This reduction in ?WC is a cash inflow at \ear 4. This
reduction in ?WC implies that when the pro:ect ends, we will ha%e to increase ?WC. So, at the end
of the pro:ect, we will ha%e a cash outflow to restore the ?WC to its le%el "efore the pro:ect. We
also must include the afterta# sal%age %alue at the end of the pro:ect. The IRR of the pro:ect is0
?+X G 4 G @=J69,444 L >69,444 L =6J8,I94.+XI;)IRRK,9/ L N.=98,944 @ >69,444/ - .>LIRR/
9
O
IRR G 63.89K
7. ;irst, we will calculate the annual depreciation of the new e&uipment. It will "e0
)nnual depreciation G 3J4,444-9
)nnual depreciation G I8,444
?ow, we calculate the afterta# sal%age %alue. The afterta# sal%age %alue is the mar,et price minus
.or plus/ the ta#es on the sale of the e&uipment, so0
)fterta# sal%age %alue G $X L .AX @ $X/tc
169
SOLUTIONS
Xer! often, the "oo, %alue of the e&uipment is ero as it is in this case. If the "oo, %alue is ero, the
e&uation for the afterta# sal%age %alue "ecomes0
)fterta# sal%age %alue G $X L .4 @ $X/tc
)fterta# sal%age %alue G $X.> @ tc/
We will use this e&uation to find the afterta# sal%age %alue since we ,now the "oo, %alue is ero. So,
the afterta# sal%age %alue is0
)fterta# sal%age %alue G H4,444.> @ 4.3D/
)fterta# sal%age %alue G 3J,H44
<sing the ta# shield approach, we find the 'C; for the pro:ect is0
'C; G >64,444.> @ 4.3D/ L 4.3D.I8,444/
'C; G >49,I64
?ow we can find the pro:ect ?+X. ?otice that we include the ?WC in the initial cash outla!. The
reco%er! of the ?WC occurs in \ear 9, along with the afterta# sal%age %alue.
?+X G @3J4,444 @ 68,444 L >49,I64.+XI;)>4K,9/ L N.3J,H44 L 68,444/ - >.>
9
O
?+X G 6D,I3H.6H
8. To find the AX at the end of four !ears, we need to find the accumulated depreciation for the first
four !ears. We could calculate a ta"le with the depreciation each !ear, "ut an easier wa! is to add the
$)CRS depreciation amounts for each of the first four !ears and multipl! this percentage times the
cost of the asset. We can then su"tract this from the asset cost. Eoing so, we get0
AXD G 2J,344,444 @ J,344,444.4.6444 L 4.3644 L 4.>J64 L 4.>>94/
AXD G 2>,H48,J44
The asset is sold at a gain to "oo, %alue, so this gain is ta#a"le.
)fterta# sal%age %alue G 26,>44,444 L .2>,H48,J44 @ 6,>44,444/..39/
)fterta# sal%age %alue G 2>,J68,>>9
9. We will "egin "! calculating the initial cash outla!, that is, the cash flow at Time 4. To underta,e the
pro:ect, we will ha%e to purchase the e&uipment and increase net wor,ing capital. So, the cash outla!
toda! for the pro:ect will "e0
E&uipment @P6,444,444
?WC @I9,444
Total @P6,4I9,444
B-170
CHAPTER 7 B-
<sing the "ottom*up approach to calculating the operating cash flow, we find the operating cash
flow each !ear will "e0
Sales P>,644,444
Costs 344,444
Eepreciation 944,444
EAT PD44,444
Ta# >D4,444
?et income P6H4,444

The operating cash flow is0
'C; G ?et income L Eepreciation
'C; G P6H4,444 L 944,444
'C; G PIH4,444
To find the ?+X of the pro:ect, we add the present %alue of the pro:ect cash flows. We must "e sure
to add "ac, the net wor,ing capital at the end of the pro:ect life, since we are assuming the net
wor,ing capital will "e reco%ered. So, the pro:ect ?+X is0
?+X G @P6,4I9,444 L PIH4,444.+XI;)>DK,D/ L PI9,444 - >.>D
D
?+X G P>83,86I.3I
10. We will need the afterta# sal%age %alue of the e&uipment to compute the E)C. E%en though the
e&uipment for each product has a different initial cost, "oth ha%e the same sal%age %alue. The
afterta# sal%age %alue for "oth is0
Aoth cases0 afterta# sal%age %alue G =64,444.> @ 4.39/ G =>3,444
To calculate the E)C, we first need the 'C; and ?+X of each option. The 'C; and ?+X for
Techron I is0
'C; G @ =3D,444.> @ 4.39/ L 4.39.=6>4,444-3/ G =6,D44
?+X G @=6>4,444 L =6,D44.+XI;)>DK,3/ L .=>3,444->.>D
3
/ G @=>J9,H93.D9
E)C G @=>J9,H93.D9 - .+XI;)>DK,3/ G @=8D,6ID.>4
)nd the 'C; and ?+X for Techron II is0
'C; G @ =63,444.> @ 4.39/ L 4.39.=364,444-9/ G =I,D94
?+X G @=364,444 L =I,D94.+XI;)>DK,9/ L .=>3,444->.>D
9
/ G @=68I,HI>.I9
E)C G @=68I,HI>.I9 - .+XI;)>DK,9/ G @=83,IJD.49
The two milling machines ha%e une&ual li%es, so the! can onl! "e compared "! e#pressing "oth on
an e&ui%alent annual "asis, which is what the E)C method does. Thus, !ou prefer the Techron II
"ecause it has the lower .less negati%e/ annual cost.
171
SOLUTIONS
&ntermediate
11. ;irst, we will calculate the depreciation each !ear, which will "e0
E> G 2D84,444.4.6444/ G 2JH,444
E6 G 2D84,444.4.3644/ G 2>93,H44
E3 G 2D84,444.4.>J64/ G 2J6,>H4
ED G 2D84,444.4.>>94/ G 299,644
The "oo, %alue of the e&uipment at the end of the pro:ect is0
AXD G 2D84,444 @ .2JH,444 L >93,H44 L J6,>H4 L 99,644/ G 283,4D4
The asset is sold at a loss to "oo, %alue, so this creates a ta# refund.
)fter*ta# sal%age %alue G 2I4,444 L .283,4D4 @ I4,444/.4.39/ G 2ID,9HD.44
So, the 'C; for each !ear will "e0
'C;> G 2>H4,444.> @ 4.39/ L 4.39.2JH,444/ G 2>3I,H44.44
'C;6 G 2>H4,444.> @ 4.39/ L 4.39.2>93,H44/ G 2>9I,IH4.44
'C;3 G 2>H4,444.> @ 4.39/ L 4.39.2J6,>H4/ G 2>3H,69H.44
'C;D G 2>H4,444.> @ 4.39/ L 4.39.299,644/ G 2>63,364.44
?ow we ha%e all the necessar! information to calculate the pro:ect ?+X. We need to "e careful with
the ?WC in this pro:ect. ?otice the pro:ect re&uires 264,444 of ?WC at the "eginning, and 23,444
more in ?WC each successi%e !ear. We will su"tract the 264,444 from the initial cash flow and
su"tract 23,444 each !ear from the 'C; to account for this spending. In \ear D, we will add "ac, the
total spent on ?WC, which is 26J,444. The 23,444 spent on ?WC capital during \ear D is
irrele%ant. Wh!7 Well, during this !ear the pro:ect re&uired an additional 23,444, "ut we would get
the mone! "ac, immediatel!. So, the net cash flow for additional ?WC would "e ero. With all this,
the e&uation for the ?+X of the pro:ect is0
?+X G @ 2D84,444 @ 64,444 L .2>3I,H44 @ 3,444/->.>9 L .2>9I,IH4 @ 3,444/->.>9
6
L .2>3H,69H @ 3,444/->.>9
3
L .2>63,364 L 6J,444 L ID,9HD/->.>9
D

?+X G @2D8,9JH.48
12. If we are tr!ing to decide "etween two pro:ects that will not "e replaced when the! wear out, the
proper capital "udgeting method to use is ?+X. Aoth pro:ects onl! ha%e costs associated with them,
not sales, so we will use these to calculate the ?+X of each pro:ect. <sing the ta# shield approach to
calculate the 'C;, the ?+X of S!stem ) is0
'C;) G @Rs.>64,444.> @ 4.3D/ L 4.3D.Rs.D34,444-D/
'C;) G @Rs.D6,H94
?+X) G @Rs.D34,444 @ Rs.D6,H94.+XI;)64K,D/
?+X) G @Rs.9D4,D4J.93
B-172
CHAPTER 7 B-
)nd the ?+X of S!stem A is0
'C;A G @Rs.84,444.> @ 4.3D/ L 4.3D.Rs.9D4,444-H/
'C;A G @Rs.66,644
?+XA G @Rs.9D4,444 @ Rs.66,644.+XI;)64K,H/
?+XA G @Rs.H>3,86H.36
If the s!stem will not "e replaced when it wears out, then S!stem ) should "e chosen, "ecause it has
the less negati%e ?+X.
13. If the e&uipment will "e replaced at the end of its useful life, the correct capital "udgeting techni&ue
is E)C. <sing the ?+Xs we calculated in the pre%ious pro"lem, the E)C for each s!stem is0
E)C) G @ Rs.9D4,D4J.93 - .+XI;)64K,D/
E)C) G @Rs.648,I9D.36
E)CA G @ Rs.H>3,86H.36 - .+XI;)64K,H/
E)CA G @Rs.>8D,98>.>4
If the con%e!or "elt s!stem will "e continuall! replaced, we should choose S!stem A since it has the
less negati%e E)C.
14. Since we need to calculate the E)C for each machine, sales are irrele%ant. E)C onl! uses the costs
of operating the e&uipment, not the sales. <sing the "ottom up approach, or net income plus
depreciation, method to calculate 'C;, we get0
$achine ) $achine A
Xaria"le costs @B3,>94,444 @B6,I44,444
;i#ed costs @>94,444 @>44,444
Eepreciation @394,444 @944,444
EAT @B3,H94,444 @B3,344,444
Ta# >,6II,944 >,>99,444
?et income @B6,3I6,944 @B6,>D9,444
L Eepreciation 394,444 944,444
'C; @B6,466,944 @B>,HD9,444
The ?+X and E)C for $achine ) is0
?+X) G @B6,>44,444 @ B6,466,944.+XI;)>4K,H/
?+X) G @B>4,J48,9>D.IH
E)C) G @ B>4,J48,9>D.IH - .+XI;)>4K,H/
E)C) G @B6,94D,HI9.94
173
SOLUTIONS
)nd the ?+X and E)C for $achine A is0
?+XA G @BD,944,444 @ >,HD9,444.+XI;)>4K,J/
?+XA G @B>3,JI3,9JD.>8
E)CA G @ B>3,JI3,9JD.>8 - .+XI;)>4K,J/
E)CA G @B6,D6H,386.D3
\ou should choose $achine A since it has a less negati%e E)C.
15. When we are dealing with nominal cash flows, we must "e careful to discount cash flows at the
nominal interest rate, and we must discount real cash flows using the real interest rate. +ro:ect )s
cash flows are in real terms, so we need to find the real interest rate. <sing the ;isher e&uation, the
real interest rate is0
> L < G .> L r/.> L h/
>.>9 G .> L r/.> L .4D/
r G .>498 or >4.98K
So, the ?+X of +ro:ect )s real cash flows, discounting at the real interest rate, is0
?+X G @2D4,444 L 264,444 - >.>498 L 2>9,444 - >.>498
6
L 2>9,444 - >.>498
3
?+X G 2>,DD8.88
+ro:ect As cash flow are in nominal terms, so the ?+X discount at the nominal interest rate is0
?+X G @294,444 L 2>4,444 - >.>9 L 264,444 - >.>9
6
L 2D4,444 - >.>9
3
?+X G 2>>J.>I
We should accept +ro:ect ) if the pro:ects are mutuall! e#clusi%e since it has the highest ?+X.
16. To determine the %alue of a firm, we can simpl! find the present %alue of the firms future cash
flows. ?o depreciation is gi%en, so we can assume depreciation is ero. <sing the ta# shield
approach, we can find the present %alue of the afterta# re%enues, and the present %alue of the afterta#
costs. The re&uired return, growth rates, price, and costs are all gi%en in real terms. Su"tracting the
costs from the re%enues will gi%e us the %alue of the firms cash flows. We must calculate the
present %alue of each separatel! since each is growing at a different rate. ;irst, we will find the
present %alue of the re%enues. The re%enues in !ear > will "e the num"er of "ottles sold, times the
price per "ottle, or0
)fterta# re%enue in !ear > in real terms G .6,444,444 Q 2>.69/.> @ 4.3D/
)fterta# re%enue in !ear > in real terms G 2>,H94,444
Re%enues will grow at si# percent per !ear in real terms fore%er. )ppl! the growing perpetuit!
formula, we find the present %alue of the re%enues is0
+X of re%enues G C> - .< @ g/
+X of re%enues G 2>,H94,444 - .4.>4 @ 4.4H/
+X of re%enues G 2D>,694,444
B-174
CHAPTER 7 B-
The real afterta# costs in !ear > will "e0
)fterta# costs in !ear > in real terms G .6,444,444 Q 24.84/.> @ 4.3D/
)fterta# costs in !ear > in real terms G 2>,49H,444
Costs will grow at fi%e percent per !ear in real terms fore%er. )ppl!ing the growing perpetuit!
formula, we find the present %alue of the costs is0
+X of costs G C> - .< @ g/
+X of costs G 2>,49H,444 - .4.>4 @ 4.49/
+X of costs G 26>,>64,444
?ow we can find the %alue of the firm, which is0
Xalue of the firm G +X of re%enues @ +X of costs
Xalue of the firm G 2D>,694,444 @ 6>,>64,444
Xalue of the firm G 264,>34,444
17. To calculate the nominal cash flows, we simple increase each item in the income statement "! the
inflation rate, e#cept for depreciation. Eepreciation is a nominal cash flow, so it does not need to "e
ad:usted for inflation in nominal cash flow anal!sis. Since the resale %alue is gi%en in nominal terms
as of the end of !ear 9, it does not need to "e ad:usted for inflation. )lso, no inflation ad:ustment is
needed for either the depreciation charge or the reco%er! of net wor,ing capital since these items are
alread! e#pressed in nominal terms. ?ote that an increase in re&uired net wor,ing capital is a
negati%e cash flow whereas a decrease in re&uired net wor,ing capital is a positi%e cash flow. We
first need to calculate the ta#es on the sal%age %alue. Remem"er, to calculate the ta#es paid .or ta#
credit/ on the sal%age %alue, we ta,e the "oo, %alue minus the mar,et %alue, times the ta# rate,
which, in this case, would "e0
Ta#es on sal%age %alue G .AX @ $X/tC
Ta#es on sal%age %alue G .Rs.4 @ 34,444/..3D/
Ta#es on sal%age %alue G @Rs.>4,644
So, the nominal afterta# sal%age %alue is0
$ar,et price Rs.34,444
Ta# on sale @>4,644
)fterta# sal%age %alue Rs.>J,844
175
SOLUTIONS
?ow we can find the nominal cash flows each !ear using the income statement. Eoing so, we find0
\ear 4 \ear > \ear 6 \ear 3 \ear D \ear 9
Sales Rs.644,444 Rs.64H,444 Rs.6>6,>84 Rs.6>8,9D9 Rs.669,>46
E#penses 94,444 9>,944 93,4D9 9D,H3H 9H,6I9
Eepreciation 94,444 94,444 94,444 94,444 94,444
EAT Rs.>44,444 Rs.>4D,944 Rs.>4J,>39 Rs.>>3,J4J Rs.>>8,86H
Ta# 3D,444 39,934 3I,>4H 38,I6J D4,D4>
?et income Rs.HH,444 Rs.H8,JI4 Rs.I6,46J Rs.I9,>84 Rs.I8,D69
'C; Rs.>>H,444 Rs.>>8,JI4 Rs.>66,46J Rs.>69,>84 Rs.>68,D69

Capital spending
@
Rs.694,444 Rs.>J,844
?WC @>4,444 >4,444
Total cash flow
@
Rs.6H4,444 Rs.>>H,444 Rs.>>8,JI4 Rs.>66,46J Rs.>69,>84 Rs.>98,669
18. The present %alue of the compan! is the present %alue of the future cash flows generated "! the
compan!. 5ere we ha%e real cash flows, a real interest rate, and a real growth rate. The cash flows
are a growing perpetuit!, with a negati%e growth rate. <sing the growing perpetuit! e&uation, the
present %alue of the cash flows are0
+X G C> - .< @ g/
+X G Ca2>64,444 - N.>6 @ .@.4H/O
+X G Ca2HHH,HHI
19. To find the E)C, we first need to calculate the ?+X of the incremental cash flows. We will "egin
with the afterta# sal%age %alue, which is0
Ta#es on sal%age %alue G .AX @ $X/tC
Ta#es on sal%age %alue G .24 @ >4,444/..3D/
Ta#es on sal%age %alue G @23,D44
$ar,et price 2>4,444
Ta# on sale @3,D44
)fterta# sal%age %alue 2H,H44
?ow we can find the operating cash flows. <sing the ta# shield approach, the operating cash flow
each !ear will "e0
'C; G @29,444.> @ 4.3D/ L 4.3D.2D9,444-3/
'C; G 2>,844
So, the ?+X of the cost of the decision to "u! is0
?+X G @2D9,444 L 2>,844.+XI;)>6K,3/ L .2H,H44->.>6
3
/
?+X G @239,J8I.J9
B-176
CHAPTER 7 B-
In order to calculate the e&ui%alent annual cost, set the ?+X of the e&uipment e&ual to an annuit!
with the same economic life. Since the pro:ect has an economic life of three !ears and is discounted
at >6 percent, set the ?+X e&ual to a three*!ear annuit!, discounted at >6 percent.
E)C G @239,J8I.J9 - .+XI;)>6K,3/
E)C G @2>D,JIJ.84
20. We will find the E)C of the EX; first. There are no ta#es since the uni%ersit! is ta#*e#empt, so the
maintenance costs are the operating cash flows. The ?+X of the decision to "u! one EX; is0
?+X G @Rs.8,444 @ Rs.6,444.+XI;)>DK,D/
?+X G @Rs.>3,86I.D6
In order to calculate the e&ui%alent annual cost, set the ?+X of the e&uipment e&ual to an annuit!
with the same economic life. Since the pro:ect has an economic life of four !ears and is discounted at
>D percent, set the ?+X e&ual to a three*!ear annuit!, discounted at >D percent. So, the E)C per unit
is0
E)C G @Rs.>3,86I.D6 - .+XI;)>DK,D/
E)C G @Rs.D,ID9.HD
Since the uni%ersit! must "u! >4 of the word processors, the total E)C of the decision to "u! the
EX; word processor is0
Total E)C G >4.@Rs.D,ID9.HD/
Total E)C G @Rs.DI,D9H.38
?ote, we could ha%e found the total E)C for this decision "! multipl!ing the initial cost "! the
num"er of word processors needed, and multipl!ing the annual maintenance cost of each "! the
same num"er. We would ha%e arri%ed at the same E)C.
We can find the E)C of the )E5 word processors using the same method, "ut we need to include
the sal%age %alue as well. There are no ta#es on the sal%age %alue since the uni%ersit! is ta#*e#empt,
so the ?+X of "u!ing one )E5 will "e0
?+X G @Rs.9,444 @ Rs.6,944.+XI;)>DK,3/ L .Rs.944->.>D
3
/
?+X G @Rs.>4,DHH.9J
So, the E)C per machine is0
E)C G @Rs.>4,DHH.9J - .+XI;)>DK,3/
E)C G @Rs.D,948.6J
177
SOLUTIONS
Since the uni%ersit! must "u! >> of the word processors, the total E)C of the decision to "u! the
)E5 word processor is0
Total E)C G >>.@Rs.D,948.6J/
Total E)C G @Rs.DJ,9J>.6>
The uni%ersit! should "u! the EX; word processors since the E)C is less negati%e. ?otice that the
E)C of the )E5 is lower on a per machine "asis, "ut "ecause the uni%ersit! needs more of these
word processors, the total E)C is higher.
21. We will calculate the afterta# sal%age %alue first. The afterta# sal%age %alue of the e&uipment will
"e0
Ta#es on sal%age %alue G .AX @ $X/tC
Ta#es on sal%age %alue G .)u24 @ >44,444/..3D/
Ta#es on sal%age %alue G @)u23D,444
$ar,et price )u2>44,444
Ta# on sale @3D,444
)fterta# sal%age %alue )u2HH,444
?e#t, we will calculate the initial cash outla!, that is, the cash flow at Time 4. To underta,e the
pro:ect, we will ha%e to purchase the e&uipment. The new pro:ect will decrease the net wor,ing
capital, so this is a cash inflow at the "eginning of the pro:ect. So, the cash outla! toda! for the
pro:ect will "e0
E&uipment @)u2944,444
?WC >44,444
Total @)u2D44,444
?ow we can calculate the operating cash flow each !ear for the pro:ect. <sing the "ottom up
approach, the operating cash flow will "e0
Sa%ed salaries )u2>64,444
Eepreciation >44,444
EAT )u264,444
Ta#es H,844
?et income )u2>3,644
)nd the 'C; will "e0
'C; G )u2>3,644 L >44,444
'C; G )u2>>3,644
?ow we can find the ?+X of the pro:ect. In \ear 9, we must replace the sa%ed ?WC, so0
?+X G @)u2D44,444 L )u2>>3,644.+XI;)>4K,9/ @ )u23D,444 - >.>6
9
?+X G @)u28,449.ID
B-178
CHAPTER 7 B-
22. Replacement decision anal!sis is the same as the anal!sis of two competing pro:ects, in this case,
,eep the current e&uipment, or purchase the new e&uipment. We will consider the purchase of the
new machine first.
+urchase new machine0
The initial cash outla! for the new machine is the cost of the new machine, plus the increased net
wor,ing capital. So, the initial cash outla! will "e0
+urchase new machine @V36,444,444
?et wor,ing capital @944,444
Total @V36,944,444
?e#t, we can calculate the operating cash flow created if the compan! purchases the new machine.
The sa%ed operating e#pense is an incremental cash flow. )dditionall!, the reduced operating
e#pense is a cash inflow, so it should "e treated as such in the income statement. The pro forma
income statement, and adding depreciation to net income, the operating cash flow created "!
purchasing the new machine each !ear will "e0
'perating e#pense V9,444,444
Eepreciation 8,444,444
EAT @V3,444,444
Ta#es @>,>I4,444
?et income @V>,834,444
'C; VH,>I4,444
So, the ?+X of purchasing the new machine, including the reco%er! of the net wor,ing capital, is0
?+X G @V36,944,444 L VH,>I4,444.+XI;)>4K,D/ L V944,444 - >.>4
D
?+X G @V>6,H44,D63.DI
)nd the IRR is0
4 G @V36,944,444 L VH,>I4,444.+XI;)IRR,D/ L V944,444 - .> L IRR/
D
<sing a spreadsheet or financial calculator, we find the IRR is0
IRR G @J.38K
?ow we can calculate the decision to ,eep the old machine0
179
SOLUTIONS
Meep old machine0
The initial cash outla! for the old machine is the mar,et %alue of the old machine, including an!
potential ta# conse&uence. The decision to ,eep the old machine has an opportunit! cost, namel!, the
compan! could sell the old machine. )lso, if the compan! sells the old machine at its current %alue,
it will incur ta#es. Aoth of these cash flows need to "e included in the anal!sis. So, the initial cash
flow of ,eeping the old machine will "e0
Meep machine @VJ,444,444
Ta#es 3J4,444
Total @V8,H>4,444
?e#t, we can calculate the operating cash flow created if the compan! ,eeps the old machine. There
are no incremental cash flows from ,eeping the old machine, "ut we need to account for the cash
flow effects of depreciation. The income statement, adding depreciation to net income to calculate
the operating cash flow will "e0
Eepreciation V6,444,444
EAT @V6,444,444
Ta#es @I84,444
?et income @V>,664,444
'C; VI84,444
So, the ?+X of the decision to ,eep the old machine will "e0
?+X G @V8,H>4,444 L VI84,444.+XI;)>4K,D/
?+X G @VH,>3I,94D.J9
)nd the IRR is0
4 G @V8,H>4,444 L VI84,444.+XI;)IRR,D/
Since the pro:ect ne%er pa!s pa! "ac,, there is no IRR.
The compan! should not purchase the new machine since it has a lower ?+X.
B-180
CHAPTER 7 B-
There is another wa! to anal!e a replacement decision that is often used. It is an incremental cash
flow anal!sis of the change in cash flows from the e#isting machine to the new machine, assuming
the new machine is purchased. In this t!pe of anal!sis, the initial cash outla! would "e the cost of the
new machine, the increased in%entor!, and the cash inflow .including an! applica"le ta#es/ of selling
the old machine. In this case, the initial cash flow under this method would "e0
+urchase new machine @V36,444,444
?et wor,ing capital @944,444
Sell old machine J,444,444
Ta#es on old machine @3J4,444
Total @V63,8J4,444
The cash flows from purchasing the new machine would "e the sa%ed operating e#penses. We would
also need to include the change in depreciation. The old machine has a depreciation of V6 million per
!ear, and the new machine has a depreciation of V8 million per !ear, so the increased depreciation
will "e VH million per !ear. The pro forma income statement and operating cash flow under this
approach will "e0
'perating e#pense sa%ings V9,444,444
Eepreciation @H,444,444
EAT @V>,444,444
Ta#es @3J4,444
?et income @VH>4,444
'C; V9,3J4,444
The ?+X under this method is0
?+X G @V63,8J4,444 L V9,3J4,444.+XI;)>4K,D/ L V944,444 - >.>4
D
?+X G @VH,DH6,J>8.96
)nd the IRR is0
4 G @V63,8J4,444 L V9,3J4,444.+XI;)IRR,D/ L V944,444 - .> L IRR/
D
<sing a spreadsheet or financial calculator, we find the IRR is0
IRR G @3.4IK
So, this anal!sis still tells us the compan! should not purchase the new machine. This is reall! the
same t!pe of anal!sis we originall! did. Consider this0 Su"tract the ?+X of the decision to ,eep the
old machine from the ?+X of the decision to purchase the new machine. \ou will get0
Eifferential ?+X G @V>6,H44,D63.DI @ .@H,>3I,94D.J9/ G @VH,DH6,J>8.96
This is the e#act same ?+X we calculated when using the second anal!sis method.
181
SOLUTIONS
b. The purchase of a new machine can ha%e a positi%e ?+X "ecause of the depreciation ta# shield.
Without the depreciation ta# shield, the new machine would ha%e a negati%e ?+X since the
sa%ed e#penses from the machine do not e#ceed the cost of the machine when we consider the
time %alue of mone!.
23. We can find the ?+X of a pro:ect using nominal cash flows or real cash flows. Either method will
result in the same ?+X. ;or this pro"lem, we will calculate the ?+X using "oth nominal and real
cash flows. The initial in%estment in either case is >64,444 since it will "e spent toda!. We will
"egin with the nominal cash flows. The re%enues and production costs increase at different rates, so
we must "e careful to increase each at the appropriate growth rate. The nominal cash flows for each
!ear will "e0
\ear 4 \ear > \ear 6 \ear 3
Re%enues 94,444.44 96,944.44 99,>69.44
Costs 64,444.44 6>,D44.44 66,8J8.44
Eepreciation >I,>D6.8H >I,>D6.8H >I,>D6.8H
EAT >6,89I.>D >3,J9I.>D >9,48D.>D
Ta#es D,3I>.D3 D,ID9.D3 9,>68.H>
?et income 8,D89.I> J,6>>.I> J,J99.93
'C; 69,H68.9I 6H,39D.9I 6I,4J8.3J

Capital spending @>64,444

Total cash flow @>64,444 69,H68.9I 6H,39D.9I 6I,4J8.3J
\ear D \ear 9 \ear H \ear I
Re%enues 9I,88>.69 H4,II9.3> H3,8>D.48 HI,44D.I8
Costs 6D,944.8H 6H,6>9.J6 68,49>.43 34,4>D.H>
Eepreciation >I,>D6.8H >I,>D6.8H >I,>D6.8H >I,>D6.8H
EAT >H,63I.93 >I,D>H.9D >8,H64.>J >J,8DI.36
Ta#es 9,964.IH 9,J6>.H6 H,334.8H H,ID8.4J
?et income >4,I>H.II >>,DJD.J> >6,68J.36 >3,4JJ.63
'C; 6I,89J.H3 68,H3I.II 6J,D36.>8 34,6D6.4J

Capital spending

Total cash flow 6I,89J.H3 68,H3I.II 6J,D36.>8 34,6D6.4J
?ow that we ha%e the nominal cash flows, we can find the ?+X. We must use the nominal re&uired
return with nominal cash flows. <sing the ;isher e&uation to find the nominal re&uired return, we
get0
.> L </ G .> L r/.> L h/
.> L </ G .> L .>D/.> L .49/
< G .>JI4 or >J.I4K
B-182
CHAPTER 7 B-
So, the ?+X of the pro:ect using nominal cash flows is0
?+X G @>64,444 L 69,H69.9I - >.>JI4 L 6H,39D.9I - >.>JI4
6
L 6I,4J8.3J - >.>JI4
3

L 6I,89J.H3 - >.>JI4
D
L 68,H3I.II - >.>JI4
9
L 6J,D36.>8 - >.>JI4
H
L 34,6D6.4J -
>.>JI4
I
?+X G @64,9IH.44
We can also find the ?+X using real cash flows and the real re&uired return. This will allow us to
find the operating cash flow using the ta# shield approach. Aoth the re%enues and e#penses are
growing annuities, "ut growing at different rates. This means we must find the present %alue of each
separatel!. We also need to account for the effect of ta#es, so we will multipl! "! one minus the ta#
rate. So, the present %alue of the afterta# re%enues using the growing annuit! e&uation is0
+X of afterta# re%enues G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[.> @ tC/
+X of afterta# re%enues G 94,444ZN>-..>D @ .49/O @ N>-..>D @ .49/O Q N.> L .49/-.> L .>D/O
I
[.> @ .3D/
+X of afterta# re%enues G >3D,II9.6J
)nd the present %alue of the afterta# costs will "e0
+X of afterta# costs G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[.> @ tC/
+X of afterta# costs G 64,444ZN>-..>D @ .4I/O @ N>-..>D @ .4I/O Q N.> L .4I/-.> L .>D/O
I
[.> @ .3D/
+X of afterta# costs G 9H,93D.J>
?ow we need to find the present %alue of the depreciation ta# shield. The depreciation amount in the
first !ear is a real %alue, so we can find the present %alue of the depreciation ta# shield as an ordinar!
annuit! using the real re&uired return. So, the present %alue of the depreciation ta# shield will "e0
+X of depreciation ta# shield G .>64,444-I/..3D/.+XI;)>J.I4K,I/
+X of depreciation ta# shield G 6>,>83.H>
<sing the present %alue of the real cash flows to find the ?+X, we get0
?+X G Initial cost L +X of re%enues @ +X of costs L +X of depreciation ta# shield
?+X G @>64,444 L >3D,II9.6J @ 9H,93D.J> L 6>,>83.H>
?+X G @64,9IH.44
?otice, the ?+X using nominal cash flows or real cash flows is identical, which is what we would
e#pect.
24. 5ere we ha%e a pro:ect in which the &uantit! sold each !ear increases. ;irst, we need to calculate the
&uantit! sold each !ear "! increasing the current !ears &uantit! "! the growth rate. So, the &uantit!
sold each !ear will "e0
\ear > &uantit! G 9,444
\ear 6 &uantit! G 9,444.> L .>9/ G 9,I94
\ear 3 &uantit! G 9,I94.> L .>9/ G H,H>3
\ear D &uantit! G H,H>3.> L .>9/ G I,H4D
\ear 9 &uantit! G I,H4D.> L .>9/ G 8,ID9
183
SOLUTIONS
?ow we can calculate the sales re%enue and %aria"le costs each !ear. The pro forma income
statements and operating cash flow each !ear will "e0
\ear 4 \ear > \ear 6 \ear 3 \ear D \ear 9
Re%enues )u2669,444.44 )u2698,I94.44 )u26JI,9H6.94 )u23D6,>JH.88 )u23J3,96H.D>
;i#ed costs I9,444.44 I9,444.44 I9,444.44 I9,444.44 I9,444.44
Xaria"le costs >44,444.44 >>9,444.44 >36,694.44 >96,48I.94 >ID,J44.H3
Eepreciation >6,444.44 >6,444.44 >6,444.44 >6,444.44 >6,444.44
EAT )u238,444.44 )u29H,I94.44 )u2I8,3>6.94 )u2>43,>4J.38 )u2>3>,H69.I8
Ta#es >6,J64.44 >J,6J9.44 6H,H6H.69 39,49I.>J DD,I96.II
?et income )u269,484.44 )u23I,D99.44 )u29>,H8H.69 )u2H8,496.>J )u28H,8I3.46
'C; )u23I,484.44 )u2DJ,D99.44 )u2H3,H8H.69 )u284,496.>J )u2J8,8I3.46

Capital spending @)u2H4,444
?WC @68,444 )u268,444

Total cash flow @)u288,444 )u23I,484.44 )u2DJ,D99.44 )u2H3,H8H.69 )u284,496.>J )u2>6H,8I3.46
So, the ?+X of the pro:ect is0
?+X G @)u288,444 L )u23I,484 - >.69 L )u2DJ,D99 - >.69
6
L )u2H3,H8H.69 - >.69
3
L
)u284,496.>J - >.69
D
L )u2>6H,8I3.46 - >.69
9
?+X G )u284,689.HJ
We could also ha%e calculated the cash flows using the ta# shield approach, with growing annuities
and ordinar! annuities. The sales and %aria"le costs increase at the same rate as sales, so "oth are
growing annuities. The fi#ed costs and depreciation are "oth ordinar! annuities. <sing the growing
annuit! e&uation, the present %alue of the re%enues is0
+X of re%enues G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[.> @ tC/
+X of re%enues G )u2669,444ZN>-..69 @ .>9/O @ N>-..69 @ .>9/O Q N.> L .>9/-.> L .69/O
9
[
+X of re%enues G )u2IHI,4HH.9I
)nd the present %alue of the %aria"le costs will "e0
+X of %aria"le costs G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[.> @ tC/
+X of %aria"le costs G )u2>44,444ZN>-..69 @ .>9/O @ N>-..69 @ .>9/O Q N.> L .>9/-.> L .69/O
9
[
+X of %aria"le costs G )u23D4,J>8.D8
The fi#ed costs and depreciation are "oth ordinar! annuities. The present %alue of each is0
+X of fi#ed costs G '.Z> @ N>-.> L r6O
t
[ - r /
+X of fi#ed costs G )u2I9,444.+XI;)69K,9/
+X of fi#ed costs G )u264>,HJH.44
B-184
CHAPTER 7 B-
+X of depreciation G '.Z> @ N>-.> L r6O
t
[ - r /
+X of depreciation G )u2>6,444.+XI;)69K,9/
+X of depreciation G )u236,6I>.3H
?ow, we can use the depreciation ta# shield approach to find the ?+X of the pro:ect, which is0
?+X G @)u288,444 L .)u2IHI,4HH.9I @ 3D4,J>8.D8 @ 64>,HJH.44/.> @ .3D/ L .)u236,6I>.3H/..3D/
L )u268,444 - >.69
9
?+X G )u284,689.HJ
25. We will "egin "! calculating the afterta# sal%age %alue of the e&uipment at the end of the pro:ects
life. The afterta# sal%age %alue is the mar,et %alue of the e&uipment minus an! ta#es paid .or
refunded/, so the afterta# sal%age %alue in four !ears will "e0
Ta#es on sal%age %alue G .AX @ $X/tC
Ta#es on sal%age %alue G .24 @ D44,444/..3D/
Ta#es on sal%age %alue G @2>96,444
$ar,et price 2D44,444
Ta# on sale @>96,444
)fterta# sal%age %alue 26D8,444
?ow we need to calculate the operating cash flow each !ear. ?ote, we assume that the net wor,ing
capital cash flow occurs immediatel!. <sing the "ottom up approach to calculating operating cash
flow, we find0
\ear 4 \ear > \ear 6 \ear 3 \ear D
Re%enues 26,434,444 26,HH4,444 2>,8J4,444 2>,334,444
;i#ed costs 394,444 394,444 394,444 394,444
Xaria"le costs 34D,944 3JJ,444 683,944 >JJ,944
Eepreciation >,6H9,D44 >,H8I,644 9H6,D44 68>,644
EAT 2>>4,>44 2663,844 2HJD,>44 2DJJ,344
Ta#es D>,838 89,4DD 6H3,I98 >8J,I3D
?et income 2H8,6H6 2>38,I9H 2D34,3D6 234J,9HH
'C; 2>,333,HH6 2>,869,J9H 2JJ6,ID6 29J4,IHH

Capital spending @23,844,444 26D8,444
Cand @844,444 844,444
?WC @2>64,444 >64,444

Total cash flow @2D,I64,444 2>,333,HH6 2>,869,J9H 2JJ6,ID6 2>,I98,IHH
185
SOLUTIONS
?otice the calculation of the cash flow at time 4. The capital spending on e&uipment and in%estment
in net wor,ing capital are cash outflows. The afterta# selling price of the land is also a cash outflow.
E%en though no cash is actuall! spent on the land "ecause the compan! alread! owns it, the afterta#
cash flow from selling the land is an opportunit! cost, so we need to include it in the anal!sis. With
all the pro:ect cash flows, we can calculate the ?+X, which is0
?+X G @2D,I64,444 L 2>,333,HH6 - >.>9 L 2>,869,J9H - >.>9
6
L 2JJ6,ID6 - >.>9
3

L 2>,I98,IHH - >.>9
D
?+X G @296>,68D.I4
The compan! should re:ect the new product line.
26. Replacement decision anal!sis is the same as the anal!sis of two competing pro:ects, in this case,
,eep the current e&uipment, or purchase the new e&uipment. We will consider the purchase of the
new machine first.
+urchase new machine0
The initial cash outla! for the new machine is the cost of the new machine. We can calculate the
operating cash flow created if the compan! purchases the new machine. The maintenance cost is an
incremental cash flow, so using the pro forma income statement, and adding depreciation to net
income, the operating cash flow created "! purchasing the new machine each !ear will "e0
$aintenance cost @944,444
Eepreciation @H44,444
EAT @>,>44,444
Ta#es @3ID,444
?et income @I6H,444
'C; @>6H,444
?otice the ta#es are negati%e, impl!ing a ta# credit. The new machine also has a sal%age %alue at the
end of fi%e !ears, so we need to include this in the cash flows anal!sis. The afterta# sal%age %alue
will "e0
Sell machine 944,444
Ta#es @>I4,444
Total 334,444
The ?+X of purchasing the new machine is0
?+X G @3,444,444 @ >6H,444.+XI;)>6K,9/ L 334,444 - >.>6
9
?+X G @3,6HH,J94.9D
?otice the ?+X is negati%e. This does not necessaril! mean we should not purchase the new
machine. In this anal!sis, we are onl! dealing with costs, so we would e#pect a negati%e ?+X. The
re%enue is not included in the anal!sis since it is not incremental to the machine. Similar to an E)C
anal!sis, we will use the machine with the least negati%e ?+X. ?ow we can calculate the decision to
,eep the old machine0
B-186
CHAPTER 7 B-
Meep old machine0
The initial cash outla! for the new machine is the mar,et %alue of the old machine, including an!
potential ta#. The decision to ,eep the old machine has an opportunit! cost, namel!, the compan!
could sell the old machine. )lso, if the compan! sells the old machine at its current %alue, it will
incur ta#es. Aoth of these cash flows need to "e included in the anal!sis. So, the initial cash flow of
,eeping the old machine will "e0
Meep machine @6,444,444
Ta#es @3D4,444
Total @6,3D4,444
?e#t, we can calculate the operating cash flow created if the compan! ,eeps the old machine. We
need to account for the cost of maintenance, as well as the cash flow effects of depreciation. The
incomes statement, adding depreciation to net income to calculate the operating cash flow will "e0
$aintenance cost @D44,444
Eepreciation @644,444
EAT @H44,444
Ta#es @64D,444
?et income @3JH,444
'C; @>JH,444
The old machine also has a sal%age %alue at the end of fi%e !ears, so we need to include this in the
cash flows anal!sis. The afterta# sal%age %alue will "e0
Sell machine 644,444
Ta#es @H8,444
Total >36,444
So, the ?+X of the decision to ,eep the old machine will "e0
?+X G @6,3D4,444 @ >JH,444.+XI;)>6K,9/ L >36,444 - >.>6
9
?+X G @6,JI>,H39.IJ
The compan! should not purchase the new machine since it has a lower ?+X.
There is another wa! to anal!e a replacement decision that is often used. It is an incremental cash
flow anal!sis of the change in cash flows from the e#isting machine to the new machine, assuming
the new machine is purchased. In this t!pe of anal!sis, the initial cash outla! would "e the cost of the
new machine, and the cash inflow .including an! applica"le ta#es/ of selling the old machine. In this
case, the initial cash flow under this method would "e0
+urchase new machine @3,444,444
Sell old machine 6,444,444
Ta#es on old machine @3D4,444
Total @>,3D4,444
187
SOLUTIONS
The cash flows from purchasing the new machine would "e the difference in the operating e#penses.
We would also need to include the change in depreciation. The old machine has a depreciation of
644,444 per !ear, and the new machine has a depreciation of H44,444 per !ear, so the increased
depreciation will "e D44,444 per !ear. The pro forma income statement and operating cash flow
under this approach will "e0
$aintenance cost @>44,444
Eepreciation @D44,444
EAT @944,444
Ta#es @>I4,444
?et income @334,444
'C; I4,444
The sal%age %alue of the differential cash flow approach is more complicated. The compan! will sell
the new machine, and incur ta#es on the sale in fi%e !ears. 5owe%er, we must also include the lost
sale of the old machine. Since we assumed we sold the old machine in the initial cash outla!, we lose
the a"ilit! to sell the machine in fi%e !ears. This is an opportunit! loss that must "e accounted for.
So, the sal%age %alue is0
Sell machine 944,444
Ta#es @>I4,444
Cost sale of old @644,444
Ta#es on lost sale of old H8,444
Total >J8,444
The ?+X under this method is0
?+X G @>,3D4,444 L I4,444.+XI;)>6K,9/ L >J8,444 - >.>6
D
?+X G @JI9,3>9.>9
So, this anal!sis still tells us the compan! should not purchase the new machine. This is reall! the
same t!pe of anal!sis we originall! did. Consider this0 Su"tract the ?+X of the decision to ,eep the
old machine from the ?+X of the decision to purchase the new machine. \ou will get0
Eifferential ?+X G @3,6HH,J94.JD @ .@6,JI>,H39.IJ/ G @JI9,3>9.>9
This is the e#act same ?+X we calculated when using the second anal!sis method.
27. 5ere we ha%e a situation where a compan! is going to "u! one of two assets, so we need to calculate
the E)C of each asset. To calculate the E)C, we can calculate the E)C of the com"ined costs of
each computer, or calculate the E)C of an indi%idual computer, then multipl! "! the num"er of
computers the compan! is purchasing. In this instance, we will calculate the E)C of each indi%idual
computer. ;or the S)C 9444, we will "egin "! calculating the afterta# sal%age %alue, then the
operating cash flows. So0
B-188
CHAPTER 7 B-
S)C 94440
Ta#es on sal%age %alue G .AX @ $X/tC
Ta#es on sal%age %alue G .24 @ 944/..3D/
Ta#es on sal%age %alue G @2>I4
$ar,et price 2944
Ta# on sale @>I4
)fterta# sal%age %alue 2334
The incremental costs will include the maintenance costs, depreciation, and ta#es. ?otice the ta#es
are negati%e, signif!ing a lower ta# "ill. So, the incremental cash flows will "e0
$aintenance cost @2944.44
Eepreciation @DH8.I9
EAT @2JH8.I9
Ta# @36J.38
?et income @2H3J.38
'C; @2>I4.H3
So, the ?+X of the decision to "u! one unit is0
?+X G @23,I94 @ 2>I4.H3.+XI;)>>K,8/ L 2334 - >.>>
8
?+X G @2D,D8D.8H
)nd the E)C on a per unit "asis is0
@2D,D8D.8H G E)C.+XI;)>>K,8/
E)C G @28I>.94
Since the compan! must "u! >4 units, the total E)C of the decision is0
Total E)C G >4.@28I>.94/
Total E)C G @28,I>9.43
)nd the E)C for the EET >4440
Ta#es on sal%age %alue G .AX @ $X/tC
Ta#es on sal%age %alue G .24 @ 944/..3D/
Ta#es on sal%age %alue G @264D
$ar,et price 2H44
Ta# on sale @64D
)fterta# sal%age %alue 23JH
189
SOLUTIONS
The incremental costs will include the maintenance costs, depreciation, and ta#es. ?otice the ta#es
are negati%e, signif!ing a lower ta# "ill. So, the incremental cash flows will "e0
$aintenance cost @2I44.44
Eepreciation @8I9.44
EAT @2>,9I9.44
Ta# @939.94
?et income @2>,43J.94
'C; @2>HD.94
So, the ?+X of the decision to "u! one unit is0
?+X G @29,694 @ 2>HD.94.+XI;)>>K,H/ L 23JH - >.>>
H
?+X G @29,I3D.6>
)nd the E)C on a per unit "asis is0
@29,I3D.6> G E)C.+XI;)>>K,H/
E)C G @2>,399.D3
Since the compan! must "u! I units, the total E)C of the decision is0
Total E)C G I.@2>,399.D3/
Total E)C G @2J,D88.46
The compan! should choose the S)C 9444 since the total E)C is greater.
28. 5ere we are comparing two mutuall! e#clusi%e assets, with inflation. Since each will "e replaced
when it wears out, we need to calculate the E)C for each. We ha%e real cash flows. Similar to other
capital "udgeting pro:ects, when calculating the E)C, we can use real cash flows with the real
interest rate, or nominal cash flows and the nominal interest rate. <sing the ;isher e&uation to find
the real re&uired return, we get0
.> L </ G .> L r/.> L h/
.> L .>D/ G .> L r/.> L .49/
r G .489I or 8.9IK
This is the interest rate we need to use with real cash flows. We are gi%en the real afterta# cash flows
for each asset, so the ?+X for the UUD4 is0
?+X G @=I44 @ =>44.+XI;)8.9IK,3/
?+X G @=J99.48
So, the E)C for the UUD4 is0
@=J99.48 G E)C.+XI;)8.9IK,3/
E)C G @=3ID.D3
B-190
CHAPTER 7 B-
)nd the E)C for the R5D9 is0
?+X G @=J44 @ =>>4.+XI;)8.9IK,9/
?+X G @=>,366.HH
@=>,366.HH G E)C.+XI;)8.9IK,9/
E)C G @=338.86
The compan! should choose the R5D9 "ecause it has the greater E)C.
29. The pro:ect has a sales price that increases at fi%e percent per !ear, and a %aria"le cost per unit that
increases at >4 percent per !ear. ;irst, we need to find the sales price and %aria"le cost for each !ear.
The ta"le "elow shows the price per unit and the %aria"le cost per unit each !ear.
\ear > \ear 6 \ear 3 \ear D \ear 9
Sales price Ca2D4.44 Ca2D6.44 Ca2DD.>4 Ca2DH.3> Ca2D8.H6
Cost per unit Ca264.44 Ca266.44 Ca26D.64 Ca26H.H6 Ca26J.68
<sing the sales price and %aria"le cost, we can now construct the pro forma income statement for
each !ear. We can use this income statement to calculate the cash flow each !ear. We must also
ma,e sure to include the net wor,ing capital outla! at the "eginning of the pro:ect, and the reco%er!
of the net wor,ing capital at the end of the pro:ect. The pro forma income statement and cash flows
for each !ear will "e0
\ear 4 \ear > \ear 6 \ear 3 \ear D \ear 9
Re%enues Ca2D44,444.44 Ca2D64,444.44 Ca2DD>,444.44 Ca2DH3,494.44 Ca2D8H,646.94
;i#ed costs 94,444.44 94,444.44 94,444.44 94,444.44 94,444.44
Xaria"le costs 644,444.44 664,444.44 6D6,444.44 6HH,644.44 6J6,864.44
Eepreciation 84,444.44 84,444.44 84,444.44 84,444.44 84,444.44
EAT Ca2I4,444.44 Ca2I4,444.44 Ca2HJ,444.44 Ca2HH,894.44 Ca2H3,386.94
Ta#es 63,844.44 63,844.44 63,DH4.44 66,I6J.44 6>,994.49
?et income Ca2DH,644.44 Ca2DH,644.44 Ca2D9,9D4.44 Ca2DD,>6>.44 Ca2D>,836.D9
'C; Ca2>6H,644.44 Ca2>6H,644.44 Ca2>69,9D4.44 Ca2>6D,>6>.44 Ca2>6>,836.D9

Capital spending
@
Ca2D44,444
?WC @69,444 69,444

Total cash flow
@
Ca2D69,444 Ca2>6H,644.44 Ca2>6H,644.44 Ca2>69,9D4.44 Ca2>6D,>6>.44 Ca2>DH,836.D9
With these cash flows, the ?+X of the pro:ect is0
?+X G @Ca2D69,444 L Ca2>6H,644 - >.>9 L Ca2>6H,644 - >.>9
6
L Ca2>69,9D4 - >.>9
3
L
Ca2>6D,>6> - >.>9
D

LCa2>DH,836.D9 - >.>9
9
?+X G Ca2H,HII.3>
191
SOLUTIONS
We could also answer this pro"lem using the depreciation ta# shield approach. The re%enues and
%aria"le costs are growing annuities, growing at different rates. The fi#ed costs and depreciation are
ordinar! annuities. <sing the growing annuit! e&uation, the present %alue of the re%enues is0
+X of re%enues G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[.> @ tC/
+X of re%enues G Ca2D44,444ZN>-..>9 @ .49/O @ N>-..>9 @ .49/O Q N.> L .49/-.> L .>9/O
9
[
+X of re%enues G Ca2>,DH>,894.44
)nd the present %alue of the %aria"le costs will "e0
+X of %aria"le costs G ' ZN>-.r @ g/O @ N>-.r @ g/O Q N.> L g/-.> L r/O
t
[.> @ tC/
+X of %aria"le costs G Ca2644,444ZN>-..>9 @ .>4/O @ N>-..>9 @ .>4/O Q N.> L .>4/-.> L .>9/O
9
[
+X of %aria"le costs G Ca2IJI,>HI.98
The fi#ed costs and depreciation are "oth ordinar! annuities. The present %alue of each is0
+X of fi#ed costs G '.Z> @ N>-.> L r6O
t
[ - r /
+X of fi#ed costs G Ca294,444.Z> @ N>-.> L .>9/O
9
[ - .>9/
+X of fi#ed costs G Ca2>HI,H4I.I9
+X of depreciation G '.Z> @ N>-.> L r6O
t
[ - r /
+X of depreciation G Ca284,444.Z> @ N>-.> L .>9/O
9
[ - .>9/
+X of depreciation G Ca26H8,>I6.D>
?ow, we can use the depreciation ta# shield approach to find the ?+X of the pro:ect, which is0
?+X G @Ca2D69,444 L .Ca2>,DH>,894.44 @ IJI,>HI.98 @ >HI,H4I.I9/.> @ .3D/ L .Ca26H8,>I6.D>/
..3D/
L Ca269,444 - >.>9
9
?+X G Ca2H,HII.3>
'hallenge

30. This is an in*depth capital "udgeting pro"lem. +ro"a"l! the easiest 'C; calculation for this pro"lem
is the "ottom up approach, so we will construct an income statement for each !ear. Aeginning with
the initial cash flow at time ero, the pro:ect will re&uire an in%estment in e&uipment. The pro:ect
will also re&uire an in%estment in ?WC. The ?WC in%estment will "e >9 percent of the ne#t !ears
sales. In this case, it will "e \ear > sales. Realiing we need \ear > sales to calculate the re&uired
?WC capital at time 4, we find that \ear > sales will "e 26I,H69,444. So, the cash flow re&uired for
the pro:ect toda! will "e0
Capital spending @26>,444,444
Change in ?WC @>,944,444
Total cash flow @266,944,444
B-192
CHAPTER 7 B-
?ow we can "egin the remaining calculations. Sales figures are gi%en for each !ear, along with the
price per unit. The %aria"le costs per unit are used to calculate total %aria"le costs, and fi#ed costs
are gi%en at 2J44,444 per !ear. To calculate depreciation each !ear, we use the initial e&uipment cost
of 26> million, times the appropriate $)CRS depreciation each !ear. The remainder of each income
statement is calculated "elow. ?otice at the "ottom of the income statement we added "ac,
depreciation to get the 'C; for each !ear. The section la"eled 1?et cash flows8 will "e discussed
"elow0
\ear > 6 3 D 9
Ending "oo, %alue 2>I,JJI,444 2>6,896,444 2J,>II,444 2H,996,444 2D,H83,444

Sales 26I,H69,444 23>,894,444 23D,D94,444 23I,494,444 234,669,444
Xaria"le costs 64,D44,444 63,964,444 69,DD4,444 6I,3H4,444 66,364,444
;i#ed costs J44,444 J44,444 J44,444 J44,444 J44,444
Eepreciation 3,443,444 9,>D9,444 3,HI9,444 6,H69,444 >,8HJ,444
EAIT 3,366,444 6,689,444 D,D39,444 H,>H9,444 9,>3H,444
Ta#es >,>H6,I44 IJJ,I94 >,996,694 6,>9I,I94 >,IJI,H44
?et income 6,>9J,344 >,D89,694 6,886,I94 D,44I,694 3,338,D44
Eepreciation 3,443,444 9,>D9,444 3,HI9,444 6,H69,444 >,8HJ,444
'perating cash flow 29,>H6,344 2H,H34,694 2H,99I,I94 2H,H36,694 29,64I,D44

Net cash flows
'perating cash flow 29,>H6,344 2H,H34,694 2H,99I,I94 2H,H36,694 29,64I,D44
Change in ?WC .H33,I94/ .3J4,444/ .3J4,444/ >,463,I94 >,8J4,444
Capital spending * * * * D,3HJ,494
Total cash flow 2D,968,994 2H,6D4,694 2H,>HI,I94 2I,H9H,444 2>>,DHH,D94
)fter we calculate the 'C; for each !ear, we need to account for an! other cash flows. The other
cash flows in this case are ?WC cash flows and capital spending, which is the afterta# sal%age of the
e&uipment. The re&uired ?WC capital is >9 percent of the sales in the ne#t !ear. We will wor,
through the ?WC cash flow for \ear >. The total ?WC in \ear > will "e >9 percent of sales
increase from \ear > to \ear 6, or0
Increase in ?WC for \ear > G .>9.23>,894,444 @ 6I,H69,444/
Increase in ?WC for \ear > G 2H33,I94
?otice that the ?WC cash flow is negati%e. Since the sales are increasing, we will ha%e to spend
more mone! to increase ?WC. In \ear D, the ?WC cash flow is positi%e since sales are declining.
)nd, in \ear 9, the ?WC cash flow is the reco%er! of all ?WC the compan! still has in the pro:ect.
To calculate the afterta# sal%age %alue, we first need the "oo, %alue of the e&uipment. The "oo,
%alue at the end of the fi%e !ears will "e the purchase price, minus the total depreciation. So, the
ending "oo, %alue is0
Ending "oo, %alue G 26>,444,444 @ .23,443,444 L 9,>D9,444 L 3,HI9,444 L 6,H69,444 L >,8HJ,444/
Ending "oo, %alue G 2D,H83,444
193
SOLUTIONS
The mar,et %alue of the used e&uipment is 64 percent of the purchase price, or 2D.6 million, so the
afterta# sal%age %alue will "e0
)fterta# sal%age %alue G 2D,644,444 L .2D,H83,444 @ D,644,444/..39/
)fterta# sal%age %alue G 2D,3HJ,494
The afterta# sal%age %alue is included in the total cash flows are capital spending. ?ow we ha%e all
of the cash flows for the pro:ect. The ?+X of the pro:ect is0
?+X G @266,944,444 L 2D,968,994->.>8 L 2H,6D4,694->.>8
6
L 2H,>HI,I94->.>8
3
L 2I,H99,444->.>8
D

L 2>>,DHH,D94->.>8
9
?+X G @2>,DH9,ID>.I>
)nd the IRR is0
?+X G 4 G @266,944,444 L 2D,968,994-.> L IRR/ L 2H,6D4,694-.> L IRR/
6
L 2H,>HI,I94-.> L IRR/
3

L 2I,H99,444-.> L IRR/
D
L 2>>,DHH,D94-.> L IRR/
9
IRR G >9.DIK
We should re:ect the pro:ect.
31. To find the initial preta# cost sa%ings necessar! to "u! the new machine, we should use the ta#
shield approach to find the 'C;. We "egin "! calculating the depreciation each !ear using the
$)CRS depreciation schedule. The depreciation each !ear is0
E> G BD84,444.4.3334/ G B>9J,8D4
E6 G BD84,444.4.DDD4/ G B6>3,>64
E3 G BD84,444.4.>D84/ G BI>,4D4
ED G BD84,444.4.4ID4/ G B39,964
<sing the ta# shield approach, the 'C; each !ear is0
'C;> G .S @ C/.> @ 4.39/ L 4.39.B>9J,8D4/
'C;6 G .S @ C/.> @ 4.39/ L 4.39.B6>3,>64/
'C;3 G .S @ C/.> @ 4.39/ L 4.39.BI>,4D4/
'C;D G .S @ C/.> @ 4.39/ L 4.39.B39,964/
'C;9 G .S @ C/.> @ 4.39/
?ow we need the afterta# sal%age %alue of the e&uipment. The afterta# sal%age %alue is0
)fter*ta# sal%age %alue G BD9,444.> @ 4.39/ G B6J,694
To find the necessar! cost reduction, we must realie that we can split the cash flows each !ear. The
'C; in an! gi%en !ear is the cost reduction .S @ C/ times one minus the ta# rate, which is an annuit!
for the pro:ect life, and the depreciation ta# shield. To calculate the necessar! cost reduction, we
would re&uire a ero ?+X. The e&uation for the ?+X of the pro:ect is0
?+X G 4 G @ BD84,444 @ D4,444 L .S @ C/.4.H9/.+XI;)>6K,9/ L 4.39.B>9J,8D4->.>6
L B6>3,>64->.>6
6
L BI>,4D4->.>6
3
L B39,964->.>6
D
/ L .BD4,444 L 6J,694/->.>6
9

B-194
CHAPTER 7 B-
Sol%ing this e&uation for the sales minus costs, we get0
.S @ C/.4.H9/.+XI;)>6K,9/ G B3D9,HJ6.JD
.S @ C/ G B>DI,93H.6J
32. To find the "id price, we need to calculate all other cash flows for the pro:ect, and then sol%e for the
"id price. The afterta# sal%age %alue of the e&uipment is0
)fterta# sal%age %alue G 294,444.> @ 4.39/ G 236,944
?ow we can sol%e for the necessar! 'C; that will gi%e the pro:ect a ero ?+X. The e&uation for the
?+X of the pro:ect is0
?+X G 4 G @ 2I84,444 @ I9,444 L 'C;.+XI;)>HK,9/ L N.2I9,444 L 36,944/ - >.>H
9
O
Sol%ing for the 'C;, we find the 'C; that ma,es the pro:ect ?+X e&ual to ero is0
'C; G 2843,8>I.89 - +XI;)>HK,9 G 26D9,DJ3.9>
The easiest wa! to calculate the "id price is the ta# shield approach, so0
'C; G 26D9,DJ3.9> G N.+ @ %/Y @ ;C O.> @ t
c
/ L t
c
E
26D9,DJ3.9> G N.+ @ 28.94/.>94,444/ @ 26D4,444 O.> @ 4.39/ L 4.39.2I84,444-9/
+ G 2>6.4H
33. a. This pro"lem is "asicall! the same as the pre%ious pro"lem, e#cept that we are gi%en a sales
price. The cash flow at Time 4 for all three parts of this &uestion will "e0
Capital spending @2I84,444
Change in ?WC @I9,444
Total cash flow @2899,444
We will use the initial cash flow and the sal%age %alue we alread! found in that pro"lem. <sing the
"ottom up approach to calculating the 'C;, we get0
Assume price per unit 1 :)0 and units2ear 1 )*/#///
\ear > 6 3 D 9
Sales 2>,J94,444 2>,J94,444 2>,J94,444 2>,J94,444 2>,J94,444
Xaria"le costs >,6I9,444 >,6I9,444 >,6I9,444 >,6I9,444 >,6I9,444
;i#ed costs 6D4,444 6D4,444 6D4,444 6D4,444 6D4,444
Eepreciation >9H,444 >9H,444 >9H,444 >9H,444 >9H,444
EAIT 6IJ,444 6IJ,444 6IJ,444 6IJ,444 6IJ,444
Ta#es .39K/ JI,H94 JI,H94 JI,H94 JI,H94 JI,H94
?et Income >8>,394 >8>,394 >8>,394 >8>,394 >8>,394
Eepreciation >9H,444 >9H,444 >9H,444 >9H,444 >9H,444
'perating C; 233I,394 233I,394 233I,394 233I,394 233I,394
195
SOLUTIONS
\ear > 6 3 D 9
'perating C; 233I,394 233I,394 233I,394 233I,394 233I,394
Change in ?WC 4 4 4 4 I9,444
Capital spending 4 4 4 4 36,944
Total C; 233I,394 233I,394 233I,394 233I,394 2DDD,894
With these cash flows, the ?+X of the pro:ect is0
?+X G @ 2I84,444 @ I9,444 L 233I,394.+XI;)>HK,9/ L N.2I9,444 L 36,944/ - >.>H
9
O
?+X G 2344,IH9.>>
If the actual price is a"o%e the "id price that results in a ero ?+X, the pro:ect will ha%e a positi%e
?+X. )s for the cartons sold, if the num"er of cartons sold increases, the ?+X will increase, and if
the costs increase, the ?+X will decrease.
b. To find the minimum num"er of cartons sold to still "rea,e%en, we need to use the ta# shield
approach to calculating 'C;, and sol%e the pro"lem similar to finding a "id price. <sing the
initial cash flow and sal%age %alue we alread! calculated, the e&uation for a ero ?+X of the
pro:ect is0
?+X G 4 G @ 2I84,444 @ I9,444 L 'C;.+XI;)>HK,9/ L N.2I9,444 L 36,944/ - >.>H
9
O
So, the necessar! 'C; for a ero ?+X is0
'C; G 2843,8>I.89 - +XI;)>HK,9 G 26D9,DJ3.9>
?ow we can use the ta# shield approach to sol%e for the minimum &uantit! as follows0
'C; G 26D9,DJ3.9> G N.+ @ %/Y @ ;C O.> @ t
c
/ L t
c
E
26D9,DJ3.9> G N.2>3.44 @ 8.94/Y @ 6D4,444 O.> @ 4.39/ L 4.39.2I84,444-9/
Y G >>8,9JH
)s a chec,, we can calculate the ?+X of the pro:ect with this &uantit!. The calculations are0
\ear > 6 3 D 9
Sales 2>,9D>,IDJ 2>,9D>,IDJ 2>,9D>,IDJ 2>,9D>,IDJ 2>,9D>,IDJ
Xaria"le costs >,448,4HI >,448,4HI >,448,4HI >,448,4HI >,448,4HI
;i#ed costs 6D4,444 6D4,444 6D4,444 6D4,444 6D4,444
Eepreciation >9H,444 >9H,444 >9H,444 >9H,444 >9H,444
EAIT >3I,H86 >3I,H86 >3I,H86 >3I,H86 >3I,H86
Ta#es .39K/ D8,>8J D8,>8J D8,>8J D8,>8J D8,>8J
?et Income 8J,DJ3 8J,DJ3 8J,DJ3 8J,DJ3 8J,DJ3
Eepreciation >9H,444 >9H,444 >9H,444 >9H,444 >9H,444
'perating C; 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD
B-196
CHAPTER 7 B-
\ear > 6 3 D 9
'perating C; 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD
Change in ?WC 4 4 4 4 I9,444
Capital spending 4 4 4 4 36,944
Total C; 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD 2396,JJD

?+X G @ 2I84,444 @ I9,444 L 26D9,DJD.+XI;)>HK,9/ L N.2I9,444 L 36,944/ - >.>H
9
O 24
?ote that the ?+X is not e#actl! e&ual to ero "ecause we had to round the num"er of cartons sold(
!ou cannot sell one*half of a carton.
c. To find the highest le%el of fi#ed costs and still "rea,e%en, we need to use the ta# shield
approach to calculating 'C;, and sol%e the pro"lem similar to finding a "id price. <sing the
initial cash flow and sal%age %alue we alread! calculated, the e&uation for a ero ?+X of the
pro:ect is0
?+X G 4 G @ 2I84,444 @ I9,444 L 'C;.+XI;)>HK,9/ L N.2I9,444 L 36,944/ - >.>H
9
O
'C; G 2843,8>I.89 - +XI;)>HK,9 G 26D9,DJD.9>
?otice this is the same 'C; we calculated in part b. ?ow we can use the ta# shield approach to sol%e
for the ma#imum le%el of fi#ed costs as follows0
'C; G 26D9,DJD.9> G N.+@%/Y @ ;C O.> @ tC/ L tCE
26D9,DJD.9> G N.2>3.44 @ 28.94/.>94,444/ @ ;CO.> @ 4.39/ L 4.39.2I84,444-9/
;C G 238>,3>I.HI
)s a chec,, we can calculate the ?+X of the pro:ect with this &uantit!. The calculations are0
\ear > 6 3 D 9
Sales 2>,J94,444 2>,J94,444 2>,J94,444 2>,J94,444 2>,J94,444
Xaria"le costs >,6I9,444 >,6I9,444 >,6I9,444 >,6I9,444 >,6I9,444
;i#ed costs 38>,3>8 38>,3>8 38>,3>8 38>,3>8 38>,3>8
Eepreciation >9H,444 >9H,444 >9H,444 >9H,444 >9H,444
EAIT >3I,H86 >3I,H86 >3I,H86 >3I,H86 >3I,H86
Ta#es .39K/ D8,>8J D8,>8J D8,>8J D8,>8J D8,>8J
?et Income 8J,DJD 8J,DJD 8J,DJD 8J,DJD 8J,DJD
Eepreciation >9H,444 >9H,444 >9H,444 >9H,444 >9H,444
'perating C; 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD
\ear > 6 3 D 9
'perating C; 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD
Change in ?WC 4 4 4 4 I9,444
Capital spending 4 4 4 4 36,944
Total C; 26D9,DJD 26D9,DJD 26D9,DJD 26D9,DJD 2396,JJD

?+X G @ 2I84,444 @ I9,444 L 26D9,DJD.+XI;)>HK,9/ L N.2I9,444 L 36,944/ - >.>H
9
O 24
197
SOLUTIONS
34. We need to find the "id price for a pro:ect, "ut the pro:ect has e#tra cash flows. Since we dont
alread! produce the ,e!"oard, the sales of the ,e!"oard outside the contract are rele%ant cash flows.
Since we ,now the e#tra sales num"er and price, we can calculate the cash flows generated "! these
sales. The cash flow generated from the sale of the ,e!"oard outside the contract is0
\ear > \ear 6 \ear 3 \ear D
Sales Rs.869,444 Rs.>,H94,444 Rs.6,644,444 Rs.>,3I9,444
Xaria"le costs DJ9,444 JJ4,444 >,364,444 869,444
EAT Rs.334,444 Rs.HH4,444 Rs.884,444 Rs.994,444
Ta# >36,444 6HD,444 396,444 664,444
?et income .and 'C;/ Rs.>J8,444 Rs.3JH,444 Rs.968,444 Rs.334,444
So, the addition to ?+X of these mar,et sales is0
?+X of mar,et sales G Rs.>J8,444->.>3 L Rs.3JH,444->.>3
6
L Rs.968,444->.>3
3
L Rs.334,444->.>3
D

?+X of mar,et sales G Rs.>,493,HI6.JJ
\ou ma! ha%e noticed that we did not include the initial cash outla!, depreciation, or fi#ed costs in
the calculation of cash flows from the mar,et sales. The reason is that it is irrele%ant whether or not
we include these here. Remem"er that we are not onl! tr!ing to determine the "id price, "ut we are
also determining whether or not the pro:ect is feasi"le. In other words, we are tr!ing to calculate the
?+X of the pro:ect, not :ust the ?+X of the "id price. We will include these cash flows in the "id
price calculation. The reason we stated earlier that whether we included these costs in this initial
calculation was irrele%ant is that !ou will come up with the same "id price if !ou include these costs
in this calculation, or if !ou include them in the "id price calculation.
?e#t, we need to calculate the afterta# sal%age %alue, which is0
)fterta# sal%age %alue G Rs.644,444.> @ .D4/ G Rs.>64,444
Instead of sol%ing for a ero ?+X as is usual in setting a "id price, the compan! president re&uires an
?+X of Rs.>44,444, so we will sol%e for a ?+X of that amount. The ?+X e&uation for this pro:ect is
.remem"er to include the ?WC cash flow at the "eginning of the pro:ect, and the ?WC reco%er! at
the end/0
?+X G Rs.>44,444 G @Rs.6,D44,444 @ I9,444 L >,493,HI6.JJ L 'C; .+XI;)>3K,D/ L N.Rs.>64,444 L
I9,444/ - >.>3
D
O
Sol%ing for the 'C;, we get0
'C; G Rs.>,D4>,I6J.8H - +XI;)>3K,D G Rs.DI>,693.DD
?ow we can sol%e for the "id price as follows0
'C; G Rs.DI>,693.DD G N.+ @ %/Y @ ;C O.> @ tC/ L tCE
Rs.DI>,693.DD G N.+ @ Rs.>H9/.>4,444/ @ Rs.944,444O.> @ 4.D4/ L 4.D4.Rs.6,D44,444-D/
+ G Rs.693.9D
B-198
CHAPTER 7 B-
35. Since the two computers ha%e une&ual li%es, the correct method to anal!e the decision is the E)C.
We will "egin with the E)C of the new computer. <sing the depreciation ta# shield approach, the
'C; for the new computer s!stem is0
'C; G .2>69,444/.> @ .38/ L .2I84,444 - 9/..38/ G 2>3H,I84
?otice that the costs are positi%e, which represents a cash inflow. The costs are positi%e in this case
since the new computer will generate a cost sa%ings. The onl! initial cash flow for the new computer
is cost of 2I84,444. We ne#t need to calculate the afterta# sal%age %alue, which is0
)fterta# sal%age %alue G 2>D4,444.> @ .38/ G 28H,844
?ow we can calculate the ?+X of the new computer as0
?+X G @2I84,444 L 2>3H,I84.+XI;)>DK,9/ L 28H,844 - >.>D
9
?+X G @26H9,3D>.JJ
)nd the E)C of the new computer is0
E)C G @ 26H9,3D>.JJ - .+XI;)>DK,9/ G @2II,68J.I9
)nal!ing the old computer, the onl! 'C; is the depreciation ta# shield, so0
'C; G 2>34,444..38/ G 2DJ,D44
The initial cost of the old computer is a little tric,ier. \ou might assume that since we alread! own
the old computer there is no initial cost, "ut we can sell the old computer, so there is an opportunit!
cost. We need to account for this opportunit! cost. To do so, we will calculate the afterta# sal%age
%alue of the old computer toda!. We need the "oo, %alue of the old computer to do so. The "oo,
%alue is not gi%en directl!, "ut we are told that the old computer has depreciation of 2>34,444 per
!ear for the ne#t three !ears, so we can assume the "oo, %alue is the total amount of depreciation
o%er the remaining life of the s!stem, or 23J4,444. So, the afterta# sal%age %alue of the old computer
is0
)fterta# sal%age %alue G 2634,444 L .23J4,444 @ 634,444/..38/ G 26J4,844
This is the initial cost of the old computer s!stem toda! "ecause we are forgoing the opportunit! to
sell it toda!. We ne#t need to calculate the afterta# sal%age %alue of the computer s!stem in two
!ears since we are 1"u!ing8 it toda!. The afterta# sal%age %alue in two !ears is0
)fterta# sal%age %alue G 2J4,444 L .2>34,444 @ J4,444/..38/ G 2>49,644
?ow we can calculate the ?+X of the old computer as0
?+X G @26J4,844 L 2DJ,D44.+XI;)>DK,6/ L >49,644 - >.>D
6
?+X G @2>68,94H.JJ
199
SOLUTIONS
)nd the E)C of the old computer is0
E)C G @ 2>68,94H.JJ - .+XI;)>DK,6/ G @2I8,4D4.JI
If we are going to replace the s!stem in two !ears no matter what our decision toda!, we should
instead replace it toda! since the E)C is lower.
b. If we are onl! concerned with whether or not to replace the machine now, and are not worr!ing
a"out what will happen in two !ears, the correct anal!sis is ?+X. To calculate the ?+X of the
decision on the computer s!stem now, we need the difference in the total cash flows of the old
computer s!stem and the new computer s!stem. ;rom our pre%ious calculations, we can sa! the cash
flows for each computer s!stem are0
t ?ew computer 'ld computer Eifference
4 @2I84,444 26J4,844 @2D8J,644
> >3H,I84 @DJ,D44 8I,384
6 >3H,I84 @>9D,H44 @>I,864
3 >3H,I84 4 >3H,I84
D >3H,I84 4 >3H,I84
9 663,984 4 663,984
Since we are onl! concerned with marginal cash flows, the cash flows of the decision to replace the
old computer s!stem with the new computer s!stem are the differential cash flows. The ?+X of the
decision to replace, ignoring what will happen in two !ears is0
?+X G @2D8J,644 L 28I,384->.>D @ 2>I,864->.>D
6
L 2>3H,I84->.>D
3
L 2>3H,I84->.>D
D

L 2663,984->.>D
9
?+X G @2>3H,839.44
If we are not concerned with what will happen in two !ears, we should not replace the old computer
s!stem.
36. To answer this &uestion, we need to compute the ?+X of all three alternati%es, specificall!, continue
to rent the "uilding, +ro:ect ), or +ro:ect A. We would choose the pro:ect with the highest ?+X. If
all three of the pro:ects ha%e a positi%e ?+X, the pro:ect that is more fa%ora"le is the one with the
highest ?+X
There are se%eral important cash flows we should not consider in the incremental cash flow anal!sis.
The remaining fraction of the %alue of the "uilding and depreciation are not incremental and should
not "e included in the anal!sis of the two alternati%es. The 669,444 purchase price of the "uilding
is a sun, cost and should "e ignored. In effect, what we are doing is finding the ?+X of the future
cash flows of each option, so the onl! cash flow toda! would "e the "uilding modifications needed
for +ro:ect ) and +ro:ect A. If we did include these costs, the effect would "e to lower the ?+X of
all three options "! the same amount, there"! leading to the same conclusion. The cash flows from
renting the "uilding after !ear >9 are also irrele%ant. ?o matter what the compan! chooses toda!, it
will rent the "uilding after !ear >9, so these cash flows are not incremental to an! pro:ect.
B-200
CHAPTER 7 B-
We will "egin "! calculating the ?+X of the decision of continuing to rent the "uilding first.
Continue to rent0
Rent >6,444
Ta#es D,484
?et income I,J64
Since there is no incremental depreciation, the operating cash flow is simpl! the net income. So, the
?+X of the decision to continue to rent is0
?+X G I,J64.+XI;)>6K,>9/
?+X G 93,JD6.49
+roduct )0
?e#t, we will calculate the ?+X of the decision to modif! the "uilding to produce +roduct ). The
income statement for this modification is the same for the first >D !ears, and in !ear >9, the compan!
will ha%e an additional e#pense to con%ert the "uilding "ac, to its original form. This will "e an
e#pense in !ear >9, so the income statement for that !ear will "e slightl! different. The cash flow at
time ero will "e the cost of the e&uipment, and the cost of the initial "uilding modifications, "oth of
which are deprecia"le on a straight*line "asis. So, the pro forma cash flows for +roduct ) are0
Initial cash outla!0
Auilding modifications @3H,444
E&uipment @>DD,444
Total cash flow @>84,444
\ears >*>D \ear >9
Re%enue >49,444 >49,444
E#penditures H4,444 H4,444
Eepreciation >6,444 >6,444
Restoration cost 4 3,I94
EAT 33,444 6J,694
Ta# >>,664 J,JD9
?I 6>,I84 >J,349
'C; 33,I84 3>,349
The 'C; each !ear is net income plus depreciation. So, the ?+X for modif!ing the "uilding to
manufacture +roduct ) is0
?+X G @>84,444 L 33,I84.+XI;)>6K,>D/ L 3>,349 - >.>6
>9
?+X G DJ,H>8.83
201
SOLUTIONS
+roduct A0
?ow we will calculate the ?+X of the decision to modif! the "uilding to produce +roduct A. The
income statement for this modification is the same for the first >D !ears, and in !ear >9, the compan!
will ha%e an additional e#pense to con%ert the "uilding "ac, to its original form. This will "e an
e#pense in !ear >9, so the income statement for that !ear will "e slightl! different. The cash flow at
time ero will "e the cost of the e&uipment, and the cost of the initial "uilding modifications, "oth of
which are deprecia"le on a straight*line "asis. So, the pro forma cash flows for +roduct ) are0
Initial cash outla!0
Auilding modifications @9D,444
E&uipment @>H6,444
Total cash flow @6>H,444
\ears >*>D \ear >9
Re%enue >6I,944 >6I,944
E#penditures I9,444 I9,444
Eepreciation >D,D44 >D,D44
Restoration cost 4 68,>69
EAT 38,>44 J,JI9
Ta# >6,J9D 3,3J6
?I 69,>DH H,98D
'C; 3J,9DH 64,J8D
The 'C; each !ear is net income plus depreciation. So, the ?+X for modif!ing the "uilding to
manufacture +roduct A is0
?+X G @6>H,444 L 3J,9DH.+XI;)>6K,>D/ L 64,J8D - >.>6
>9
?+X G DJ,J9>.>9
We could ha%e also done the anal!sis as the incremental cash flows "etween +roduct ) and
continuing to rent the "uilding, and the incremental cash flows "etween +roduct A and continuing to
rent the "uilding. The results of this t!pe of anal!sis would "e0
?+X of differential cash flows "etween +roduct ) and continuing to rent0
?+X G ?+X+roduct ) @ ?+XRent
?+X G DJ,H>8.83 @ 93,JD6.49
?+X G @D,363.66
?+X of differential cash flows "etween +roduct A and continuing to rent0
?+X G ?+X+roduct A @ ?+XRent
?+X G DJ,J9>.>9 @ 93,JD6.49
?+X G @3,JJ4.J4
Aoth of these incremental anal!ses ha%e a negati%e ?+X, so the compan! should continue to rent,
which is the same as our original result.
B-202
CHAPTER 7 B-
37. The discount rate is e#pressed in real terms, and the cash flows are e#pressed in nominal terms. We
can answer this &uestion "! con%erting all of the cash flows to real pounds. We can then use the real
interest rate. The real %alue of each cash flow is the present %alue of the !ear > nominal cash flows,
discounted "ac, to the present at the inflation rate. So, the real %alue of the re%enue and costs will
"e0
Re%enue in real terms G =>94,444 - >.4H G =>D>,94J.D3
Ca"or costs in real terms G =84,444 - >.4H G =I9,DI>.I4
'ther costs in real terms G =D4,444 - >.4H G =3I,I39.89
Cease pa!ment in real terms G =64,444 - >.4H G =>8,8HI.J6
Re%enues, la"or costs, and other costs are all growing perpetuities. Each has a different growth rate,
so we must calculate the present %alue of each separatel!. 'ther costs are a growing perpetuit! with
a negati%e growth rate. <sing the real re&uired return, the present %alue of each of these is0
+XRe%enue G =>D>,94J.D3 - .4.>4 @ 4.49/ G =6,834,>88.H8
+XCa"or costs G =I9,DI>.I4 - .4.>4 @ 4.43/ G =>,4I8,>HI.>6
+X'ther costs G =3I,I39.89 - N4.>4 @ .@4.4>/O G =3D3,493.>I
The lease pa!ments are constant in nominal terms, so the! are declining in real terms "! the inflation
rate. Therefore, the lease pa!ments form a growing perpetuit! with a negati%e growth rate. The real
present %alue of the lease pa!ments is0
+XCease pa!ments G =>8,8HI.J6 - N4.>4 @ .@4.4H/O G =>>I,J6D.93
?ow we can use the ta# shield approach to calculate the net present %alue. Since there is no
in%estment in e&uipment, there is no depreciation( therefore, no depreciation ta# shield, so we will
ignore this in our calculation. This means the cash flows each !ear are e&ual to net income. There is
also no initial cash outla!, so the ?+X is the present %alue of the future afterta# cash flows. The
?+X of the pro:ect is0
?+X G +XRe%enue @ +XCa"or costs @ +X'ther costs @ +XCease pa!ments
?+X G .=6,834,>88.H8 @ >,4I8,>HI.>6 @ 3D3,493.>I @ >>I,J6D.93/.> @ .3D/
?+X G =896,488.J9
)lternati%el!, we could ha%e sol%ed this pro"lem "! e#pressing e%er!thing in nominal terms. This
approach !ields the same answer as gi%en a"o%e. 5owe%er, in this case, the computation would ha%e
"een much more difficult. The reason is that we are dealing with growing perpetuities. In other
pro"lems, when calculating the ?+X of nominal cash flows, we could simpl! calculate the nominal
cash flow each !ear since the cash flows were finite. Aecause of the perpetual nature of the cash
flows in this pro"lem, we cannot calculate the nominal cash flows each !ear until the end of the
pro:ect. When faced with two alternati%e approaches, where "oth are e&uall! correct, alwa!s choose
the simplest one.
203
SOLUTIONS
38. We are gi%en the real re%enue and costs, and the real growth rates, so the simplest wa! to sol%e this
pro"lem is to calculate the ?+X with real %alues. While we could calculate the ?+X using nominal
%alues, we would need to find the nominal growth rates, and con%ert all %alues to nominal terms.
The real la"or costs will increase at a real rate of two percent per !ear, and the real energ! costs will
increase at a real rate of three percent per !ear, so the real costs each !ear will "e0
\ear > \ear 6 \ear 3 \ear D
Real la"or cost each !ear B>9.34 B>9.H> B>9.J6 B>H.6D
Real energ! cost each !ear B9.>9 B9.34 B9.DH B9.H3
Remem"er that the depreciation ta# shield also affects a firms afterta# cash flows. The present %alue
of the depreciation ta# shield must "e added to the present %alue of a firms re%enues and e#penses
to find the present %alue of the cash flows related to the pro:ect. The depreciation the firm will
recognie each !ear is0
)nnual depreciation G In%estment - Economic Cife
)nnual depreciation G B36,444,444 - D
)nnual depreciation G B8,444,444
Eepreciation is a nominal cash flow, so to find the real %alue of depreciation each !ear, we discount
the real depreciation amount "! the inflation rate. Eoing so, we find the real depreciation each !ear
is0
\ear > real depreciation G B8,444,444 - >.49 G BI,H>J,4DI.H6
\ear 6 real depreciation G B8,444,444 - >.49
6
G BI,69H,639.83
\ear 3 real depreciation G B8,444,444 - >.49
3
G BH,J>4,I44.IJ
\ear D real depreciation G B8,444,444 - >.49
D
G BH,98>,H>J.84
?ow we can calculate the pro forma income statement each !ear in real terms. We can then add "ac,
depreciation to net income to find the operating cash flow each !ear. Eoing so, we find the cash flow
of the pro:ect each !ear is0
\ear 4 \ear > \ear 6 \ear 3 \ear D
Re%enues
BD4,444,444.4
4
B84,444,444.4
4
B84,444,444.4
4
BH4,444,444.4
4
Ca"or cost 34,H44,444.44 3>,6>6,444.44 3>,83H,6D4.44 36,DI6,JHD.84
Energ! cost >,434,444.44 >,4H4,J44.44 >,4J6,I6I.44 >,>69,948.8>
Eepreciation I,H>J,4DI.H6 I,69H,639.83 H,J>4,I44.IJ H,98>,H>J.84
EAT BI94,J96.38
BD4,DI4,8HD.>
I
BD4,>H4,336.6
>
B>J,8>J,J4H.9
J
Ta#es 699,363.8> >3,IH4,4J3.86 >3,H9D,9>6.J9 H,I38,IH8.6D
?et income BDJ9,H68.9I
B6H,I>4,II4.3
9
B6H,949,8>J.6
H
B>3,48>,>38.3
9
'C; B8,>>D,HIH.>J
B33,JHI,44H.>
8
B33,D>H,964.4
9
B>J,HH6,I98.>
9

Capital spending @B36,444,444

B-204
CHAPTER 7 B-
Total cash flow @B36,444,444 B8,>>D,HIH.>J
B33,JHI,44H.>
8
B33,D>H,964.4
9
B>J,HH6,I98.>
9
205
SOLUTIONS
We can use the total cash flows each !ear to calculate the ?+X, which is0
?+X G @B36,444,444 L B8,>>D,HIH.>J - >.48 L B33,JHI,44H.>8 - >.48
6
L B33,D>H,964.49 - >.48
3
L B>J,HH6,I98.>9 - >.48
D
?+X G BD9,H>D,HDI.34
39. 5ere we ha%e the sales price and production costs in real terms. The simplest method to calculate the
pro:ect cash flows is to use the real cash flows. In doing so, we must "e sure to ad:ust the
depreciation, which is in nominal terms. We could anal!e the cash flows using nominal %alues,
which would re&uire calculating the nominal discount rate, nominal price, and nominal production
costs. This method would "e more complicated, so we will use the real num"ers. We will first
calculate the ?+X of the headache onl! pill.
5eadache onl!0
We can find the real re%enue and production costs "! multipl!ing each "! the units sold. We must "e
sure to discount the depreciation, which is in nominal terms. We can then find the pro forma net
income, and add "ac, depreciation to find the operating cash flow. Eiscounting the depreciation
each !ear "! the inflation rate, we find the following cash flows each !ear0
\ear > \ear 6 \ear 3
Sales 264,444,444 264,444,444 264,444,444
+roduction costs I,944,444 I,944,444 I,944,444
Eepreciation 3,638,4J9 3,483,J44 6,J3I,4D8
EAT 2J,6H>,J49 2J,D>H,>44 2J,9H6,J96
Ta# 3,>DJ,4D8 3,64>,DID 3,69>,D4D
?et income 2H,>>6,89I 2H,6>D,H6H 2H,3>>,9D8
'C; 2J,394,J96 2J,6J8,96H 2J,6D8,9JH
)nd the ?+X of the headache onl! pill is0
?+X G @2>4,644,444 L 2J,394,J96 - >.>3 L 2J,6J8,96H - >.>3
6
L 2J,6D8,9JH - >.>3
3
?+X G 2>6,>DD,IH4.83
5eadache and arthritis0
;or the headache and arthritis pill pro:ect, the e&uipment has a sal%age %alue. We will find the
afterta# sal%age %alue of the e&uipment first, which will "e0
$ar,et %alue 2>,444,444
Ta#es @3D4,444
Total 2HH4,444
B-206
CHAPTER 7 B-
Remem"er, to calculate the ta#es on the e&uipment sal%age %alue, we ta,e the "oo, %alue minus the
mar,et %alue, times the ta# rate. <sing the same method as the headache onl! pill, the cash flows
each !ear for the headache and arthritis pill will "e0

\ear > \ear 6 \ear 3
Sales 2D4,444,444 2D4,444,444 2D4,444,444
+roduction costs >I,444,444 >I,444,444 >I,444,444
Eepreciation 3,84J,96D 3,H68,>>8 3,D99,394
EAT 2>J,>J4,DIH 2>J,3I>,886 2>J,9DD,H94
Ta# H,96D,IH6 H,98H,DD4 H,HD9,>8>
?et income 2>6,HH9,I>D 2>6,I89,DD6 2>6,8JJ,DHJ
'C; 2>H,DI9,638 2>H,D>3,9H4 2>H,39D,8>J
So, the ?+X of the headache and arthritis pill is0
?+X G @2>6,444,444 L 2>H,DI9,638 - >.>3 L 2>H,D>3,9H4 - >.>3
6
L .2>H,39D,8>J L HH4,444/ - >.>3
3
?+X G 26I,J49,H39.8>
The compan! should manufacture the headache and arthritis remed! since the pro:ect has a higher
?+X.
40. This is an in*depth capital "udgeting pro"lem. Since the pro:ect re&uires an initial in%estment in
in%entor! as a percentage of sales, we will calculate the sales figures for each !ear first. The
incremental sales will include the sales of the new ta"le, "ut we also need to include the lost sales of
the e#isting model. This is an erosion cost of the new ta"le. The lost sales of the e#isting ta"le are
constant for e%er! !ear, "ut the sales of the new ta"le change e%er! !ear. So, the total incremental
sales figure for the fi%e !ears of the pro:ect will "e0
\ear > \ear 6 \ear 3 \ear D \ear 9
?ew =I,684,444 =I,D64,444 =I,I44,444 =8,>64,444 =I,3J6,444
Cost sales @J44,444 @J44,444 @J44,444 @J44,444 @J44,444
Total =H,384,444 =H,964,444 =H,844,444 =I,664,444 =H,DJ6,444
?ow we will calculate the initial cash outla! that will occur toda!. The compan! has the necessar!
production capacit! to manufacture the new ta"le without adding e&uipment toda!. So, the
e&uipment will not "e purchased toda!, "ut rather in two !ears. The reason is that the e#isting
capacit! is not "eing used. If the e#isting capacit! were "eing used, the new e&uipment would "e
re&uired, so it would "e a cash flow toda!. The old e&uipment would ha%e an opportunit! cost if it
could "e sold. )s there is no discussion that the e#isting e&uipment could "e sold, we must assume it
cannot "e sold. The onl! initial cash flow is the cost of the in%entor!. The compan! will ha%e to
spend mone! for in%entor! in the new ta"le, "ut will "e a"le to reduce in%entor! of the e#isting
ta"le. So, the initial cash flow toda! is0
?ew ta"le @=I68,444
'ld ta"le J4,444
Total @=H38,444
207
SOLUTIONS
In !ear 6, the compan! will ha%e a cash outflow to pa! for the cost of the new e&uipment. Since the
e&uipment will "e purchased in two !ears rather than now, the e&uipment will ha%e a higher sal%age
%alue. The "oo, %alue of the e&uipment in fi%e !ears will "e the initial cost, minus the accumulated
depreciation, or0
Aoo, %alue G =>4,944,444 @ >,944,944 @ 6,9I6,944 @ >,838,DD9
Aoo, %alue G =D,98I,999
The ta#es on the sal%age %alue will "e0
Ta#es on sal%age G .=D,9J>,H94 @ H,>44,444/..D4/
Ta#es on sal%age G @=H43,3D4
So, the afterta# sal%age %alue of the e&uipment in fi%e !ears will "e0
Sell e&uipment =H,>44,444
Ta#es @H43,3D4
Sal%age %alue =9,DJH,HH4
?e#t, we need to calculate the %aria"le costs each !ear. The %aria"le costs of the lost sales are
included as a %aria"le cost sa%ings, so the %aria"le costs will "e0
\ear > \ear 6 \ear 3 \ear D \ear 9
?ew =3,6IH,444 =3,33J,444 =3,DH9,444 =3,H9D,444 =3,36H,D44
Cost sales @3H4,444 @3H4,444 @3H4,444 @3H4,444 @3H4,444
Xaria"le costs =6,J>H,444 =6,JIJ,444 =3,>49,444 =3,6JD,444 =6,JHH,D44
?ow we can prepare the rest of the pro forma income statements for each !ear. The pro:ect will ha%e
no incremental depreciation for the first two !ears as the e&uipment is not purchased for two !ears.
)dding "ac, depreciation to net income to calculate the operating cash flow, we get0
\ear > \ear 6 \ear 3 \ear D \ear 9
Sales =H,384,444 =H,964,444 =H,844,444 =I,664,444 =H,DJ6,444
XC 6,J>H,444 6,JIJ,444 3,>49,444 3,6JD,444 6,JHH,D44
;i#ed costs >,I44,444 >,I44,444 >,I44,444 >,I44,444 >,I44,444
Eep. * * >,94>,944 6,9I6,944 >,838,DD9
EAT =>,IHD,444 =>,8D>,444 =DJ3,944 @=3DH,944 @=>6,8D9
Ta# I49,H44 I3H,D44 >JI,D44 @>38,H44 @9,>38
?I =>,498,D44 =>,>4D,H44 =6JH,>44 @=64I,J44 @=I,I4I
Eep. * * >,94>,944 6,9I6,944 >,838,DD9
'C; =>,498,D44 =>,>4D,H44 =>,IJI,H44 =6,3HD,H44 =>,834,I38
B-208
CHAPTER 7 B-
?e#t, we need to account for the changes in in%entor! each !ear. The in%entor! is a percentage of
sales. The wa! we will calculate the change in in%entor! is the "eginning of period in%entor! minus
the end of period in%entor!. The sign of this calculation will tell us whether the in%entor! change is a
cash inflow, or a cash outflow. The in%entor! each !ear, and the in%entor! change, will "e0
\ear > \ear 6 \ear 3 \ear D \ear 9
Aeginning =I68,444 =ID6,444 =II4,444 =8>6,444 =I3J,644
Ending ID6,444 II4,444 8>6,444 I3J,644 4
Change @=>D,444 @=68,444 @=D6,444 =I6,844 =I3J,644
?otice that we reco%er the remaining in%entor! at the end of the pro:ect. The total cash flows for the
pro:ect will "e the sum of the operating cash flow, the capital spending, and the in%entor! cash
flows, so0
\ear > \ear 6 \ear 3 \ear D \ear 9
'C; =>,498,D44 =>,>4D,H44 =>,IJI,H44 =6,3HD,H44 =>,834,I38
E&uipment 4 @>4,944,444 4 4 9,DJH,HH4
In%entor! @>D,444 @68,444 @D6,444 I6,844 I3J,644
Total =>,4DD,D44 @=J,D63,D44 =>,I99,H44 =6,D3I,D44 =8,4HD,JH4
The ?+X of the pro:ect, including the in%entor! cash flow at the "eginning of the pro:ect, will "e0
?+X G @=H38,444 L =>,4DD,D44 - >.>D @ =J,D63,D44 - >.>D
6
L =>,I99,H44 - >.>D
3

L =6,D3I,D44 - >.>D
D
L =8,4HD,JH4 - >.>D
9
?+X G @=>9H,499.JJ
The compan! should not go ahead with the new ta"le.
b. \ou can perform an IRR anal!sis, and would e#pect to find three IRRs since the cash flows
change signs three times.
c. The profita"ilit! inde# is intended as a 1"ang for the "uc,8 measure( that is, it shows how much
shareholder wealth is created for e%er! dollar of initial in%estment. In this case, the largest
in%estment is not at the "eginning of the pro:ect, "ut later in its life. 5owe%er, since the future
negati%e cash flow is discounted, the profita"ilit! inde# will still measure the amount of
shareholder wealth created for e%er! dollar spent toda!.
209
CHAPTER 8
R*$: A)A6,$*$; R1A6 0%*0)$; A)8
CA%*A6 27831*)3
Answers to Concepts Review and Critical !in"in# Questions
1. ;orecasting ris, is the ris, that a poor decision is made "ecause of errors in pro:ected cash flows.
The danger is greatest with a new product "ecause the cash flows are pro"a"l! harder to predict.
2. With a sensiti%it! anal!sis, one %aria"le is e#amined o%er a "road range of %alues. With a scenario
anal!sis, all %aria"les are e#amined for a limited range of %alues.
3. It is true that if a%erage re%enue is less than a%erage cost, the firm is losing mone!. This much of the
statement is therefore correct. )t the margin, howe%er, accepting a pro:ect with marginal re%enue in
e#cess of its marginal cost clearl! acts to increase operating cash flow.
4. ;rom the shareholder perspecti%e, the financial "rea,*e%en point is the most important. ) pro:ect can
e#ceed the accounting and cash "rea,*e%en points "ut still "e "elow the financial "rea,*e%en point.
This causes a reduction in shareholder .!our/ wealth.
5. The pro:ect will reach the cash "rea,*e%en first, the accounting "rea,*e%en ne#t and finall! the
financial "rea,*e%en. ;or a pro:ect with an initial in%estment and sales aftewardr, this ordering will
alwa!s appl!. The cash "rea,*e%en is achie%ed first since it e#cludes depreciation. The accounting
"rea,*e%en is ne#t since it includes depreciation. ;inall!, the financial "rea,*e%en, which includes
the time %alue of mone!, is achie%ed.
6. Traditional ?+X anal!sis is often too conser%ati%e "ecause it ignores profita"le options such as the
a"ilit! to e#pand the pro:ect if it is profita"le, or a"andon the pro:ect if it is unprofita"le. The option
to alter a pro:ect when it has alread! "een accepted has a %alue, which increases the ?+X of the
pro:ect.
7. The t!pe of option most li,el! to affect the decision is the option to e#pand. If the countr! :ust
li"eralied its mar,ets, there is li,el! the potential for growth. ;irst entr! into a mar,et, whether an
entirel! new mar,et, or with a new product, can gi%e a compan! name recognition and mar,et share.
This ma! ma,e it more difficult for competitors entering the mar,et.
8. Sensiti%it! anal!sis can determine how the financial "rea,*e%en point changes when some factors
.such as fi#ed costs, %aria"le costs, or re%enue/ change.
9. There are two sources of %alue with this decision to wait. +otentiall!, the price of the tim"er can
potentiall! increase, and the amount of tim"er will almost definitel! increase, "arring a natural
catastrophe or forest fire. The option to wait for a logging compan! is &uite %alua"le, and companies
in the industr! ha%e models to estimate the future growth of a forest depending on its age.
CHAPTER 8 B-
10. When the additional anal!sis has a negati%e ?+X. Since the additional anal!sis is li,el! to occur
almost immediatel!, this means when the "enefits of the additional anal!sis outweigh the costs. The
"enefits of the additional anal!sis are the reduction in the possi"ilit! of ma,ing a "ad decision. 'f
course, the additional "enefits are often difficult, if not impossi"le, to measure, so much of this
decision is "ased on e#perience.
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. To calculate the accounting "rea,e%en, we first need to find the depreciation for each !ear. The
depreciation is0
Eepreciation G =8JH,444-8
Eepreciation G =>>6,444 per !ear
)nd the accounting "rea,e%en is0
Y) G .=J44,444 L >>6,444/-.=38 @ 69/
Y) G II,8DH units
b. We will use the ta# shield approach to calculate the 'C;. The 'C; is0
'C;"ase G N.+ @ %/Y @ ;CO.> @ tc/ L tcE
'C;"ase G N.=38 @ 69/.>44,444/ @ =J44,444O.4.H9/ L 4.39.=>>6,444/
'C;"ase G =6JJ,644
?ow we can calculate the ?+X using our "ase*case pro:ections. There is no sal%age %alue or
?WC, so the ?+X is0
?+X"ase G @=8JH,444 L =6JJ,644.+XI;)>9K,8/
?+X"ase G =DDH,H4H.H4
To calculate the sensiti%it! of the ?+X to changes in the &uantit! sold, we will calculate the
?+X at a different &uantit!. We will use sales of >49,444 units. The ?+X at this sales le%el is0

'C;new G N.=38 @ 69/.>49,444/ @ =J44,444O.4.H9/ L 4.39.=>>6,444/
'C;new G =3D>,D94
)nd the ?+X is0
?+Xnew G @=8JH,444 L =3D>,D94.+XI;)>9K,8/
?+Xnew G =H3H,>J9.J3
211
SOLUTIONS
So, the change in ?+X for e%er! unit change in sales is0
?+X- S G .=H3H,>J9.J3 @ DDH,H4H.H4/-.>49,444 @ >44,444/
?+X- S G L=3I.J>8
If sales were to drop "! 944 units, then ?+X would drop "!0
?+X drop G =3I.J>8.944/ G =>8,J98.J3
\ou ma! wonder wh! we chose >49,444 units. Aecause it doesnt matter_ Whate%er sales
num"er we use, when we calculate the change in ?+X per unit sold, the ratio will "e the same.
c. To find out how sensiti%e 'C; is to a change in %aria"le costs, we will compute the 'C; at a
%aria"le cost of =6D. )gain, the num"er we choose to use here is irrele%ant0 We will get the
same ratio of 'C; to a one pound change in %aria"le cost no matter what %aria"le cost we use.
So, using the ta# shield approach, the 'C; at a %aria"le cost of =6D is0
'C;new G N.=38 @ 6D/.>44,444/ @ J44,444O.4.H9/ L 4.39.=>>6,444/
'C;new G =3HD,644
So, the change in 'C; for a => change in %aria"le costs is0
'C;- % G .=6JJ,644 @ 3HD,644/-.=69 @ 6D/
'C;- % G @=H9,444
If %aria"le costs decrease "! => then, 'C; would increase "! =H9,444
2. We will use the ta# shield approach to calculate the 'C; for the "est* and worst*case scenarios. ;or
the "est*case scenario, the price and &uantit! increase "! >4 percent, so we will multipl! the "ase
case num"ers "! >.>, a >4 percent increase. The %aria"le and fi#ed costs "oth decrease "! >4 percent,
so we will multipl! the "ase case num"ers "! .J, a >4 percent decrease. Eoing so, we get0
'C;"est G ZN.=38/.>.>/ @ .=69/.4.J/O.>44M/.>.>/ @ =J44M.4.J/[.4.H9/ L 4.39.=>>6M/
'C;"est G =8J6,H94
The "est*case ?+X is0
?+X"est G @=8JH,444 L =8J6,H94.+XI;)>9K,8/
?+X"est G =3,>4J,H4I.9D
;or the worst*case scenario, the price and &uantit! decrease "! >4 percent, so we will multipl! the
"ase case num"ers "! .J, a >4 percent decrease. The %aria"le and fi#ed costs "oth increase "! >4
percent, so we will multipl! the "ase case num"ers "! >.>, a >4 percent increase. Eoing so, we get0
'C;worst G ZN.=38/.4.J/ @ .=69/.>.>/O.>44M/.4.J/ @ =J44M.>.>/[.4.H9/ L 4.39.=>>6M/
'C;worst G @=6>6,394
B-212
CHAPTER 8 B-
The worst*case ?+X is0
?+Xworst G @=8JH,444 @ =6>6,394.+XI;)>9K,8/
?+Xworst G @=>,8D8,886.I6
3. We can use the accounting "rea,e%en e&uation0
Y) G .;C L E/-.+ @ %/
to sol%e for the un,nown %aria"le in each case. Eoing so, we find0
.>/0 Y) G >34,644 G .2864,444 L E/-.2D> @ 34/
E G 2H>6,644
.6/0 Y) G >39,444 G .23.6$ L >.>9$/-.+ @ 29I/
+ G 28J.66
.3/0 Y) G 9,DI8 G .2>H4,444 L >49,444/-.2>49 @ %/
% G 29H.H6
4. When calculating the financial "rea,e%en point, we e#press the initial in%estment as an e&ui%alent
annual cost .E)C/. Ei%iding the in initial in%estment "! the se%en*!ear annuit! factor, discounted at
>4 percent, the E)C of the initial in%estment is0
E)C G Initial In%estment - +XI;)>4K,9
E)C G 2644,444 - 3.IJ4IJ
E)C G 296,I9J.94
?ote that this calculation sol%es for the annuit! pa!ment with the initial in%estment as the present
%alue of the annuit!. In other words0
+X) G '.Z> @ N>-.> L </O
t
[ - </
2644,444 G 'ZN> @ .>->.>4/
9
O - .>4[
' G 296,I9J.94

The annual depreciation is the cost of the e&uipment di%ided "! the economic life, or0
)nnual depreciation G 2644,444 - 9
)nnual depreciation G 2D4,444
?ow we can calculate the financial "rea,e%en point. The financial "rea,e%en point for this pro:ect is0
Y; G NE)C L ;C.> @ tC/ @ Eepreciation.tC/O - N.+ @ XC/.> @ tC/O
Y; G N296,I9J.94 L 2394,444.> @ 4.69/ @ 2D4,444.4.69/O - N.269 @ 9/.> @ 4.69/O
Y; G 64,394.H3 or a"out 64,39> units
5. If we purchase the machine toda!, the ?+X is the cost plus the present %alue of the increased cash
flows, so0
?+X4 G @Ca2>,944,444 L Ca2684,444.+XI;)>6K,>4/
?+X4 G Ca286,4H6.D9
213
SOLUTIONS
We should not purchase the machine toda!. We would want to purchase the machine when the ?+X
is the highest. So, we need to calculate the ?+X each !ear. The ?+X each !ear will "e the cost plus
the present %alue of the increased cash sa%ings. We must "e careful, howe%er. In order to ma,e the
correct decision, the ?+X for each !ear must "e ta,en to a common date. We will discount all of the
?+Xs to toda!. Eoing so, we get0
\ear >0 ?+X> G N@Ca2>,3I9,444 L Ca2684,444.+XI;)>6K,J/O - >.>6
?+X> G Ca2>4D,383.88
\ear 60 ?+X6 G N@Ca2>,694,444 L Ca2684,444.+XI;)>6K,8/O - >.>6
6

?+X6 G Ca2>>6,399.86
\ear 30 ?+X3 G N@Ca2>,>69,444 L Ca2684,444.+XI;)>6K,I/O - >.>6
3

?+X3 G Ca2>48,IJH.J>
\ear D0 ?+XD G N@Ca2>,444,444 L Ca2684,444.+XI;)>6K,H/O - >.>6
D

?+XD G Ca2JH,48H.99
\ear 90 ?+X9 G N@Ca2>,444,444 L Ca2684,444.+XI;)>6K,9/O - >.>6
9

?+X9 G Ca29,6J8.6H
\ear H0 ?+XH G N@Ca2>,444,444 L Ca2684,444.+XI;)>6K,D/O - >.>6
H

?+XH G @Ca2I9,IH6.I6
The compan! should purchase the machine two !ears from now when the ?+X is the highest.
6. We need to calculate the ?+X of the two options, go directl! to mar,et now, or utilie test mar,eting
first. The ?+X of going directl! to mar,et now is0
?+X G CSuccess .+ro". of Success/ L C;ailure .+ro". of ;ailure/
?+X G V64,444,444.4.94/ L V9,444,444.4.94/
?+X G V>6,944,444
?ow we can calculate the ?+X of test mar,eting first. Test mar,eting re&uires a V6 million cash
outla!. Choosing the test mar,eting option will also dela! the launch of the product "! one !ear.
Thus, the e#pected pa!off is dela!ed "! one !ear and must "e discounted "ac, to !ear 4.
?+XG C4 L ZNCSuccess .+ro". of Success/O L NC;ailure .+ro". of ;ailure/O[ - .> L </
t
?+X G @V6,444,444 L ZNV64,444,444 .4.I9/O L NV9,444,444 .4.69/O[ - >.64
?+X G V>>,9D>,HHH,HI
The compan! should go directl! to mar,et with the product since that option has the highest
e#pected pa!off.
7. We need to calculate the ?+X of each option, and choose the option with the highest ?+X. So, the
?+X of going directl! to mar,et is0
?+X G CSuccess .+ro". of Success/
?+X G B>,644,444 .4.94/
?+X G BH44,444
B-214
CHAPTER 8 B-
The ?+X of the focus group is0
?+X G C4 L CSuccess .+ro". of Success/
?+X G @B>64,444 L B>,644,444 .4.I4/
?+X G BI64,444
)nd the ?+X of using the consulting firm is0
?+X G C4 L CSuccess .+ro". of Success/
?+X G @BD44,444 L B>,644,444 .4.J4/
?+X G BH84,444
The firm should conduct a focus group since that option has the highest ?+X.
8. The compan! should anal!e "oth options, and choose the option with the greatest ?+X. So, if the
compan! goes to mar,et immediatel!, the ?+X is0
?+X G CSuccess .+ro". of Success/ L C;ailure .+ro". of ;ailure/
?+X G 234,444,444..H4/ L 23,444,444..D4/
?+X G 2>J,644,444.44
Customer segment research re&uires a 2> million cash outla!. Choosing the research option will also
dela! the launch of the product "! one !ear. Thus, the e#pected pa!off is dela!ed "! one !ear and
must "e discounted "ac, to !ear 4. So, the ?+X of the customer segment research is0
?+XG C4 L ZNCSuccess .+ro". of Success/O L NC;ailure .+ro". of ;ailure/O[ - .> L </
t
?+X G @2>,444,444 L ZN234,444,444 .4.I4/O L N23,444,444 .4.34/O[ - >.>9
?+X G 2>8,4D3,DI8.6H
Rraphicall!, the decision tree for the pro:ect is0
The compan! should not underta,e the mar,et segment research since it has lower ?+X.
215
Start
Research
?o Research
2>8.4D39 million at t G 4
2>J.64 million at t G 4
Success
;ailure
Success
;ailure
234 million at t G >
.26H.48I million at t G 4/
23 million at t G >
.26.H48I million at t G 4/
234 million at t G 4
23 million at t G 4
SOLUTIONS
9. a. The accounting "rea,e%en is the afterta# sum of the fi#ed costs and depreciation charge di%ided
"! the afterta# contri"ution margin .selling price minus %aria"le cost/. So, the accounting
"rea,e%en le%el of sales is0
Y) G N.;C L Eepreciation/.> @ tC/O - N.+ @ XC/.> @ tC/O
Y) G N.3D4,444 L 64,444/ .> @ 4.39/O - N.6.44 @ 4.I6/ .> @ 4.39/O
Y) G 68>,694.44
b. When calculating the financial "rea,e%en point, we e#press the initial in%estment as an
e&ui%alent annual cost .E)C/. Ei%iding the in initial in%estment "! the se%en*!ear annuit!
factor, discounted at >9 percent, the E)C of the initial in%estment is0
E)C G Initial In%estment - +XI;)>9K,I
E)C G >D4,444 - D.>H4D
E)C G 33,H94.D9
?ote that this calculation sol%es for the annuit! pa!ment with the initial in%estment as the
present %alue of the annuit!. In other words0
+X) G '.Z> @ N>-.> L </O
t
[ - </
>D4,444 G 'ZN> @ .>->.>9/
I
O - .>9[
' G 33,H94.D9

?ow we can calculate the financial "rea,e%en point. The financial "rea,e%en point for this
pro:ect is0
Y; G NE)C L ;C.> @ tC/ @ Eepreciation.tC/O - N.+ @ XC/.> @ tC/O
Y; G N33,H94.D9 L 3D4,444..H9/ @ 64,444..39/O - N.6 @ 4.I6/ ..H9/O
Y; G 6JI,H9H.IJ or a"out 6JI,H9I units
10. When calculating the financial "rea,e%en point, we e#press the initial in%estment as an e&ui%alent
annual cost .E)C/. Ei%iding the in initial in%estment "! the fi%e*!ear annuit! factor, discounted at 8
percent, the E)C of the initial in%estment is0
E)C G Initial In%estment - +XI;)8K,9
E)C G 2344,444 - 3.H4DI8
E)C G 2I9,>3H.JD
?ote that this calculation sol%es for the annuit! pa!ment with the initial in%estment as the present
%alue of the annuit!. In other words0
+X) G '.Z> @ N>-.> L </O
t
[ - </
2344,444 G 'ZN> @ .>->.48/
9
O - .48[
' G 2I9,>3H.JD

The annual depreciation is the cost of the e&uipment di%ided "! the economic life, or0
)nnual depreciation G 2344,444 - 9
)nnual depreciation G 2H4,444
?ow we can calculate the financial "rea,e%en point. The financial "rea,e%en point for this pro:ect is0
B-216
CHAPTER 8 B-
Y; G NE)C L ;C.> @ tC/ @ Eepreciation.tC/O - N.+ @ XC/.> @ tC/O
Y; G N2I9,>3H.JD L 2>44,444.> @ 4.3D/ @ 2H4,444.4.3D/O - N.2H4 @ 8/ .> @ 4.3D/O
Y; G 3,9>I.J8 or a"out 3,9>8 units
&ntermediate
11. a. )t the accounting "rea,e%en, the IRR is ero percent since the pro:ect reco%ers the initial
in%estment. The pa!"ac, period is ? !ears, the length of the pro:ect since the initial in%estment
is e#actl! reco%ered o%er the pro:ect life. The ?+X at the accounting "rea,e%en is0
?+X G I N.>-?/.+XI;)RK,?/ @ >O
b. )t the cash "rea,e%en le%el, the IRR is @>44 percent, the pa!"ac, period is negati%e, and the
?+X is negati%e and e&ual to the initial cash outla!.
c. The definition of the financial "rea,e%en is where the ?+X of the pro:ect is ero. If this is true,
then the IRR of the pro:ect is e&ual to the re&uired return. It is impossi"le to state the pa!"ac,
period, e#cept to sa! that the pa!"ac, period must "e less than the length of the pro:ect. Since
the discounted cash flows are e&ual to the initial in%estment, the undiscounted cash flows are
greater than the initial in%estment, so the pa!"ac, must "e less than the pro:ect life.
12. <sing the ta# shield approach, the 'C; at >>4,444 units will "e0
'C; G N.+ @ %/Y @ ;CO.> @ tC/ L tC.E/
'C; G N.)u268 @ >J/.>>4,444/ @ >J4,444O.4.HH/ L 4.3D.)u2D64,444-D/
'C; G )u29H3,I44
We will calculate the 'C; at >>>,444 units. The choice of the second le%el of &uantit! sold is
ar"itrar! and irrele%ant. ?o matter what le%el of units sold we choose, we will still get the same
sensiti%it!. So, the 'C; at this le%el of sales is0
'C; G N.)u268 @ >J/.>>>,444/ @ >J4,444O.4.HH/ L 4.3D.)u2D64,444-D/
'C; G )u29HJ,HD4
The sensiti%it! of the 'C; to changes in the &uantit! sold is0
Sensiti%it! G 'C;- Y G .)u29HJ,HD4 @ 9H3,I44/-.>>>,444 @ >>4,444/
'C;- Y G L)u29.JD
'C; will increase "! )u29.JD for e%er! additional unit sold.
13. a. The "ase*case, "est*case, and worst*case %alues are shown "elow. Remem"er that in the "est*
case, sales and price increase, while costs decrease. In the worst*case, sales and price decrease,
and costs increase.
Scenario <nit sales Xaria"le cost ;i#ed costs
Aase >J4 2>9,444 2669,444
Aest 64J 2>3,944 2646,944
Worst >I> 2>H,944 26DI,944
217
SOLUTIONS
<sing the ta# shield approach, the 'C; and ?+X for the "ase case estimate are0
'C;"ase G N.26>,444 @ >9,444/.>J4/ @ 2669,444O.4.H9/ L 4.39.2I64,444-D/
'C;"ase G 2H9I,I94
?+X"ase G @2I64,444 L 2H9I,I94.+XI;)>9K,D/
?+X"ase G 2>,>9I,8H6.46
The 'C; and ?+X for the worst case estimate are0
'C;worst G N.26>,444 @ >H,944/.>I>/ @ 26DI,944O.4.H9/ L 4.39.2I64,444-D/
'C;worst G 2D46,344
?+Xworst G @2I64,444 L 2D46,344.+XI;)>9K,D/
?+Xworst G 2D68,99I.84
)nd the 'C; and ?+X for the "est case estimate are0
'C;"est G N.26>,444 @ >3,944/.64J/ @ 2646,944O.4.H9/ L 4.39.2I64,444-D/
'C;"est G 2J94,694
?+X"est G @2I64,444 L 2J94,694.+XI;)>9K,D/
?+X"est G 2>,JJ6,JD3.>J
b. To calculate the sensiti%it! of the ?+X to changes in fi#ed costs, we choose another le%el of
fi#ed costs. We will use fi#ed costs of 2634,444. The 'C; using this le%el of fi#ed costs and
the other "ase case %alues with the ta# shield approach, we get0

'C; G N.26>,444 @ >9,444/.>J4/ @ 2634,444O.4.H9/ L 4.39.2I64,444-D/
'C; G 2H9D,944
)nd the ?+X is0
?+X G @2I64,444 L 2H9D,944.+XI;)>9K,D/
?+X G 2>,>D8,983.3D
The sensiti%it! of ?+X to changes in fi#ed costs is0
?+X- ;C G .2>,>9I,8H6.46 @ >,>D8,983.3D/-.2669,444 @ 634,444/
?+X- ;C G @2>.89H
;or e%er! dollar ;C increase, ?+X falls "! 2>.8H.
B-218
CHAPTER 8 B-
c. The accounting "rea,e%en is0
Y)

G .;C L E/-.+ @ %/
Y
)
G N2669,444 L .2I64,444-D/O-.26>,444 @ >9,444/
Y) G H8
)t the accounting "rea,e%en, the E'C is0
E'C G > L ;C-'C;
E'C G > L .2669,444-2>84,444/ G 6.69
;or each >K increase in unit sales, 'C; will increase "! 6.69K.
14. The mar,eting stud! and the research and de%elopment are "oth sun, costs and should "e ignored.
We will calculate the sales and %aria"le costs first. Since we will lose sales of the e#pensi%e shoes
and gain sales of the cheap shoes, these must "e accounted for as erosion. The total sales for the new
pro:ect will "e0
Sales
?ew shoes
2I44 99,444 G 238,944,444
E#p. shoes
2>,>44 .@>3,444/ G @>D,344,444
Cheap shoes
2D44 >4,444 G D,444,444
268,644,444
;or the %aria"le costs, we must include the units gained or lost from the e#isting shoes. ?ote that the
%aria"le costs of the e#pensi%e shoes are an inflow. If we are not producing the pairs an! more, we
will sa%e these %aria"le costs, which is an inflow. So0
Xar. costs
?ew shoes
@2364 99,444 G @2>I,H44,444
E#p. shoes
@2H44 .@>3,444/ G I,844,444
Cheap shoes
@2>84 >4,444 G @>,844,444
@2>>,H44,444
The pro forma income statement will "e0
Sales 268,644,444
Xaria"le costs >>,H44,444
;i#ed costs I,944,444
Eepreciation 6,H44,444
EAT H,944,444
Ta#es 6,H44,444
?et income 2 3,J44,444
<sing the "ottom up 'C; calculation, we get0
'C; G ?I L Eepreciation G 23,J44,444 L 6,H44,444
'C; G 2H,944,444
219
SOLUTIONS
So, the pa!"ac, period is0
+a!"ac, period G 6 L 2H.>9$-2H.9$
+a!"ac, period G 6.JDH !ears
The ?+X is0
?+X G @2>8.6$ @ .J9$ L 2H.9$.+XI;)>DK,I/ L 24.J9$->.>D
I

?+X G 2J,>43,H3H.J>
)nd the IRR is0
IRR G @2>8.6$ @ .J9$ L 2H.9$.+XI;)IRRK,I/ L 24.J9$-.> L IRR/
I

IRR G 68.6DK
15. The upper and lower "ounds for the %aria"les are0
Aase Case Cower Aound <pper Aound
<nit sales .new/ 99,444 DJ,944 H4,944
+rice .new/ 2I44 2H34 2II4
XC .new/ 2364 2688 2396
;i#ed costs 2I,944,444 2H,I94,444 28,694,444
Sales lost .e#pensi%e/ >3,444 >>,I44 >D,344
Sales gained .cheap/ >4,444 J,444 >>,444
Aest*case
We will calculate the sales and %aria"le costs first. Since we will lose sales of the e#pensi%e shoes
and gain sales of the cheap shoes, these must "e accounted for as erosion. The total sales for the new
pro:ect will "e0
Sales
?ew shoes
2II4 H4,944 G 2DH,989,444
E#p. shoes
2>,>44 .@>>,I44/ G @ >6,8I4,444
Cheap shoes
2D44 >>,444 G D,D44,444
238,>>9,444
;or the %aria"le costs, we must include the units gained or lost from the e#isting shoes. ?ote that the
%aria"le costs of the e#pensi%e shoes are an inflow. If we are not producing the pairs an! more, we
will sa%e these %aria"le costs, which is an inflow. So0
Xar. costs
?ew shoes
2688 H4,944 G 2>I,D6D,444
E#p. shoes
2H44 .@>>,I44/ G @ I,464,444
Cheap shoes
2>84 >>,444 G >,J84,444
2>6,38D,444
B-220
CHAPTER 8 B-
The pro forma income statement will "e0
Sales 238,>>9,444
Xaria"le costs >6,38D,444
Costs H,I94,444
Eepreciation 6,H44,444
EAT >H,38>,444
Ta#es H,996,D44
?et income 2J,868,H44
<sing the "ottom up 'C; calculation, we get0
'C; G ?et income L Eepreciation G 2J,868,H44 L 6,H44,444
'C; G 2>6,D68,H44
)nd the "est*case ?+X is0
?+X G @2>8.6$ @ .J9$ L 2>6,D68,H44.+XI;)>DK,I/ L .J9$->.>D
I

?+X G 23D,96I,684.J8
Worst*case
We will calculate the sales and %aria"le costs first. Since we will lose sales of the e#pensi%e shoes
and gain sales of the cheap shoes, these must "e accounted for as erosion. The total sales for the new
pro:ect will "e0
Sales
?ew shoes
2H34 DJ,944 G 23>,>89,444
E#p. shoes
2>,>44 .@ >D,344/ G @ >9,I34,444
Cheap shoes
2D44 J,444 G 3,H44,444
2>J,499,444
;or the %aria"le costs, we must include the units gained or lost from the e#isting shoes. ?ote that the
%aria"le costs of the e#pensi%e shoes are an inflow. If we are not producing the pairs an! more, we
will sa%e these %aria"le costs, which is an inflow. So0
Xar. costs
?ew shoes
2396 DJ,944 G 2>I,D6D,444
E#p. shoes
2H44 .@ >D,344/ G @ 8,984,444
Cheap shoes
2>84 J,444 G >,H64,444
2>4,DHD,444
221
SOLUTIONS
The pro forma income statement will "e0
Sales 2>J,499,444
Xaria"le costs >4,DHD,444
Costs 8,694,444
Eepreciation 6,H44,444
EAT @ 6,69J,444
Ta#es J43,H44 cassumes a ta# credit
?et income @2>,399,D44
<sing the "ottom up 'C; calculation, we get0
'C; G ?I L Eepreciation G @2>,399,D44 L 6,H44,444
'C; G 2>,6DD,H44
)nd the worst*case ?+X is0
?+X G @2>8.6$ @ .J9$ L 2>,6DD,H44.+XI;)>DK,I/ L .J9$->.>D
I

?+X G @2>3,D33,>64.3D
16. To calculate the sensiti%it! of the ?+X to changes in the price of the new shoe, we simpl! need to
change the price of the new shoe. We will choose 2I94, "ut the choice is irrele%ant as the sensiti%it!
will "e the same no matter what price we choose.
We will calculate the sales and %aria"le costs first. Since we will lose sales of the e#pensi%e shoes
and gain sales of the cheap shoes, these must "e accounted for as erosion. The total sales for the new
pro:ect will "e0
Sales
?ew shoes
2I94 99,444 G 2D>,694,444
E#p. shoes
2>,>44 .@ >3,444/ G @>D,344,444
Cheap shoes
2D44 >4,444 G D,444,444
234,J94,444
;or the %aria"le costs, we must include the units gained or lost from the e#isting shoes. ?ote that the
%aria"le costs of the e#pensi%e shoes are an inflow. If we are not producing the pairs an! more, we
will sa%e these %aria"le costs, which is an inflow. So0
Xar. costs
?ew shoes
2364 99,444 G 2>I,H44,444
E#p. shoes
2H44 .@>3,444/ G @I,844,444
Cheap shoes
2>84 >4,444 G >,844,444
2>>,H44,444
B-222
CHAPTER 8 B-
The pro forma income statement will "e0
Sales 234,J94,444
Xaria"le costs >>,H44,444
Costs I,944,444
Eepreciation 6,H44,444
EAT J,694,444
Ta#es 3,I44,444
?et income 2 9,994,444
<sing the "ottom up 'C; calculation, we get0
'C; G ?I L Eepreciation G 29,994,444 L 6,H44,444
'C; G 28,>94,444
)nd the ?+X is0
?+X G @2>8.6$ @ 4.J9$ L 28.>9$.+XI;)>DK,I/ L .J9$->.>D
I

?+X G 2>H,>IJ,33J.8J
So, the sensiti%it! of the ?+X to changes in the price of the new shoe is0
?+X- + G .2>H,>IJ,33J.8J @ J,>43,H3H.J>/-.2I94 @ I44/
?+X- + G 2>D>,9>D.4H
;or e%er! dollar increase .decrease/ in the price of the shoes, the ?+X increases .decreases/ "!
2>D>,9>D.4H.
To calculate the sensiti%it! of the ?+X to changes in the &uantit! sold of the new shoe, we simpl!
need to change the &uantit! sold. We will choose H4,444 units, "ut the choice is irrele%ant as the
sensiti%it! will "e the same no matter what &uantit! we choose.
We will calculate the sales and %aria"le costs first. Since we will lose sales of the e#pensi%e shoes
and gain sales of the cheap shoes, these must "e accounted for as erosion. The total sales for the new
pro:ect will "e0
Sales
?ew shoes
2I44 H4,444 G 2D6,444,444
E#p. shoes
2>,>44 .@ >3,444/ G @>D,344,444
Cheap shoes
2D44 >4,444 G D,444,444
23>,I44,444
223
SOLUTIONS
;or the %aria"le costs, we must include the units gained or lost from the e#isting shoes. ?ote that the
%aria"le costs of the e#pensi%e shoes are an inflow. If we are not producing the pairs an! more, we
will sa%e these %aria"le costs, which is an inflow. So0
Xar. costs
?ew shoes
2364 H4,444 G 2>J,644,444
E#p. shoes
2H44 .@>3,444/ G @I,844,444
Cheap shoes
2>84 >4,444 G >,844,444
2>3,644,444
The pro forma income statement will "e0
Sales 23>,I44,444
Xaria"le costs >3,644,444
Costs I,944,444
Eepreciation 6,H44,444
EAT 8,D44,444
Ta#es 3,3H4,444
?et income 2 9,4D4,444
<sing the "ottom up 'C; calculation, we get0
'C; G ?I L Eepreciation G 29,4D4,444 L 6,H44,444
'C; G 2I,HD4,444
The ?+X at this &uantit! is0
?+X G @2>8.6$ @ 24.J9$ L 2I.HD$.+XI;)>DK,I/ L 24.J9$->.>D
I

?+X G 2>3,JJ6,34D.D3
So, the sensiti%it! of the ?+X to changes in the &uantit! sold is0
?+X- Y G .2>3,JJ6,34D.D3 @ J,>43,H3H.J>/-.H4,444 @ 99,444/
?+X- Y G 2JII.I3
;or an increase .decrease/ of one pair of shoes sold per !ear, the ?+X increases .decreases/ "!
2JII.I3.
17. a. The "ase*case ?+X is0
?+X G @>,844,444 L D64,444.+XI;)>HK,>4/
?+X G 66J,J99.9D
b. We would a"andon the pro:ect if the cash flow from selling the e&uipment is greater than the
present %alue of the future cash flows. We need to find the sale &uantit! where the two are
e&ual, so0
>,D44,444 G .H4/Y.+XI;)>HK,J/
Y G >,D44,444-NH4.D.H4H9/O
Y G 9,4H9
B-224
CHAPTER 8 B-
)"andon the pro:ect if Y d 9,4H9 units, "ecause the ?+X of a"andoning the pro:ect is greater
than the ?+X of the future cash flows.
c. The >,D44,444 is the mar,et %alue of the pro:ect. If !ou continue with the pro:ect in one
!ear, !ou forego the >,D44,444 that could ha%e "een used for something else.
18. a. If the pro:ect is a success, present %alue of the future cash flows will "e0
+X future C;s G H4.J,444/.+XI;)>HK,J/
+X future C;s G 6,D8I,933.HJ
;rom the pre%ious &uestion, if the &uantit! sold is D,444, we would a"andon the pro:ect, and the
cash flow would "e >,D44,444. Since the pro:ect has an e&ual li,elihood of success or failure
in one !ear, the e#pected %alue of the pro:ect in one !ear is the a%erage of the success and
failure cash flows, plus the cash flow in one !ear, so0
E#pected %alue of pro:ect at !ear > G N.6,D8I,933.HJ L >,D44,444/-6O L D64,444
E#pected %alue of pro:ect at !ear > G 6,3H3,IHH.89
The ?+X is the present %alue of the e#pected %alue in one !ear plus the cost of the e&uipment,
so0
?+X G @>,844,444 L .6,3H3,IHH.89/->.>H
?+X G 63I,I34.4D
b. If we couldnt a"andon the pro:ect, the present %alue of the future cash flows when the &uantit!
is D,444 will "e0
+X future C;s G H4.D,444/.+XI;)>HK,J/
+X future C;s G >,>49,9I4.93
The gain from the option to a"andon is the a"andonment %alue minus the present %alue of the
cash flows if we cannot a"andon the pro:ect, so0
Rain from option to a"andon G >,D44,444 @ >,>49,9I4.93
Rain from option to a"andon G 6JD,D6J.DI
We need to find the %alue of the option to a"andon times the li,elihood of a"andonment. So,
the %alue of the option to a"andon toda! is0
'ption %alue G ..94/.6JD,D6J.DI/->.>H
Option value = 126,909.25
19. If the project is a success, present value of the future cash flows will be:
+X future C;s G H4.>8,444/.+XI;)>HK,J/
+X future C;s G D,JI9,4HI.3J
225
SOLUTIONS
If the sales are onl! D,444 units, from +ro"lem e>D, we ,now we will a"andon the pro:ect, with a
%alue of >,D44,444. Since the pro:ect has an e&ual li,elihood of success or failure in one !ear, the
e#pected %alue of the pro:ect in one !ear is the a%erage of the success and failure cash flows, plus the
cash flow in one !ear, so0
E#pected %alue of pro:ect at !ear > G N.D,JI9,4HI.3J L >,D44,444/-6O L D64,444
E#pected %alue of pro:ect at !ear > G 3,H4I,933.HJ
The ?+X is the present %alue of the e#pected %alue in one !ear plus the cost of the e&uipment, so0
?+X G @>,844,444 L 3,H4I,933.HJ->.>H
?+X G >,34J,JD6.8D
The gain from the option to e#pand is the present %alue of the cash flows from the additional units
sold, so0
Rain from option to e#pand G H4.J,444/.+XI;)>HK,J/
Rain from option to e#pand G 6,D8I,933.HJ
We need to find the %alue of the option to e#pand times the li,elihood of e#pansion. We also need to
find the %alue of the option to e#pand toda!, so0
'ption %alue G ..94/.6,D8I,933.HJ/->.>H
'ption %alue G >,4I6,6>6.84
20. a. The accounting "rea,e%en is the afterta# sum of the fi#ed costs and depreciation charge di%ided
"! the contri"ution margin .selling price minus %aria"le cost/. In this case, there are no fi#ed
costs, and the depreciation is the entire price of the press in the first !ear. So, the accounting
"rea,e%en le%el of sales is0
Y) G N.;C L Eepreciation/.> @ tC/O - N.+ @ XC/.> @ tC/O
Y) G N.24 L 6,444/ .> @ 4.34/O - N.2>4 @ 8/ .> @ 4.34/O
Y) G >,444 units
b. When calculating the financial "rea,e%en point, we e#press the initial in%estment as an
e&ui%alent annual cost .E)C/. The initial in%estment is the 2>4,444 in licensing fees. Ei%iding
the in initial in%estment "! the three*!ear annuit! factor, discounted at >6 percent, the E)C of
the initial in%estment is0
E)C G Initial In%estment - +XI;)>6K,3
E)C G 2>4,444 - 6.D4>8
E)C G 2D,>H3.DJ
?ote, this calculation sol%es for the annuit! pa!ment with the initial in%estment as the present
%alue of the annuit!, in other words0
+X) G '.Z> @ N>-.> L </O
t
[ - </
2>4,444 G 'ZN> @ .>->.>6/
3
O - .>6[
' G 2D,>H3.DJ

B-226
CHAPTER 8 B-
?ow we can calculate the financial "rea,e%en point. ?otice that there are no fi#ed costs or
depreciation. The financial "rea,e%en point for this pro:ect is0
Y; G NE)C L ;C.> @ tC/ @ Eepreciation.tC/O - N.+ @ XC/.> @ tC/O
Y; G .2D,>H3.DJ L 4 @ 4/ - N.2>4 @ 8/ ..I4/O
Y; G 6,JI3.J6 or a"out 6,JID units
21. The pa!off from ta,ing the lump sum is B9,444, so we need to compare this to the e#pected pa!off
from ta,ing one percent of the profit. The decision tree for the mo%ie pro:ect is0
Aig audience
34K B>4,444,444

$o%ie is
good
>4K
$a,e
mo%ie

Script is
good
$o%ie is
"ad

Read
script I4K
Small
audience

Script is
"ad ?o profit
J4K
EonTt ma,e
mo%ie
?o profit
The %alue of one percent of the profits as follows. There is a 34 percent pro"a"ilit! the mo%ie is
good, and the audience is "ig, so the e#pected %alue of this outcome is0
Xalue G B>4,444,444 Q .34
Xalue G B3,444,444
The %alue that the mo%ie is good, and has a "ig audience, assuming the script is good is0
Xalue G B3,444,444 Q .>4
Xalue G B344,444
This is the e#pected %alue for the studio, "ut the screenwriter will onl! recei%e one percent of this
amount, so the pa!ment to the screenwriter will "e0
+a!ment to screenwriter G B344,444 Q .4>
+a!ment to screenwriter G B3,444
The screenwriter should ta,e the upfront offer of B9,444.
22. )ppl! the accounting profit "rea,*e%en point formula and sol%e for the sales price, +, that allows the
firm to "rea, e%en when producing 64,444 calculators. In order for the firm to "rea, e%en, the
re%enues from the calculator sales must e&ual the total annual cost of producing the calculators. The
depreciation charge each !ear will "e0
227
SOLUTIONS
Eepreciation G Initial in%estment - Economic life
Eepreciation G =H44,444 - 9
Eepreciation G =>64,444 per !ear
?ow we can sol%e the accounting "rea,*e%en e&uation for the sales price at 64,444 units. The
accounting "rea,*e%en is the point at which the net income of the product is ero. So, sol%ing the
accounting "rea,*e%en e&uation for the sales price, we get0
Y) G N.;C L Eepreciation/ .> @ tC/O - N.+ @ XC/.> @ tC/O
64,444 G N.=J44,444 L >64,444/.> @ .D4/O - N.+ @ >9/.> @ .D4/O
+ G =HH
23. a. The ?+X of the pro:ect is sum of the present %alue of the cash flows generated "! the pro:ect.
The cash flows from this pro:ect are an annuit!, so the ?+X is0
?+X G @2>44,444,444 L 269,444,444.+XI;)64K,>4/
?+X G 2D,8>>,846.>D
b. The compan! should a"andon the pro:ect if the +X of the re%ised cash flows for the ne#t nine
!ears is less than the pro:ects afterta# sal%age %alue. Since the option to a"andon the pro:ect
occurs in !ear >, discount the re%ised cash flows to !ear > as well. To determine the le%el of
e#pected cash flows "elow which the compan! should a"andon the pro:ect, calculate the
e&ui%alent annual cash flows the pro:ect must earn to e&ual the afterta# sal%age %alue. We will
sol%e for C6, the re%ised cash flow "eginning in !ear 6. So, the re%ised annual cash flow "elow
which it ma,es sense to a"andon the pro:ect is0
)fterta# sal%age %alue G C6.+XI;)64K,J/
294,444,444 G C6.+XI;)64K,J/
C6 G 294,444,444 - +XI;)64K,J
C6 G 2>6,D43,JI3.48
B-228
CHAPTER 8 B-
24. a. The ?+X of the pro:ect is sum of the present %alue of the cash flows generated "! the pro:ect.
The annual cash flow for the pro:ect is the num"er of units sold times the cash flow per unit,
which is0
)nnual cash flow G >4.V344,444/
)nnual cash flow G V3,444,444
The cash flows from this pro:ect are an annuit!, so the ?+X is0
?+X G @V>4,444,444 L V3,444,444.+XI;)69K,9/
?+X G @V>,J36,>H4.44
b. The compan! will a"andon the pro:ect if unit sales are not re%ised upward. If the unit sales are
re%ised upward, the afterta# cash flows for the pro:ect o%er the last four !ears will "e0
?ew annual cash flow G 64.V344,444/
?ew annual cash flow G VH,444,444
The ?+X of the pro:ect will "e the initial cost, plus the e#pected cash flow in !ear one "ased on
>4 unit sales pro:ection, plus the e#pected %alue of a"andonment, plus the e#pected %alue of
e#pansion. We need to remem"er that the a"andonment %alue occurs in !ear >, and the present
%alue of the e#pansion cash flows are in !ear one, so each of these must "e discounted "ac, to
toda!. So, the pro:ect ?+X under the a"andonment or e#pansion scenario is0
?+X G @V>4,444,444 L V3,444,444 - >.69 L .94.V9,444,444/ - >.69
L N.94.VH,444,444/.+XI;)69K,D/O - >.69
?+X G VHI,8D4.44
25. To calculate the unit sales for each scenario, we multipl! the mar,et sales times the compan!s
mar,et share. We can then use the &uantit! sold to find the re%enue each !ear, and the %aria"le costs
each !ear. )fter doing these calculations, we will construct the pro forma income statement for each
scenario. We can then find the operating cash flow using the "ottom up approach, which is net
income plus depreciation. Eoing so, we find0
=essimistic E8pected Optimistic
<nits per !ear 6D,644 34,444 39,>44

Re%enue =6,I83,444 =3,H44,444 =D,38I,944
Xaria"le costs >,ID6,D44 6,>44,444 6,38H,844
;i#ed costs 894,444 844,444 I94,444
Eepreciation 344,444 344,444 344,444
EAT @=>4J,D44 =D44,444 =J94,I44
Ta# @D3,IH4 >H4,444 384,684
?et income @=H9,HD4 =6D4,444 =9I4,D64
'C; =63D,3H4 =9D4,444 =8I4,D64
229
SOLUTIONS
?ote that under the pessimistic scenario, the ta#a"le income is negati%e. We assumed a ta# credit in
the case. ?ow we can calculate the ?+X under each scenario, which will "e0
?+X+essimistic G @=>,944,444 L=63D,3H4.+XI;)>3K,9/
?+X G @=HI9,I4>.H8
?+XE#pected G @=>,944,444 L=9D4,444.+XI;)>3K,9/
?+X G =3JJ,34D.88
?+X'ptimistic G @=>,944,444 L=8I4,D64.+XI;)>3K,9/
?+X G =>,9H>,DH8.D3
The ?+X under the pessimistic scenario is negati%e, "ut the compan! should pro"a"l! accept the
pro:ect.
'hallenge
26. a. <sing the ta# shield approach, the 'C; is0
'C; G N.2634 @ 6>4/.D4,444/ @ 2D94,444O.4.H6/ L 4.38.2>,I44,444-9/
'C; G 23DH,644
)nd the ?+X is0
?+X G @2>.I$ @ D94M L 23DH,644.+XI;)>3K,9/ L N2D94M L 2944M.> @ .38/O->.>3
9

?+X G @29>J,83H.JJ
b. In the worst*case, the 'C; is0
'C;worst G ZN.2634/.4.J/ @ 6>4O.D4,444/ @ 2D94,444[.4.H6/ L 4.38.2>,J99,444-9/
'C;worst G @264D,864
)nd the worst*case ?+X is0
?+Xworst G @2>,J99,444 @ 2D94,444.>.49/ L @264D,864.+XI;)>3K,9/ L
N2D94,444.>.49/ L 2944,444.4.89/.> @ .38/O->.>3
9

?+Xworst G @26,ID8,D6I.JJ
The "est*case 'C; is0
'C;"est G ZN2634.>.>/ @ 6>4O.D4,444/ @ 2D94,444[.4.H6/ L 4.38.2>,DD9,444-9/
'C;"est G 28JI,664
)nd the "est*case ?+X is0
?+X"est G @ 2>,DD9,444 @ 2D94,444.4.J9/ L 28JI,664.+XI;)>3K,9/ L
N2D94,444.4.J9/ L 2944,444.>.>9/.> @ .38/O->.>3
9

?+X"est G 2>,I48,I9D.46
B-230
CHAPTER 8 B-
27. To calculate the sensiti%it! to changes in &uantit! sold, we will choose a &uantit! of D>,444. The
'C; at this le%el of sale is0
'C; G N.2634 @ 6>4/.D>,444/ @ 2D94,444O.4.H6/ L 4.38.2>,I44,444-9/
'C; G 2398,H44
The sensiti%it! of changes in the 'C; to &uantit! sold is0
'C;- Y G .2398,H44 @ 3DH,644/-.D>,444 @ D4,444/
'C;- Y G L2>6.D4
The ?+X at this le%el of sales is0
?+X G @2>.I$ @ 2D94,444 L 2398,H44.+XI;)>3K,9/ L N2D94M L 2944M.> @ .38/O->.>3
9

?+X G @2DIH,663.36
)nd the sensiti%it! of ?+X to changes in the &uantit! sold is0
?+X- Y G .@2DIH,663.36 @ .@9>J,83H.JJ//-.D>,444 @ D4,444/
?+X- Y G L2D3.H>
\ou wouldnt want the &uantit! to fall "elow the point where the ?+X is ero. We ,now the ?+X
changes 2D3.H> for e%er! unit sale, so we can di%ide the ?+X for D4,444 units "! the sensiti%it! to
get a change in &uantit!. Eoing so, we get0
@29>J,83H.JJ G 2D3.H>. Y/
Y G @>>,J>J
;or a ero ?+X, we need to increase sales "! >>,J>J units, so the minimum &uantit! is0
Y$in G D4,444 L >>,J>J
Y$in G 9>,J>J
231
SOLUTIONS
28. We will use the "ottom up approach to calculate the operating cash flow. )ssuming we operate the
pro:ect for all four !ears, the cash flows are0
\ear 4 > 6 3 D
Sales 2I,444,444 2I,444,444 2I,444,444 2I,444,444
'perating costs 3,444,444 3,444,444 3,444,444 3,444,444
Eepreciation 6,444,444 6,444,444 6,444,444 6,444,444
EAT 26,444,444 26,444,444 26,444,444 26,444,444
Ta# IH4,444 IH4,444 IH4,444 IH4,444
?et income 2>,6D4,444 2>,6D4,444 2>,6D4,444 2>,6D4,444
LEepreciation 6,444,444 6,444,444 6,444,444 6,444,444
'perating C; 23,6D4,444 23,6D4,444 23,6D4,444 23,6D4,444
Change in ?WC @26,444,444 4 4 4 26,444,444
Capital spending @8,444,444 4 4 4 23>4,444
Total cash flow @2>4,444,444 23,6D4,444 23,6D4,444 23,6D4,444 29,994,444
There is 2944,444 sal%age %alue for the e&uipment.
The after*ta# sal%age %alue will "e 2944,444.>*.38/ G 23>4,444
The ?+X is0
?+X G @2>4,444,444 L 23,6D4,444.+XI;)>HK,D/ L .29,994,444/->.>H
D
?+X G 23D>,8JI.I4
The cash flows if we a"andon the pro:ect after one !ear are0
\ear 4 >
Sales 2I,444,444
'perating costs 3,444,444
Eepreciation 6,444,444
EAT 26,444,444
Ta# IH4,444
?et income 2>,6D4,444
LEepreciation 6,444,444
'perating C; 23,6D4,444
Change in ?WC @26,444,444 26,444,444
Capital spending @8,444,444 H,3>4,444
Total cash flow @2>4,444,444 2>>,994,444
The "oo, %alue of the e&uipment is0
Aoo, %alue G 28,444,444 @ .>/.28,444,444-D/
B-232
CHAPTER 8 B-
Aoo, %alue G 2H,444,444
So the ta#es on the sal%age %alue will "e0
Ta#es G .2H,444,444 @ H,944,444/..38/
Ta#es G @2>J4,444
This ma,es the afterta# sal%age %alue0
)fterta# sal%age %alue G 2H,944,444 @ >J4,444
)fterta# sal%age %alue G 2H,3>4,444
The ?+X if we a"andon the pro:ect after one !ear is0
?+X G @2>4,444,444 L 2>>,994,444->.>H
?+X G @2D3,>43.D9
If we a"andon the pro:ect after two !ears, the cash flows are0
\ear 4 > 6
Sales 2I,444,444 2I,444,444
'perating costs 3,444,444 3,444,444
Eepreciation 6,444,444 6,444,444
EAT 26,444,444 26,444,444
Ta# IH4,444 IH4,444
?et income 2>,6D4,444 2>,6D4,444
LEepreciation 6,444,444 6,444,444
'perating C; 23,6D4,444 23,6D4,444
Change in ?WC @26,444,444 4 26,444,444
Capital spending @8,444,444 4 9,6D4,444
Total cash flow @2>4,444,444 23,6D4,444 2>4,D84,444
The "oo, %alue of the e&uipment is0
Aoo, %alue G 28,444,444 @ .6/.28,444,444-D/
Aoo, %alue G 2D,444,444
So the ta#es on the sal%age %alue will "e0
Ta#es G .2D,444,444 @ H,444,444/..38/
Ta#es G @2IH4,444
This ma,es the afterta# sal%age %alue0
)fterta# sal%age %alue G 2H,444,444 @ IH4,444
)fterta# sal%age %alue G 29,6D4,444
233
SOLUTIONS
The ?+X if we a"andon the pro:ect after two !ears is0
?+X G @2>4,444,444 L 23,6D4,444->.>H L 2>4,D84,444->.>H
6
?+X G 298>,D94.H9
If we a"andon the pro:ect after three !ears, the cash flows are0
\ear 4 > 6 3
Sales 2I,444,444 2I,444,444 2I,444,444
'perating costs 3,444,444 3,444,444 3,444,444
Eepreciation 6,444,444 6,444,444 6,444,444
EAT 26,444,444 26,444,444 26,444,444
Ta# IH4,444 IH4,444 IH4,444
?et income 2>,6D4,444 2>,6D4,444 2>,6D4,444
LEepreciation 6,444,444 6,444,444 6,444,444
'perating C; 23,6D4,444 23,6D4,444 23,6D4,444
Change in ?WC @26,444,444 4 4 26,444,444
Capital spending @8,444,444 4 4 6,H64,444
Total cash flow @2>4,444,444 23,6D4,444 23,6D4,444 2I,8H4,444
The "oo, %alue of the e&uipment is0
Aoo, %alue G 28,444,444 @ .3/.28,444,444-D/
Aoo, %alue G 26,444,444
So the ta#es on the sal%age %alue will "e0
Ta#es G .26,444,444 @ 3,444,444/..38/
Ta#es G @2384,444
This ma,es the afterta# sal%age %alue0
)fterta# sal%age %alue G 23,444,444 @ 384,444
)fterta# sal%age %alue G 26,H64,444
The ?+X if we a"andon the pro:ect after two !ears is0
?+X G @2>4,444,444 L 23,6D4,444.+XI;)>HK,6/ L 2I,8H4,444->.>H
3
?+X G 263H,964.9H
We should a"andon the e&uipment after two !ears since the ?+X of a"andoning the pro:ect after two
!ears has the highest ?+X.
B-234
CHAPTER 8 B-
29. a. The ?+X of the pro:ect is sum of the present %alue of the cash flows generated "! the pro:ect.
The cash flows from this pro:ect are an annuit!, so the ?+X is0
?+X G @Rs.D,444,444 L Rs.I94,444.+XI;)>4K,>4/
?+X G Rs.H48,D69.33
b. The compan! will a"andon the pro:ect if %alue of a"andoning the pro:ect is greater than the
%alue of the future cash flows. The present %alue of the future cash flows if the compan!
re%ises it sales downward will "e0
+X of downward re%ision G Rs.>64,444.+XI;)>4K,J/
+X of downward re%ision G Rs.HJ>,486.8H
Since this is less than the %alue of a"andoning the pro:ect, the compan! should a"andon in one
!ear. So, the re%ised ?+X of the pro:ect will "e the initial cost, plus the e#pected cash flow in
!ear one "ased on upward sales pro:ection, plus the e#pected %alue of a"andonment. We need
to remem"er that the a"andonment %alue occurs in !ear >, and the present %alue of the
e#pansion cash flows are in !ear one, so each of these must "e discounted "ac, to toda!. So,
the pro:ect ?+X under the a"andonment or e#pansion scenario is0
?+X G @Rs.D,444,444 L Rs.I94,444 - >.>4 L .94.Rs.844,444/ - >.>4
L N.94.Rs.>,944,444/.+XI;)>4K,J/O - >.>4
?+X G Rs.JI6,4H>.HJ
30. ;irst, determine the cash flow from selling the old har%ester. When calculating the sal%age %alue,
remem"er that ta# lia"ilities or credits are generated on the difference "etween the resale %alue and
the "oo, %alue of the asset. <sing the original purchase price of the old har%ester to determine
annual depreciation, the annual depreciation for the old har%ester is0
Eepreciation'ld G BD9,444 - >9
Eepreciation'ld G B3,444
Since the machine is fi%e !ears old, the firm has accumulated fi%e annual depreciation charges,
reducing the "oo, %alue of the machine. The current "oo, %alue of the machine is e&ual to the initial
purchase price minus the accumulated depreciation, so0
Aoo, %alue G Initial +urchase +rice @ )ccumulated Eepreciation
Aoo, %alue G BD9,444 @ .B3,444 9 !ears/
Aoo, %alue G B34,444
Since the firm is a"le to resell the old har%ester for B64,444, which is less than the B34,444 "oo,
%alue of the machine, the firm will generate a ta# credit on the sale. The afterta# sal%age %alue of the
old har%ester will "e0
)fterta# sal%age %alue G $ar,et %alue L tC.Aoo, %alue @ $ar,et %alue/
)fterta# sal%age %alue G B64,444 L .3D.B34,444 @ 64,444/
)fterta# sal%age %alue G B63,D44
235
SOLUTIONS
?e#t, we need to calculate the incremental depreciation. We need to calculate depreciation ta# shield
generated "! the new har%ester less the forgone depreciation ta# shield from the old har%ester. Cet =
"e the "rea,*e%en purchase price of the new har%ester. So, we find0
Eepreciation ta# shield?ew G .Initial In%estment - Economic Cife/ tC
Eepreciation ta# shield?ew G .= - >4/ ..3D/
)nd the depreciation ta# shield on the old har%ester is0
Eepreciation ta# shield'ld G .BD9,444 - >9/ ..3D/
Eepreciation ta# shield'ld G .B3,444/.4.3D/
So, the incremental depreciation ta#, which is the depreciation ta# shield from the new har%ester,
minus the depreciation ta# shield from the old har%ester, is0
Incremental depreciation ta# shield G .= - >4/..3D/ @ .B3,444/..3D/
Incremental depreciation ta# shield G .= - >4 @ B3,444/..3D/
The present %alue of the incremental depreciation ta# shield will "e0
+XEepreciation ta# shield G .= - >4/..3D/.+XI;)>9K,>4/ @ B3,444..3D/.+XI;)>9K,>4/
The new har%ester will generate !ear*end pre*ta# cash flow sa%ings of B>4,444 per !ear for >4 !ears.
We can find the afterta# present %alue of the cash flows sa%ings as0
+XSsa%ings G C>.> @ tC/.+XI;)>9K,>4/
+XSsa%ings G B>4,444.> @ 4.3D/.+XI;)>9K,>4/
+XSsa%ings G B33,>63.8I
The "rea,*e%en purchase price of the new har%ester is the price, =, which ma,es the ?+X of the
machine e&ual to ero.
?+X G @= L Sal%age %alue'ld L +XEepreciation ta# shield L +XSa%ings
B4 G @= L B63,D44 L .= - >4/..3D/.+XI;)>9K,>4/ @ B3,444..3D/.+XI;)>9K,>4/ L B33,>63.8I
= @ .= - >4/..3D/.+XI;)>9K,>4/ G B9H,963.8I @ B3,444..3D/.+XI;)>9K,>4/
=N> @ .> - >4/..3D/.+XI;)>9K,>4/ G B9>,D4D.I3
= G BH>,J8>.4H
B-236
CHAPTER 9
RISK AND RETURN: LESSONS FROM
MARKET HISTORY
Answers to Concepts Review and Critical !in"in# Questions
1. The! all wish the! had_ Since the! didnt, it must ha%e "een the case that the stellar performance
was not foreseea"le, at least not "! most.
2. )s in the pre%ious &uestion, its eas! to see after the fact that the in%estment was terri"le, "ut it
pro"a"l! wasnt so eas! ahead of time.
3. ?o, stoc,s are ris,ier. Some in%estors are highl! ris, a%erse, and the e#tra possi"le return doesnt
attract them relati%e to the e#tra ris,.
4. <nli,e gam"ling, the stoc, mar,et is a positi%e sum game( e%er!"od! can win. )lso, speculators
pro%ide li&uidit! to mar,ets and thus help to promote efficienc!.
5. T*"ill rates were highest in the earl! eighties. This was during a period of high inflation and is
consistent with the ;isher effect.
6. Aefore the fact, for most assets, the ris, premium will "e positi%e( in%estors demand compensation
o%er and a"o%e the ris,*free return to in%est their mone! in the ris,! asset. )fter the fact, the
o"ser%ed ris, premium can "e negati%e if the assets nominal return is une#pectedl! low, the ris,*
free return is une#pectedl! high, or if some com"ination of these two e%ents occurs.
7. \es, the stoc, prices are currentl! the same. Aelow is a diagram that depicts the stoc,s price
mo%ements. Two !ears ago, each stoc, had the same price, +4. '%er the first !ear, Reneral
$aterials stoc, price increased "! >4 percent, or .>.>/ +4. Standard ;i#tures stoc, price declined
"! >4 percent, or .4.J/ +4. '%er the second !ear, Reneral $aterials stoc, price decreased "! >4
percent, or .4.J/.>.>/ +4, while Standard ;i#tures stoc, price increased "! >4 percent, or .>.>/
.4.J/ +4. Toda!, each of the stoc,s is worth JJ percent of its original %alue.
6 !ears ago > !ear ago Toda!
Reneral $aterials +4 .>.>/+4 .>.>/.4.J/+4 G .4.JJ/+4
Standard ;i#tures +4 .4.J/+4 .4.J/.>.>/+4 G .4.JJ/+4
8. The stoc, prices are not the same. The return &uoted for each stoc, is the arithmetic return, not the
geometric return. The geometric return tells !ou the wealth increase from the "eginning of the period
to the end of the period, assuming the asset had the same return each !ear. )s such, it is a "etter
measure of ending wealth. To see this, assuming each stoc, had a "eginning price of 2>44 per share,
the ending price for each stoc, would "e0
SOLUTIONS
Ca,e $inerals ending price G 2>44.>.>4/.>.>4/ G 2>6>.44
Small Town ;urniture ending price G 2>44.>.69/..J9/ G 2>>8.I9
B-238
CHAPTER 9 B-
Whene%er there is an! %ariance in returns, the asset with the larger %ariance will alwa!s ha%e the
greater difference "etween the arithmetic and geometric return.
9. To calculate an arithmetic return, !ou simpl! sum the returns and di%ide "! the num"er of returns.
)s such, arithmetic returns do not account for the effects of compounding. Reometric returns do
account for the effects of compounding. )s an in%estor, the more important return of an asset is the
geometric return.
10. Ris, premiums are a"out the same whether or not we account for inflation. The reason is that ris,
premiums are the difference "etween two returns, so inflation essentiall! nets out. Returns, ris,
premiums, and %olatilit! would all "e lower than we estimated "ecause afterta# returns are smaller
than preta# returns.
$olutions to Questions and %ro&le's
NOTE: All end of chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. The return of an! asset is the increase in price, plus an! di%idends or cash flows, all di%ided "! the
initial price. The return of this stoc, is0
R G N.2JD @ 83/ L >.D4O - 283
R G .>DJD or >D.JDK
2. The di%idend !ield is the di%idend di%ided "! price at the "eginning of the period, so0
Ei%idend !ield G 2>.D4 - 283
Ei%idend !ield G .4>HJ or >.HJK
)nd the capital gains !ield is the increase in price di%ided "! the initial price, so0
Capital gains !ield G .2JD @ 83/ - 283
Capital gains !ield G .>369 or >3.69K
3. <sing the e&uation for total return, we find0
R G N.2IH @ 83/ L >.D4O - 283
R G @.4HI9 or @H.I9K
)nd the di%idend !ield and capital gains !ield are0
Ei%idend !ield G 2>.D4 - 283
Ei%idend !ield G .4>HJ or >.HJK
239
SOLUTIONS
Capital gains !ield G .2IH @ 83/ - 283
Capital gains !ield G @.48D3 or @8.D3K
5eres a &uestion for !ou0 Can the di%idend !ield e%er "e negati%e7 ?o, that would mean !ou were
pa!ing the compan! for the pri%ilege of owning the stoc,. It has happened on "onds. Remem"er the
Auffett "onds we discussed in the "ond chapter.
4. The total pound return is the change in price plus the coupon pa!ment, so0
Total pound return G =>,4ID @ >,>64 L J4
Total pound return G =DD
The total percentage return of the "ond is0
R G N.=>,4ID @ >,>64/ L J4O - =>,>64
R G .43J3 or 3.J3K
?otice here that we could ha%e simpl! used the total pound return of =DD in the numerator of this
e&uation.
<sing the ;isher e&uation, the real return was0
.> L R/ G .> L r/.> L h/
r G .>.43J3 - >.434/ @ >
r G .44J4 or 4.J4K
5. The nominal return is the stated return, which is >6.D4 percent. <sing the ;isher e&uation, the real
return was0
.> L R/ G .> L r/.> L h/
r G .>.>6D4/-.>.43>/ @ >
r G .4J46 or J.46K
6. <sing the ;isher e&uation, the real returns for go%ernment and corporate "onds were0
.> L R/ G .> L r/.> L h/
rR G >.498->.43> @ >
rR G .46H6 or 6.H6K
rC G >.4H6->.43> @ >
rC G .434> or 3.4>K
B-240
CHAPTER 9 B-
7. The a%erage return is the sum of the returns, di%ided "! the num"er of returns. The a%erage return for each
stoc, was0
[ ]
+ .
. . . . .
N 8 @
N
i
i
44 >4 or .>444
9
>3 68 48 4H >>
>

+ + +

1
]
1


[ ]
+ .
. . . . .
N A
N
i
i
64 >H or .>H64
9
D3 >6 6> 4I 3H
>

+ +

1
]
1

We calculate the %ariance of each stoc, as0


( ) ( )
( ) ( ) ( ) ( ) ( ) { }
( ) ( ) ( ) ( ) ( ) { } 4H>HI4 >H6 D3 >H6 >6 >H6 6> >H6 4I >H6 3H
> 9
>
4>H894 >44 >3 >44 68 >44 48 >44 4H >44 >>
> 9
>
>
6 6 6 6 6 6
6 6 6 6 6 6
>
6 6
. . . . . . . . . . . s
. . . . . . . . . . . s
N 8 8 s
A
@
N
i
i @
+ + + +

+ + + +

1
]
1

The standard de%iation is the s&uare root of the %ariance, so the standard de%iation of each stoc, is0
s@ G ..4>H894/
>-6

s@ G .>6J8 or >6.J8K
sA G ..4H>HI4/
>-6

sA G .6D83 or 6D.83K
8. We will calculate the sum of the returns for each asset and the o"ser%ed ris, premium first. Eoing
so, we get0
\ear Carge co. stoc, return T*"ill return Ris, premium
>JI3 @>D.HJK I.6JK 6>.J8K
>JID @6H.DI I.JJ @3D.DH
>JI9 3I.63 9.8I 3>.3H
>JIH 63.J3 9.4I >8.8H
>JII @I.>H 9.D9 @>6.H>
>JI8 H.9I I.HD @>.4I
>J.D> 3J.3> @>J.J4
a. The a%erage return for large compan! stoc,s o%er this period was0
Carge compan! stoc, a%erage return G >J.D>K -H
Carge compan! stoc, a%erage return G 3.6DK
241
SOLUTIONS
)nd the a%erage return for T*"ills o%er this period was0
T T*"ills a%erage return G 3J.3>K - H
<T*"ills a%erage return G H.99K
X
b. <sing the e&uation for %ariance, we find the %ariance for large compan! stoc,s o%er this period
was0
Xariance G >-9N.@.>DHJ @ .436D/
6
L .@.6HDI @ .436D/
6
L ..3I63 @ .436D/
6
L ..63J3 @ .436D/
6
L
.@.4I>H @ .436D/
6
L ..4H9I @ .436D/
6
O
Xariance G 4.498>3H
)nd the standard de%iation for large compan! stoc,s o%er this period was0
Standard de%iation G .4.498>3H/
>-6

Standard de%iation G 4.6D>> or 6D.>>K
<sing the e&uation for %ariance, we find the %ariance for T*"ills o%er this period was0
Xariance G >-9N..4I6J @ .4H99/
6
L ..4IJJ @ .4H99/
6
L ..498I @ .4H99/
6
L ..494I @ .4H99/
6
L
..49D9 @ .4H99/
6
L ..4IHD @ .4H99/
6
O
Xariance G 4.444>93
)nd the standard de%iation for T*"ills o%er this period was0
Standard de%iation G .4.444>93/
>-6

Standard de%iation G 4.4>6D or >.6DK
c. The a%erage o"ser%ed ris, premium o%er this period was0
)%erage o"ser%ed ris, premium G @>J.J4K - H
)%erage o"ser%ed ris, premium G @3.36K
The %ariance of the o"ser%ed ris, premium was0
Xariance G >-9N.@.6>J8 @ .4336/
6
L .@.3DDH @ .4336/
6
L ..3>3H @ .4336/
6
L
..>88H @ .4336/
6
L .@.>6H> @ .4336/
6
L .@.4>4I @ .4336/
6
O
Xariance G 4.4H64I8
)nd the standard de%iation of the o"ser%ed ris, premium was0
Standard de%iation G .4.4H6I8/
>-6

Standard de%iation G 4.6DJ6 or 6D.J6K
9. a. To find the a%erage return, we sum all the returns and di%ide "! the num"er of returns, so0
)rithmetic a%erage return G .6.>H L.6> L .4D L .>H L .>J/-9
)rithmetic a%erage return G .9964 or 99.64K
B-242
CHAPTER 9 B-
b. <sing the e&uation to calculate %ariance, we find0
Xariance G >-DN.6.>H @ .996/
6
L ..6> @ .996/
6
L ..4D @ .996/
6
L ..>H @ .996/
6
L
..>J @ .996/
6
O
Xariance G 4.48>63I
So, the standard de%iation is0
Standard de%iation G .4.8>63I/
>-6

Standard de%iation G 4.J4>3 or J4.>3K
10. a. To calculate the a%erage real return, we can use the a%erage return of the asset and the a%erage
inflation rate in the ;isher e&uation. Eoing so, we find0
.> L R/ G .> L r/.> L h/
r G .>.9964->.4D6/ @ >
r G .D8JD or D8.JDK
b. The a%erage ris, premium is simpl! the a%erage return of the asset, minus the a%erage ris,*free
rate, so, the a%erage ris, premium for this asset would "e0
R R+ @
f
R
R+ G .9964 @ .49>4
R+ G .94>4 or 94.>4K
11. We can find the a%erage real ris,*free rate using the ;isher e&uation. The a%erage real ris,*free rate
was0
.> L R/ G .> L r/.> L h/
f r G .>.49>->.4D6/ @ >
f r G .448H or 4.8HK
)nd to calculate the a%erage real ris, premium, we can su"tract the a%erage ris,*free rate from the
a%erage real return. So, the a%erage real ris, premium was0
r rp @
f r G D.D>K @ 4.8HK
rp G 3.99K
12. )ppl! the fi%e*!ear holding*period return formula to calculate the total return of the stoc, o%er the
fi%e*!ear period, we find0
9*!ear holding*period return G N.> L R>/.> L R6/.> LR3/.> LRD/.> LR9/O @ >
9*!ear holding*period return G N.> @ .4DJ>/.> L .6>HI/.> L .369I/.> L .4H>J/.> L .3>89/O @ >
9*!ear holding*period return G >.>DI9 or >>D.I9K
243
SOLUTIONS
13. To find the return on the ero coupon "ond, we first need to find the price of the "ond toda!. Since
one !ear has elapsed, the "ond now has >J !ears to maturit!, so the price toda! is0
+> G =>,444->.>4
>J

+> G =>H3.9>
There are no intermediate cash flows on a ero coupon "ond, so the return is the capital gains, or0
R G .=>H3.9> @ >96.3I/ - =>96.3I
R G .4I3> or I.3>K
14. The return of an! asset is the increase in price, plus an! di%idends or cash flows, all di%ided "! the
initial price. This preferred stoc, paid a di%idend of B9, so the return for the !ear was0
R G .B84.6I @ 8D.>6 L 9.44/ - B8D.>6
R G .4>3I or >.3IK
15. The return of an! asset is the increase in price, plus an! di%idends or cash flows, all di%ided "! the
initial price. This stoc, paid no di%idend, so the return was0
R G .)u2D6.46 @ 38.H9/ - )u238.H9
R G .48I6 or 8.I6K
This is the return for three months, so the )+R is0
)+R G D.8.I6K/
)+R G 3D.88K
)nd the E)R is0
E)R G .> L .48I6/
D
@ >
E)R G .3JI> or 3J.I>K
16. To find the real return each !ear, we will use the ;isher e&uation, which is0
> L R G .> L r/.> L h/
<sing this relationship for each !ear, we find0
T*"ills Inflation Real Return
>J6H
4.4334 .4.4>>6/ 4.4DDI
>J6I
4.43>9 .4.466H/ 4.499D
>J68
4.4D49 .4.4>>H/ 4.496I
>J6J
4.4DDI 4.4498 4.438I
>J34
4.466I .4.4HD4/ 4.4J6H
>J3>
4.4>>9 .4.4J36/ 4.>>99
>J36
4.4488 .4.>46I/ 4.>6D3
B-244
CHAPTER 9 B-
So, the a%erage real return was0
)%erage G ..4DDI L .499D L .496I L .438I L .4J6H L .>>99 L .>6D3/ - I
)%erage G .4ID8 or I.D8K
?otice the real return was higher than the nominal return during this period "ecause of deflation, or
negati%e inflation.
17. Coo,ing at the long*term corporate "ond return histor! in ;igure J.6, we see that the mean return
was H.6 percent, with a standard de%iation of 8.H percent. The range of returns !ou would e#pect to
see H8 percent of the time is the mean plus or minus > standard de%iation, or0
R fa > G H.6K a 8.HK G @6.D4K to >D.84K
The range of returns !ou would e#pect to see J9 percent of the time is the mean plus or minus 6
standard de%iations, or0
R fa 6 G H.6K a 6.8.HK/ G @>>.44K to 63.D4K
18. Coo,ing at the large*compan! stoc, return histor! in ;igure J.6, we see that the mean return was
>6.D percent, with a standard de%iation of 64.3 percent. The range of returns !ou would e#pect to see
H8 percent of the time is the mean plus or minus > standard de%iation, or0
R fa > G >6.DK a 64.3K G @I.J4K to 36.I4K
The range of returns !ou would e#pect to see J9 percent of the time is the mean plus or minus 6
standard de%iations, or0
R fa 6 G >6.DK a 6.64.3K/ G @68.64K to 93.44K
19. To find the "est forecast, we appl! Alumes formula as follows0
R.9/ G
6J
> * 9
Q >4.IK L
6J
9 * 34
Q >6.8K G >6.9>K
R.>4/ G
6J
> * >4
Q >4.IK L
6J
>4 * 34
Q >6.8K G >6.>9K
R.64/ G
6J
> * 64
Q >4.IK L
6J
64 * 34
Q >6.8K G >>.D6K
245
SOLUTIONS
20. The "est forecast for a one !ear return is the arithmetic a%erage, which is >6.D percent. The
geometric a%erage, found in Ta"le J.3 is >4.D percent. To find the "est forecast for other periods, we
appl! Alumes formula as follows0
R.9/ G
> * 84
> * 9
Q >4.DK L
> * 84
9 * 84
Q >6.DK G >6.34K
R(20) =
> * 84
> * 64
10.4% +
> * 84
64 * 84
12.4% = 11.92%
R(30) =
> * 84
> * 34
10.4% +
> * 84
34 * 84
12.4% = 11.67%
&ntermediate
21. 5ere we ,now the a%erage stoc, return, and four of the fi%e returns used to compute the a%erage
return. We can wor, the a%erage return e&uation "ac,ward to find the missing return. The a%erage
return is calculated as0
.99 G .48 @ .>3 @ .4I L .66 L R
R G .D9 or D9K
The missing return has to "e D9 percent. ?ow we can use the e&uation for the %ariance to find0
Xariance G >-DN..48 @ .>>/
6
L .@.>3 @ .>>/
6
L .@.4I @ .>>/
6
L ..66 @ .>>/
6
L ..D9 @ .>>/
6
O
Xariance G 4.49DH94
)nd the standard de%iation is0
Standard de%iation G .4.49DH94/
>-6

Standard de%iation G 4.6338 or 63.38K
22. The arithmetic a%erage return is the sum of the ,nown returns di%ided "! the num"er of returns, so0
)rithmetic a%erage return G ..6> L .>D L .63 @.48 L .4J @.>D/ - H
)rithmetic a%erage return G .4I9 or I.9K
<sing the e&uation for the geometric return, we find0
Reometric a%erage return G N.> L R>/ Q .> L R6/ Q ` Q .> L RT/O
>-T
@ >
Reometric a%erage return G N.> L .6>/.> L .>D/.> L .63/.> @ .48/.> L .4J/.> @ .>D/O
.>-H/
@ >
Reometric a%erage return G .4H99 or H.99K
Remem"er, the geometric a%erage return will alwa!s "e less than the arithmetic a%erage return if the
returns ha%e an! %ariation.
B-246
CHAPTER 9 B-
23. To calculate the arithmetic and geometric a%erage returns, we must first calculate the return for each
!ear. The return for each !ear is0
R> G .BDJ.4I @ D3.>6 L 4.99/ - BD3.>6 G .>94I or >9.4IK
R6 G .B9>.>J @ DJ.4I L 4.H4/ - BDJ.4I G .499D or 9.9DK
R3 G .BDI.6D @ 9>.>J L 4.H3/ - B9>.>J G @.4HDJ or @H.DJK
RD G .B9H.4J @ DI.6D L 4.I6/- BDI.6D G .646H or 64.6HK
R9 G .BHI.6> @ 9H.4J L 4.8>/ - B9H.4J G .6>6I or 6>.6IK
The arithmetic a%erage return was0
R) G .4.>94I L 4.499D @ 4.4HDJ L 4.646H L 4.6>6I/-9
R) G 4.>>>3 or >>.>3K
)nd the geometric a%erage return was0
RR G N.> L .>94I/.> L .499D/.> @ .4HDJ/.> L .646H/.> L .6>6I/O
>-9
@ >
RR G 4.>4H6 or >4.H6K
24. To find the real return we need to use the ;isher e&uation. Re*writing the ;isher e&uation to sol%e for
the real return, we get0
r G N.> L R/-.> L h/O @ >
So, the real return each !ear was0
,ear T*"ill return Inflation Real return
>JI3
4.4I6J 4.48I> @4.4>3>
>JID
4.4IJJ 4.>63D @4.438I
>JI9
4.498I 4.4HJD @4.4>44
>JIH
4.494I 4.4D8H 4.4464
>JII
4.49D9 4.4HI4 @4.4>>I
>JI8
4.4IHD 4.4J46 @4.4>6I
>JIJ
4.>49H 4.>36J @4.46D>
>J84
4.>6>4 4.>696 @4.443I
4.H>JI 4.ID38 @4.>>64
a. The a%erage return for T*"ills o%er this period was0
)%erage return G 4.H>J - 8
)%erage return G .4II9 or I.I9K
)nd the a%erage inflation rate was0
W )%erage inflation G 4.ID38 - 8
U)%erage inflation G .4J34 or J.34K
\
247
SOLUTIONS
b. <sing the e&uation for %ariance, we find the %ariance for T*"ills o%er this period was0
Xariance G >-IN..4I6J @ .4II9/
6
L ..4IJJ @ .4II9/
6
L ..498I @ .4II9/
6
L ..494I @ .4II9/
6
L
..49D9 @ .4II9/
6
L ..4IHD @ .4II9/
6
L ..>49H @ .4II9/
6
L ..>6>4 .4II9/
6
O
Xariance G 4.444H>H
)nd the standard de%iation for T*"ills was0
Standard de%iation G .4.444H>H/
>-6

Standard de%iation G 4.46D8 or 6.D8K
The %ariance of inflation o%er this period was0
Xariance G >-IN..48I> @ .4J34/
6
L ..>63D @ .4J34/
6
L ..4HJD @ .4J34/
6
L ..4D8H @ .4J34/
6
L
..4HI4 @ .4J34/
6
L ..4J46 @ .4J34/
6
L ..>36J @ .4J34/
6
L ..>696 .4J34/
6
O
Xariance G 4.444JI>
)nd the standard de%iation of inflation was0
Standard de%iation G .4.444JI>/
>-6

Standard de%iation G 4.43>6 or 3.>6K
c. The a%erage o"ser%ed real return o%er this period was0
)%erage o"ser%ed real return G @.>>66 - 8
)%erage o"ser%ed real return G @.4>D4 or @>.D4K
d. The statement that T*"ills ha%e no ris, refers to the fact that there is onl! an e#tremel! small
chance of the go%ernment defaulting, so there is little default ris,. Since T*"ills are short term,
there is also %er! limited interest rate ris,. 5owe%er, as this e#ample shows, there is inflation
ris,, i.e. the purchasing power of the in%estment can actuall! decline o%er time e%en if the
in%estor is earning a positi%e return.
25. To find the return on the coupon "ond, we first need to find the price of the "ond toda!. Since one
!ear has elapsed, the "ond now has si# !ears to maturit!, so the price toda! is0
+> G 284.+XI;)IK,H/ L 2>,444->.4I
H
+> G 2>,4DI.HI
\ou recei%ed the coupon pa!ments on the "ond, so the nominal return was0
R G .2>,4DI.HI @ >,468.94 L 84/ - 2>,468.94
R G .4JHD or J.HDK
)nd using the ;isher e&uation to find the real return, we get0
r G .>.4JHD - >.4D8/ @ >
r G .4DH6 or D.H6K
B-248
CHAPTER 9 B-
26. Coo,ing at the long*term go%ernment "ond return histor! in Ta"le J.6, we see that the mean return
was 9.8 percent, with a standard de%iation of J.3 percent. In the normal pro"a"ilit! distri"ution,
appro#imatel! 6-3 of the o"ser%ations are within one standard de%iation of the mean. This means
that >-3 of the o"ser%ations are outside one standard de%iation awa! from the mean. 'r0
+r.Rd @3.9 or RS>9.>/
>
-
3

Aut we are onl! interested in one tail here, that is, returns less than @3.9 percent, so0
+r.Rd @3.9/
>
-
H
\ou can use the *statistic and the cumulati%e normal distri"ution ta"le to find the answer as well.
Eoing so, we find0
G .U @ g/-
G .@3.9K @ 9.8/-J.3K G @>.44
Coo,ing at the *ta"le, this gi%es a pro"a"ilit! of >9.8IK, or0
+r.Rd @3.9/ .>98I or >9.8IK
The range of returns !ou would e#pect to see J9 percent of the time is the mean plus or minus 6
standard de%iations, or0
J9K le%el0 R fa 6 G 9.8K a 6.J.3K/ G @>6.84K to 6D.D4K
The range of returns !ou would e#pect to see JJ percent of the time is the mean plus or minus 3
standard de%iations, or0
JJK le%el0 R fa 3 G 9.8K a 3.J.3K/ G @66.>4K to 33.I4K
27. The mean return for small compan! stoc,s was >I.9 percent, with a standard de%iation of 33.>
percent. Eou"ling !our mone! is a >44K return, so if the return distri"ution is normal, we can use
the *statistic. So0
G .U @ g/-
G .>44K @ >I.9K/-33.>K G 6.DJ6 standard de%iations a"o%e the mean
This corresponds to a pro"a"ilit! of 4.H3DK, or less than once e%er! >44 !ears. Tripling !our
mone! would "e0
G .644K @ >I.9K/-33.>K G 9.9>D standard de%iations a"o%e the mean.
This corresponds to a pro"a"ilit! of .much/ less than 4.9K, or once e%er! 644 !ears. The actual
answer is .44444>IHK, or a"out once e%er! > million !ears.
249
SOLUTIONS
28. It is impossi"le to lose more than >44 percent of !our in%estment. Therefore, return distri"utions are
truncated on the lower tail at @>44 percent.
'hallenge
29. <sing the *statistic, we find0
G .U @ g/-
G .4K @ >6.DK/-64.3K G @4.H>48
+r.R4/ 6I.4IK
30. ;or each of the &uestions as,ed here, we need to use the *statistic, which is0
G .U @ g/-
a.
>
G .>4K @ H.6K/-8.HK G 4.DD>J
This *statistic gi%es us the pro"a"ilit! that the return is less than >4 percent, "ut we are loo,ing
for the pro"a"ilit! the return is greater than >4 percent. Ri%en that the total pro"a"ilit! is >44
percent .or >/, the pro"a"ilit! of a return greater than >4 percent is > minus the pro"a"ilit! of a
return less than >4 percent. <sing the cumulati%e normal distri"ution ta"le, we get0
+r.R>4K/ G > @ +r.R>4K/ G > @ .HI4I 36.J3K
;or a return less than 4 percent0

6
G .4K @ H.6K/-8.H G @4.I64J
+r.Rd>4K/ G > @ +r.RS4K/ G > @ .IHD9 63.99K
b. The pro"a"ilit! that T*"ill returns will "e greater than >4 percent is0

3
G .>4K @ 3.8K/-3.>K G 6
+r.R>4K/ G > @ +r.R>4K/ G > @ .JII6 6.68K
)nd the pro"a"ilit! that T*"ill returns will "e less than 4 percent is0

D
G .4K @ 3.8K/-3.>K G @>.6698
+r.R4/ >>.4>K
B-250
CHAPTER 9 B-
c. The pro"a"ilit! that the return on long*term corporate "onds will "e less than @D.>8 percent is0

9
G .@D.>8K @ H.6K/-8.HK G @>.64HJ8
+r.R@D.>8K/ >>.3IK
)nd the pro"a"ilit! that T*"ill returns will "e greater than >4.36 percent is0

H
G .>4.36K @ 3.8K/-3.>K G 6.>436
+r.R>4.38K/ G > @ +r.R>4.38K/ G > @ .J863 >.IIK
251
CHAPTER 10
RETURN AND RISK: THE CAPITAL
ASSET PRICING MODEL (CAPM)
Answers to Concepts Review and Critical !in"in# Questions
1. Some of the ris, in holding an! asset is uni&ue to the asset in &uestion. A! in%esting in a %ariet! of
assets, this uni&ue portion of the total ris, can "e eliminated at little cost. 'n the other hand, there
are some ris,s that affect all in%estments. This portion of the total ris, of an asset cannot "e
costlessl! eliminated. In other words, s!stematic ris, can "e controlled, "ut onl! "! a costl!
reduction in e#pected returns.
2. a. s!stematic
b. uns!stematic
c. "oth( pro"a"l! mostl! s!stematic
d. uns!stematic
e. uns!stematic
f. s!stematic
3. ?o to "oth &uestions. The portfolio e#pected return is a weighted a%erage of the assets returns, so it
must "e less than the largest asset return and greater than the smallest asset return.
4. ;alse. The %ariance of the indi%idual assets is a measure of the total ris,. The %ariance on a well*
di%ersified portfolio is a function of s!stematic ris, onl!.
5. \es, the standard de%iation can "e less than that of e%er! asset in the portfolio. 5owe%er, p cannot
"e less than the smallest "eta "ecause p is a weighted a%erage of the indi%idual asset "etas.
6. \es. It is possi"le, in theor!, to construct a ero "eta portfolio of ris,! assets whose return would "e
e&ual to the ris,*free rate. It is also possi"le to ha%e a negati%e "eta( the return would "e less than the
ris,*free rate. ) negati%e "eta asset would carr! a negati%e ris, premium "ecause of its %alue as a
di%ersification instrument.
7. The co%ariance is a more appropriate measure of a securit!s ris, in a well*di%ersified portfolio
"ecause the co%ariance reflects the effect of the securit! on the %ariance of the portfolio. In%estors
are concerned with the %ariance of their portfolios and not the %ariance of the indi%idual securities.
Since co%ariance measures the impact of an indi%idual securit! on the %ariance of the portfolio,
co%ariance is the appropriate measure of ris,.
CHAPTER 10 B-
8. If we assume that the mar,et has not sta!ed constant during the past three !ears, then the lac, in
mo%ement of Southern Co.s stoc, price onl! indicates that the stoc, either has a standard de%iation
or a "eta that is %er! near to ero. The large amount of mo%ement in Te#as Instrument stoc, price
does not impl! that the firms "eta is high. Total %olatilit! .the price fluctuation/ is a function of "oth
s!stematic and uns!stematic ris,. The "eta onl! reflects the s!stematic ris,. '"ser%ing the standard
de%iation of price mo%ements does not indicate whether the price changes were due to s!stematic
factors or firm specific factors. Thus, if !ou o"ser%e large stoc, price mo%ements li,e that of TI, !ou
cannot claim that the "eta of the stoc, is high. )ll !ou ,now is that the total ris, of TI is high.
9. The wide fluctuations in the price of oil stoc,s do not indicate that these stoc,s are a poor
in%estment. If an oil stoc, is purchased as part of a well*di%ersified portfolio, onl! its contri"ution to
the ris, of the entire portfolio matters. This contri"ution is measured "! s!stematic ris, or "eta.
Since price fluctuations in oil stoc,s reflect di%ersifia"le plus non*di%ersifia"le ris,, o"ser%ing the
standard de%iation of price mo%ements is not an ade&uate measure of the appropriateness of adding
oil stoc,s to a portfolio.
10. The statement is false. If a securit! has a negati%e "eta, in%estors would want to hold the asset to
reduce the %aria"ilit! of their portfolios. Those assets will ha%e e#pected returns that are lower than
the ris,*free rate. To see this, e#amine the Capital )sset +ricing $odel0
E.RS/ G Rf L SNE.R$/ @ RfO
If S d 4, then the E.RS/ d Rf
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. The portfolio weight of an asset is total in%estment in that asset di%ided "! the total portfolio %alue.
;irst, we will find the portfolio %alue, which is0
Total %alue G I4.2D4/ L >>4.26>/ G 29,>>4
The portfolio weight for each stoc, is0
Weight) G I4.2D4/-29,>>4 G .9DIJ
WeightA G >>4.26>/-29,>>4 G .D96>
253
SOLUTIONS
2. The e#pected return of a portfolio is the sum of the weight of each asset times the e#pected return of
each asset. The total %alue of the portfolio is0
Total %alue G 2>,644 L >,J44 G 23,>44
So, the e#pected return of this portfolio is0
E.Rp/ G .2>,644-23,>44/.4.>4/ L .2>,J44-23,>44/.4.>H/ G .>3H8 or >3.H8K
3. The e#pected return of a portfolio is the sum of the weight of each asset times the e#pected return of
each asset. So, the e#pected return of the portfolio is0
E.Rp/ G .94..>>/ L .34..>I/ L .64..>D/ G .>3D4 or >3.D4K
4. 5ere we are gi%en the e#pected return of the portfolio and the e#pected return of each asset in the
portfolio and are as,ed to find the weight of each asset. We can use the e&uation for the e#pected
return of a portfolio to sol%e this pro"lem. Since the total weight of a portfolio must e&ual > .>44K/,
the weight of Stoc, \ must "e one minus the weight of Stoc, U. $athematicall! spea,ing, this
means0
E.Rp/ G .>66 G .>DwU L .4J.> @ wU/
We can now sol%e this e&uation for the weight of Stoc, U as0
.>66 G .>DwU L .4J @ .4JwU
.436 G .49wU
wU G 4.HD
So, the dollar amount in%ested in Stoc, U is the weight of Stoc, U times the total portfolio %alue, or0
In%estment in U G 4.HD.V>,444,444/ G VHD4,444
)nd the dollar amount in%ested in Stoc, \ is0
In%estment in \ G .> @ 4.HD/.V>,444,444/ G V3H4,444
5. The e#pected return of an asset is the sum of the pro"a"ilit! of each return occurring times the
pro"a"ilit! of that return occurring. So, the e#pected return of the asset is0
E.R/ G .6.@.49/ L .9..>6/ L .3..69/ G .>694 or >6.94K
B-254
CHAPTER 10 B-
6. The e#pected return of an asset is the sum of the pro"a"ilit! of each return occurring times the
pro"a"ilit! of that return occurring. So, the e#pected return of each stoc, asset is0
E.R)/ G .>4..4H/ L .H4..4I/ L .34..>>/ G .48>4 or 8.>4K
E.RA/ G .>4.@.6/ L .H4..>3/ L .34..33/ G .>9I4 or >9.I4K
To calculate the standard de%iation, we first need to calculate the %ariance. To find the %ariance, we
find the s&uared de%iations from the e#pected return. We then multipl! each possi"le s&uared
de%iation "! its pro"a"ilit!, and then add all of these up. The result is the %ariance. So, the %ariance
and standard de%iation of each stoc, are0
)
6
G.>4..4H @ .48>4/
6
L .H4..4I@.48>4/
6
L .34..>> @ .48>4/
6
G .4443I
) G ..4443I/
>-6
G .4>J6 or >.J6K
A
6
G.>4.@.6 @ .>9I4/
6
L .H4..>3@.>9I4/
6
L .34..33 @ .>9I4/
6
G .466>H
A G ..4666>H/
>-6
G .>D8J or >D.8JK
7. The e#pected return of an asset is the sum of the pro"a"ilit! of each return occurring times the
pro"a"ilit! of that return occurring. So, the e#pected return of the stoc, is0
E.R)/ G .>4.@.4D9/ L .34..4DD/ L .94..>6/ L .>4..64I/ G .48JD or 8.JDK
To calculate the standard de%iation, we first need to calculate the %ariance. To find the %ariance, we
find the s&uared de%iations from the e#pected return. We then multipl! each possi"le s&uared
de%iation "! its pro"a"ilit!, and then add all of these up. The result is the %ariance. So, the %ariance
and standard de%iation are0

6
G.>4.@.4D9 @ . 48JD/
6
L .34..4DD @ . 48JD/
6
L .94..>6 @ .48JD/
6
L .>4..64I @ .48JD/
6
G .44D68
G ..44D68/
>-6
G .4H9D or H.9DK
8. The e#pected return of a portfolio is the sum of the weight of each asset times the e#pected return of
each asset. So, the e#pected return of the portfolio is0
E.Rp/ G .64..48/ L .I4..>9/ L .>..6D/ G .>D94 or >D.94K
If we own this portfolio, we would e#pect to get a return of >D.94 percent.
255
SOLUTIONS
9. a. To find the e#pected return of the portfolio, we need to find the return of the portfolio in each
state of the econom!. This portfolio is a special case since all three assets ha%e the same
weight. To find the e#pected return in an e&uall! weighted portfolio, we can sum the returns of
each asset and di%ide "! the num"er of assets, so the e#pected return of the portfolio in each
state of the econom! is0
Aoom0 E.Rp/ G ..4I L .>9 L .33/-3 G .>833 or >8.33K
Aust0 E.Rp/ G ..>3 L .43 .4H/-3 G .4333 or 3.33K
To find the e#pected return of the portfolio, we multipl! the return in each state of the econom!
"! the pro"a"ilit! of that state occurring, and then sum. Eoing this, we find0
E.Rp/ G .I4..>833/ L .34..4333/ G .>383 or >3.83K
b. This portfolio does not ha%e an e&ual weight in each asset. We still need to find the return of
the portfolio in each state of the econom!. To do this, we will multipl! the return of each asset
"! its portfolio weight and then sum the products to get the portfolio return in each state of the
econom!. Eoing so, we get0
Aoom0 E.Rp/G.64..4I/ L.64..>9/ L .H4..33/ G.6D64 or 6D.64K
Aust0 E.Rp/ G.64..>3/ L.64..43/ L .H4..4H/ G @.44D4 or @4.D4K
)nd the e#pected return of the portfolio is0
E.Rp/ G .I4..6D64/ L .34..44D/ G .>H86 or >H.86K
To calculate the standard de%iation, we first need to calculate the %ariance. To find the %ariance,
we find the s&uared de%iations from the e#pected return. We then multipl! each possi"le
s&uared de%iation "! its pro"a"ilit!, and then add all of these up. The result is the %ariance. So,
the %ariance and standard de%iation the portfolio is0
p
6
G .I4..6D64 @ .>H86/
6
L .34..44D4 @ .>H86/
6
G .4>6I48
p G ..4>6I48/
>-6
G .>>6I or >>.6IK
10. a. This portfolio does not ha%e an e&ual weight in each asset. We first need to find the return of
the portfolio in each state of the econom!. To do this, we will multipl! the return of each asset
"! its portfolio weight and then sum the products to get the portfolio return in each state of the
econom!. Eoing so, we get0
Aoom0 E.R
p
/ G .34..3/ L .D4..D9/ L .34..33/ G .3HJ4 or 3H.J4K
Rood0 E.R
p
/ G .34..>6/ L .D4..>4/ L .34..>9/ G .>6>4 or >6.>4K
+oor0 E.R
p
/ G .34..4>/ L .D4.@.>9/ L .34.@.49/ G @.4I64 or @I.64K
Aust0 E.R
p
/ G .34.@.4H/ L .D4.@.34/ L .34.@.4J/ G @.>H94 or @>H.94K
)nd the e#pected return of the portfolio is0
E.R
p
/ G .34..3HJ4/ L .D4..>6>4/ L .69.@.4I64/ L .49.@.>H94/ G .>36J or >3.6JK
B-256
CHAPTER 10 B-
b. To calculate the standard de%iation, we first need to calculate the %ariance. To find the %ariance,
we find the s&uared de%iations from the e#pected return. We then multipl! each possi"le
s&uared de%iation "! its pro"a"ilit!, and then add all of these up. The result is the %ariance. So,
the %ariance and standard de%iation the portfolio is0
p
6
G .34..3HJ4 @ .>36J/
6
L .D4..>6>4 @ .>36J/
6
L .69 .@.4I64 @ .>36J/
6
L .49.@.>H94 @ .>36J/
6

p
6
G .43>I>
p G ..43>I>/
>-6
G .>I8> or >I.8>K
11. The "eta of a portfolio is the sum of the weight of each asset times the "eta of each asset. So, the
"eta of the portfolio is0
p G .69..H/ L .64.>.I/ L .>9.>.>9/ L .D4.>.J4/ G >.D6
12. The "eta of a portfolio is the sum of the weight of each asset times the "eta of each asset. If the
portfolio is as ris,! as the mar,et it must ha%e the same "eta as the mar,et. Since the "eta of the
mar,et is one, we ,now the "eta of our portfolio is one. We also need to remem"er that the "eta of
the ris,*free asset is ero. It has to "e ero since the asset has no ris,. Setting up the e&uation for the
"eta of our portfolio, we get0
p G >.4 G
>
-
3
.4/ L
>
-
3
.>.9/ L
>
-
3
. U/
Sol%ing for the "eta of Stoc, U, we get0
U G >.9
13. C)+$ states the relationship "etween the ris, of an asset and its e#pected return. C)+$ is0
E.Ri/ G Rf L NE.R$/ @ RfO Q i
Su"stituting the %alues we are gi%en, we find0
E.Ri/ G .4D L ..>D @ .4D/.>.3/ G .>I or >I.44K
14. We are gi%en the %alues for the C)+$ e#cept for the of the stoc,. We need to su"stitute these
%alues into the C)+$, and sol%e for the of the stoc,. 'ne important thing we need to realie is
that we are gi%en the mar,et ris, premium. The mar,et ris, premium is the e#pected return of the
mar,et minus the ris,*free rate. We must "e careful not to use this %alue as the e#pected return of the
mar,et. <sing the C)+$, we find0
E.Ri/ G .>D G .4D L .4H i
i G >.HI
257
SOLUTIONS
15. 5ere we need to find the e#pected return of the mar,et using the C)+$. Su"stituting the %alues
gi%en, and sol%ing for the e#pected return of the mar,et, we find0
E.Ri/ G .>> G .4D9 L NE.R$/ @ .4D9O..89/
E.R$/ G .>6>9 or >6.>9K
16. 5ere we need to find the ris,*free rate using the C)+$. Su"stituting the %alues gi%en, and sol%ing
for the ris,*free rate, we find0
E.Ri/ G .>I G Rf L ..>> @ Rf/.>.J/
.>I G Rf L .64J @ >.JRf
Rf G .4D33 or D.33K
17. a. )gain, we ha%e a special case where the portfolio is e&uall! weighted, so we can sum the
returns of each asset and di%ide "! the num"er of assets. The e#pected return of the portfolio is0
E.Rp/ G ..>H L .49/-6 G .>494 or >4.94K
b. We need to find the portfolio weights that result in a portfolio with a of 4.I9. We ,now the
of the ris,*free asset is ero. We also ,now the weight of the ris,*free asset is one minus the
weight of the stoc, since the portfolio weights must sum to one, or >44 percent. So0
p G 4.I9 G wS.>.6/ L .> @ wS/.4/
4.I9 G >.6wS L 4 @ 4wS
wS G 4.I9->.6
wS G .H694
)nd, the weight of the ris,*free asset is0
wRf G > @ .H694 G .3I94
c. We need to find the portfolio weights that result in a portfolio with an e#pected return of 8
percent. We also ,now the weight of the ris,*free asset is one minus the weight of the stoc,
since the portfolio weights must sum to one, or >44 percent. So0
E.Rp/ G .48 G .>HwS L .49.> @ wS/
.48 G .>HwS L .49 @ .49wS
wS G .6I6I
So, the of the portfolio will "e0
p G .6I6I.>.6/ L .> @ .6I6I/.4/ G 4.36I
B-258
CHAPTER 10 B-
d. Sol%ing for the of the portfolio as we did in part a, we find0
p G 6.3 G wS.>.6/ L .> @ wS/.4/
wS G 6.3->.6 G >.J>HI
wRf G > @ >.J>HI G @4.J>HI
The portfolio is in%ested >J>.HIK in the stoc, and @J>.HIK in the ris,*free asset. This
represents "orrowing at the ris,*free rate to "u! more of the stoc,.
18. ;irst, we need to find the of the portfolio. The of the ris,*free asset is ero, and the weight of
the ris,*free asset is one minus the weight of the stoc,, the of the portfolio is0
hp G wW.>.3/ L .> @ wW/.4/ G >.3wW
So, to find the of the portfolio for an! weight of the stoc,, we simpl! multipl! the weight of the
stoc, times its .
E%en though we are sol%ing for the and e#pected return of a portfolio of one stoc, and the ris,*
free asset for different portfolio weights, we are reall! sol%ing for the S$C. )n! com"ination of this
stoc,, and the ris,*free asset will fall on the S$C. ;or that matter, a portfolio of an! stoc, and the
ris,*free asset, or an! portfolio of stoc,s, will fall on the S$C. We ,now the slope of the S$C line
is the mar,et ris, premium, so using the C)+$ and the information concerning this stoc,, the
mar,et ris, premium is0
E.RW/ G .>H G .49 L $R+.>.34/
$R+ G .>>->.3 G .48DH or 8.DHK
So, now we ,now the C)+$ e&uation for an! stoc, is0
E.Rp/ G .49 L .48DH p
The slope of the S$C is e&ual to the mar,et ris, premium, which is 4.48DH. <sing these e&uations to
fill in the ta"le, we get the following results0
wW E.Rp/ hp
4K .4944 4
69 .4II9 4.369
94 .>494 4.H94
I9 .>369 4.JI9
>44 .>H44 >.344
>69 .>8I9 >.H69
>94 .6>94 >.J94
259
SOLUTIONS
19. There are two wa!s to correctl! answer this &uestion. We will wor, through "oth. ;irst, we can use
the C)+$. Su"stituting in the %alue we are gi%en for each stoc,, we find0
E.R\/ G .499 L .4I9.>.94/ G .>HI9 or >H.I9K
It is gi%en in the pro"lem that the e#pected return of Stoc, \ is >I percent, "ut according to the
C)+$, the return of the stoc, "ased on its le%el of ris,, the e#pected return should "e >H.I9 percent.
This means the stoc, return is too high, gi%en its le%el of ris,. Stoc, \ plots a"o%e the S$C and is
under%alued. In other words, its price must increase to reduce the e#pected return to >H.I9 percent.
;or Stoc, b, we find0
E.Rb/ G .499 L .4I9.4.84/ G .>>94 or >>.94K
The return gi%en for Stoc, b is >4.9 percent, "ut according to the C)+$ the e#pected return of the
stoc, should "e >>.94 percent "ased on its le%el of ris,. Stoc, b plots "elow the S$C and is
o%er%alued. In other words, its price must decrease to increase the e#pected return to >>.94 percent.
We can also answer this &uestion using the reward*to*ris, ratio. )ll assets must ha%e the same
reward*to*ris, ratio, that is, e%er! asset must ha%e the same ratio of the asset ris, premium to its
"eta. This follows from the linearit! of the S$C in ;igure >>.>>. The reward*to*ris, ratio is the ris,
premium of the asset di%ided "! its . This is also ,now as the Tre!nor ratio or Tre!nor inde#. We
are gi%en the mar,et ris, premium, and we ,now the of the mar,et is one, so the reward*to*ris,
ratio for the mar,et is 4.4I9, or I.9 percent. Calculating the reward*to*ris, ratio for Stoc, \, we
find0
Reward*to*ris, ratio \ G ..>I @ .499/ - >.94 G .4IHI
The reward*to*ris, ratio for Stoc, \ is too high, which means the stoc, plots a"o%e the S$C, and
the stoc, is under%alued. Its price must increase until its reward*to*ris, ratio is e&ual to the mar,et
reward*to*ris, ratio. ;or Stoc, b, we find0
Reward*to*ris, ratio b G ..>49 @ .499/ - .84 G .4H69
The reward*to*ris, ratio for Stoc, b is too low, which means the stoc, plots "elow the S$C, and the
stoc, is o%er%alued. Its price must decrease until its reward*to*ris, ratio is e&ual to the mar,et
reward*to*ris, ratio.

20. We need to set the reward*to*ris, ratios of the two assets e&ual to each other .see the pre%ious
pro"lem/, which is0
..>I @ Rf/->.94 G ..>49 @ Rf/-4.84
We can cross multipl! to get0
4.84..>I @ Rf/ G >.94..>49 @ Rf/
Sol%ing for the ris,*free rate, we find0
4.>3H @ 4.84Rf G 4.>9I9 @ >.94Rf
Rf G .434I or 3.4IK
B-260
CHAPTER 10 B-261
SOLUTIONS
&ntermediate
21. ;or a portfolio that is e&uall! in%ested in large*compan! stoc,s and long*term "onds0
Return G .>6.DK L 9.8K/-6 G J.>K
;or a portfolio that is e&uall! in%ested in small stoc,s and Treasur! "ills0
Return G .>I.9K L 3.8K/-6 G >4.H9K
22. We ,now that the reward*to*ris, ratios for all assets must "e e&ual .See Yuestion >J/. This can "e
e#pressed as0
NE.R)/ @ RfO- ) G NE.RA/ @ RfO-hA
The numerator of each e&uation is the ris, premium of the asset, so0
R+)- ) G R+A- A
We can rearrange this e&uation to get0
A- ) G R+A-R+)
If the reward*to*ris, ratios are the same, the ratio of the "etas of the assets is e&ual to the ratio of the
ris, premiums of the assets.
23. a. We need to find the return of the portfolio in each state of the econom!. To do this, we will
multipl! the return of each asset "! its portfolio weight and then sum the products to get the portfolio
return in each state of the econom!. Eoing so, we get0
Aoom0 E.Rp/ G .D..64/ L .D..39/ L .6..H4/ G .3D44 or 3D.44K
?ormal0 E.Rp/ G .D..>9/ L .D..>6/ L .6..49/ G .>>84 or >>.84K
Aust0 E.Rp/ G .D..4>/ L .D.@.69/ L .6.@.94/ G @.>JH4 or @>J.H4K
)nd the e#pected return of the portfolio is0
E.Rp/ G .D..3D/ L .D..>>8/ L .6.@.>JH/ G .>DD4 or >D.D4K
To calculate the standard de%iation, we first need to calculate the %ariance. To find the %ariance,
we find the s&uared de%iations from the e#pected return. We then multipl! each possi"le
s&uared de%iation "! its pro"a"ilit!, than add all of these up. The result is the %ariance. So, the
%ariance and standard de%iation of the portfolio is0

6
p G .D..3D @ .>DD4/
6
L .D..>>8 @ .>DD4/
6
L .6.@.>JH @ .>DD4/
6

6
p G .438IH
p G ..438IH/
>-6
G .>JHJ or >J.HJK
B-262
CHAPTER 10 B-
b. The ris, premium is the return of a ris,! asset, minus the ris,*free rate. T*"ills are often used as
the ris,*free rate, so0
R+i G E.Rp/ @ Rf G .>DD4 @ .438 G .>4H4 or >4.H4K
c. The appro#imate e#pected real return is the e#pected nominal return minus the inflation rate,
so0
)ppro#imate e#pected real return G .>DD4 @ .43D G .>> or >>K
To find the e#act real return, we will use the ;isher e&uation. Eoing so, we get0
> L E.Ri/ G .> L h/N> L e.ri/O
>.>DD4 G .>.43D4/N> L e.ri/O
e.ri/ G .>.>DD4->.43D/ @ > G .>4HD or >4.HDK
The appro#imate real ris, premium is the e#pected return minus the inflation rate, so0
)ppro#imate e#pected real ris, premium G .>4H4 @ .43D G .4I64 or I.64K
To find the e#act e#pected real ris, premium we use the ;isher effect. Eoing do, we find0
E#act e#pected real ris, premium G .>.>4H4->.43D/ @ > G .4HJH or H.JHK
24. We ,now the total portfolio %alue and the in%estment of two stoc,s in the portfolio, so we can find
the weight of these two stoc,s. The weights of Stoc, ) and Stoc, A are0
w) G V644,444 - V>,444,444 G .64
wA G V694,444-V>,444,444 G .69
Since the portfolio is as ris,! as the mar,et, the of the portfolio must "e e&ual to one. We also
,now the of the ris,*free asset is ero. We can use the e&uation for the of a portfolio to find the
weight of the third stoc,. Eoing so, we find0
p G >.4 G w)..8/ L wA.>.3/ L wC.>.9/ L wRf.4/
Sol%ing for the weight of Stoc, C, we find0
wC G .3D3333
So, the !en in%estment in Stoc, C must "e0
In%est in Stoc, C G .3D3333.V>,444,444/ G V3D3,333

263
SOLUTIONS
We also ,now the total portfolio weight must "e one, so the weight of the ris,*free asset must "e one
minus the asset weight we ,now, or0
> G w) L wA L wC L wRf
> G .64 L .69 L .3D333 L wRf
wRf G .64HHHI
So, the !en in%estment in the ris,*free asset must "e0
In%est in ris,*free asset G .64HHHI.V>,444,444/ G V64H,HHI
25. We are gi%en the e#pected return and of a portfolio and the e#pected return and of assets in the
portfolio. We ,now the of the ris,*free asset is ero. We also ,now the sum of the weights of
each asset must "e e&ual to one. So, the weight of the ris,*free asset is one minus the weight of
Stoc, U and the weight of Stoc, \. <sing this relationship, we can e#press the e#pected return of
the portfolio as0
E.Rp/ G .>39 G wU..3>/ L w\..64/ L .> @ wU @ w\/..4I/
)nd the of the portfolio is0
p G .I G wU.>.8/ L w\.>.3/ L .> @ wU @ w\/.4/
We ha%e two e&uations and two un,nowns. Sol%ing these e&uations, we find that0
wU G @4.4833333
w\ G 4.H938DH6
wRf G 4.D6J8DI6
The amount to in%est in Stoc, U is0
In%estment in stoc, U G @4.4833333.=>44,444/ G @=8,333.33
) negati%e portfolio weight means that !ou short sell the stoc,. If !ou are not familiar with short
selling, it means !ou "orrow a stoc, toda! and sell it. \ou must then purchase the stoc, at a later
date to repa! the "orrowed stoc,. If !ou short sell a stoc,, !ou ma,e a profit if the stoc, decreases in
%alue.
26. The e#pected return of an asset is the sum of the pro"a"ilit! of each return occurring times the
pro"a"ilit! of that return occurring. So, the e#pected return of each stoc, is0
E.R)/ G .33..4H3/ L .33..>49/ L .33..>HI/ G .>>>I or >>.>IK
E.RA/ G .33.@.43I/ L .33..4HD/ L .33..693/ G .4J33 or J.33K
B-264
CHAPTER 10 B-
To calculate the standard de%iation, we first need to calculate the %ariance. To find the %ariance, we
find the s&uared de%iations from the e#pected return. We then multipl! each possi"le s&uared
de%iation "! its pro"a"ilit!, and then add all of these up. The result is the %ariance. So, the %ariance
and standard de%iation of Stoc, ) are0

6
G.33..4H3 @ .>>>I/
6
L .33..>49 @ .>>>I/
6
L .33..>HI @ .>>>I/
6
G .44>86
G ..44>86/
>-6
G .4D6I or D.6IK
)nd the standard de%iation of Stoc, A is0

6
G.33.@.43I @ .4J33/
6
L .33..4HD @ .4J33/
6
L .33..693 @ .4J33/
6
G .4>DD9
G ..4>DD9/
>-6
G .>646 or >6.46K
To find the co%ariance, we multipl! each possi"le state times the product of each assets de%iation
from the mean in that state. The sum of these products is the co%ariance. So, the co%ariance is0
Co%.),A/ G .33..4H3 @ .>>>I/.@.43I @ .4J33/ L .33..>49 @ .>>>I/..4HD @ .4J33/
L .33..>HI @ .>>>I/..693 @ .4J33/
Co%.),A/ G .449>6D
)nd the correlation is0
),A G Co%.),A/ - ) A
),A G .449>6D - ..4D6I/..>646/
),A G .JJ84
27. The e#pected return of an asset is the sum of the pro"a"ilit! of each return occurring times the
pro"a"ilit! of that return occurring. So, the e#pected return of each stoc, is0
E.R)/ G .69.@.464/ L .H4..4J6/ L .>9..>9D/ G .4I33 or I.33K
E.RA/ G .69..494/ L .H4..4H6/ L .>9..4ID/ G .4H48 or H.48K
To calculate the standard de%iation, we first need to calculate the %ariance. To find the %ariance, we
find the s&uared de%iations from the e#pected return. We then multipl! each possi"le s&uared
de%iation "! its pro"a"ilit!, and then add all of these up. The result is the %ariance. So, the %ariance
and standard de%iation of Stoc, ) are0

6
)
G.69.@.464 @ .4I33/
6
L .H4..4J6 @ .4I33/
6
L .>9..>9D @ .4I33/
6
G .4433H
) G ..4433H/
>-6
G .4984 or 9.84K
)nd the standard de%iation of Stoc, A is0

6
A
G.69..494 @ .4H48/
6
L .H4..4H6 @ .4H48/
6
L .>9..4ID @ .4H48/
6
G .4444H
A G ..4444H/
>-6
G .44I9 or 4.I9K
265
SOLUTIONS
To find the co%ariance, we multipl! each possi"le state times the product of each assets de%iation
from the mean in that state. The sum of these products is the co%ariance. So, the co%ariance is0
Co%.),A/ G .69.@.464 @ .4I33/..494 @ .4H48/ L .H4..4J6 @ .4I33/..4H6 @ .4H48/
L .>9..>9D @ .4I33/..4ID @ .4H48/
Co%.),A/ G .444D69
)nd the correlation is0
),A G Co%.),A/ - ) A
),A G .444D69 - ..4984/..44I9/
),A G .JI83
28. a. The e#pected return of the portfolio is the sum of the weight of each asset times the e#pected
return of each asset, so0
E.R+/ G w<E.R</ L wIE.RI/
E.R+/ G .34..>6/ L .I4..>8/
E.R+/ G .>H64 or >H.64K
b. The %ariance of a portfolio of two assets can "e e#pressed as0

6
+
G w
6
<

6
<
L w
6
I

6
I
L 6w<wI < I <,I

6
+
G .34
6
..3D
6
/ L .I4
6
..94
6
/ L 6..34/..I4/..3D/..94/..64/

6
+
G .>DI>8
So, the standard de%iation is0
G ..>DI>8/
>-6
G .383H or 38.3HK
29. a. The e#pected return of the portfolio is the sum of the weight of each asset times the e#pected
return of each asset, so0
E.R+/ G w)E.R)/ L wAE.RA/
E.R+/ G .D4..>9/ L .H4..69/
E.R+/ G .6>44 or 6>.44K
The %ariance of a portfolio of two assets can "e e#pressed as0

6
+
G w
6
)

6
)
L w
6
A

6
A
L 6w)wA ) A ),A

6
+
G .D4
6
..D4
6
/ L .H4
6
..H9
6
/ L 6..D4/..H4/..D4/..H9/..94/

6
+
G .6D4>4
So, the standard de%iation is0
G ..6D4>4/
>-6
G .DJ44 or DJ.44K
B-266
CHAPTER 10 B-
b. The e#pected return of the portfolio is the sum of the weight of each asset times the e#pected
return of each asset, so0
E.R+/ G w)E.R)/ L wAE.RA/
E.R+/ G .D4..>9/ L .H4..69/
E.R+/ G .6>44 or 6>.44K
The %ariance of a portfolio of two assets can "e e#pressed as0

6
+
G w
6
)

6
)
L w
6
A

6
A
L 6w)wA ) A ),A

6
+
G .D4
6
..D4
6
/ L .H4
6
..H9
6
/ L 6..D4/..H4/..D4/..H9/.@.94/

6
+
G .>>934
So, the standard de%iation is0
G ..>>934/
>-6
G .33JH or 33.JHK
c. )s Stoc, ) and Stoc, A "ecome less correlated, or more negati%el! correlated, the standard
de%iation of the portfolio decreases.
30. a. .i/ We can use the e&uation to calculate "eta, we find0
I G . I,$/. I/ - $
4.J G . I,$/.4.38/ - 4.64
I,$ G 4.DI
.ii/ <sing the e&uation to calculate "eta, we find0
I G . I,$/. I/ - $
>.> G ..D4/. I/ - 4.64
I G 4.99
.iii/ <sing the e&uation to calculate "eta, we find0
I G . I,$/. I/ - $
I G ..39/..H9/ - 4.64
I G >.>D
.i%/ The mar,et has a correlation of > with itself.
.%/ The "eta of the mar,et is >.
267
SOLUTIONS
.%i/ The ris,*free asset has ero standard de%iation.
.%ii/ The ris,*free asset has ero correlation with the mar,et portfolio.
.%iii/ The "eta of the ris,*free asset is 4.
b. <sing the C)+$ to find the e#pected return of the stoc,, we find0
Firm A:
E.R)/ G Rf L )NE.R$/ @ RfO
E.R)/ 4 4.49 L 4.J.4.>9 @ 4.49/
E.R)/ G .>D44 or >D.44K
)ccording to the C)+$, the e#pected return on ;irm )s stoc, should "e >D percent.
5owe%er, the e#pected return on ;irm )s stoc, gi%en in the ta"le is onl! >3 percent.
Therefore, ;irm )s stoc, is o%erpriced, and !ou should sell it.
Firm %:
E.RA/ G Rf L ANE.R$/ @ RfO
E.RA/ 4 4.49 L >.>.4.>9 @ 4.49/
E.RA/ G .>H44 or >H.44K
)ccording to the C)+$, the e#pected return on ;irm As stoc, should "e >H percent. The
e#pected return on ;irm As stoc, gi%en in the ta"le is also >H percent. Therefore, ;irm As
stoc, is correctl! priced.
Firm ':
E.RC/ G Rf L CNE.R$/ @ RfO
E.RC/ 4 4.49 L >.>D.4.>9 @ 4.49/
E.RC/ G .>H38 or >H.38K
)ccording to the C)+$, the e#pected return on ;irm Cs stoc, should "e >H.38 percent.
5owe%er, the e#pected return on ;irm Cs stoc, gi%en in the ta"le is 64 percent. Therefore,
;irm Cs stoc, is underpriced, and !ou should "u! it.
31. Aecause a well*di%ersified portfolio has no uns!stematic ris,, this portfolio should lie on the Capital
$ar,et Cine .C$C/. The slope of the C$C e&uals0
SlopeC$C G NE.R$/ @ RfO - $
SlopeC$C G .4.>6 @ 4.4D/ - 4.>4
SlopeC$C G 4.84
a. The e#pected return on the portfolio e&uals0
E.R+/ G Rf L SlopeC$C. +/
E.R+/ G .4D L .I4..48/
E.R+/ G .4JH4 or J.H4K
B-268
CHAPTER 10 B-
b. The e#pected return on the portfolio e&uals0
E.R+/ G Rf L SlopeC$C. +/
.64 G .4D L .84. +/
+ G .64 or 64K
32. ;irst, we can calculate the standard de%iation of the mar,et portfolio using the Capital $ar,et Cine
.C$C/. We ,now that the ris,*free rate asset has a return of 9 percent and a standard de%iation of
ero and the portfolio has an e#pected return of >D percent and a standard de%iation of >8 percent.
These two points must lie on the Capital $ar,et Cine. The slope of the Capital $ar,et Cine e&uals0
SlopeC$C G Rise - Run
SlopeC$C G Increase in e#pected return - Increase in standard de%iation
SlopeC$C G ..>6 @ .49/ - ..>8 @ 4/
SlopeC$C G .3J
)ccording to the Capital $ar,et Cine0
E.RI/ G Rf L SlopeC$C. I/
Since we ,now the e#pected return on the mar,et portfolio, the ris,*free rate, and the slope of the
Capital $ar,et Cine, we can sol%e for the standard de%iation of the mar,et portfolio which is0
E.R$/ G Rf L SlopeC$C. $/
.>6 G .49 L ..3J/. $/
$ G ..>6 @ .49/ - .3J
$ G .>844 or >8.44K
269
Capital Market Line
0
0.05
0.1
0.15
0.2
0.25
0.3
0 0.01 0.02 0.03 0.04 0.05
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n
SOLUTIONS
?e#t, we can use the standard de%iation of the mar,et portfolio to sol%e for the "eta of a securit!
using the "eta e&uation. Eoing so, we find the "eta of the securit! is0
I G . I,$/. I/ - $
I G ..D4/..D4/ - .>844
I G .8J
?ow we can use the "eta of the securit! in the C)+$ to find its e#pected return, which is0
E.RI/ G Rf L INE.R$/ @ RfO
E.RI/ 4 4.49 L .8J..>D @ 4.49/
E.RI/ G .>344 or >3.44K
33. ;irst, we need to find the standard de%iation of the mar,et and the portfolio, which are0
$ G ..4DJ8/
>-6
$ G .6636 or 66.36K
b G ..>I83/
>-6
b G .D663 or D6.63K
?ow we can use the e&uation for "eta to find the "eta of the portfolio, which is0
b G . b,$/. b/ - $
b G ..D9/..D663/ - .6636
b G .89
?ow, we can use the C)+$ to find the e#pected return of the portfolio, which is0
E.Rb/ G Rf L bNE.R$/ @ RfO
E.Rb/ 4 .4H6 L .89..>D8 @ .4H6/
E.Rb/ G .>396 or >3.96K
34. The amount of s!stematic ris, is measured "! the of an asset. Since we ,now the mar,et ris,
premium and the ris,*free rate, if we ,now the e#pected return of the asset we can use the C)+$ to
sol%e for the of the asset. The e#pected return of Stoc, \ is0
E.R\/ G .>9..4J/ L .I4..D6/ L .>9..6H/ G .3DH9 or 3D.H9K
<sing the C)+$ to find the of Stoc, \, we find0
.3DH9 G .4D L .4J \
\ G 3.D>
B-270
CHAPTER 10 B-
The total ris, of the asset is measured "! its standard de%iation, so we need to calculate the standard
de%iation of Stoc, \. Aeginning with the calculation of the stoc,s %ariance, we find0
\
6
G .>9..4J @ .3DH9/
6
L .I4..D6 @ .3DH9/
6
L .>9..6H @ .3DH9/
6

\
6
G .4>DII
\ G ..4>DII/
>-6
G .>6>9 or >6.>9K
<sing the same procedure for Stoc, b, we find the e#pected return to "e0
E.Rb/ G .>9.@.34/ L .I4..>6/ L .>9..DD/ G .>494
<sing the C)+$ to find the of Stoc, b, we find0
.>494 G .4D L .4J b
b G 4.I6
)nd the standard de%iation of Stoc, b is0
b
6
G .>9.@.34 @ .>49/
6
L .I4..>6 @ .>49/
6
L .>9..DD @ .>49/
6

b
6
G .4D>H4
b G ..4D>H4/
>-6
G .643J or 64.3JK
)lthough Stoc, b has more total ris, than \, it has much less s!stematic ris,, since its "eta is much
smaller than \s. Thus, \ has more s!stematic ris,, and b has more uns!stematic and more total
ris,. Since uns!stematic ris, can "e di%ersified awa!, \ is actuall! the 1ris,ier8 stoc, despite the
lac, of %olatilit! in its returns. Stoc, \ will ha%e a higher ris, premium and a greater e#pected
return.
35. 5ere we ha%e the e#pected return and "eta for two assets. We can e#press the returns of the two
assets using C)+$. ?ow we ha%e two e&uations and two un,nowns. Roing "ac, to )lge"ra, we can
sol%e the two e&uations. We will sol%e the e&uation for Reliance Co. to find the ris,*free rate, and
sol%e the e&uation for )lliance Co. to find the e#pected return of the mar,et. We ne#t su"stitute the
e#pected return of the mar,et into the e&uation for Reliance Co., and then sol%e for the ris,*free rate.
?ow that we ha%e the ris,*free rate, we can su"stitute this into either original C)+$ e#pression and
sol%e for e#pected return of the mar,et. Eoing so, we get0

E.RReliance Co./ G .63 G Rf L >.3.R$ @ Rf/( E.R)lliance Co./ G .>3 G Rf L .H.R$ @ Rf/
.63 G Rf L >.3R$ @ >.3Rf G >.3R$ @ .3Rf( .>3 G Rf L .H.R$ @ Rf/ G Rf L .HR$ @ .HRf
Rf G .>.3R$ @ .63/-.3 R$ G ..>3 @ .DRf/-.H
R$ G .6>I @ .HHIRf
Rf G N>.3..6>I @ .HHIRf/ @ .63O-.3
>.>HIRf G .496>
Rf G .4DD3 or D.D3K
.63 G .4DD3 L >.3.R$ @ .4DD3/ .>3 G .4DD3 L .H.R$ @ .4DD3/
R$ G .>8I> or >8.I>K R$ G .>8I> or >8.I>K
271
SOLUTIONS
36. a. The e#pected return of an asset is the sum of the pro"a"ilit! of each return occurring times the
pro"a"ilit! of that return occurring. To calculate the standard de%iation, we first need to
calculate the %ariance. To find the %ariance, we find the s&uared de%iations from the e#pected
return. We then multipl! each possi"le s&uared de%iation "! its pro"a"ilit!, and then add all of
these up. The result is the %ariance. So, the e#pected return and standard de%iation of each stoc,
are0
Asset ):
E.R>/ G .>4..69/ L .D4..64/ L .D4..>9/ L .>4..>4/ G .>I94 or >I.94K

6
>
G.>4..69 @ .>I94/
6
L .D4..64 @ .>I94/
6
L .D4..>9 @ .>I94/
6
L .>4..>4 @ .>I94/
6
G .44>H3
> G ..44>H3/
>-6
G .4D43 or D.43K
Asset .:
E.R6/ G .>4..69/ L .D4..>9/ L .D4..64/ L .>4..>4/ G .>I94 or >I.94K

6
6
G.>4..69 @ .>I94/
6
L .D4..>9 @ .>I94/
6
L .D4..64 @ .>I94/
6
L .>4..>4 @ .>I94/
6
G .44>H3
6 G ..44>H3/
>-6
G .4D43 or D.43K
Asset 0:
E.R3/ G .>4..>4/ L .D4..>9/ L .D4..64/ L .>4..69/ G .>I94 or >I.94K

6
3
G.>4..>4 @ .>I94/
6
L .D4..>9 @ .>I94/
6
L .D4..64 @ .>I94/
6
L .>4..69 @ .>I94/
6
G .44>H3
3 G ..44>H3/
>-6
G .4D43 or D.43K
b. To find the co%ariance, we multipl! each possi"le state times the product of each assets
de%iation from the mean in that state. The sum of these products is the co%ariance. The
correlation is the co%ariance di%ided "! the product of the two standard de%iations. So, the
co%ariance and correlation "etween each possi"le set of assets are0
Asset ) and Asset .:
Co%.>,6/ G .>4..69 @ .>I94/..69 @ .>I94/ L .D4..64 @ .>I94/..>9 @ .>I94/
L .D4..>9 @ .>I94/..64 @ .>I94/ L .>4..>4 @ .>I94/..>4 @ .>I94/
Co%.>,6/ G .444H69
>,6 G Co%.>,6/ - > 6
>,6 G .444H69 - ..4D43/..4D43/
>,6 G .38DH
B-272
CHAPTER 10 B-
Asset ) and Asset 0:
Co%.>,3/ G .>4..69 @ .>I94/..>4 @ .>I94/ L .D4..64 @ .>I94/..>9 @ .>I94/
L .D4..>9 @ .>I94/..64 @ .>I94/ L .>4..>4 @ .>I94/..69 @ .>I94/
Co%.>,3/ G @.44>H69
>,3 G Co%.>,3/ - > 3
>,3 G @.44>H69 - ..4D43/..4D43/
>,3 G @>
Asset . and Asset 0:
Co%.6,3/ G .>4..69 @ .>I94/..>4 @ .>I94/ L .D4..>9 @ .>I94/..>9 @ .>I94/
L .D4..64 @ .>I94/..64 @ .>I94/ L .>4..>4 @ .>I94/..69 @ .>I94/
Co%.6,3/ G @.444H69
6,3 G Co%.6,3/ - 6 3
6,3 G @.444H69 - ..4D43/..4D43/
6,3 G @.38DH
c. The e#pected return of the portfolio is the sum of the weight of each asset times the e#pected
return of each asset, so, for a portfolio of )sset > and )sset 60
E.R+/ G w>E.R>/ L w6E.R6/
E.R+/ G .94..>I94/ L .94..>I94/
E.R+/ G .>I94 or >I.94K
The %ariance of a portfolio of two assets can "e e#pressed as0

6
+
G w
6
>

6
>
L w
6
6

6
6
L 6w>w6 > 6 >,6

6
+
G .94
6
..4D43
6
/ L .94
6
..4D43
6
/ L 6..94/..94/..4D43/..4D43/..38DH/

6
+
G .44>>69
)nd the standard de%iation of the portfolio is0
+ G ..44>>69/
>-6
+ G .4339 or 3.39K
d. The e#pected return of the portfolio is the sum of the weight of each asset times the e#pected
return of each asset, so, for a portfolio of )sset > and )sset 30
E.R+/ G w>E.R>/ L w3E.R3/
E.R+/ G .94..>I94/ L .94..>I94/
E.R+/ G .>I94 or >I.94K
273
SOLUTIONS
The %ariance of a portfolio of two assets can "e e#pressed as0

6
+
G w
6
>

6
>
L w
6
3

6
3
L 6w>w3 > 3 >,3

6
+
G .94
6
..4D43
6
/ L .94
6
..4D43
6
/ L 6..94/..94/..4D43/..4D43/.@>/

6
+
G .444444
Since the %ariance is ero, the standard de%iation is also ero.
e. The e#pected return of the portfolio is the sum of the weight of each asset times the e#pected
return of each asset, so, for a portfolio of )sset > and )sset 30
E.R+/ G w6E.R6/ L w3E.R3/
E.R+/ G .94..>I94/ L .94..>I94/
E.R+/ G .>I94 or >I.94K
The %ariance of a portfolio of two assets can "e e#pressed as0

6
+
G w
6
6

6
6
L w
6
3

6
3
L 6w6w3 6 3 >,3

6
+
G .94
6
..4D43
6
/ L .94
6
..4D43
6
/ L 6..94/..94/..4D43/..4D43/.@.38DH/

6
+
G .444944
)nd the standard de%iation of the portfolio is0
+ G ..444944/
>-6
+ G .466D or 6.6DK
f. )s long as the correlation "etween the returns on two securities is "elow >, there is a "enefit to
di%ersification. ) portfolio with negati%el! correlated stoc,s can achie%e greater ris, reduction
than a portfolio with positi%el! correlated stoc,s, holding the e#pected return on each stoc,
constant. )ppl!ing proper weights on perfectl! negati%el! correlated stoc,s can reduce
portfolio %ariance to 4.
37. a. The e#pected return of an asset is the sum of the pro"a"ilit! of each return occurring times the
pro"a"ilit! of that return occurring. So, the e#pected return of each stoc, is0
E.R)/ G .69.@.>4/ L .94..>4/ L .69..64/ G .4I94 or I.94K
E.RA/ G .69.@.34/ L .94..49/ L .69..D4/ G .4944 or 9.44K
B-274
CHAPTER 10 B-
b. We can use the e#pected returns we calculated to find the slope of the Securit! $ar,et Cine.
We ,now that the "eta of Stoc, ) is .64 greater than the "eta of Stoc, A. Therefore, as "eta
increases "! .64, the e#pected return on a securit! increases "! .464 .G .4I9 @ .9/. The slope of
the securit! mar,et line .S$C/ e&uals0
SlopeS$C G Rise - Run
SlopeS$C G Increase in e#pected return - Increase in "eta
SlopeS$C G ..4I9 @ .49/ - .64
SlopeS$C G .>694 or >6.94K
Since the mar,ets "eta is > and the ris,*free rate has a "eta of ero, the slope of the Securit!
$ar,et Cine e&uals the e#pected mar,et ris, premium. So, the e#pected mar,et ris, premium
must "e >6.9 percent.
38. a. ) t!pical, ris,*a%erse in%estor see,s high returns and low ris,s. ;or a ris,*a%erse in%estor
holding a well*di%ersified portfolio, "eta is the appropriate measure of the ris, of an indi%idual
securit!. To assess the two stoc,s, we need to find the e#pected return and "eta of each of the
two securities.
,toc( A:
Since Stoc, ) pa!s no di%idends, the return on Stoc, ) is simpl!0 .+> @ +4/ - +4. So, the return
for each state of the econom! is0
RRecession G .BD4 @ 94/ - B94 G @.64 or 64K
R?ormal G .B99 @ 94/ - B94 G .>4 or >4K
RE#panding G .BH4 @ 94/ - B94 G .64 or 64K
The e#pected return of an asset is the sum of the pro"a"ilit! of each return occurring times the
pro"a"ilit! of that return occurring. So, the e#pected return of the stoc, is0
E.R)/ G .>4.@.64/ L .84..>4/ L .>4..64/ G .4844 or 8.44K
)nd the %ariance of the stoc, is0

6
)
G .>4.@4.64 @ 4.48/
6
L .84..>4 @ .48/
6
L .>4..64 @ .48/
6

6
)
G 4.44JH
275
Security Market Line
0
0.02
0.04
0.06
0.08
Beta
E
x
p
e
c
t
e
d

R
e
t
u
r
n
SOLUTIONS
Which means the standard de%iation is0
) G .4.44JH/
>-6
) G .4J8 or J.8K
?ow we can calculate the stoc,s "eta, which is0
) G . ),$/. )/ - $
) G ..84/..4J8/ - .>4
) G .I8D
;or Stoc, A, we can directl! calculate the "eta from the information pro%ided. So, the "eta for
Stoc, A is0
,toc( %:
A G . A,$/. A/ - $
A G ..64/..>6/ - .>4
A G .6D4
The e#pected return on Stoc, A is higher than the e#pected return on Stoc, ). The ris, of
Stoc, A, as measured "! its "eta, is lower than the ris, of Stoc, ). Thus, a t!pical ris,*a%erse
in%estor holding a well*di%ersified portfolio will prefer Stoc, A. ?ote, this situation implies
that at least one of the stoc,s is mispriced since the higher ris, ."eta/ stoc, has a lower return
than the lower ris, ."eta/ stoc,.
b. The e#pected return of the portfolio is the sum of the weight of each asset times the e#pected
return of each asset, so0
E.R+/ G w)E.R)/ L wAE.RA/
E.R+/ G .I4..48/ L .34..4J/
E.R+/ G .483 or 8.34K
To find the standard de%iation of the portfolio, we first need to calculate the %ariance. The
%ariance of the portfolio is0

6
+
G w
6
)

6
)
L w
6
A

6
%
L 6w)wA ) A ),A

6
+
G ..I4/
6
..4J8/
6
L ..34/
6
..>6/
6
L 6..I4/..34/..4J8/..>6/..H4/

6
+
G .448JH
)nd the standard de%iation of the portfolio is0
+ G .4.448JH/
>-6
+ G .4JDI or J.DIK
B-276
CHAPTER 10 B-
c. The "eta of a portfolio is the weighted a%erage of the "etas of its indi%idual securities. So the
"eta of the portfolio is0
+ G .I4..I8D/ L .34.4.6D/
+ G .H6>
39. a. The %ariance of a portfolio of two assets e&uals0

6
+
G w
6
)

6
)
L w
6
A

6
A
L 6w)wA ) ACo%.),A/
Since the weights of the assets must sum to one, we can write the %ariance of the portfolio as0

6
+
G w
6
)

6
)
L .> @ w)/
6
A
L 6w).> @ w)/ ) ACo%.),A/
To find the minimum for an! function, we find the deri%ati%e and set the deri%ati%e e&ual to
ero. ;inding the deri%ati%e of the %ariance function, setting the deri%ati%e e&ual to ero, and
sol%ing for the weight of )sset ), we find0
w) G N
6
A
@ Co%.),A/O - N
6
)
L
6
A
@ 6Co%.),A/O
<sing this e#pression, we find the weight of )sset ) must "e0
w) G ..64
6
@ .44>/ - N.>4
6
L .64
6
@ 6..44>/O
w) G .8>69
This implies the weight of Stoc, A is0
wA G > @ w)
wA G > @ .8>69
wA G .>8I9
b. <sing the weights calculated in part a, determine the e#pected return of the portfolio, we find0
E.R+/ G w)E.R)/ L wAE.RA/
E.R+/ G .8>69..49/ L .>8I9.4.>4/
E.R+/ G 4.49JD
c. <sing the deri%ati%e from part a, with the new co%ariance, the weight of each stoc, in the
minimum %ariance portfolio is0
w) G N
6
A
L Co%.),A/O - N
6
)
L
6
A
@ 6Co%.),A/O
w) G ..>4
6
L @.46/ - N.>4
6
L .64
6
@ 6.@.46/O
w) G .HHHI
This implies the weight of Stoc, A is0
wA G > @ w)
wA G > @ .HHHI
wA G .3333
277
SOLUTIONS
d. The %ariance of the portfolio with the weights on part c is0

6
+
G w
6
)

6
)
L w
6
A

6
A
L 6w)wA ) ACo%.),A/

6
+
G ..HHHI/
6
..>4/
6
L ..3333/
6
..64/
6
L 6..HHHI/..3333/..>4/..64/.@.46/

6
+
G .4444
Aecause the stoc,s ha%e a perfect negati%e correlation .@>/, we can find a portfolio of the two
stoc,s with a ero %ariance.
B-278
CHAPTER 11
AN ALTERNATIVE VIEW OF RISK AND
RETURN: THE ARBITRAGE PRICING
THEORY
Answers to Concept Questions
1. S!stematic ris, is ris, that cannot "e di%ersified awa! through formation of a portfolio. Renerall!,
s!stematic ris, factors are those factors that affect a large num"er of firms in the mar,et, howe%er,
those factors will not necessaril! affect all firms e&uall!. <ns!stematic ris, is the t!pe of ris, that
can "e di%ersified awa! through portfolio formation. <ns!stematic ris, factors are specific to the
firm or industr!. Surprises in these factors will affect the returns of the firm in which !ou are
interested, "ut the! will ha%e no effect on the returns of firms in a different industr! and perhaps
little effect on other firms in the same industr!.
2. )n! return can "e e#plained with a large enough num"er of s!stematic ris, factors. 5owe%er, for a
factor model to "e useful as a practical matter, the num"er of factors that e#plain the returns on an
asset must "e relati%el! limited.
3. The mar,et ris, premium and inflation rates are pro"a"l! good choices. The price of wheat, while a
ris, factor for <ltra +roducts, is not a mar,et ris, factor and will not li,el! "e priced as a ris, factor
common to all stoc,s. In this case, wheat would "e a firm specific ris, factor, not a mar,et ris,
factor. ) "etter model would emplo! macroeconomic ris, factors such as interest rates, RE+, energ!
prices, and industrial production, among others.
4. a. Real R?+ was higher than anticipated. Since returns are positi%el! related to the le%el of R?+,
returns should rise "ased on this factor.
b. Inflation was e#actl! the amount anticipated. Since there was no surprise in this announcement,
it will not affect Cewis*Striden returns.
c. Interest rates are lower than anticipated. Since returns are negati%el! related to interest rates,
the lower than e#pected rate is good news. Returns should rise due to interest rates.
d. The +residents death is "ad news. )lthough the president was e#pected to retire, his retirement
would not "e effecti%e for si# months. Euring that period he would still contri"ute to the firm.
5is untimel! death means that those contri"utions will not "e made. Since he was generall!
considered an asset to the firm, his death will cause returns to fall. 5owe%er, since his departure
was e#pected soon, the drop might not "e %er! large.
e. The poor research results are also "ad news. Since Cewis*Striden must continue to test the drug,
it will not go into production as earl! as e#pected. The dela! will affect e#pected future
earnings, and thus it will dampen returns now.
f. The research "rea,through is positi%e news for Cewis Striden. Since it was une#pected, it will
cause returns to rise.
SOLUTIONS
g. The competitors announcement is also une#pected, "ut it is not a welcome surprise. This
announcement will lower the returns on Cewis*Striden.
The s!stematic factors in the list are real R?+, inflation, and interest rates. The uns!stematic ris,
factors are the presidents a"ilit! to contri"ute to the firm, the research results, and the competitor.
5. The main difference is that the mar,et model assumes that onl! one factor, usuall! a stoc, mar,et
aggregate, is enough to e#plain stoc, returns, while a (*factor model relies on ( factors to e#plain
returns.
6. The fact that )+T does not gi%e an! guidance a"out the factors that influence stoc, returns is a
commonl!*cited criticism. 5owe%er, in choosing factors, we should choose factors that ha%e an
economicall! %alid reason for potentiall! affecting stoc, returns. ;or e#ample, a smaller compan!
has more ris, than a large compan!. Therefore, the sie of a compan! can affect the returns of the
compan! stoc,.
7. )ssuming the mar,et portfolio is properl! scaled, it can "e shown that the one*factor model is
identical to the C)+$.
8. It is the weighted a%erage of e#pected returns plus the weighted a%erage of each securit!Ts "eta times
a factor ; plus the weighted a%erage of the uns!stematic ris,s of the indi%idual securities.
9. Choosing %aria"les "ecause the! ha%e "een shown to "e related to returns is data mining. The
relation found "etween some attri"ute and returns can "e accidental, thus o%erstated. ;or e#ample,
the occurrence of sun"urns and ice cream consumption are related( howe%er, sun"urns do not
necessaril! cause ice cream consumption, or %ice %ersa. ;or a factor to trul! "e related to asset
returns, there should "e sound economic reasoning for the relationship, not :ust a statistical one.
10. <sing a "enchmar, composed of English stoc,s is wrong "ecause the stoc,s included are not of the
same st!le as those in a <.S. growth stoc, fund.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. Since we ha%e the e#pected return of the stoc,, the re%ised e#pected return can "e determined using
the inno%ation, or surprise, in the ris, factors. So, the re%ised e#pected return is0
R G >>K L >.6.D.6K @ 3K/ @ 4.8.D.DK @ D.9K/
R G >6.96K
2. a. If m is the s!stematic ris, portion of return, then0
m G R?+WR?+ L InflationWInflation L rWInterest rates
m G .44498H.29,D3H @ 9,3JH/ @ >.D4.3.84K @ 3.>4K/ @ .I4.>4.34K @ J.94K/
m G 4.84K
B-280
CHAPTER 11 B-
b. The uns!stematic return is the return that occurs "ecause of a firm specific factor such as the
"ad news a"out the compan!. So, the uns!stematic return of the stoc, is @6.H percent. The total
return is the e#pected return, plus the two components of une#pected return0 the s!stematic ris,
portion of return and the uns!stematic portion. So, the total return of the stoc, is0
R G R L m L
R G J.94K L 4.84K @ 6.HK
R G I.IK
3. a. If m is the s!stematic ris, portion of return, then0
m G R?+WKR?+ L rWInterest rates
m G 6.4D.D.8K @ 3.9K/ @ >.J4.I.84K @ I.>4K/
m G >.36K
b. The uns!stematic is the return that occurs "ecause of a firm specific factor such as the increase
in mar,et share. If is the uns!stematic ris, portion of the return, then0
G 4.3H.68K @ 63K/
G >.84K
c. The total return is the e#pected return, plus the two components of une#pected return0 the
s!stematic ris, portion of return and the uns!stematic portion. So, the total return of the stoc,
is0
R G R L m L
R G >4.94K L >.36K L >.84K
R G >3.H6K
4. The "eta for a particular ris, factor in a portfolio is the weighted a%erage of the "etas of the assets.
This is true whether the "etas are from a single factor model or a multi*factor model. So, the "etas of
the portfolio are0
F> G .64.>.64/ L .64.4.84/ L .H4.4.J9/
F> G 4.JI
F6 G .64.4.J4/ L .64.>.D4/ L .H4.@4.49/
F6 G 4.D3
F> G .64.4.64/ L .64.@4.34/ L .H4.>.94/
F> G 4.88
So, the e#pression for the return of the portfolio is0
Ri G HK L 4.JIF> L 4.D3F6 L 4.88F3
Which means the return of the portfolio is0
Ri G HK L 4.JI.9.94K/ L 4.D3.D.64K/ L 4.88.D.J4K/
Ri G >I.D9K
281
SOLUTIONS
5. We can e#press the multifactor model for each portfolio as0
E.R+ / G R; L >F> L 6F6
where F> and F6 are the respecti%e ris, premiums for each factor. E#pressing the return e&uation for
each portfolio, we get0
>8K G HK L 4.I9F> L >.6F6
>DK G HK L >.H4F> @ 4.6F6
We can sol%e the s!stem of two e&uations with two un,nowns. $ultipl!ing each e&uation "! the
respecti%e F6 factor for the other e&uation, we get0
3.HK G >.6K L .>9F> L 4.6DF6
>H.8K G I.6K L >.J6F> @ 4.6DF6
Summing the e&uations and sol%ing F> for gi%es us0
64.D4K G 8.D4K L 6.4I F>
F> G 9.84K
)nd now, using the e&uation for portfolio ), we can sol%e for F6, which is0
>8K G HK L 4.I9.9.84K/ L >.6F6
F6 G H.38K
6. a. The mar,et model is specified "!0
R G R L .R$ @
$
R
/ L
so appl!ing that to each Stoc,0
Stoc, C5'CC)TE0
RC5'CC)TE G
C5'CC)TE
R
L C5'CC)TE.R$ @
$
R / L C5'CC)TE
RC5'CC)TE G >4.9K L >.6.R$ @ >D.6K/ L C5'CC)TE
Stoc, X)?ICC)0
RX)?ICC) G
X)?ICC)
R
L X)?ICC).R$ @
$
R / L X)?ICC)
RX)?ICC) G >3.4K L 4.J8.R$ @ >D.6K/ L X)?ICC)
Stoc, STR)WAERR\0
RSTR)WAERR\ G
STR)WAERR\
R
L STR)WAERR\.R$ @
$
R / L STR)WAERR\
RSTR)WAERR\ G >9.IK L >.3I.R$ @ >D.6K/ L STR)WAERR\
B-282
CHAPTER 11 B-
b. Since we donTt ha%e the actual mar,et return or uns!stematic ris,, we will get a formula with
those %alues as un,nowns0
R+ G .34RC5'CC)TE L .D9RX)?ICC) L .34RSTR)WAERR\
R+ G .34N>4.9K L >.6.R$ @ >D.6K/ L C5'CC)TEO L .D9N>3.4K L 4.J8.R$ @ >D.6K/ L X)?ICC)O
L .69N>9.IK L >.3I.R$ @ >D.6K/ L STR)WAERR\O
R+ G .34.>4.9K/ L .D9.>3K/ L .69.>9.IK/ L N.34.>.6/ L .D9..J8/ L .69.>.3I/O.R$ @ >D.6K/
L .34 C5'CC)TE L .D9 X)?ICC) L .34 STR)WAERR\
R+ G >6.J69K L >.>D39.R$ @ >D.6K/ L .34 C5'CC)TE L .D9 X)?ICC) L .34 STR)WAERR\
c. <sing the mar,et model, if the return on the mar,et is >9 percent and the s!stematic ris, is
ero, the return for each indi%idual stoc, is0
RC5'CC)TE G >4.9K L >.64.>9K @ >D.6K/
RC5'CC)TE G >>.DHK
RX)?ICC) G >3K L 4.J8.>9K @ >D.6K/
RX)?ICC) G >3.I8K
RSTR)WAERR\ G >9.I4K L >.3I.>9K @ >D.6K/
RSTR)WAERR\ G >H.84K
To calculate the return on the portfolio, we can use the e&uation from part b, so0
R+ G >6.J69K L >.>D39.>9K @ >D.6K/
R+ G >3.8DK
)lternati%el!, to find the portfolio return, we can use the return of each asset and its portfolio
weight, or0
R+ G U>R> L U6R6 L U3R3
R+ G .34.>>.DHK/ L .D9.>3.I8K/ L .69.>H.84K/
R+ G >3.8DK
7. a. Since fi%e stoc,s ha%e the same e#pected returns and the same "etas, the portfolio also has the
same e#pected return and "eta. 5owe%er, the uns!stematic ris,s might "e different, so the
e#pected return of the portfolio is0
+
R G >>K L 4.I6;> L >.HJ;6 L .>-9/. > L 6 L 3 L D L 9/
283
SOLUTIONS
b. Consider the e#pected return e&uation of a portfolio of fi%e assets we calculated in part a. Since
we now ha%e a %er! large num"er of stoc,s in the portfolio, as0
? ,
?
>
4
Aut, the :s are infinite, so0
.>-?/. > L 6 L 3 L D L`..L ?/ 4
Thus0
+
R G >>K L 4.I6;> L >.HJ;6
8. To determine which in%estment an in%estor would prefer, !ou must compute the %ariance of
portfolios created "! man! stoc,s from either mar,et. Aecause !ou ,now that di%ersification is good,
it is reasona"le to assume that once an in%estor has chosen the mar,et in which she will in%est, she
will "u! man! stoc,s in that mar,et.
Mnown0
E; G 4 and G 4.>4
E

G 4 and S
i G 4.64 for all i
If we assume the stoc,s in the portfolio are e&uall!*weighted, the weight of each stoc, is
?
>
, that
is0
Ui G
?
>
for all i
If a portfolio is composed of ? stoc,s each forming >-? proportion of the portfolio, the return on the
portfolio is >-? times the sum of the returns on the ? stoc,s. To find the %ariance of the respecti%e
portfolios in the 6 mar,ets, we need to use the definition of %ariance from Statistics0
Xar.#/ G EN# @ E.#/O
6
In our case0
Xar.R+/ G ENR+ @ E.R+/O
6
B-284
CHAPTER 11 B-
?ote howe%er, to use this, first we must find R+ and E.R+/. So, using the assumption a"out e&ual
weights and then su"stituting in the ,nown e&uation for Ri0
R+ G

R
?
>
i
R+ G


?
>
.4.>4 L F L i/
R+ G 4.>4 L F L


?
>
i

)lso, recall from Statistics a propert! of e#pected %alue, that is0


If0 \ U b
B B
a
B
+
where a is a constant, and
b
B
,
U
B
, and
\
B
are random %aria"les, then0
/ \ E. / U /E. E. / b E.
B B
a
B
+
and
E.a/ G a
?ow use the a"o%e to find E.R+/0
E.R+/ G E
,
_

+ +
i
F
?
>
i 4.>4
E.R+/ G 4.>4 L E.F/ L

/ E.
?
>
i

E.R+/ G 4.>4 L .4/ L

4
?
>
E.R+/ G 4.>4
?e#t, su"stitute "oth of these results into the original e&uation for %ariance0
Xar.R+/ G ENR+ @ E.R+/O
6
Xar.R+/ G E
6
4.>4 *
?
>
i 4.>4
1
]
1

+ +
i
C F
Xar.R+/ G E
6
?
>
i
1
]
1

+

C F
Xar.R+/ G E ( )
6
6
6
6 6
?
>

?
>
6i i
1
]
1

+ +

C F F
Xar.R+/ G
6
6 6 6
/ , Co%.
?
>
* > j
?
>
j i
1
]
1

,
_

+ +
> i

285
SOLUTIONS
;inall!, since we can ha%e as man! stoc,s in each mar,et as we want, in the limit, as ? ,
?
>
4, so we get0
Xar.R+/ G
6

6
L Co%. i, >/
and, since0
Co%. i, >/ G i > . i, >/
and the pro"lem states that > G 6 G 4.>4, so0
Xar.R+/ G
6

6
L > 6 . i, >/
Xar.R+/ G
6
.4.4>/ L 4.4D . i, >/
So now, summarie what we ha%e so far0
R>i G 4.>4 L >.9F L >i
R6i G 4.>4 L 4.9F L 6i
E.R>+/ G E.R6+/ G 4.>4
Xar.R>+/ G 4.4669 L 4.4D . >i, >>/
Xar.R6+/ G 4.4469 L 4.4D . 6i, 6>/
;inall! we can "egin answering the &uestions a, ", F c for %arious %alues of the correlations0
a. Su"stitute . >i, >>/ G . 6i, 6>/ G 4 into the respecti%e %ariance formulas0
Xar.R>+/ G 4.4669
Xar.R6+/ G 4.4469
Since Xar.R>+/ S Xar.R6+/, and e#pected returns are e&ual, a ris, a%erse in%estor will prefer to
in%est in the second mar,et.
b. If we assume . >i, >>/ G 4.J, and . 6i, 6>/ G 4, the %ariance of each portfolio is0
Xar.R>+/ G 4.4669 L 4.4D . >i, >>/
Xar.R>+/ G 4.4669 L 4.4D.4.J/
Xar.R>+/ G 4.4989
Xar.R6+/ G 4.4469 L 4.4D . 6i, 6>/
Xar.R6+/ G 4.4469 L 4.4D.4/
Xar.R6+/ G 4.4469
Since Xar.R>+/ S Xar.R6+/, and e#pected returns are e&ual, a ris, a%erse in%estor will prefer to
in%est in the second mar,et.
B-286
CHAPTER 11 B-
c. If we assume . >i, >>/ G 4, and . 6i, 6>/ G 4, the %ariance of each portfolio is0
Xar.R>+/ G 4.4669 L 4.4D . >i, >>/
Xar.R>+/ G 4.4669 L 4.4D.4/
Xar.R>+/ G 4.4669
Xar.R6+/ G 4.4469 L 4.4D . 6i, 6>/
Xar.R6+/ G 4.4469 L 4.4D.4.9/
Xar.R6+/ G 4.4669
Since Xar.R>+/ G Xar.R6+/, and e#pected returns are e&ual, a ris, a%erse in%estor will "e
indifferent "etween the two mar,ets.
d. Since the e#pected returns are e&ual, indifference implies that the %ariances of the portfolios in
the two mar,ets are also e&ual. So, set the %ariance e&uations e&ual, and sol%e for the
correlation of one mar,et in terms of the other0
Xar.R>+/ G Xar.R6+/
4.4669 L 4.4D . >i, >>/ G 4.4469 L 4.4D . 6i, 6>/
. 6i, 6>/ G . >i, >>/ L 4.9
Therefore, for an! set of correlations that ha%e this relationship .as found in part c/, a ris,
ad%erse in%estor will "e indifferent "etween the two mar,ets.
9. a. In order to find standard de%iation, , !ou must first find the Xariance, since G Xar .
Recall from Statistics a propert! of Xariance0
If0 \ U b
B B
a
B
+
where a is a constant, and
b
B
,
U
B
, and
\
B
are random %aria"les, then0
/ \ Xar. / U Xar. / b Xar.
6
B B
a
B
+
and0
Xar.a/ G 4
The pro"lem states that return*generation can "e descri"ed "!0
Ri#t G i L i.R$/ L i#t
287
SOLUTIONS
Realie that Ri#t, R$, and i#t are random %aria"les, and i and i are constants. Then,
appl!ing the a"o%e properties to this model, we get0
Xar.R>/ G
6
i
i
Xar.R$/ L Xar. i/
and now we can find the standard de%iation for each asset0
6
)
j G 4.I
6
.4.4>6>/ L 4.4> G 4.4>9J6J
)
j G 4.4>9J6J G .>6H6 or >6.H6K
6
A
j G >.6
6
.4.4>6>/ L 4.4>DD G 4.43>86D
A
j G 4.43>86D G .>I8D or >I.8DK
6
C
j G >.9
6
.4.4>6>/ L 4.4669 G 4.4DJI69
C
j G 4.4DJI69 G .6634 or 66.34K
b. ;rom a"o%e formula for %ariance, note that as ? ,
?
/ Xar. k
i
4, so !ou get0
Xar.Ri/ G
6
i
i
Xar.R$/
So, the %ariances for the assets are0
6
)
j G 4.I
6
..4>6>/ G 4.449J6J
6
A
j G >.6
6
..4>6>/ G 4.4>ID6D
6
C
j G >.9
6
..4>6>/ G 4.46I669
c. We can use the model0
i
R
G R; L i.
$
R
@ R;/
which is the C)+$ .or )+T $odel when there is one factor and that factor is the $ar,et/. So,
the e#pected return of each asset is0
)
R G 3.9K L 4.I.>4.HK @ 3.9K/ G 8.DIK
A
R G 3.9K L >.6.>4.HK @ 3.9K/ G >6.46K
C
R G 3.9K L >.9.>4.HK @ 3.9K/ G >D.>9K
We can compare these results for e#pected asset returns as per C)+$ or )+T with the
e#pected returns gi%en in the ta"le. This shows that assets ) F A are accuratel! priced, "ut
asset C is o%erpriced .the model shows the return should "e higher/. Thus, rational in%estors
will not hold asset C.
B-288
CHAPTER 11 B-
d. If short selling is allowed, rational in%estors will sell short asset C, causing the price of asset C
to decrease until no ar"itrage opportunit! e#ists. In other words, the price of asset C should
decrease until the return "ecomes >D.>9 percent.
10. a. Cet0

U> G the proportion of Securit! > in the portfolio and
U6 G the proportion of Securit! 6 in the portfolio
and note that since the weights must sum to >.4,
U> G > @ U6
Recall from Chapter >4 that the "eta for a portfolio .or in this case the "eta for a factor/ is the
weighted a%erage of the securit! "etas, so
+> G U> >> L U6 6>
+> G U> >> L .> @ U>/ 6>
?ow, appl! the condition gi%en in the hint that the return of the portfolio does not depend on
;>. This means that the portfolio "eta for that factor will "e 4, so0
+> G 4 G U> >> L .> @ U>/ 6>
+> G 4 G U>.>.4/ L .> @ U>/.4.9/
and sol%ing for U> and U60
U> G @ >
U6 G 6
Thus, sell short Securit! > and "u! Securit! 6.
To find the e#pected return on that portfolio, use
R+ G U>R> L U6R6
so appl!ing the a"o%e0
E.R+/ G @>.64K/ L 6.64K/
E.R+/ G 64K
+> G @>.>/ L 6.4.9/
+> G 4
289
SOLUTIONS
b. ;ollowing the same logic as in part a, we ha%e
+6 G 4 G U3 3> L .> @ U3/ D>
+6 G 4 G U3.>/ L .> @ U3/.>.9/
and
U3 G 3
UD G @6
Thus, sell short Securit! D and "u! Securit! 3. Then,
E.R+6/ G 3.>4K/ L .@6/.>4K/
E.R+6/ G >4K
+6 G 3.4.9/ @ 6.4.I9/
+6 G 4
?ote that since "oth +> and +6 are 4, this is a ris, free portfolio_
c. The portfolio in part " pro%ides a ris, free return of >4K, which is higher than the D.JK return
pro%ided "! the ris, free securit!. To ta,e ad%antage of this opportunit!, "orrow at the ris, free
rate of D.JK and in%est the funds in a portfolio "uilt "! selling short securit! four and "u!ing
securit! three with weights .3,@6/ as in part ".
d. ;irst assume that the ris, free securit! will not change. The price of securit! four .that e%er!one
is tr!ing to sell short/ will decrease, and the price of securit! three .that e%er!one is tr!ing to
"u!/ will increase. 5ence the return of securit! four will increase and the return of securit!
three will decrease.
The alternati%e is that the prices of securities three and four will remain the same, and the price
of the ris,*free securit! drops until its return is >4K.
B-290
CHAPTER 11 B-
;inall!, a com"ined mo%ement of all securit! prices is also possi"le. The prices of securit! four
and the ris,*free securit! will decrease and the price of securit! three will increase until the
opportunit! disappears.
291
CHAPTER 12
RISK, COST OF CAPITAL, AND CAPITAL
BUDGETING
Answers to Concepts Review and Critical !in"in# Questions
1. ?o. The cost of capital depends on the ris, of the pro:ect, not the source of the mone!.
2. Interest e#pense is ta#*deducti"le. There is no difference "etween preta# and afterta# e&uit! costs.
3. \ou are assuming that the new pro:ects ris, is the same as the ris, of the firm as a whole, and that
the firm is financed entirel! with e&uit!.
4. Two primar! ad%antages of the S$C approach are that the model e#plicitl! incorporates the rele%ant
ris, of the stoc, and the method is more widel! applica"le than is the EC; model, since the S$C
doesnt ma,e an! assumptions a"out the firms di%idends. The primar! disad%antages of the S$C
method are .>/ three parameters .the ris,*free rate, the e#pected return on the mar,et, and "eta/ must
"e estimated, and .6/ the method essentiall! uses historical information to estimate these parameters.
The ris,*free rate is usuall! estimated to "e the !ield on %er! short maturit! T*"ills and is, hence,
o"ser%a"le( the mar,et ris, premium is usuall! estimated from historical ris, premiums and, hence,
is not o"ser%a"le. The stoc, "eta, which is uno"ser%a"le, is usuall! estimated either "! determining
some a%erage historical "eta from the firm and the mar,ets return data, or "! using "eta estimates
pro%ided "! anal!sts and in%estment firms.
5. The appropriate afterta# cost of de"t to the compan! is the interest rate it would ha%e to pa! if it
were to issue new de"t toda!. 5ence, if the \T$ on outstanding "onds of the compan! is o"ser%ed,
the compan! has an accurate estimate of its cost of de"t. If the de"t is pri%atel!*placed, the firm
could still estimate its cost of de"t "! .>/ loo,ing at the cost of de"t for similar firms in similar ris,
classes, .6/ loo,ing at the a%erage de"t cost for firms with the same credit rating .assuming the
firms pri%ate de"t is rated/, or .3/ consulting anal!sts and in%estment "an,ers. E%en if the de"t is
pu"licl! traded, an additional complication arises when the firm has more than one issue
outstanding( these issues rarel! ha%e the same !ield "ecause no two issues are e%er completel!
homogeneous.
6. a. This onl! considers the di%idend !ield component of the re&uired return on e&uit!.
b. This is the current !ield onl!, not the promised !ield to maturit!. In addition, it is "ased on the
"oo, %alue of the lia"ilit!, and it ignores ta#es.
c. E&uit! is inherentl! ris,ier than de"t .e#cept, perhaps, in the unusual case where a firms assets
ha%e a negati%e "eta/. ;or this reason, the cost of e&uit! e#ceeds the cost of de"t. If ta#es are
considered in this case, it can "e seen that at reasona"le ta# rates, the cost of e&uit! does e#ceed
the cost of de"t.
7. RSup G .>6 L .I9..48/ G .>844 or >8.44K
CHAPTER 12 B-
Aoth should proceed. The appropriate discount rate does not depend on which compan! is in%esting(
it depends on the ris, of the pro:ect. Since Superior is in the "usiness, it is closer to a pure pla!.
Therefore, its cost of capital should "e used. With an >8K cost of capital, the pro:ect has an ?+X of
2> million regardless of who ta,es it.
8. If the different operating di%isions were in much different ris, classes, then separate cost of capital
figures should "e used for the different di%isions( the use of a single, o%erall cost of capital would "e
inappropriate. If the single hurdle rate were used, ris,ier di%isions would tend to recei%e more funds
for in%estment pro:ects, since their return would e#ceed the hurdle rate despite the fact that the! ma!
actuall! plot "elow the S$C and, hence, "e unprofita"le pro:ects on a ris,*ad:usted "asis. The
t!pical pro"lem encountered in estimating the cost of capital for a di%ision is that it rarel! has its
own securities traded on the mar,et, so it is difficult to o"ser%e the mar,ets %aluation of the ris, of
the di%ision. Two t!pical wa!s around this are to use a pure pla! pro#! for the di%ision, or to use
su":ecti%e ad:ustments of the o%erall firm hurdle rate "ased on the percei%ed ris, of the di%ision.
9. The discount rate for the pro:ects should "e lower that the rate implied "! the securit! mar,et line.
The securit! mar,et line is used to calculate the cost of e&uit!. The appropriate discount rate for
pro:ects is the firms weighted a%erage cost of capital. Since the firms cost of de"t is generall! less
that the firms cost of e&uit!, the rate implied "! the securit! mar,et line will "e too high.
10. Aeta measures the responsi%eness of a securit!Ts returns to mo%ements in the mar,et. Aeta is
determined "! the c!clicalit! of a firmTs re%enues. This c!clicalit! is magnified "! the firmTs
operating and financial le%erage. The following three factors will impact the firms "eta. .>/
Re%enues. The c!clicalit! of a firmTs sales is an important factor in determining "eta. In general,
stoc, prices will rise when the econom! e#pands and will fall when the econom! contracts. )s we
said a"o%e, "eta measures the responsi%eness of a securit!Ts returns to mo%ements in the mar,et.
Therefore, firms whose re%enues are more responsi%e to mo%ements in the econom! will generall!
ha%e higher "etas than firms with less*c!clical re%enues. .6/ 'perating le%erage. 'perating le%erage
is the percentage change in earnings "efore interest and ta#es .EAIT/ for a percentage change in
sales. ) firm with high operating le%erage will ha%e greater fluctuations in EAIT for a change in
sales than a firm with low operating le%erage. In this wa!, operating le%erage magnifies the
c!clicalit! of a firmTs re%enues, leading to a higher "eta. .3/ ;inancial le%erage. ;inancial le%erage
arises from the use of de"t in the firmTs capital structure. ) le%ered firm must ma,e fi#ed interest
pa!ments regardless of its re%enues. The effect of financial le%erage on "eta is analogous to the
effect of operating le%erage on "eta. ;i#ed interest pa!ments cause the percentage change in net
income to "e greater than the percentage change in EAIT, magnif!ing the c!clicalit! of a firmTs
re%enues. Thus, returns on highl!*le%ered stoc,s should "e more responsi%e to mo%ements in the
mar,et than the returns on stoc,s with little or no de"t in their capital structure.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. With the information gi%en, we can find the cost of e&uit! using the C)+$. The cost of e&uit! is0
RE G .4D9 L >.34 ..>3 @ .4D9/ G .>999 or >9.99K
293
SOLUTIONS B-294
CHAPTER 12 B-
2. The preta# cost of de"t is the \T$ of the compan!s "onds, so0
+4 G 2>,494 G 2D4.+XI;)RK,6D/ L 2>,444.+XI;RK,6D/
R G 3.H83K
\T$ G 6 Q 3.H83K G I.3IK
)nd the afterta# cost of de"t is0
RE G .4I3I.> @ .34/ G .49>H or 9.>HK
3. a. The preta# cost of de"t is the \T$ of the compan!s "onds, so0
+4 G 2>,484 G 294.+XI;)RK,DH/ L 2>,444.+XI;RK,DH/
R G D.98K
\T$ G 6 Q D.98K G J.>HK
b. The afterta# cost of de"t is0
RE G .4J>H.> @ .D4/ G .4994 or 9.94K
c. The afterta# rate is more rele%ant "ecause that is the actual cost to the compan!.
4. The "oo, %alue of de"t is the total par %alue of all outstanding de"t, so0
AXE G B64$ L 84$ G B>44$
To find the mar,et %alue of de"t, we find the price of the "onds and multipl! "! the num"er of
"onds. )lternati%el!, we can multipl! the price &uote of the "ond times the par %alue of the "onds.
Eoing so, we find0
$XE G >.48.B64$/ L .98.B84$/ G BH8$
The \T$ of the ero coupon "onds is0
+b G B984 G B>,444.+XI;RK,I/
R G 8.4JK
So, the afterta# cost of the ero coupon "onds is0
Rb G .484J.> @ .D4/ G .4D8H or D.8HK
The afterta# cost of de"t for the compan! is the weighted a%erage of the afterta# cost of de"t for all
outstanding "ond issues. We need to use the mar,et %alue weights of the "onds. The total afterta#
cost of de"t for the compan! is0
RE G .4994.B6>.H-BH8/ L .4D8H.BDH.D-BH8/ G .494H or 9.4HK
5. <sing the e&uation to calculate the W)CC, we find0
W)CC G .H4 ..>H/ L .D4..4J/.> @ .39/ G .>>JD or >>.JDK
295
SOLUTIONS
6. 5ere we need to use the de"t*e&uit! ratio to calculate the W)CC. Eoing so, we find0
W)CC G .>8.>->.H4/ L .4J..H4->.H4/.> @ .D4/ G .>368 or >3.68K
7. 5ere we ha%e the W)CC and need to find the de"t*e&uit! ratio of the compan!. Setting up the
W)CC e&uation, we find0
W)CC G .>>94 G .>H.E-X/ L .489.E-X/.> @ .39/
Rearranging the e&uation, we find0
.>>9.X-E/ G .>H L .489..H9/.E-E/
?ow we must realie that the X-E is :ust the e&uit! multiplier, which is e&ual to0
X-E G > L E-E
.>>9.E-E L >/ G .>H L .49969.E-E/
?ow we can sol%e for E-E as0
.49JI9.E-E/ G .4D94
E-E G .I93>
8. a. The "oo, %alue of e&uit! is the "oo, %alue per share times the num"er of shares, and the "oo,
%alue of de"t is the face %alue of the compan!s de"t, so0
AXE G J.9$.=9/ G =DI.9$
AXE G =I9$ L H4$ G =>39$
So, the total %alue of the compan! is0
X G =DI.9$ L >39$ G =>86.9$
)nd the "oo, %alue weights of e&uit! and de"t are0
E-X G =DI.9-=>86.9 G .6H43
E-X G > @ E-X G .I3JI
B-296
CHAPTER 12 B-
b. The mar,et %alue of e&uit! is the share price times the num"er of shares, so0
$XE G J.9$.=93/ G =943.9$
<sing the relationship that the total mar,et %alue of de"t is the price &uote times the par %alue
of the "ond, we find the mar,et %alue of de"t is0
$XE G .J3.=I9$/ L .JH9.=H4$/ G =>6I.H9$
This ma,es the total mar,et %alue of the compan!0
X G =943.9$ L >6I.H9$ G =H3>.>9$

)nd the mar,et %alue weights of e&uit! and de"t are0
E-X G =943.9-=H3>.>9 G .IJI8
E-X G > @ E-X G .6466
c. The mar,et %alue weights are more rele%ant.
9. ;irst, we will find the cost of e&uit! for the compan!. The information pro%ided allows us to sol%e
for the cost of e&uit! using the C)+$, so0
RE G .496 L >.9..4J/ G .>8I or >8.I4K
?e#t, we need to find the \T$ on "oth "ond issues. Eoing so, we find0
+> G =J34 G =D4.+XI;)RK,64/ L =>,444.+XI;RK,64/
R G D.9DK
\T$ G D.9DK Q 6 G J.48K
+6 G =JH9 G =3I.9.+XI;)RK,>6/ L =>,444.+XI;RK,>6/
R G D.>3K
\T$ G D.>3K Q 6 G 8.69K
To find the weighted a%erage afterta# cost of de"t, we need the weight of each "ond as a percentage
of the total de"t. We find0
wE> G .J3.=I9$/-=>6I.H9$ G .9DH
wE6 G .JH9.=H4$/-=>6I.H9$ G .D9D
?ow we can multipl! the weighted a%erage cost of de"t times one minus the ta# rate to find the
weighted a%erage afterta# cost of de"t. This gi%es us0
RE G .> @ .39/N..9DH/..4J48/ L ..D9D/..4869/O G .49HH or 9.HHK
<sing these costs and the weight of de"t we calculated earlier, the W)CC is0
W)CC G .IJI8..>8I4/ L .6466..49HH/ G .>H4H or >H.4HK
297
SOLUTIONS
10. a. <sing the e&uation to calculate W)CC, we find0
W)CC G .>49 G .>->.8/..>9/ L ..8->.8/.> @ .39/RE
RE G .4I94 or I.94K
b. <sing the e&uation to calculate W)CC, we find0
W)CC G .>49 G .>->.8/RE L ..8->.8/..4HD/
RE G .>3I8 or >3.I8K
11. We will begin by finding the market value of each type of financing. We find:

MVD = 4,000(Rs.1,000)(1.03) = Rs.4,120,000
MV
E
= 90,000(Rs.57) = Rs.5,130,000
)nd the total mar,et %alue of the firm is0
X G Rs.D,>64,444 L 9,>34,444 G Rs.J,694,444
?ow, we can find the cost of e&uit! using the C)+$. The cost of e&uit! is0
RE G .4H L >.>4..48/ G .>D84 or >D.84K
The cost of de"t is the \T$ of the "onds, so0
+4 G Rs.>,434 G Rs.39.+XI;)RK,D4/ L Rs.>,444.+XI;RK,D4/
R G 3.3HK
\T$ G 3.3HK Q 6 G H.I6K
)nd the afterta# cost of de"t is0
RE G .> @ .39/..4HI6/ G .4D3I or D.3IK
?ow we ha%e all of the components to calculate the W)CC. The W)CC is0
W)CC G .4D3I.D.>6-J.69/ L .>D84.9.>3-J.69/ G .>4>9 or >4.>9K
?otice that we didnt include the .> @ tC/ term in the W)CC e&uation. We simpl! used the afterta#
cost of de"t in the e&uation, so the term is not needed here.
12. a. We will begin by finding the market value of each type of financing. We find:
$XE G >64,444.2>,444/.4.J3/ G 2>>>,H44,444
$XE G J,444,444.23D/ G 234H,444,444
)nd the total mar,et %alue of the firm is0
X G 2>>>,H44,444 L 34H,444,444 G 2D>I,H44,444
B-298
CHAPTER 12 B-
So, the mar,et %alue weights of the compan!s financing is0
E-X G 2>>>,H44,444-2D>I,H44,444 G .6HI6
E-X G 234H,444,444-2D>I,H44,444 G .I368
b. ;or pro:ects e&uall! as ris,! as the firm itself, the W)CC should "e used as the discount rate.
;irst we can find the cost of e&uit! using the C)+$. The cost of e&uit! is0
RE G .49 L >.64..>4/ G .>I44 or >I.44K
The cost of de"t is the \T$ of the "onds, so0
+4 G 2J34 G 2D6.9.+XI;)RK,34/ L 2>,444.+XI;RK,34/
R G D.HJK
\T$ G D.HJK Q 6 G J.38K
)nd the afterta# cost of de"t is0
RE G .> @ .39/..4J38/ G .4H>4 or H.>4K
?ow we can calculate the W)CC as0
W)CC G .>I44..I368/ L .4H>4 ..6HI6/ G .>D4J or >D.4JK
13. a. +ro:ects U, \ and b.
b. <sing the C)+$ to consider the pro:ects, we need to calculate the e#pected return of each
pro:ect gi%en its le%el of ris,. This e#pected return should then "e compared to the e#pected
return of the pro:ect. If the return calculated using the C)+$ is higher than the pro:ect
e#pected return, we should accept the pro:ect( if not, we re:ect the pro:ect. )fter considering
ris, %ia the C)+$0
ENWO G .49 L .H4..>6 @ .49/ G .4J64 d .>>, so accept W
ENUO G .49 L .J4..>6 @ .49/ G .>>34 d .>3, so accept U
EN\O G .49 L >.64..>6 @ .49/ G .>3D4 d .>D, so accept \
ENbO G .49 L >.I4..>6 @ .49/ G .>HJ4 S .>H, so re:ect b
c. +ro:ect W would "e incorrectl! re:ected( +ro:ect b would "e incorrectl! accepted.
299
SOLUTIONS
&ntermediate
14. <sing the de"t*e&uit! ratio to calculate the W)CC, we find0
W)CC G ..H9->.H9/..499/ L .>->.H9/..>9/ G .>>6H or >>.6HK
Since the pro:ect is ris,ier than the compan!, we need to ad:ust the pro:ect discount rate for the
additional ris,. <sing the su":ecti%e ris, factor gi%en, we find0
+ro:ect discount rate G >>.6HK L 6.44K G >3.6HK
We would accept the pro:ect if the ?+X is positi%e. The ?+X is the +X of the cash outflows plus the
+X of the cash inflows. Since we ha%e the costs, we :ust need to find the +X of inflows. The cash
inflows are a growing perpetuit!. If !ou remem"er, the e&uation for the +X of a growing perpetuit!
is the same as the di%idend growth e&uation, so0
+X of future C; G 23,944,444-..>36H @ .49/ G 2D6,389,36>
The pro:ect should onl! "e underta,en if its cost is less than 2D6,389,36> since costs less than this
amount will result in a positi%e ?+X.
15. We will begin by finding the market value of each type of financing. We will use D1 to represent the
coupon bond, and D2 to represent the zero coupon bond. So, the market value of the firms financing
is:

MVD1 = 50,000(1,000)(1.1980) = 59,900,000
MVD2 = 150,000(1,000)(.1385) = 20,775,000
MVP = 120,000(112) = 13,440,000
MV
E
= 2,000,000(65) = 130,000,000
)nd the total mar,et %alue of the firm is0
X G =9J,J44,444 L 64,II9,444 L >3,DD4,444 L >34,444,444 G =66D,>>9,444
?ow, we can find the cost of e&uit! using the C)+$. The cost of e&uit! is0
RE G .4D L >.>4..4J/ G .>3J4 or >3.J4K
The cost of de"t is the \T$ of the "onds, so0
+4 G =>,>J8 G =D4.+XI;)RK,94/ L =>,444.+XI;RK,94/
R G 3.64K
\T$ G 3.64K Q 6 G H.D4K
)nd the afterta# cost of de"t is0
RE> G .> @ .D4/..4HD4/ G .438D or 3.8DK
B-300
CHAPTER 12 B-
)nd the afterta# cost of the ero coupon "onds is0
+4 G =>38.94 G =>,444.+XI;RK,H4/
R G 3.39K
\T$ G 3.39K Q 6 G H.I4K
RE6 G .> @ .D4/..4HI4/ G .4D46 or D.46K
E%en though the ero coupon "onds ma,e no pa!ments, the calculation for the \T$ .or price/ still
assumes semiannual compounding, consistent with a coupon "ond. )lso remem"er that, e%en though
the compan! does not ma,e interest pa!ments, the accrued interest is still ta# deducti"le for the
compan!.
To find the re&uired return on preferred stoc,, we can use the preferred stoc, pricing e&uation,
which is the le%el perpetuit! e&uation, so the re&uired return on the compan!s preferred stoc, is0
R+ G E> - +4
R+ G =H.94 - =>>6
R+ G .4984 or 9.84K
?otice that the re&uired return in the preferred stoc, is lower than the re&uired on the "onds. This
result is not consistent with the ris, le%els of the two instruments, "ut is a common occurrence.
There is a practical reason for this0 )ssume Compan! ) owns stoc, in Compan! A. The ta# code
allows Compan! ) to e#clude at least I4 percent of the di%idends recei%ed from Compan! A,
meaning Compan! ) does not pa! ta#es on this amount. In practice, much of the outstanding
preferred stoc, is owned "! other companies, who are willing to ta,e the lower return since it is
effecti%el! ta# e#empt.
?ow we ha%e all of the components to calculate the W)CC. The W)CC is0
W)CC G .438D.9J.J-66D.>>9/ L .4D46.64.II9-66D.>>9/ L .>3J4.>34-66D.>>9/
L .4984.>3.DD-66D.>>9/
W)CC G .4J8> or J.8>K
'hallenge
16. We can use the de"t*e&uit! ratio to calculate the weights of e&uit! and de"t. The de"t of the
compan! has a weight for long*term de"t and a weight for accounts pa!a"le. We can use the weight
gi%en for accounts pa!a"le to calculate the weight of accounts pa!a"le and the weight of long*term
de"t. The weight of each will "e0
)ccounts pa!a"le weight G .64->.64 G .>I
Cong*term de"t weight G >->.64 G .83
Since the accounts pa!a"le has the same cost as the o%erall W)CC, we can write the e&uation for the
W)CC as0
W)CC G .>-6.3/..>I/ L .>.3-6.3/N..64->.6/W)CC L .>->.6/..4J/.> @ .39/O
301
SOLUTIONS
Sol%ing for W)CC, we find0
W)CC G .4I3J L .9H96N..64->.6/W)CC L .4D88O
W)CC G .4I3J L ..4JD6/W)CC L .46IH
..J498/W)CC G .>4>9
W)CC G .>>36 or >>.36K
Since the cash flows go to perpetuit!, we can calculate the future cash inflows using the e&uation for
the +X of a perpetuit!. The ?+X is0
?+X G @VD9,444,444 L .V9,I44,444-.>>36/
?+X G @VD9,444,444 L 94,3I6,996 G V9,3I6,996
17. The BD million cost of the land 3 !ears ago is a sun, cost and irrele%ant( the BH.9 million appraised
%alue of the land is an opportunit! cost and is rele%ant. The rele%ant mar,et %alue capitaliation
weights are0
$XE G >9,444.B>,444/.4.J6/ G B>3,844,444
$XE G 344,444.BI9/ G B66,944,444
$X+ G 64,444.BI6/ G B>,DD4,444
The total mar,et %alue of the compan! is0
X G B>3,844,444 L 66,944,444 L >,DD4,444 G B3I,ID4,444
?e#t we need to find the cost of funds. We ha%e the information a%aila"le to calculate the cost of
e&uit! using the C)+$, so0
RE G .49 L >.3..48/ G .>9D4 or >9.D4K
The cost of de"t is the \T$ of the compan!s outstanding "onds, so0
+4 G BJ64 G B39.+XI;)RK,34/ L B>,444.+XI;RK,34/
R G 3.JHK
\T$ G 3.JHK Q 6 G I.J6K
)nd the afterta# cost of de"t is0
RE G .> @ .39/..4IJ6/ G .49>9 or 9.>9K
The cost of preferred stoc, is0
R+ G B9-BI6 G .4HJD or H.JDK
B-302
CHAPTER 12 B-
a. The initial cost to the compan! will "e the opportunit! cost of the land, the cost of the plant,
and the net wor,ing capital cash flow, so0
C;4 G @BH,944,444 @ >9,444,444 @ J44,444 G @B66,D44,444
b. To find the re&uired return on this pro:ect, we first need to calculate the W)CC for the
compan!. The compan!s W)CC is0
W)CC G N.B66.9-B3I.ID/..>9D4/ L .B>.DD-B3I.ID/..4HJD/ L .B>3.8-B3I.ID/..49>9/O G .>>33
The compan! wants to use the su":ecti%e approach to this pro:ect "ecause it is located o%erseas.
The ad:ustment factor is 6 percent, so the re&uired return on this pro:ect is0
+ro:ect re&uired return G .>>33 L .46 G .>333
c. The annual depreciation for the e&uipment will "e0
B>9,444,444-8 G B>,8I9,444
So, the "oo, %alue of the e&uipment at the end of fi%e !ears will "e0
AX9 G B>9,444,444 @ 9.B>,8I9,444/ G B9,H69,444
So, the afterta# sal%age %alue will "e0
)fterta# sal%age %alue G B9,444,444 L .39.B9,H69,444 @ 9,444,444/ G B9,6>8,I94
d. <sing the ta# shield approach, the 'C; for this pro:ect is0
'C; G N.+ @ %/Y @ ;CO.> @ t/ L tCE
'C; G N.B>4,444 @ J,444/.>6,444/ @ D44,444O.> @ .39/ L .39.B>9$-8/ G B8,>JH,694
e. The accounting "rea,e%en sales figure for this pro:ect is0
Y) G .;C L E/-.+ @ %/ G .BD44,444 L >,8I9,444/-.B>4,444 @ J,444/ G 6,6I9 units
303
SOLUTIONS
f. We ha%e calculated all cash flows of the pro:ect. We :ust need to ma,e sure that in \ear 9 we
add "ac, the afterta# sal%age %alue, the reco%er! of the initial ?WC, and the afterta# %alue of
the land. The cash flows for the pro:ect are0
Aear Flow 'ash
4 @B66,D44,444
> 8,>JH,694
6 8,>JH,694
3 8,>JH,694
D 8,>JH,694
9 >8,8>9,444
<sing the re&uired return of >3.33 percent, the ?+X of the pro:ect is0
?+X G @B66,D44,444 L B8,>JH,694.+XI;)>3.33K,D/ L B>8,8>9,444->.>333
9
?+X G B>>,8I8,H>4.I8
)nd the IRR is0
?+X G 4 G @B66,D44,444 L B8,>JH,694.+XI;)IRRK,D/ L B>8,8>9,444-.> L IRR/
9
IRR G 34.8IK
B-304
CHAPTER 13
C0R%0RA1 /*)A)C*)3 81C*$*0)$
A)8 1//*C*1) CA%*A6 .AR:1$
Answers to Concepts Review and Critical !in"in# Questions
1. To create %alue, firms should accept financing proposals with positi%e net present %alues. ;irms can
create %alua"le financing opportunities in three wa!s0 >/ ;ool in%estors. ) firm can issue a comple#
securit! to recei%e more than the fair mar,et %alue. ;inancial managers attempt to pac,age securities
to recei%e the greatest %alue. 6/ Reduce costs or increase su"sidies. ) firm can pac,age securities to
reduce ta#es. Such a securit! will increase the %alue of the firm. In addition, financing techni&ues
in%ol%e man! costs, such as accountants, law!ers, and in%estment "an,ers. +ac,aging securities in a
wa! to reduce these costs will also increase the %alue of the firm. 3/ Create a new securit!. )
pre%iousl! unsatisfied in%estor ma! pa! e#tra for a specialied securit! catering to his or her needs.
Corporations gain from de%eloping uni&ue securities "! issuing these securities at premium prices.
2. The three forms of the efficient mar,ets h!pothesis are0 >/ Wea, form. $ar,et prices reflect
information contained in historical prices. In%estors are una"le to earn a"normal returns using
historical prices to predict future price mo%ements. 6/ Semi*strong form. In addition to historical
data, mar,et prices reflect all pu"licl!*a%aila"le information. In%estors with insider, or pri%ate
information, are a"le to earn a"normal returns. 3/ Strong form. $ar,et prices reflect all information,
pu"lic or pri%ate. In%estors are una"le to earn a"normal returns using insider information or
historical prices to predict future price mo%ements.
3. a. ;alse. $ar,et efficienc! implies that prices reflect all a%aila"le information, "ut it does not
impl! certain ,nowledge. $an! pieces of information that are a%aila"le and reflected in prices
are fairl! uncertain. Efficienc! of mar,ets does not eliminate that uncertaint! and therefore
does not impl! perfect forecasting a"ilit!.
b. True. $ar,et efficienc! e#ists when prices reflect all a%aila"le information. To "e efficient in
the wea, form, the mar,et must incorporate all historical data into prices. <nder the semi*
strong form of the h!pothesis, the mar,et incorporates all pu"licl!*a%aila"le information in
addition to the historical data. In strong form efficient mar,ets, prices reflect all pu"licl! and
pri%atel! a%aila"le information.
c. ;alse. $ar,et efficienc! implies that mar,et participants are rational. Rational people will
immediatel! act upon new information and will "id prices up or down to reflect that
information.
d. ;alse. In efficient mar,ets, prices reflect all a%aila"le information. Thus, prices will fluctuate
whene%er new information "ecomes a%aila"le.
SOLUTIONS
e. True. Competition among in%estors results in the rapid transmission of new mar,et
information. In efficient mar,ets, prices immediatel! reflect new information as in%estors "id
the stoc, price up or down.
4. 'n a%erage, the onl! return that is earned is the re&uired returnlin%estors "u! assets with returns in
e#cess of the re&uired return .positi%e ?+X/, "idding up the price and thus causing the return to fall
to the re&uired return .ero ?+X/( in%estors sell assets with returns less than the re&uired return
.negati%e ?+X/, dri%ing the price lower and thus causing the return to rise to the re&uired return
.ero ?+X/.
5. The mar,et is not wea, form efficient.
6. \es, historical information is also pu"lic information( wea, form efficienc! is a su"set of semi*
strong form efficienc!.
7. Ignoring trading costs, on a%erage, such in%estors merel! earn what the mar,et offers( the trades all
ha%e ero ?+X. If trading costs e#ist, then these in%estors lose "! the amount of the costs.
8. <nli,e gam"ling, the stoc, mar,et is a positi%e sum game( e%er!"od! can win. )lso, speculators
pro%ide li&uidit! to mar,ets and thus help to promote efficienc!.
9. The E$5 onl! sa!s, within the "ounds of increasingl! strong assumptions a"out the information
processing of in%estors, that assets are fairl! priced. )n implication of this is that, on a%erage, the
t!pical mar,et participant cannot earn e#cessi%e profits from a particular trading strateg!. 5owe%er,
that does not mean that a few particular in%estors cannot outperform the mar,et o%er a particular
in%estment horion. Certain in%estors who do well for a period of time get a lot of attention from the
financial press, "ut the scores of in%estors who do not do well o%er the same period of time generall!
get considera"l! less attention from the financial press.
10. a. If the mar,et is not wea, form efficient, then this information could "e acted on and a profit
earned from following the price trend. <nder .6/, .3/, and .D/, this information is full!
impounded in the current price and no a"normal profit opportunit! e#ists.
b. <nder .6/, if the mar,et is not semi*strong form efficient, then this information could "e used to
"u! the stoc, 1cheap8 "efore the rest of the mar,et disco%ers the financial statement anomal!.
Since .6/ is stronger than .>/, "oth impl! that a profit opportunit! e#ists( under .3/ and .D/, this
information is full! impounded in the current price and no profit opportunit! e#ists.
c. <nder .3/, if the mar,et is not strong form efficient, then this information could "e used as a
profita"le trading strateg!, "! noting the "u!ing acti%it! of the insiders as a signal that the stoc,
is underpriced or that good news is imminent. Since .>/ and .6/ are wea,er than .3/, all three
impl! that a profit opportunit! e#ists. ?ote that this assumes the indi%idual who sees the insider
trading is the onl! one who sees the trading. If the information a"out the trades made "!
compan! management is pu"lic information, it will "e discounted in the stoc, price and no
profit opportunit! e#ists. <nder .D/, this information does not signal an! profit opportunit! for
traders( an! pertinent information the manager*insiders ma! ha%e is full! reflected in the
current share price.
11. ) technical anal!st would argue that the mar,et is not efficient. Since a technical anal!st e#amines
past prices, the mar,et cannot "e wea, form efficient for technical anal!sis to wor,. If the mar,et is
not wea, form efficient, it cannot "e efficient under stronger assumptions a"out the information
a%aila"le.
B-306
CHAPTER 13 B-
12. Investor sentiment captures the mood of the investing public. If investors are bearish in general, it
may be that the market is headed down in the future since investors are less likely to invest. If the
sentiment is bullish, it would be taken as a positive signal to the market. To use investor sentiment in
technical analysis, you would probably want to construct a ratio such as a bulls/bears ratio. To use
the ratio, simply compare the historical ratio to the market to determine if a certain level on the ratio
indicates a market upturn or downturn.
13. Ta,en at face %alue, this fact suggests that mar,ets ha%e "ecome more efficient. The increasing ease
with which information is a%aila"le o%er the Internet lends strength to this conclusion. 'n the other
hand, during this particular period, large*capitaliation growth stoc,s were the top performers.
Xalue*weighted inde#es such as the SF+ 944 are naturall! concentrated in such stoc,s, thus ma,ing
them especiall! hard to "eat during this period. So, it ma! "e that the dismal record compiled "! the
pros is :ust a matter of "ad luc, or "enchmar, error.
14. It is li,el! the mar,et has a "etter estimate of the stoc, price, assuming it is semistrong form
efficient. 5owe%er, semistrong form efficienc! onl! states that !ou cannot easil! profit from
pu"licl! a%aila"le information. If financial statements are not a%aila"le, the mar,et can still price
stoc,s "ased upon the a%aila"le pu"lic information, limited though it ma! "e. Therefore, it ma! ha%e
"een as difficult to e#amine the limited pu"lic information and ma,e an e#tra return.
15. a. )erotechs stoc, price should rise immediatel! after the announcement of the positi%e news.
b. 'nl! scenario .ii/ indicates mar,et efficienc!. In that case, the price of the stoc, rises
immediatel! to the le%el that reflects the new information, eliminating all possi"ilit! of
a"normal returns. In the other two scenarios, there are periods of time during which an in%estor
could trade on the information and earn a"normal returns.
16. ;alse. The stoc, price would ha%e ad:usted "efore the founders death onl! if in%estors had perfect
forecasting a"ilit!. The >6.9 percent increase in the stoc, price after the founders death indicates
that either the mar,et did not anticipate the death or that the mar,et had anticipated it imperfectl!.
5owe%er, the mar,et reacted immediatel! to the new information, impl!ing efficienc!. It is
interesting that the stoc, price rose after the announcement of the founders death. This price
"eha%ior indicates that the mar,et felt he was a lia"ilit! to the firm.
17. The announcement should not deter in%estors from "u!ing <+Cs stoc,. If the mar,et is semi*strong
form efficient, the stoc, price will ha%e alread! reflected the present %alue of the pa!ments that <+C
must ma,e. The e#pected return after the announcement should still "e e&ual to the e#pected return
"efore the announcement. <+Cs current stoc,holders "ear the "urden of the loss, since the stoc,
price falls on the announcement. )fter the announcement, the e#pected return mo%es "ac, to its
original le%el.
18. The mar,et is often considered to "e relati%el! efficient up to the semi*strong form. If so, no
s!stematic profit can "e made "! trading on pu"licl!*a%aila"le information. )lthough illegal, the
lead engineer of the de%ice can profit from purchasing the firms stoc, before the news release on
the implementation of the new technolog!. The price should immediatel! and full! ad:ust to the new
information in the article. Thus, no a"normal return can "e e#pected from purchasing after the
pu"lication of the article. .
307
SOLUTIONS
19. <nder the semi*strong form of mar,et efficienc!, the stoc, price should sta! the same. The
accounting s!stem changes are pu"licl! a%aila"le information. In%estors would identif! no changes
in either the firms current or its future cash flows. Thus, the stoc, price will not change after the
announcement of increased earnings.
20. Aecause the num"er of su"scri"ers has increased dramaticall!, the time it ta,es for information in
the newsletter to "e reflected in prices has shortened. With shorter ad:ustment periods, it "ecomes
impossi"le to earn a"normal returns with the information pro%ided "! Eur,in. If Eur,in is using
onl! pu"licl!*a%aila"le information in its newsletter, its a"ilit! to pic, stoc,s is inconsistent with the
efficient mar,ets h!pothesis. <nder the semi*strong form of mar,et efficienc!, all pu"licl!*a%aila"le
information should "e reflected in stoc, prices. The use of pri%ate information for trading purposes
is illegal.
21. \ou should not agree with !our "ro,er. The performance ratings of the small manufacturing firms
were pu"lished and "ecame pu"lic information. +rices should ad:ust immediatel! to the information,
thus pre%enting future a"normal returns.
22. Stoc, prices should immediatel! and full! rise to reflect the announcement. Thus, one cannot e#pect
a"normal returns following the announcement.
23. a. ?o. Earnings information is in the pu"lic domain and reflected in the current stoc, price.
b. +ossi"l!. If the rumors were pu"licl! disseminated, the prices would ha%e alread! ad:usted for
the possi"ilit! of a merger. If the rumor is information that !ou recei%ed from an insider, !ou
could earn e#cess returns, although trading on that information is illegal.
c. ?o. The information is alread! pu"lic, and thus, alread! reflected in the stoc, price.
24. Serial correlation occurs when the current %alue of a %aria"le is related to the future %alue of the
%aria"le. If the mar,et is efficient, the information a"out the serial correlation in the macroeconomic
%aria"le and its relationship to net earnings should alread! "e reflected in the stoc, price. In other
words, although there is serial correlation in the %aria"le, there will not "e serial correlation in stoc,
returns. Therefore, ,nowledge of the correlation in the macroeconomic %aria"le will not lead to
a"normal returns for in%estors.
25. The statement is false "ecause e%er! in%estor has a different ris, preference. )lthough the e#pected
return from e%er! well*di%ersified portfolio is the same after ad:usting for ris,, in%estors still need to
choose funds that are consistent with their particular ris, le%el.
26. The share price will decrease immediatel! to reflect the new information. )t the time of the
announcement, the price of the stoc, should immediatel! decrease to reflect the negati%e
information.
B-308
CHAPTER 13 B-
27. In an efficient mar,et, the cumulati%e a"normal return .C)R/ for +rospectors would rise
su"stantiall! at the announcement of a new disco%er!. The C)R falls slightl! on an! da! when no
disco%er! is announced. There is a small positi%e pro"a"ilit! that there will "e a disco%er! on an!
gi%en da!. If there is no disco%er! on a particular da!, the price should fall slightl! "ecause the good
e%ent did not occur. The su"stantial price increases on the rare da!s of disco%er! should "alance the
small declines on the other da!s, lea%ing C)Rs that are horiontal o%er time.
28. Aeha%ioral finance attempts to e#plain "oth the >J8I stoc, mar,et crash and the Internet "u""le "!
changes in in%estor sentiment and ps!cholog!. These changes can lead to non*random price
"eha%ior.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. To find the cumulati%e a"normal returns, we chart the a"normal returns for each of the three airlines
for the da!s preceding and following the announcement. . The a"normal return is calculated "!
su"tracting the mar,et return from a stoc,s return on a particular da!, <i 7 <M. Rroup the returns "!
the num"er of da!s "efore or after the announcement for each respecti%e airline. Calculate the
cumulati%e a%erage a"normal return "! adding each a"normal return to the pre%ious da!s a"normal
return.
)"normal returns . < i 7 < M/
Ea!s from
announcement Eelta <nited )merican Sum
)%erage
a"normal return
Cumulati%e
a%erage residual
@D @4.6 @4.6 @4.6 @4.H @4.6 @4.6
@3 4.6 @4.> 4.6 4.3 4.> @4.>
@6 4.6 @4.6 4.4 4.4 4.4 @4.>
@> 4.6 4.6 @4.D 4.4 4.4 @4.>
4 3.3 4.6 >.J 9.D >.8 >.I
> 4.6 4.> 4.4 4.3 4.> >.8
6 @4.> 4.4 4.> 4.4 4.4 >.8
3 @4.6 4.> @4.6 @4.3 @4.> >.I
D @4.> @4.> @4.> @4.3 @4.> >.H
309
SOLUTIONS
The mar,et reacts fa%ora"l! to the announcements. $oreo%er, the mar,et reacts onl! on the da! of
the announcement. Aefore and after the e%ent, the cumulati%e a"normal returns are relati%el! flat.
This "eha%ior is consistent with mar,et efficienc!.
2. The diagram does not support the efficient mar,ets h!pothesis. The C)R should remain relati%el!
flat following the announcements. The diagram re%eals that the C)R rose in the first month, onl! to
drift down to lower le%els during later months. Such mo%ement %iolates the semi*strong form of the
efficient mar,ets h!pothesis "ecause an in%estor could earn a"normal profits while the stoc, price
graduall! decreased.
3. a. Supports. The C)R remained constant after the e%ent at time 4. This result is consistent with
mar,et efficienc!, "ecause prices ad:ust immediatel! to reflect the new information. Erops in
C)R prior to an e%ent can easil! occur in an efficient capital mar,et. ;or e#ample, consider a
sample of forced remo%als of the CE'. Since an! CE' is more li,el! to "e fired following "ad
rather than good stoc, performance, C)Rs are li,el! to "e negati%e prior to remo%al. Aecause
the firing of the CE' is announced at time 4, one cannot use this information to trade profita"l!
before the announcement. Thus, price drops prior to an e%ent are neither consistent nor
inconsistent with the efficient mar,ets h!pothesis.
b. Re:ects. Aecause the C)R increases after the e%ent date, one can profit "! "u!ing after the
e%ent. This possi"ilit! is inconsistent with the efficient mar,ets h!pothesis.
c. Supports. The C)R does not fluctuate after the announcement at time 4. While the C)R was
rising "efore the e%ent, insider information would "e needed for profita"le trading. Thus, the
graph is consistent with the semi*strong form of efficient mar,ets.
Cumulati%e )"normal Returns
*4.6
*4.> *4.> *4.>
>.I
>.8 >.8
>.I
>.H
*4.9
4
4.9
>
>.9
6
*D *3 *6 *> 4 > 6 3 D
Ea!s from announcement
C
)
R
B-310
CHAPTER 13 B-
d. Supports. The diagram indicates that the information announced at time 4 was of no %alue.
There appears to "e a slight drop in the C)R prior to the e%ent da!. Similar to part a, such
mo%ement is neither consistent nor inconsistent with the efficient mar,ets h!pothesis .E$5/.
$o%ements at the e%ent date are neither consistent nor inconsistent with the efficient mar,ets
h!pothesis.
4. 'nce the %erdict is reached, the diagram shows that the C)R continues to decline after the court
decision, allowing in%estors to earn a"normal returns. The C)R should remain constant on a%erage,
e%en if an appeal is in progress, "ecause no new information a"out the compan! is "eing re%ealed.
Thus, the diagram is not consistent with the efficient mar,ets h!pothesis .E$5/.
311
CHAPTER 14
LONG-TERM FINANCING: AN
INTRODUCTION
Answers to Concepts Review and Critical !in"in# Questions
1. The differences "etween preferred stoc, and de"t are0
a. The di%idends on preferred stoc, cannot "e deducted as interest e#pense when determining
ta#a"le corporate income. ;rom the indi%idual in%estors point of %iew, preferred di%idends are
ordinar! income for ta# purposes. ;rom corporate in%estors, I4K of the amount the! recei%e as
di%idends from preferred stoc, are e#empt from income ta#es.
b. In case of li&uidation .at "an,ruptc!/, preferred stoc, is :unior to de"t and senior to common
stoc,.
c. There is no legal o"ligation for firms to pa! out preferred di%idends as opposed to the o"ligated
pa!ment of interest on "onds. Therefore, firms cannot "e forced into default if a preferred stoc,
di%idend is not paid in a gi%en !ear. +referred di%idends can "e cumulati%e or non*cumulati%e,
and the! can also "e deferred indefinitel! .of course, indefinitel! deferring the di%idends might
ha%e an undesira"le effect on the mar,et %alue of the stoc,/.
2. Some firms can "enefit from issuing preferred stoc,. The reasons can "e0
a. +u"lic utilities can pass the ta# disad%antage of issuing preferred stoc, on to their customers, so
there is su"stantial amount of straight preferred stoc, issued "! utilities.
b. ;irms reporting losses to the IRS alread! dont ha%e positi%e income for an! ta# deductions, so
the! are not affected "! the ta# disad%antage of di%idends %ersus interest pa!ments. The! ma!
"e willing to issue preferred stoc,.
c. ;irms that issue preferred stoc, can a%oid the threat of "an,ruptc! that e#ists with de"t
financing "ecause preferred di%idends are not a legal o"ligation li,e interest pa!ments on
corporate de"t.
3. The return on non*con%erti"le preferred stoc, is lower than the return on corporate "onds for two
reasons0 >/ Corporate in%estors recei%e I4 percent ta# deducti"ilit! on di%idends if the! hold the
stoc,. Therefore, the! are willing to pa! more for the stoc,( that lowers its return. 6/ Issuing
corporations are willing and a"le to offer higher returns on de"t since the interest on the de"t reduces
their ta# lia"ilities. +referred di%idends are paid out of net income, hence the! pro%ide no ta# shield.
Corporate in%estors are the primar! holders of preferred stoc, since, unli,e indi%idual in%estors, the!
can deduct I4 percent of the di%idend when computing their ta# lia"ilities. Therefore, the! are
willing to accept the lower return that the stoc, generates.
CHAPTER 14 B-
4. The following ta"le summaries the main difference "etween de"t and e&uit!0
Ee"t E&uit!
Repa!ment is an o"ligation of the firm \es ?o
Rrants ownership of the firm ?o \es
+ro%ides a ta# shield \es ?o
Ci&uidation will result if not paid \es ?o
Companies often issue h!"rid securities "ecause of the potential ta# shield and the "an,ruptc!
ad%antage. If the IRS accepts the securit! as de"t, the firm can use it as a ta# shield. If the securit!
maintains the "an,ruptc! and ownership ad%antages of e&uit!, the firm has the "est of "oth worlds.
5. The trends in long*term financing in the <nited States were presented in the te#t. If Ca"le Compan!
follows the trends, it will pro"a"l! use a"out 84 percent internal financing @ net income of the
pro:ect plus depreciation less di%idends @ and 64 percent e#ternal financing, long*term de"t and
e&uit!.
6. It is the grant of authorit! "! a shareholder to someone else to %ote his or her shares.
7. +referred stoc, is similar to "oth de"t and common e&uit!. +referred shareholders recei%e a stated
di%idend onl!, and if the corporation is li&uidated, preferred stoc,holders get a stated %alue.
5owe%er, unpaid preferred di%idends are not de"ts of a compan! and preferred di%idends are not a
ta# deducti"le "usiness e#pense.
8. ) compan! has to issue more de"t to replace the old de"t that comes due if the compan! wants to
maintain its capital structure. There is also the possi"ilit! that the mar,et %alue of a compan!
continues to increase .we hope/. This also means that to maintain a specific capital structure on a
mar,et %alue "asis the compan! has to issue new de"t, since the mar,et %alue of e#isting de"t
generall! does not increase as the %alue of the compan! increases .at least "! not as much/.
9. Internal financing comes from internall! generated cash flows and does not re&uire issuing
securities. In contrast, e#ternal financing re&uires the firm to issue new securities.
10. The three "asic factors that affect the decision to issue e#ternal e&uit! are0 >/ The general economic
en%ironment, specificall!, "usiness c!cles. 6/ The le%el of stoc, prices, and 3/ The a%aila"ilit! of
positi%e ?+X pro:ects.
$olutions to Questions and %ro&le's
NOTE: All end of chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. Since the common stoc, entr! in the "alance sheet represents the total par %alue of the stoc,,
simpl! di%ide that "! the par per share0
Shares outstanding G B>H9,364 - B4.94
Shares outstanding G 334,HD4
313
SOLUTIONS
b. Capital surplus is the amount recei%ed o%er par, so capital surplus plus par gi%es !ou the total
dollars recei%ed. In aggregate, the solution is0
?et capital from the sale of shares G Common Stoc, L Capital Surplus
?et capital from the sale of shares G B>H9,364 L 6,8IH,>D9
?et capital from the sale of shares G B3,4D>,469
Therefore, the a%erage price is0
)%erage price G B3,4D>,DH9 - 334,HD4
)%erage price G BJ.64 per share
)lternati%el!, !ou can do this per share0
)%erage price G +ar %alue L )%erage capital surplus
)%erage price G B4.94 L B6,8IH,>D9 - 334,DH4
)%erage price G BJ.64 per share
c. The "oo, %alue per share is the total "oo, %alue of e&uit! di%ided "! the shares outstanding, or0
Aoo, %alue per share G B9,D>>,DJ4 - 334,HD4
Aoo, %alue per share G B>H.3I
2. a. The common stoc, account is the shares outstanding times the par %alue per share, or0
Common stoc, G 944.=6/
Common stoc, G =>,444
So, the total e&uit! account is0
Total e&uit! G =>,444 L 694,444 L I94,444
Total e&uit! G =>,44>,444

b. The capital surplus on the sale of the new shares of stoc, is the price per share a"o%e par times
the shares sold, or0
Capital surplus on sale G .=34 @ 6/.9,444/
Capital surplus on sale G =>D4,444
So, the new e&uit! accounts will "e0
Common stoc,, =6 par %alue
9,944 shares outstanding = >>,444
Capital surplus 3J4,444
Retained earnings I94,444
Total =>,>9>,444
B-314
CHAPTER 14 B-
3. a. ;irst, we will find the common stoc, account %alue, which is the shares outstanding times the
par %alue, or0
Common stoc, G D>4,444.9/
Common stoc, G 6,494,444
The capital surplus account is the amount paid for the stoc, o%er par %alue. Since the stoc, was
sold at an a%erage premium of 34 percent to par %alue, the a%erage stoc, price when sold was0
)%erage stoc, price when sold G 9.>.34/
)%erage stoc, price G H.94
So, the capital surplus is0
Capital surplus G .)%erage sale price @ +ar/.?um"er of shares/
Capital surplus G .H.94 @ 9/.D>4,444/
Capital surplus G H>9,444
)nd the new retained earnings "alance will "e0
Retained earnings G +re%ious retained earnings L ?et income @ Ei%idends
Retained earnings G 3,9D9,444 L H94,444 @ .H94,444/.4.34/
Retained earnings G D,444,444
So, the e&uit! accounts will "e0
Common stoc,, 9 par %alue 6,494,444
Capital surplus H>9,444
Retained earnings D,444,444
Total H,HH9,444
b. The onl! account that will change is the capital surplus account. The new capital surplus will
"e0
Capital surplus G +re%ious capital surplus, L Surplus from sale of new issues
Capital surplus G H>9,444 L .Sales price @ +ar %alue/.?um"er of shares sold/
Capital surplus G H>9,444 L .D @ 9/.69,444/
Capital surplus G 9J4,444
?ote that "ecause the stoc, was sold for less than par %alue, the additional capital surplus from
the sale of the stoc, is negati%e.
So, the new e&uit! accounts will "e0
Common stoc,, 9 par %alue 6,494,444
Capital surplus 9J4,444
Retained earnings D,444,444
Total H,HHD,444
315
SOLUTIONS
4. If the compan! uses straight %oting, the "oard of directors is elected one at a time. \ou will need to
own one*half of the shares, plus one share, in order to guarantee enough %otes to win the election.
So, the num"er of shares needed to guarantee election under straight %oting will "e0
Shares needed G .944,444 shares - 6/ L >
Shares needed G 694,44>
)nd the total cost to !ou will "e the shares needed times the price per share, or0
Total cost G 694,44> V>4,9I6
Total cost G V6,HD3,4>4,9I6
If the compan! uses cumulati%e %oting, the "oard of directors are all elected at once. \ou will need
>-.N L >/ percent of the stoc, .plus one share/ to guarantee election, where N is the num"er of seats
up for election. So, the percentage of the compan!s stoc, !ou need is0
+ercent of stoc, needed G >-.N L >/
+ercent of stoc, needed G > - .I L >/
+ercent of stoc, needed G .>694 or >6.94K
So, the num"er of shares !ou need to purchase is0
?um"er of shares to purchase G .944,444 Q .>694/ L >
?um"er of shares to purchase G H6,94>
)nd the total cost to !ou will "e the shares needed times the price per share, or0
Total cost G H6,94> V>4,9I6
Total cost G VHH4,IH4,9I6
5. If the compan! uses cumulati%e %oting, the "oard of directors are all elected at once. \ou will need
>-.N L >/ percent of the stoc, .plus one share/ to guarantee election, where N is the num"er of seats
up for election. So, the percentage of the compan!s stoc, !ou need is0
+ercent of stoc, needed G >-.N L >/
+ercent of stoc, needed G > - .3 L >/
+ercent of stoc, needed G .69 or 69K
So, the num"er of shares !ou need is0
?um"er of shares to purchase G .6,944 Q .69/ L >
?um"er of shares to purchase G H6H
So, the num"er of additional shares !ou need to purchase is0
?ew shares to purchase G H6H @ 344
?ew shares to purchase G 36H
6. If the compan! uses cumulati%e %oting, the "oard of directors are all elected at once. \ou will need
>-.N L >/ percent of the stoc, .plus one share/ to guarantee election, where N is the num"er of seats
up for election. So, the percentage of the compan!s stoc, !ou need is0
B-316
CHAPTER 14 B-
+ercent of stoc, needed G >-.N L >/
+ercent of stoc, needed G > - .3 L >/
+ercent of stoc, needed G .69 or 69K
So, the num"er of shares !ou need to purchase is0
?um"er of shares to purchase G .6,444,444 Q .69/ L >
?um"er of shares to purchase G 944,44>
)nd the total cost will "e the shares needed times the price per share, or0
Total cost G 944,44> Rs.D64
Total cost G Rs.6>4,444,D64
7. <nder cumulati%e %oting, she will need >-.N L >/ percent of the stoc, .plus one share/ to guarantee
election, where N is the num"er of seats up for election. So, the percentage of the compan!s stoc,
she needs is0
+ercent of stoc, needed G >-.N L >/
+ercent of stoc, needed G > - .8 L >/
+ercent of stoc, needed G .>>>> or >>.>>K
5er nominee is guaranteed election. If the elections are staggered, the percentage of the compan!s
stoc, needed is0
+ercent of stoc, needed G >-.N L >/
+ercent of stoc, needed G > - .D L >/
+ercent of stoc, needed G .64 or 64K
5er nominee is no longer guaranteed election.
317
CHAPTER 15
CA%*A6 $R7C7R1< BASIC
CONCEPTS
Answers to Concepts Review and Critical !in"in# Questions
1. )ssumptions of the $odigliani*$iller theor! in a world without ta#es0 >/ Indi%iduals can "orrow at
the same interest rate at which the firm "orrows. Since in%estors can purchase securities on margin,
an indi%iduals effecti%e interest rate is pro"a"l! no higher than that for a firm. Therefore, this
assumption is reasona"le when appl!ing $$s theor! to the real world. If a firm were a"le to
"orrow at a rate lower than indi%iduals, the firms %alue would increase through corporate le%erage.
)s $$ +roposition I states, this is not the case in a world with no ta#es. 6/ There are no ta#es. In
the real world, firms do pa! ta#es. In the presence of corporate ta#es, the %alue of a firm is positi%el!
related to its de"t le%el. Since interest pa!ments are deducti"le, increasing de"t reduces ta#es and
raises the %alue of the firm. 3/ There are no costs of financial distress. In the real world, costs of
financial distress can "e su"stantial. Since stoc,holders e%entuall! "ear these costs, there are
incenti%es for a firm to lower the amount of de"t in its capital structure. This topic will "e discussed
in more detail in later chapters.
2. ;alse. ) reduction in le%erage will decrease "oth the ris, of the stoc, and its e#pected return.
$odigliani and $iller state that, in the a"sence of ta#es, these two effects e#actl! cancel each other
out and lea%e the price of the stoc, and the o%erall %alue of the firm unchanged.
3. ;alse. $odigliani*$iller +roposition II .?o Ta#es/ states that the re&uired return on a firms e&uit!
is positi%el! related to the firms de"t*e&uit! ratio NRS G R4 L .A-S/.R4 @ RA/O. Therefore, an!
increase in the amount of de"t in a firms capital structure will increase the re&uired return on the
firms e&uit!.
4. Interest pa!ments are ta# deducti"le, where pa!ments to shareholders .di%idends/ are not ta#
deducti"le.
5. Ausiness ris, is the e&uit! ris, arising from the nature of the firms operating acti%it!, and is directl!
related to the s!stematic ris, of the firms assets. ;inancial ris, is the e&uit! ris, that is due entirel!
to the firms chosen capital structure. )s financial le%erage, or the use of de"t financing, increases,
so does financial ris, and, hence, the o%erall ris, of the e&uit!. Thus, ;irm A could ha%e a higher
cost of e&uit! if it uses greater le%erage.
6. ?o, it doesnt follow. While it is true that the e&uit! and de"t costs are rising, the ,e! thing to
remem"er is that the cost of de"t is still less than the cost of e&uit!. Since we are using more and
more de"t, the W)CC does not necessaril! rise.
CHAPTER 15 B-
7. Aecause man! rele%ant factors such as "an,ruptc! costs, ta# as!mmetries, and agenc! costs cannot
easil! "e identified or &uantified, it is practicall! impossi"le to determine the precise de"t-e&uit!
ratio that ma#imies the %alue of the firm. 5owe%er, if the firms cost of new de"t suddenl! "ecomes
much more e#pensi%e, its pro"a"l! true that the firm is too highl! le%eraged.
8. Its called le%erage .or 1gearing8 in the <M/ "ecause it magnifies gains or losses.
9. 5omemade le%erage refers to the use of "orrowing on the personal le%el as opposed to the corporate
le%el.
10. The "asic goal is to minimie the %alue of non*mar,eted claims.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. ) ta"le outlining the income statement for the three possi"le states of the econom! is shown
"elow. The E+S is the net income di%ided "! the 6,944 shares outstanding. The last row shows
the percentage change in E+S the compan! will e#perience in a recession or an e#pansion
econom!.
Recession ?ormal E#pansion
EAIT 2D,644 2>D,444 2>J,H44
Interest 4 4 4
?I 2D,644 2>D,444 2>J,H44
E+S 2 >.H8 2 9.H4 2 I.8D
K E+S
@I4 @@@ LD4
b. If the compan! undergoes the proposed recapitaliation, it will repurchase0
Share price G E&uit! - Shares outstanding
Share price G 2>94,444-6,944
Share price G 2H4
Shares repurchased G Ee"t issued - Share price
Shares repurchased G2H4,444-2H4
Shares repurchased G >,444
The interest pa!ment each !ear under all three scenarios will "e0
Interest pa!ment G 2H4,444..49/ G 23,444
319
SOLUTIONS
The last row shows the percentage change in E+S the compan! will e#perience in a recession
or an e#pansion econom! under the proposed recapitaliation.
Recession ?ormal E#pansion
EAIT 2D,644 2>D,444 2>J,H44
Interest 3,444 3,444 3,444
?I 2>,644 2>>,444 2>H,H44
E+S 24.84 2 I.33 2>>.4I
K E+S
@8J.4J @@@ L94.J>
2. a. ) ta"le outlining the income statement with ta#es for the three possi"le states of the econom! is
shown "elow. The share price is still 2H4, and there are still 6,944 shares outstanding. The last
row shows the percentage change in E+S the compan! will e#perience in a recession or an
e#pansion econom!.
Recession ?ormal E#pansion
EAIT 2D,644 2>D,444 2>J,H44
Interest 4 4 4
Ta#es >,H84 9,H44 I,8D4
?I 26,964 28,D44 2>>,IH4
E+S 2>.4> 23.3H 2D.I4
K E+S
@I4 @@@ LD4
b. ) ta"le outlining the income statement with ta#es for the three possi"le states of the econom!
and assuming the compan! underta,es the proposed capitaliation is shown "elow. The interest
pa!ment and shares repurchased are the same as in part b of +ro"lem >.
Recession ?ormal E#pansion
EAIT 2D,644 2>D,444 2>J,H44
Interest 3,444 3,444 3,444
Ta#es D84 D,D44 H,HD4
?I 2I64 2H,H44 2J,JH4
E+S 2.D8 2D.D4 2H.HD
K E+S
@8J.4J @@@ L94.J>
?otice that the percentage change in E+S is the same "oth with and without ta#es.
3. a. Since the compan! has a mar,et*to*"oo, ratio of >.4, the total e&uit! of the firm is e&ual to the
mar,et %alue of e&uit!. <sing the e&uation for R'E0
R'E G ?I-2>94,444
B-320
CHAPTER 15 B-
The R'E for each state of the econom! under the current capital structure and no ta#es is0
Recession ?ormal E#pansion
R'E .4684 .4J33 .>34I
K R'E
@I4 @@@ LD4
The second row shows the percentage change in R'E from the normal econom!.
b. If the compan! underta,es the proposed recapitaliation, the new e&uit! %alue will "e0
E&uit! G 2>94,444 @ H4,444
E&uit! G 2J4,444
So, the R'E for each state of the econom! is0
R'E G ?I-2J4,444
Recession ?ormal E#pansion
R'E .4>33 .>666 .>8DD
K R'E
@8J.4J @@@ L94.J>
c. If there are corporate ta#es and the compan! maintains its current capital structure, the R'E is0
R'E .4>H8 .49H4 .4I8D
K R'E
@I4 @@@ LD4
If the compan! underta,es the proposed recapitaliation, and there are corporate ta#es, the R'E
for each state of the econom! is0
R'E .4484 .4I33 .>>4I
K R'E
@8J.4J @@@ L94.J>
?otice that the percentage change in R'E is the same as the percentage change in E+S. The
percentage change in R'E is also the same with or without ta#es.
4. a. <nder +lan I, the unle%ered compan!, net income is the same as EAIT with no corporate ta#.
The E+S under this capitaliation will "e0
E+S G R2644,444->94,444 shares
E+S G R2>.33
<nder +lan II, the le%ered compan!, EAIT will "e reduced "! the interest pa!ment. The interest
pa!ment is the amount of de"t times the interest rate, so0
?I G R2644,444 @ .>4.R2>,944,444/
?I G R294,444
321
SOLUTIONS
)nd the E+S will "e0
E+S G R294,444-H4,444 shares
E+S G R24.83
+lan I has the higher E+S when EAIT is R2644,444.
b. <nder +lan I, the net income is R2I44,444 and the E+S is0
E+S G R2I44,444->94,444 shares
E+S G R2D.HI
<nder +lan II, the net income is0
?I G R2I44,444 @ .>4.R2>,944,444/
?I G R2994,444
)nd the E+S is0
E+S G R2994,444-H4,444 shares
E+S G R2J.>I
+lan II has the higher E+S when EAIT is R2I44,444.
c. To find the "rea,e%en EAIT for two different capital structures, we simpl! set the e&uations for
E+S e&ual to each other and sol%e for EAIT. The "rea,e%en EAIT is0
EAIT->94,444 G NEAIT @ .>4.R2>,944,444/O-H4,444
EAIT G R2694,444
5. We can find the price per share "! di%iding the amount of de"t used to repurchase shares "! the
num"er of shares repurchased. Eoing so, we find the share price is0
Share price G R2>,944,444-.>94,444 @ H4,444/
Share price G R2>H.HI per share
The %alue of the compan! under the all*e&uit! plan is0
X

G R2>H.HI.>94,444 shares/ G R26,944,444
)nd the %alue of the compan! under the le%ered plan is0
X G R2>H.HI.H4,444 shares/ L R2>,944,444 de"t G R26,944,444
B-322
CHAPTER 15 B-
6. a. The income statement for each capitaliation plan is0
& && All-e!uit
EAIT 2>4,444 2>4,444 2>4,444
Interest >,H94 6,I94 4
?I 28,394 2I,694 2>4,444
E+S 2I.9J 2 8.4H 2 I.>D
+lan II has the highest E+S( the all*e&uit! plan has the lowest E+S.
b. The "rea,e%en le%el of EAIT occurs when the capitaliation plans result in the same E+S. The
E+S is calculated as0
E+S G .EAIT @ REE/-Shares outstanding
This e&uation calculates the interest pa!ment .REE/ and su"tracts it from the EAIT, which
results in the net income. Ei%iding "! the shares outstanding gi%es us the E+S. ;or the all*
e&uit! capital structure, the interest paid is ero. To find the "rea,e%en EAIT for two different
capital structures, we simpl! set the e&uations e&ual to each other and sol%e for EAIT. The
"rea,e%en EAIT "etween the all*e&uit! capital structure and +lan I is0
EAIT->,D44 G NEAIT @ .>4.2>H,944/O->,>44
EAIT G 2I,I44
)nd the "rea,e%en EAIT "etween the all*e&uit! capital structure and +lan II is0
EAIT->,D44 G NEAIT @ .>4.26I,944/O-J44
EAIT G 2I,I44
The "rea,*e%en le%els of EAIT are the same "ecause of $F$ +roposition I.
c. Setting the e&uations for E+S from +lan I and +lan II e&ual to each other and sol%ing for EAIT,
we get0
NEAIT @ .>4.2>H,944/O->,>44 G NEAIT @ .>4.26I,944/O-J44
EAIT G 2I,I44
This "rea,*e%en le%el of EAIT is the same as in part b again "ecause of $F$ +roposition I.
323
SOLUTIONS
d. The income statement for each capitaliation plan with corporate income ta#es is0
& && All-e!uit
EAIT 2>4,444 2>4,444 2>4,444
Interest >,H94 6,I94 4
Ta#es 3,3D4 6,J44 D,444
?I 29,4>4 2D,394 2H,444
E+S 2D.99 2 D.83 2 D.6J
+lan II still has the highest E+S( the all*e&uit! plan still has the lowest E+S.
We can calculate the E+S as0
E+S G N.EAIT @ REE/.> @ tC/O-Shares outstanding
This is similar to the e&uation we used "efore, e#cept that now we need to account for ta#es.
)gain, the interest e#pense term is ero in the all*e&uit! capital structure. So, the "rea,e%en
EAIT "etween the all*e&uit! plan and +lan I is0
EAIT.> @ .D4/->,D44 G NEAIT @ .>4.2>H,944/O.> @ .D4/->,>44
EAIT G 2I,I44
The "rea,e%en EAIT "etween the all*e&uit! plan and +lan II is0
EAIT.> @ .D4/->,D44 G NEAIT @ .>4.26I,944/O.> @ .D4/-J44
EAIT G 2I,I44
)nd the "rea,e%en "etween +lan I and +lan II is0
NEAIT @ .>4.2>H,944/O.> @ .D4/->,>44 G NEAIT @ .>4.26I,944/O.> @ .D4/-J44
EAIT G 2I,I44
The "rea,*e%en le%els of EAIT do not change "ecause the addition of ta#es reduces the income
of all three plans "! the same percentage( therefore, the! do not change relati%e to one another.
B-324
CHAPTER 15 B-
7. To find the %alue per share of the stoc, under each capitaliation plan, we can calculate the price as
the %alue of shares repurchased di%ided "! the num"er of shares repurchased. So, under +lan I, the
%alue per share is0
+ G 2>>,444-644 shares
+ G 299 per share
)nd under +lan II, the %alue per share is0
+ G 26I,944-944 shares
+ G 299 per share
This shows that when there are no corporate ta#es, the stoc,holder does not care a"out the capital
structure decision of the firm. This is $F$ +roposition I without ta#es.
8. a. The earnings per share are0
E+S G Rs.>H,444-6,444 shares
E+S G Rs.8.44
So, the cash flow for the compan! is0
Cash flow G Rs.8.44.>44 shares/
Cash flow G Rs.844
b. To determine the cash flow to the shareholder, we need to determine the E+S of the firm under
the proposed capital structure. The mar,et %alue of the firm is0
X G Rs.I4.6,444/
X G Rs.>D4,444

<nder the proposed capital structure, the firm will raise new de"t in the amount of0
E G 4.D4.Rs.>D4,444/
E G Rs.9H,444
This means the num"er of shares repurchased will "e0
Shares repurchased G Rs.9H,444-Rs.I4
Shares repurchased G 844
<nder the new capital structure, the compan! will ha%e to ma,e an interest pa!ment on the new
de"t. The net income with the interest pa!ment will "e0
?I G Rs.>H,444 @ .48.Rs.9H,444/
?I G Rs.>>,964
325
SOLUTIONS
This means the E+S under the new capital structure will "e0
E+S G Rs.>>,964->,644 shares
E+S G Rs.J.H4
Since all earnings are paid as di%idends, the shareholder will recei%e0
Shareholder cash flow G Rs.J.H4.>44 shares/
Shareholder cash flow G Rs.JH4
c. To replicate the proposed capital structure, the shareholder should sell D4 percent of their
shares, or D4 shares, and lend the proceeds at 8 percent. The shareholder will ha%e an interest
cash flow of0
Interest cash flow G D4.Rs.I4/..48/
Interest cash flow G Rs.66D
The shareholder will recei%e di%idend pa!ments on the remaining H4 shares, so the di%idends
recei%ed will "e0
Ei%idends recei%ed G Rs.J.H4.H4 shares/
Ei%idends recei%ed G Rs.9IH
The total cash flow for the shareholder under these assumptions will "e0
Total cash flow G Rs.66D L 9IH
Total cash flow G Rs.844
This is the same cash flow we calculated in part a.
d. The capital structure is irrele%ant "ecause shareholders can create their own le%erage or unle%er
the stoc, to create the pa!off the! desire, regardless of the capital structure the firm actuall!
chooses.
9. a. The rate of return earned will "e the di%idend !ield. The compan! has de"t, so it must ma,e an
interest pa!ment. The net income for the compan! is0
?I G 2I3,444 @ .>4.2344,444/
?I G 2D3,444
The in%estor will recei%e di%idends in proportion to the percentage of the compan!s share the!
own. The total di%idends recei%ed "! the shareholder will "e0
Ei%idends recei%ed G 2D3,444.234,444-2344,444/
Ei%idends recei%ed G 2D,344
B-326
CHAPTER 15 B-
So the return the shareholder e#pects is0
R G 2D,344-234,444
R G .>D33 or >D.33K
b. To generate e#actl! the same cash flows in the other compan!, the shareholder needs to match
the capital structure of )AC. The shareholder should sell all shares in U\b. This will net
234,444. The shareholder should then "orrow 234,444. This will create an interest cash flow
of0
Interest cash flow G .>4.@234,444/
Interest cash flow G @23,444
The in%estor should then use the proceeds of the stoc, sale and the loan to "u! shares in )AC.
The in%estor will recei%e di%idends in proportion to the percentage of the compan!s share the!
own. The total di%idends recei%ed "! the shareholder will "e0
Ei%idends recei%ed G 2I3,444.2H4,444-2H44,444/
Ei%idends recei%ed G 2I,344
The total cash flow for the shareholder will "e0

Total cash flow G 2I,344 @ 3,444
Total cash flow G 2D,344
The shareholders return in this case will "e0
R G 2D,344-234,444
R G .>D33 or >D.33K
c. )AC is an all e&uit! compan!, so0
RE

G R) G 2I3,444-2H44,444
RE

G .>6>I or >6.>IK
To find the cost of e&uit! for U\b, we need to use $F$ +roposition II, so0
RE G R) L .R) @ RE/.E-E/.> @ tC/
RE G .>6>I L ..>6>I @ .>4/.>/.>/
RE G .>D33 or >D.33K
327
SOLUTIONS
d. To find the W)CC for each compan!, we need to use the W)CC e&uation0
W)CC G .E-X/RE L .E-X/RE.> @ tC/
So, for )AC, the W)CC is0
W)CC G .>/..>6>I/ L .4/..>4/
W)CC G .>6>I or >6.>IK
)nd for U\b, the W)CC is0
W)CC G .>-6/..>D33/ L .>-6/..>4/
W)CC G .>6>I or >6.>IK
When there are no corporate ta#es, the cost of capital for the firm is unaffected "! the capital
structure( this is $F$ +roposition II without ta#es.
10. With no ta#es, the %alue of an unle%ered firm is the interest rate di%ided "! the unle%ered cost of
e&uit!, so0
X G EAIT-W)CC
239,444,444 G EAIT-.>9
EAIT G .>9.239,444,444/
EAIT G 29,694,444
11. If there are corporate ta#es, the %alue of an unle%ered firm is0
X< G EAIT.> @ tC/-R<
<sing this relationship, we can find EAIT as0
239,444,444 G EAIT.> @ .D4/-.>9
EAIT G 28,I94,444
The W)CC remains at >9 percent. Eue to ta#es, EAIT for an all*e&uit! firm would ha%e to "e
higher for the firm to still "e worth 239 million.
12. a. With the information pro%ided, we can use the e&uation for calculating W)CC to find the cost
of e&uit!. The e&uation for W)CC is0
W)CC G .E-X/RE L .E-X/RE.> @ tC/
The compan! has a de"t*e&uit! ratio of >.9, which implies the weight of de"t is >.9-6.9, and the
weight of e&uit! is >-6.9, so
W)CC G .>6 G .>-6.9/RE L .>.9-6.9/..>6/.> @ .39/
RE G .>834 or >8.34K
B-328
CHAPTER 15 B-
b. To find the unle%ered cost of e&uit!, we need to use $F$ +roposition II with ta#es, so0
RE G R4 L .R4 @ RE/.E-E/.> @ tC/
.>834 G R4 L .R4 @ .>6/.>.9/.> @ .39/
R' G .>9>J or >9.>JK
c. To find the cost of e&uit! under different capital structures, we can again use $F$ +roposition
II with ta#es. With a de"t*e&uit! ratio of 6, the cost of e&uit! is0
RE G R4 L .R4 @ RE/.E-E/.> @ tC/
RE G .>9>J L ..>9>J @ .>6/.6/.> @ .39/
RE G .>J3D or >J.3DK
With a de"t*e&uit! ratio of >.4, the cost of e&uit! is0
RE G .>9>J L ..>9>J @ .>6/.>/.> @ .39/
RE G .>I6H or >I.6HK
)nd with a de"t*e&uit! ratio of 4, the cost of e&uit! is0
RE G .>9>J L ..>9>J @ .>6/.4/.> @ .39/
RE G R4 G .>9>J or >9.>JK
13. a. ;or an all*e&uit! financed compan!0
W)CC G R4 G RE G .>6 or >6K
b. To find the cost of e&uit! for the compan! with le%erage, we need to use $F$ +roposition II
with ta#es, so0
RE G R4 L .R4 @ RE/.E-E/.> @ tC/
RE G .>6 L ..>6 @ .48/..69-.I9/.> @ .39/
RE G .>68I or >6.8IK
c. <sing $F$ +roposition II with ta#es again, we get0
RE G R4 L .R4 @ RE/.E-E/.> @ tC/
RE G .>6 L ..>6 @ .48/..94-.94/.> @ .39/
RE G .>DH4 or >D.H4K
329
SOLUTIONS
d. The W)CC with 69 percent de"t is0
W)CC G .E-X/RE L .E-X/RE.> @ tC/
W)CC G .I9..>68I/ L .69..48/.> @ .39/
W)CC G .>4J9 or >4.J9K
)nd the W)CC with 94 percent de"t is0
W)CC G .E-X/RE L .E-X/RE.> @ tC/
W)CC G .94..>DH4/ L .94..48/.> @ .39/
W)CC G .4JJ4 or J.J4K
14. a. The %alue of the unle%ered firm is0
X G EAIT.> @ tC/-R4
X G 2J9,444.> @ .39/-.66
X G 2684,H8>.86
b. The %alue of the le%ered firm is0
X G X< L t
C
A
X G 2684,H8>.86 L .39.2H4,444/
X G 234>,H8>.86
15. We can find the cost of e&uit! using $F$ +roposition II with ta#es. ;irst, we need to find the
mar,et %alue of e&uit!, which is0
X G E L E
234>,H8>.86 G 2H44,444 L E
E G 26D>,H8>.86
?ow we can find the cost of e&uit!, which is0
RE G R4 L .R4 @ RE/.E-E/.> @ t/
RE G .66 L ..66 @ .>>/.2H4,444-26D>,H8>.86/.> @ .39/
RE G .63I8 or 63.I8K
<sing this cost of e&uit!, the W)CC for the firm after recapitaliation is0
W)CC G .E-X/RE L .E-X/RE.> @ tC/
W)CC G .26D>,H8>.86-234>,H8>.86/..63I8/ L .2H4,444-234>,H8>.86/.>>.> @ .39/
W)CC G .64DI or 64.DIK
When there are corporate ta#es, the o%erall cost of capital for the firm declines the more highl!
le%eraged is the firms capital structure. This is $F$ +roposition I with ta#es.
B-330
CHAPTER 15 B-
16. Since <nle%ered is an all*e&uit! firm, its %alue is e&ual to the mar,et %alue of its outstanding shares.
<nle%ered has >4 million shares of common stoc, outstanding, worth B84 per share. Therefore, the
%alue of <nle%ered0
X< G >4,444,444.B84/ G B844,444,444
$odigliani*$iller +roposition I states that, in the a"sence of ta#es, the %alue of a le%ered firm e&uals
the %alue of an otherwise identical unle%ered firm. Since Ce%ered is identical to <nle%ered in e%er!
wa! e#cept its capital structure and neither firm pa!s ta#es, the %alue of the two firms should "e
e&ual. Therefore, the mar,et %alue of Ce%ered, Inc., should be B844 million also. Since Ce%ered has
D.9 million outstanding shares, worth B>44 per share, the mar,et %alue of Ce%ereds e&uit! is0
EC G D,944,444.B>44/ G BD94,444,444
The mar,et %alue of Ce%ereds de"t is B6I9 million. The %alue of a le%ered firm e&uals the mar,et
%alue of its de"t plus the mar,et %alue of its e&uit!. Therefore, the current mar,et %alue of Ce%ered
is0
XC G A L S
XC G B6I9,444,444 L D94,444,444
XC G BI69,444,444
The mar,et %alue of Ce%ereds e&uit! needs to "e B969 million, BI9 million higher than its current
mar,et %alue of BD94 million, for $$ +roposition I to hold. Since Ce%ereds mar,et %alue is less
than <nle%ereds mar,et %alue, Ce%ered is relati%el! underpriced and an in%estor should "u! shares
of the firms stoc,.
&ntermediate
17. To find the %alue of the le%ered firm, we first need to find the %alue of an unle%ered firm. So, the %alue
of the unle%ered firm is0
X< G EAIT.> @ tC/-R4
X< G .239,444/.> @ .39/-.>D
X< G 2>H6,944
?ow we can find the %alue of the le%ered firm as0
XC G X< L tCA
XC G 2>H6,944 L .39.2I4,444/
XC G 2>8I,444
)ppl!ing $F$ +roposition I with ta#es, the firm has increased its %alue "! issuing de"t. )s long as
$F$ +roposition I holds, that is, there are no "an,ruptc! costs and so forth, then the compan!
should continue to increase its de"t-e&uit! ratio to ma#imie the %alue of the firm.
331
SOLUTIONS
18. With no de"t, we are finding the %alue of an unle%ered firm, so0
X G EAIT.> @ tC/-R4
X G Rs.D4,444,444.> @ .39/-.>I
X G Rs.>96,JD>,>IH.DI
With de"t, we simpl! need to use the e&uation for the %alue of a le%ered firm. With 94 percent de"t,
one*half of the firm %alue is de"t, so the %alue of the le%ered firm is0
X G X< L tCA
X G Rs. >96,JD>,>IH.DIL .39.Rs. >96,JD>,>IH.DI-6/
X G Rs.>IJ,I49,886.39
)nd with >44 percent de"t, the %alue of the firm is0
X G X< L tCA
X G Rs. >96,JD>,>IH.DIL .39.Rs. >96,JD>,>IH.DI/
X G Rs.64H,DI4,988.6D
19. )ccording to $F$ +roposition I with ta#es, the increase in the %alue of the compan! will "e the
present %alue of the interest ta# shield. Since the loan will "e repaid in e&ual installments, we need to
find the loan interest and the interest ta# shield each !ear. The loan schedule will "e0
\ear Coan Aalance Interest Ta# Shield
4 >,444,444,44
4
> 944,444,444 84,444,444 .39.84,444,444/
G 68,444,444
6 4 D4,444,444 .39.D4,444,444/
G >D,444,444
So, the increase in the %alue of the compan! is0
Xalue increase G 68,444,444->.48 L >D,444,444-.>.48/
6
Xalue increase G 3I,J68,HHJ.D>
20. a. Since )lpha Corporation is an all*e&uit! firm, its %alue is e&ual to the mar,et %alue of its
outstanding shares. )lpha has 9,444 shares of common stoc, outstanding, worth 264 per share,
so the %alue of )lpha Corporation is0
X)lpha G 9,444.264/ G 2>44,444
b. $odigliani*$iller +roposition I states that in the a"sence of ta#es, the %alue of a le%ered firm
e&uals the %alue of an otherwise identical unle%ered firm. Since Aeta Corporation is identical to
)lpha Corporation in e%er! wa! e#cept its capital structure and neither firm pa!s ta#es, the
%alue of the two firms should "e e&ual. So, the %alue of Aeta Corporation is 2>44,444 as well.
B-332
CHAPTER 15 B-
c. The %alue of a le%ered firm e&uals the mar,et %alue of its de"t plus the mar,et %alue of its
e&uit!. So, the %alue of Aetas e&uit! is0
XC G A L S
2>44,444 G 269,444 L S
S G 2I9,444
d. The in%estor would need to in%est 64 percent of the total mar,et %alue of )lphas e&uit!, which
is0
)mount to in%est in )lpha G .64.2>44,444/ G 264,444
Aeta has less e&uit! outstanding, so to purchase 64 percent of Aetas e&uit!, the in%estor would
need0
)mount to in%est in Aeta G .64.2I9,444/ G 2>9,444
e. )lpha has no interest pa!ments, so the dollar return to an in%estor who owns 64 percent of the
compan!s e&uit! would "e0
Eollar return on )lpha in%estment G .64.239,444/ G 2I,444
Aeta Corporation has an interest pa!ment due on its de"t in the amount of0
Interest on Aetas de"t G .>6.269,444/ G 23,444
So, the in%estor who owns 64 percent of the compan! would recei%e 64 percent of EAIT minus
the interest e#pense, or0
Eollar return on Aeta in%estment G .64.239,444 @ 3,444/ G 2H,D44
f. ;rom part d, we ,now the initial cost of purchasing 64 percent of )lpha Corporations e&uit! is
264,444, "ut the cost to an in%estor of purchasing 64 percent of Aeta Corporations e&uit! is
onl! 2>9,444. In order to purchase 264,444 worth of )lphas e&uit! using onl! 2>9,444 of his
own mone!, the in%estor must "orrow 29,444 to co%er the difference. The in%estor will recei%e
the same dollar return from the )lpha in%estment, "ut will pa! interest on the amount
"orrowed, so the net dollar return to the in%estment is0
?et dollar return G 2I,444 @ .>6.29,444/ G 2H,D44
?otice that this amount e#actl! matches the dollar return to an in%estor who purchases 64
percent of Aetas e&uit!.
g. The e&uit! of Aeta Corporation is ris,ier. Aeta must pa! off its de"t holders "efore its e&uit!
holders recei%e an! of the firms earnings. If the firm does not do particularl! well, all of the
firms earnings ma! "e needed to repa! its de"t holders, and e&uit! holders will recei%e
nothing.
333
SOLUTIONS
21. a. ) firms de"t*e&uit! ratio is the mar,et %alue of the firms de"t di%ided "! the mar,et %alue of
a firms e&uit!. So, the de"t*e&uit! ratio of the compan! is0
Ee"t*e&uit! ratio G $X of de"t - $X of e&uit!
Ee"t*e&uit! ratio G =>4,444,444 - =64,444,444
Ee"t*e&uit! ratio G .94
b. We first need to calculate the cost of e&uit!. To do this, we can use the C)+$, which gi%es us0
<S G <; L NE.<$/ @ <;O
<S G .48 L .J4..>8 @ .48/
<S G .>I44 or >I.44K
We need to remem"er that an assumption of the $odigliani*$iller theorem is that the compan!
de"t is ris,*free, so we can use the Treasur! "ill rate as the cost of de"t for the compan!. In the
a"sence of ta#es, a firms weighted a%erage cost of capital is e&ual to0
<W)CC G NA - .A L S/O<A L NS - .A L S/O<S
<W)CC G .=>4,444,444-=34,444,444/..48/ L .=64,444,444-=34,444,444/..>I/
<W)CC G .>D44 or >D.44K
c. )ccording to $odigliani*$iller +roposition II with no ta#es0
<, G <4 L .A-S/.<4 @ <A/
.>I G <4 L ..94/.<4 @ .48/
<4 G .>D44 or >D.44K
This is consistent with $odigliani*$illers proposition that, in the a"sence of ta#es, the cost of
capital for an all*e&uit! firm is e&ual to the weighted a%erage cost of capital of an otherwise
identical le%ered firm.
22. a. To purchase 9 percent of W5\s e&uit!, the in%estor would need0
W5\ in%estment G .49.)u2>,I>D,444/ G )u289,I44
)nd to purchase 9 percent of W5)T without "orrowing would re&uire0
W5)T in%estment G .49.)u26,D44,444/ G )u2>64,444
In order to compare dollar returns, the initial net cost of "oth positions should "e the same.
Therefore, the in%estor will need to "orrow the difference "etween the two amounts, or0
)mount to "orrow G )u2>64,444 @ 89,I44 G )u23D,344
B-334
CHAPTER 15 B-
)n in%estor who owns 9 percent of W5\s e&uit! will "e entitled to 9 percent of the firms
earnings a%aila"le to common stoc, holders at the end of each !ear. While W5\s e#pected
operating income is )u2344,444, it must pa! )u2H4,444 to de"t holders "efore distri"uting an!
of its earnings to stoc,holders. So, the amount a%aila"le to this shareholder will "e0
Cash flow from W5\ to shareholder G .49.)u2344,444 @ H4,444/ G )u2>6,444
W5)T will distri"ute all of its earnings to shareholders, so the shareholder will recei%e0
Cash flow from W5)T to shareholder G .49.)u2344,444/ G )u2>9,444
5owe%er, to ha%e the same initial cost, the in%estor has "orrowed )u23D,344 to in%est in
W5)T, so interest must "e paid on the "orrowings. The net cash flow from the in%estment in
W5)T will "e0
?et cash flow from W5)T in%estment G )u2>9,444 @ .4H.)u23D,344/ G )u2>6,JD6
;or the same initial cost, the in%estment in W5)T produces a higher dollar return.
b. Aoth of the two strategies ha%e the same initial cost. Since the dollar return to the in%estment in
W5)T is higher, all in%estors will choose to in%est in W5)T o%er W5\. The process of
in%estors purchasing W5)Ts e&uit! rather than W5\s will cause the mar,et %alue of
W5)Ts e&uit! to rise and-or the mar,et %alue of W5\s e&uit! to fall. )n! differences in the
dollar returns to the two strategies will "e eliminated, and the process will cease when the total
mar,et %alues of the two firms are e&ual.
23. a. Aefore the announcement of the stoc, repurchase plan, the mar,et %alue of the outstanding de"t
is Ca2I,944,444. <sing the de"t*e&uit! ratio, we can find that the %alue of the outstanding
e&uit! must "e0
Ee"t*e&uit! ratio G A - S
.D4 G Ca2I,944,444 - S
S G Ca2>8,I94,444
The %alue of a le%ered firm is e&ual to the sum of the mar,et %alue of the firms de"t and the
mar,et %alue of the firms e&uit!, so0
XC G A L S
XC G Ca2I,944,444 L >8,I94,444
XC G Ca26H,694,444
)ccording to $$ +roposition I without ta#es, changes in a firms capital structure ha%e no
effect on the o%erall %alue of the firm. Therefore, the %alue of the firm will not change after the
announcement of the stoc, repurchase plan
335
SOLUTIONS
b. The e#pected return on a firms e&uit! is the ratio of annual earnings to the mar,et %alue of the
firms e&uit!, or return on e&uit!. Aefore the restructuring, the compan! was e#pected to pa!
interest in the amount of0
Interest pa!ment G .>4.Ca2I,944,444/ G Ca2I94,444
The return on e&uit!, which is e&ual to <S, will "e0
R'E G <S G .Ca23,I94,444 @ I94,444/ - Ca2>8,I94,444
<S G .>H44 or >H.44K
c. )ccording to $odigliani*$iller +roposition II with no ta#es0
<, G <4 L .A-S/.<4 @ <A/
.>H G <4 L ..D4/.<4 @ .>4/
<4 G .>D6J or >D.6JK
This pro"lem can also "e sol%ed in the following wa!0
<4 G Earnings "efore interest - X<
)ccording to $odigliani*$iller +roposition I, in a world with no ta#es, the %alue of a le%ered
firm e&uals the %alue of an otherwise*identical unle%ered firm. Since the %alue of the compan!
as a le%ered firm is Ca26H.69 million .G Ca2I,944,444 L >8,I94,444/ and since the firm pa!s
no ta#es, the %alue of the compan! as an unle%ered firm is also Ca26H.69 million. So0
<4 G Ca23,I94,444 - Ca26H,694,444
<4 G .>D6J or >D.6JK
d. In part c, we calculated the cost of an all*e&uit! firm. We can use $odigliani*$iller
+roposition II with no ta#es again to find the cost of e&uit! for the firm with the new le%erage
ratio. The cost of e&uit! under the stoc, repurchase plan will "e0
<S G <4 L .A-S/.<4 @ <A/
<S G .>D6J L ..94/..>D6J @ .>4/
<S G .>HD3 or >H.D3K
B-336
CHAPTER 15 B-
24. a. The e#pected return on a firms e&uit! is the ratio of annual afterta# earnings to the mar,et
%alue of the firms e&uit!. The amount the firm must pa! each !ear in ta#es will "e0
Ta#es G .D4.2>,944,444/ G 2H44,444
So, the return on the unle%ered e&uit! will "e0
<4 G .2>,944,444 @ H44,444/ - 2>4,444,444
<4 G .4J44 or J.44K
?otice that perpetual annual earnings of 2J44,444, discounted at J percent, !ields the mar,et
%alue of the firms e&uit!
b. The compan!s mar,et %alue "alance sheet "efore the announcement of the de"t issue is0
Ee"t @
)ssets 2>4,444,444 E&uit! 2>4,444,444
Total assets 2>4,444,444 Total EFE 2>4,444,444
The price per share is simpl! the total mar,et %alue of the stoc, di%ided "! the shares
outstanding, or0
+rice per share G 2>4,444,444 - 944,444 G 264.44
c. $odigliani*$iller +roposition I states that in a world with corporate ta#es0
XC G X< L TCA
When Cauria announces the de"t issue, the %alue of the firm will increase "! the present %alue
of the ta# shield on the de"t. The present %alue of the ta# shield is0
+X.Ta# Shield/ G TCA
+X.Ta# Shield/ G .D4.26,444,444/
+X.Ta# Shield/ G 2844,444
Therefore, the %alue of Cauria $anufacturing will increase "! 2844,444 as a result of the de"t
issue. The %alue of Cauria $anufacturing after the repurchase announcement is0
XC G X< L TCA
XC G 2>4,444,444 L .D4.26,444,444/
XC G 2>4,844,444
Since the firm has not !et issued an! de"t, Caurias e&uit! is also worth 2>4,844,444.
337
SOLUTIONS
Caurias mar,et %alue "alance sheet after the announcement of the de"t issue is0
'ld assets 2>4,444,444 Ee"t @
+X.ta# shield/ 844,444 E&uit! 2>48,44,444
Total assets 2>4,844,444 Total EFE 2>4,844,444
d. The share price immediatel! after the announcement of the de"t issue will "e0
?ew share price G 2>4,844,444 - 944,444 G 26>.H4
e. The num"er of shares repurchase will "e the amount of the de"t issue di%ided "! the new share
price, or0
Shares repurchased G 26,444,444 - 26>.H4 G J6,9J6.9J
The num"er of shares outstanding will "e the current num"er of shares minus the num"er of
shares repurchased, or0
?ew shares outstanding G 944,444 @ J6,9J6.9J G D4I,D4I.D>
f. The share price will remain the same after restructuring ta,es place. The total mar,et %alue of
the outstanding e&uit! in the compan! will "e0
$ar,et %alue of e&uit! G 26>.H4.D4I,D4I.D>/ G 28,844,444
The mar,et*%alue "alance sheet after the restructuring is0
'ld assets 2>4,444,444 Ee"t 26,444,444
+X.ta# shield/ 844,444 E&uit! 8,844,444
Total assets 2>4,844,444 Total EFE 2>4,844,444
g. )ccording to $odigliani*$iller +roposition II with corporate ta#es
<S G <4 L .A-S/.<4 @ <A/.> @ tC/
<S G .4J L .26,444,444 - 28,844,444/..4J @ .4H/.> @ .D4/
<S G .4JD> or J.D>K
B-338
CHAPTER 15 B-
25. a. In a world with corporate ta#es, a firms weighted a%erage cost of capital is e&ual to0
<W)CC G NA - .ALS/O.> @ tC/<A L NS - .ALS/O<S
We do not ha%e the compan!s de"t*to*%alue ratio or the e&uit!*to*%alue ratio, "ut we can
calculate either from the de"t*to*e&uit! ratio. With the gi%en de"t*e&uit! ratio, we ,now the
compan! has 6.9 dollars of de"t for e%er! dollar of e&uit!. Since we onl! need the ratio of de"t*
to*%alue and e&uit!*to*%alue, we can sa!0
A - .ALS/ G 6.9 - .6.9 L >/ G .I>D3
E - .ALS/ G > - .6.9 L >/ G .689I
We can now use the weighted a%erage cost of capital e&uation to find the cost of e&uit!, which
is0
.>9 G ..I>D3/.> @ 4.39/..>4/ L ..689I/.<S/
<S G .3H69 or 3H.69K
b. We can use $odigliani*$iller +roposition II with corporate ta#es to find the unle%ered cost of
e&uit!. Eoing so, we find0
<S G <4 L .A-S/.<4 @ <A/.> @ tC/
.3H69 G <4 L .6.9/.<4 @ .>4/.> @ .39/
<4 G .6444 or 64.44K
c. We first need to find the de"t*to*%alue ratio and the e&uit!*to*%alue ratio. We can then use the
cost of le%ered e&uit! e&uation with ta#es, and finall! the weighted a%erage cost of capital
e&uation. So0
&f debt-e!uit 1 .4*
A - .ALS/ G .I9 - ..I9 L >/ G .D68H
S - .ALS/ G > - ..I9 L >/ G .9I>D
The cost of le%ered e&uit! will "e0
<S G <4 L .A-S/.<4 @ <A/.> @ tC/
<S G .64 L ..I9/..64 @ .>4/.> @ .39/
<S G .6D88 or 6D.88K
)nd the weighted a%erage cost of capital will "e0
<W)CC G NA - .ALS/O.> @ tC/<A L NS - .ALS/O<S
<W)CC G ..D68H/.> @ .39/..>4/ L ..9I>D/..6D88/
<W)CC G .>I
339
SOLUTIONS
&f debt-e!uit 1).*/
A - .ALS/ G >.94 - .>.94 L >/ G .H444
E - .ALS/ G > - .>.94 L >/ G .D444
The cost of le%ered e&uit! will "e0
<S G <4 L .A-S/.<4 @ <A/.> @ tC/
<S G .64 L .>.94/..64 @ .>4/.> @ .39/
<S G .6JI9 or 6J.I9K
)nd the weighted a%erage cost of capital will "e0
<W)CC G NA - .ALS/O.> @ tC/<A L NS - .ALS/O<S
<W)CC G ..H444/.> @ .39/..>4/ L ..D444/..6JI9/
<W)CC G .>984 or >9.84K
'hallenge
26. $F$ +roposition II states0
RE G R4 L .R4 @ RE/.E-E/.> @ tC/
)nd the e&uation for W)CC is0

W)CC G .E-X/RE L .E-X/RE.> @ tC/
Su"stituting the $F$ +roposition II e&uation into the e&uation for W)CC, we get0
W)CC G .E-X/NR4 L .R4 @ RE/.E-E/.> @ tC/O L .E-X/RE.> @ tC/
Rearranging and reducing the e&uation, we get0
W)CC G R4N.E-X/ L .E-X/.E-E/.> @ tC/O L RE.> @ tC/N.E-X/ @ .E-X/.E-E/O
W)CC G R4N.E-X/ L .E-X/.> @ tC/O
W)CC G R4NZ.ELE/-X[ @ tC.E-X/O
W)CC G R4N> @ tC.E-X/O
B-340
CHAPTER 15 B-
27. The return on e&uit! is net income di%ided "! e&uit!. ?et income can "e e#pressed as0
?I G .EAIT @ REE/.> @ tC/
So, R'E is0
RE G .EAIT @ REE/.> @ tC/-E
?ow we can rearrange and su"stitute as follows to arri%e at $F$ +roposition II with ta#es0
RE G NEAIT.> @ tC/-EO @ NRE.E-E/.> @ tC/O
RE G R)X<-E @ NRE.E-E/.> @ tC/O
RE G R).XC

@ tCE/-E @ NRE.E-E/.> @ tC/O
RE G R).E L E @ tCE/-E @ NRE.E-E/.> @ tC/O
RE G R) L .R) @ RE/.E-E/.> @ tC/
28. $F$ +roposition II, with no ta#es is0
RE G R) L .R) @ Rf/.A-S/
?ote that we use the ris,*free rate as the return on de"t. This is an important assumption of $F$
+roposition II. The C)+$ to calculate the cost of e&uit! is e#pressed as0
RE G E.R$ @ Rf/ L Rf
We can rewrite the C)+$ to e#press the return on an unle%ered compan! as0
R) G ).R$ @ Rf/ L Rf


We can now su"stitute the C)+$ for an unle%ered compan! into $F$ +roposition II. Eoing so
and rearranging the terms we get0
RE G ).R$ @ Rf/ L Rf L N ).R$ @ Rf/ L Rf @ RfO.A-S/
RE G ).R$ @ Rf/ L Rf L N ).R$ @ Rf/O.A-S/
RE G .> L A-S/ ).R$ @ Rf/ L Rf
?ow we set this e&uation e&ual to the C)+$ e&uation to calculate the cost of e&uit! and reduce0
E.R$ @ Rf/ L Rf G .> L A-S/ ).R$ @ Rf/ L Rf
E.R$ @ Rf/ G .> L A-S/ ).R$ @ Rf/
E G ).> L A-S/
341
SOLUTIONS
29. <sing the e&uation we deri%ed in +ro"lem 680
E G ).> L E-E/
The e&uit! "eta for the respecti%e asset "etas is0
Ee"t*e&uit! ratio E&uit! "eta
4 >.> L 4/ G >
> >.> L >/ G 6
9 >.> L 9/ G H
64 >.> L 64/ G 6>
The e&uit! ris, to the shareholder is composed of "oth "usiness and financial ris,. E%en if the assets
of the firm are not %er! ris,!, the ris, to the shareholder can still "e large if the financial le%erage is
high. These higher le%els of ris, will "e reflected in the shareholders re&uired rate of return RE,
which will increase with higher de"t-e&uit! ratios.
30. We first need to set the cost of capital e&uation e&ual to the cost of capital for an all*e&uit! firm, so0
, %
%
+
<% L
, %
,
+
<, 1 <4
$ultipl!ing "oth sides "! .% L ,/-, !ields0
,
%
<% L <, G
,
, % +
<4
We can rewrite the right*hand side as0
,
%
<% L RS G
,
%
<4 L <4
$o%ing .A-S/RA to the right*hand side and rearranging gi%es us0
<, G <4 L
,
%
.<4 @ <%/
B-342
CHAPTER 16
CAPITAL STRUCTURE: LIMITS TO THE
USE OF DEBT
Answers to Concepts Review and Critical !in"in# Questions
1. Eirect costs are potential legal and administrati%e costs. These are the costs associated with the
litigation arising from a li&uidation or "an,ruptc!. These costs include law!ers fees, courtroom
costs, and e#pert witness fees. Indirect costs include the following0 >/ Impaired a"ilit! to conduct
"usiness. ;irms ma! suffer a loss of sales due to a decrease in consumer confidence and loss of
relia"le supplies due to a lac, of confidence "! suppliers. 6/ Incenti%e to ta,e large ris,s. When
faced with pro:ects of different ris, le%els, managers acting in the stoc,holders interest ha%e an
incenti%e to underta,e high*ris, pro:ects. Imagine a firm with onl! one pro:ect, which pa!s 2>44 in
an e#pansion and 2H4 in a recession. If de"t pa!ments are 2H4, the stoc,holders recei%e 2D4 .G 2>44
@ H4/ in the e#pansion "ut nothing in the recession. The "ondholders recei%e 2H4 for certain. ?ow,
alternati%el! imagine that the pro:ect pa!s 2>>4 in an e#pansion "ut 294 in a recession. 5ere, the
stoc,holders recei%e 294 .G 2>>4 @ H4/ in the e#pansion "ut nothing in the recession. The
"ondholders recei%e onl! 294 in the recession "ecause there is no more mone! in the firm. That is,
the firm simpl! declares "an,ruptc!, lea%ing the "ondholders 1holding the "ag.8 Thus, an increase in
ris, can "enefit the stoc,holders. The ,e! here is that the "ondholders are hurt "! ris,, since the
stoc,holders ha%e limited lia"ilit!. If the firm declares "an,ruptc!, the stoc,holders are not
responsi"le for the "ondholders shortfall. 3/ Incenti%e to under*in%est. If a compan! is near
"an,ruptc!, stoc,holders ma! well "e hurt if the! contri"ute e&uit! to a new pro:ect, e%en if the
pro:ect has a positi%e ?+X. The reason is that some .or all/ of the cash flows will go to the
"ondholders. Suppose a real estate de%eloper owns a "uilding that is li,el! to go "an,rupt, with the
"ondholders recei%ing the propert! and the de%eloper recei%ing nothing. Should the de%eloper ta,e
2> million out of his own poc,et to add a new wing to a "uilding7 +erhaps not, e%en if the new wing
will generate cash flows with a present %alue greater than 2> million. Since the "ondholders are
li,el! to end up with the propert! an!wa!, the de%eloper will pa! the additional 2> million and li,el!
end up with nothing to show for it. D/ $il,ing the propert!. In the e%ent of "an,ruptc!, "ondholders
ha%e the first claim to the assets of the firm. When faced with a possi"le "an,ruptc!, the
stoc,holders ha%e strong incenti%es to %ote for increased di%idends or other distri"utions. This will
ensure them of getting some of the assets of the firm "efore the "ondholders can la! claim to them.
2. The statement is incorrect. If a firm has de"t, it might "e ad%antageous to stoc,holders for the firm to
underta,e ris,! pro:ects, e%en those with negati%e net present %alues. This incenti%e results from the
fact that most of the ris, of failure is "orne "! "ondholders. Therefore, %alue is transferred from the
"ondholders to the shareholders "! underta,ing ris,! pro:ects, e%en if the pro:ects ha%e negati%e
?+Xs. This incenti%e is e%en stronger when the pro"a"ilit! and costs of "an,ruptc! are high.
3. The firm should issue e&uit! in order to finance the pro:ect. The ta#*loss carr!*forwards ma,e the
firms effecti%e ta# rate ero. Therefore, the compan! will not "enefit from the ta# shield that de"t
pro%ides. $oreo%er, since the firm alread! has a moderate amount of de"t in its capital structure,
additional de"t will li,el! increase the pro"a"ilit! that the firm will face financial distress or
SOLUTIONS
"an,ruptc!. )s long as there are "an,ruptc! costs, the firm should issue e&uit! in order to finance
the pro:ect.
B-344
CHAPTER 16 B-
4. Stoc,holders can underta,e the following measures in order to minimie the costs of de"t0 >/ <se
protecti%e co%enants. ;irms can enter into agreements with the "ondholders that are designed to
decrease the cost of de"t. There are two t!pes of protecti%e co%enants. ?egati%e co%enants prohi"it
the compan! from ta,ing actions that would e#pose the "ondholders to potential losses. )n e#ample
would "e prohi"iting the pa!ment of di%idends in e#cess of earnings. +ositi%e co%enants specif! an
action that the compan! agrees to ta,e or a condition the compan! must a"ide "!. )n e#ample would
"e agreeing to maintain its wor,ing capital at a minimum le%el. 6/ Repurchase de"t. ) firm can
eliminate the costs of "an,ruptc! "! eliminating de"t from its capital structure. 3/ Consolidate de"t.
If a firm decreases the num"er of de"t holders, it ma! "e a"le to decrease the direct costs of
"an,ruptc! should the firm "ecome insol%ent.
5. $odigliani and $illers theor! with corporate ta#es indicates that, since there is a positi%e ta#
ad%antage of de"t, the firm should ma#imie the amount of de"t in its capital structure. In realit!,
howe%er, no firm adopts an all*de"t financing strateg!. $$s theor! ignores "oth the financial
distress and agenc! costs of de"t. The marginal costs of de"t continue to increase with the amount of
de"t in the firms capital structure so that, at some point, the marginal costs of additional de"t will
outweigh its marginal ta# "enefits. Therefore, there is an optimal le%el of de"t for e%er! firm at the
point where the marginal ta# "enefits of the de"t e&ual the marginal increase in financial distress and
agenc! costs.
6. There are two ma:or sources of the agenc! costs of e&uit!0 >/ Shir,ing. $anagers with small e&uit!
holdings ha%e a tendenc! to reduce their wor, effort, there"! hurting "oth the de"t holders and
outside e&uit! holders. 6/ +er&uisites. Since management recei%es all the "enefits of increased
per&uisites "ut onl! shoulder a fraction of the cost, managers ha%e an incenti%e to o%erspend on
lu#ur! items at the e#pense of de"t holders and outside e&uit! holders.
7. The more capital intensi%e industries, such as airlines, ca"le tele%ision, and electric utilities, tend to
use greater financial le%erage. )lso, industries with less predicta"le future earnings, such as
computers or drugs, tend to use less financial le%erage. Such industries also ha%e a higher
concentration of growth and startup firms. '%erall, the general tendenc! is for firms with
identifia"le, tangi"le assets and relati%el! more predicta"le future earnings to use more de"t
financing. These are t!picall! the firms with the greatest need for e#ternal financing and the greatest
li,elihood of "enefiting from the interest ta# shelter.
8. 'ne answer is that the right to file for "an,ruptc! is a %alua"le asset, and the financial manager acts
in shareholders "est interest "! managing this asset in wa!s that ma#imie its %alue. To the e#tent
that a "an,ruptc! filing pre%ents 1a race to the courthouse steps,8 it would seem to "e a reasona"le
use of the process.
9. )s in the pre%ious &uestion, it could "e argued that using "an,ruptc! laws as a sword ma! simpl! "e
the "est use of the asset. Creditors are aware at the time a loan is made of the possi"ilit! of
"an,ruptc!, and the interest charged incorporates it.
345
SOLUTIONS
10. 'ne side is that Continental was going to go "an,rupt "ecause its costs made it uncompetiti%e. The
"an,ruptc! filing ena"led Continental to restructure and ,eep fl!ing. The other side is that
Continental a"used the "an,ruptc! code. Rather than renegotiate la"or agreements, Continental
simpl! a"rogated them to the detriment of its emplo!ees. In this, and the last se%eral, &uestions, an
important thing to ,eep in mind is that the "an,ruptc! code is a creation of law, not economics. )
strong argument can alwa!s "e made that ma,ing the "est use of the "an,ruptc! code is no different
from, for e#ample, minimiing ta#es "! ma,ing "est use of the ta# code. Indeed, a strong case can "e
made that it is the financial managers dut! to do so. )s the case of Continental illustrates, the code
can "e changed if sociall! undesira"le outcomes are a pro"lem.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. <sing $F$ +roposition I with ta#es, the %alue of a le%ered firm is0
DC G NEAIT.> @ tC/-R4O L tC%
DC G NE'+I94,444.> @ .39/-.>9O L .39.E'+>,944,444/
DC G E'+3,II9,444
b. The C;' ma! "e correct. The %alue calculated in part a does not include the costs of an! non*
mar,eted claims, such as "an,ruptc! or agenc! costs.
2. a. "ebt issue:
The compan! needs a cash infusion of 26 million. If the compan! issues de"t, the annual
interest pa!ments will "e0
Interest G 26,444,444..4J/ G 2>84,444
The cash flow to the owner will "e the EAIT minus the interest pa!ments, or0
D4 hour wee, cash flow G 2944,444 @ >84,444 G 2364,444
94 hour wee, cash flow G 2H44,444 @ >84,444 G 2D64,444
E!uit issue:
If the compan! issues e&uit!, the compan! %alue will increase "! the amount of the issue. So,
the current owners e&uit! interest in the compan! will decrease to0
Tharus ownership percentage G 23,444,444 - .23,444,444 L 6,444,444/ G .H4
B-346
CHAPTER 16 B-
So, Tharus cash flow under an e&uit! issue will "e H4 percent of EAIT, or0
D4 hour wee, cash flow G .H4.2944,444/ G 2344,444
94 hour wee, cash flow G .H4.2H44,444/ G 23H4,444
b. Tharu will wor, harder under the de"t issue since his cash flows will "e higher. Tharu will gain
more under this form of financing since the pa!ments to "ondholders are fi#ed. <nder an e&uit!
issue, new in%estors share proportionall! in his hard wor,, which will reduce his propensit! for
this additional wor,.
c. The direct cost of "oth issues is the pa!ments made to new in%estors. The indirect costs to the
de"t issue include potential "an,ruptc! and financial distress costs. The indirect costs of an
e&uit! issue include shir,ing and per&uisites.
3. a. The interest pa!ments each !ear will "e0
Interest pa!ment G .>6.=84,444/ G =J,H44
This is e#actl! e&ual to the EAIT, so no cash is a%aila"le for shareholders. <nder this scenario,
the %alue of e&uit! will "e ero since shareholders will ne%er recei%e a pa!ment. Since the
mar,et %alue of the compan!s de"t is =84,444, and there is no pro"a"ilit! of default, the total
%alue of the compan! is the mar,et %alue of de"t. This implies the de"t to %alue ratio is > .one/.
b. )t a 9 percent growth rate, the earnings ne#t !ear will "e0
Earnings ne#t !ear G =J,H44.>.49/ G =>4,484
So, the cash a%aila"le for shareholders is0
+a!ment to shareholders G =>4,484 @ J,H44 G =D84
Since there is no ris,, the re&uired return for shareholders is the same as the re&uired return on
the compan!s de"t. The pa!ments to stoc,holders will increase at the growth rate of fi%e
percent .a growing perpetuit!/, so the %alue of these pa!ments toda! is0
Xalue of e&uit! G =D84 - ..>6 @ .49/ G =H,89I.>D
)nd the de"t to %alue ratio now is0
Ee"t-Xalue ratio G =84,444 - .=84,444 L H,89I.>D/ G 4.J6>
347
SOLUTIONS
c. )t a 8 percent growth rate, the earnings ne#t !ear will "e0
Earnings ne#t !ear G =J,H44.>.48/ G =>4,3H8
So, the cash a%aila"le for shareholders is0
+a!ment to shareholders G =>4,3H8 @ J,H44 G =IH8
Since there is no ris,, the re&uired return for shareholders is the same as the re&uired return on
the compan!s de"t. The pa!ments to stoc,holders will increase at the growth rate of eight
percent .a growing perpetuit!/, so the %alue of these pa!ments toda! is0
Xalue of e&uit! G =IH8 - ..>6 @ .48/ G =>J,644.44
)nd the de"t to %alue ratio now is0
Ee"t-Xalue ratio G =84,444 - .=84,444 L >J,644/ G .84HD96
4. )ccording to $F$ +roposition I with ta#es, the %alue of the le%ered firm is0
DC G D< L tC%
DC G 2>6,444,444 L .39.2D,444,444/
DC G 2>3,D44,444
We can also calculate the mar,et %alue of the firm "! adding the mar,et %alue of the de"t and e&uit!.
<sing this procedure, the total mar,et %alue of the firm is0
D G % L ,
D G 2D,444,444 L 694,444.239/
D G 2>6,I94,444
With no nonmar,eted claims, such as "an,ruptc! costs, we would e#pect the two %alues to "e the
same. The difference is the %alue of the nonmar,eted claims, which are0
DT G D$ L D?
2>6,I94,444 G 2>3,D44,444 @ D?
D? G 2H94,444
5. The president ma! "e correct, "ut he ma! also "e incorrect. It is true the interest ta# shield is
%alua"le, and adding de"t can possi"l! increase the %alue of the compan!. 5owe%er, if the
compan!s de"t is increased "e!ond some le%el, the %alue of the interest ta# shield "ecomes less
than the additional costs from financial distress.
B-348
CHAPTER 16 B-
&ntermediate
6. a. The total %alue of a firms e&uit! is the discounted e#pected cash flow to the firms
stoc,holders. If the e#pansion continues, each firm will generate earnings "efore interest and
ta#es of 26 million. If there is a recession, each firm will generate earnings "efore interest and
ta#es of onl! 2844,444. Since Stein"erg owes its "ondholders 2I94,444 at the end of the !ear,
its stoc,holders will recei%e 2>.69 million .G 26,444,444 @ I94,444/ if the e#pansion continues.
If there is a recession, its stoc,holders will onl! recei%e 294,444 .G 2844,444 @ I94,444/. So,
assuming a discount rate of >3 percent, the mar,et %alue of Stein"ergs e&uit! is0
SStein"erg G N.84.2>,694,444/ L .64.294,444/O - >.>3 G 28J3,849
Stein"ergs "ondholders will recei%e 2I94,444 whether there is a recession or a continuation of
the e#pansion. So, the mar,et %alue of Stein"ergs de"t is0
AStein"erg G N.84.2I94,444/ L .64.2I94,444/O - >.>3 G 2HH3,I>I
Since Eietrich owes its "ondholders 2> million at the end of the !ear, its stoc,holders will
recei%e 2> million .G 26 million @ > million/ if the e#pansion continues. If there is a recession,
its stoc,holders will recei%e nothing since the firms "ondholders ha%e a more senior claim on
all 2844,444 of the firms earnings. So, the mar,et %alue of Eietrichs e&uit! is0
SEietrich G N.84.2>,444,444/ L .64.24/O - >.>3 G 2I4I,JH9
Eietrichs "ondholders will recei%e 2> million if the e#pansion continues and 2844,444 if there
is a recession. So, the mar,et %alue of Eietrichs de"t is0
AEietrich G N.84.2>,444,444/ L .64.2844,444/O - >.>3 G 28DJ,998
b. The %alue of compan! is the sum of the %alue of the firms de"t and e&uit!. So, the %alue of
Stein"erg is0
XStein"erg G A L S
XStein"erg G 2HH3,I>I L 28J3,849
XStein"erg G 2>,99I,966
)nd %alue of Eietrich is0
XEietrich G A L S
XEietrich G 2I4I,JH9 L 8DJ,998
XEietrich G 2>,99I,966
\ou should disagree with the CE's statement. The ris, of "an,ruptc! per se does not affect a
firms %alue. It is the actual costs of "an,ruptc! that decrease the %alue of a firm. ?ote that this
pro"lem assumes that there are no "an,ruptc! costs.
349
SOLUTIONS
7. a. The e#pected %alue of each pro:ect is the sum of the pro"a"ilit! of each state of the econom!
times the %alue in that state of the econom!. Since this is the onl! pro:ect for the compan!, the
compan! %alue will "e the same as the pro:ect %alue, so0
Cow*%olatilit! pro:ect %alue G .94.=944/ L .94.=I44/
Cow*%olatilit! pro:ect %alue G =H44
5igh*%olatilit! pro:ect %alue G .94.=>44/ L .94.=844/
5igh*%olatilit! pro:ect %alue G =D94
The low*%olatilit! pro:ect ma#imies the e#pected %alue of the firm.
b. The %alue of the e&uit! is the residual %alue of the compan! after the "ondholders are paid off.
If the low*%olatilit! pro:ect is underta,en, the firms e&uit! will "e worth =4 if the econom! is
"ad and =644 if the econom! is good. Since each of these two scenarios is e&uall! pro"a"le, the
e#pected %alue of the firms e&uit! is0
E#pected %alue of e&uit! with low*%olatilit! pro:ect G .94.=4/ L .94.=644/
E#pected %alue of e&uit! with low*%olatilit! pro:ect G =>44
)nd the %alue of the compan! if the high*%olatilit! pro:ect is underta,en will "e0
E#pected %alue of e&uit! with high*%olatilit! pro:ect G .94.=4/ L .94.=344/
E#pected %alue of e&uit! with high*%olatilit! pro:ect G =>94
c. Ris,*neutral in%estors prefer the strateg! with the highest e#pected %alue. Thus, the compan!s
stoc,holders prefer the high*%olatilit! pro:ect since it ma#imies the e#pected %alue of the
compan!s e&uit!.
d. In order to ma,e stoc,holders indifferent "etween the low*%olatilit! pro:ect and the high*
%olatilit! pro:ect, the "ondholders will need to raise their re&uired de"t pa!ment so that the
e#pected %alue of e&uit! if the high*%olatilit! pro:ect is underta,en is e&ual to the e#pected
%alue of e&uit! if the low*%olatilit! pro:ect is underta,en. )s shown in part a, the e#pected
%alue of e&uit! if the low*%olatilit! pro:ect is underta,en is =>44. If the high*%olatilit! pro:ect is
underta,en, the %alue of the firm will "e =>44 if the econom! is "ad and =844 if the econom! is
good. If the econom! is "ad, the entire =>44 will go to the "ondholders and stoc,holders will
recei%e nothing. If the econom! is good, stoc,holders will recei%e the difference "etween =844,
the total %alue of the firm, and the re&uired de"t pa!ment. Cet U "e the de"t pa!ment that
"ondholders will re&uire if the high*%olatilit! pro:ect is underta,en. In order for stoc,holders to
"e indifferent "etween the two pro:ects, the e#pected %alue of e&uit! if the high*%olatilit!
pro:ect is underta,en must "e e&ual to =>44, so0
E#pected %alue of e&uit! G =>44 G .94.=4/ L .94.=844 @ U/
U G =H44
B-350
CHAPTER 16 B-
8. a. The e#pected pa!off to "ondholders is the face %alue of de"t or the %alue of the compan!,
whiche%er is less. Since the %alue of the compan! in a recession is V>44 million and the
re&uired de"t pa!ment in one !ear is V>94 million, "ondholders will recei%e the lesser amount,
or V>44 million.
b. The promised return on de"t is0
+romised return G .;ace %alue of de"t - $ar,et %alue of de"t/ @ >
+romised return G .V>94,444,444 - V>48,J34,444/ @ >
+romised return G .3II4 or 3I.I4K
c. In part a, we determined "ondholders will recei%e V>44 million in a recession. In a "oom, the
"ondholders will recei%e the entire V>94 million promised pa!ment since the mar,et %alue of
the compan! is greater than the pa!ment. So, the e#pected %alue of de"t is0
E#pected pa!ment to "ondholders G .H4.V>94,444,444/ L .D4.V>44,444,444/
E#pected pa!ment to "ondholders G V>34,444,444
So, the e#pected return on de"t is0
E#pected return G .E#pected %alue of de"t - $ar,et %alue of de"t/ @ >
E#pected return G .V>34,444,444 - V>48,J34,444/ @ >
E#pected return G .>J3D or >J.3DK
'hallenge
9. a. In their no ta# model, $$ assume that t', tA, and 'E%6 are all ero. <nder these assumptions,
XC G X<, signif!ing that the capital structure of a firm has no effect on its %alue. There is no
optimal de"t*e&uit! ratio.
b. In their model with corporate ta#es, $$ assume that tC S 4 and "oth tA and 'E%6 are e&ual to
ero. <nder these assumptions, XC G X< L tCA, impl!ing that raising the amount of de"t in a
firms capital structure will increase the o%erall %alue of the firm. This model implies that the
de"t*e&uit! ratio of e%er! firm should "e infinite.
c. If the costs of financial distress are ero, the %alue of a le%ered firm e&uals0
DC G D< L Z> @ N.> @ tC/ - .> @ tA/[O Q %
Therefore, the change in the %alue of this all*e&uit! firm that issues de"t and uses the proceeds
to repurchase e&uit! is0
Change in %alue G Z> @ N.> @ tC/ - .> @ tA/[O Q %
Change in %alue G Z> @ N.> @ .3D/ - .> @ .64/O[ Q >,444,444
Change in %alue G >I9,444
351
SOLUTIONS
d. If the costs of financial distress are ero, the %alue of a le%ered firm e&uals0
XC G X< L Z> @ N.> @ tC/ - .> @ tA/O[ Q A
Therefore, the change in the %alue of an all*e&uit! firm that issues > of perpetual de"t
instead of > of perpetual e&uit! is0
Change in %alue G Z> @ N.> @ tC/ - .> @ tA/O[ Q >
If the firm is not a"le to "enefit from interest deductions, the firms ta#a"le income will remain
the same regardless of the amount of de"t in its capital structure, and no ta# shield will "e
created "! issuing de"t. Therefore, the firm will recei%e no ta# "enefit as a result of issuing de"t
in place of e&uit!. In other words, the effective corporate ta# rate when we consider the change
in the %alue of the firm is ero. Ee"t will ha%e no effect on the %alue of the firm since interest
pa!ments will not "e ta# deducti"le. So, for this firm, the change in %alue is0
Change in %alue G Z> @ N.> @ 4/ - .> @ .64/O[ Q >
Change in %alue G @4.69
The %alue of the firm will decrease "! 4.69 if it adds > of perpetual de"t rather than >
of e&uit!.
10. a. If the compan! decides to retire all of its de"t, it will "ecome an unle%ered firm. The %alue of
an all*e&uit! firm is the present %alue of the afterta# cash flow to e&uit! holders, which will "e0
X< G .EAIT/.> @ tC/ - <4
X< G .<\<>,>44,444/.> @ .39/ - .64
X< G <\<3,9I9,444
b. Since there are no "an,ruptc! costs, the %alue of the compan! as a le%ered firm is0
DC G D< L Z> @ N.> @ tC/ - .> @ tA/[O Q %
DC G <\<3,9I9,444 L Z> @ N.> @ .39/ - .> @ .69/O[ Q <\<6,444,444
DC G <\<3,8D>,HHH.HI
c. The "an,ruptc! costs would not affect the %alue of the unle%ered firm since it could ne%er "e
forced into "an,ruptc!. So, the %alue of the le%ered firm with "an,ruptc! would "e0
DC G D< L Z> @ N.> @ tC/ - .> @ tA/[O Q % @ C.A/
DC G .<\<3,9I9,444 L Z> @ N.> @ .39/ - .> @ .69/O[ Q <\<6,444,444/ @ <\<344,444
DC G <\<3,9D>,HHH.HI
The compan! should choose the all*e&uit! plan with this "an,ruptc! cost.
B-352
CHAPTER 17
VALUATION AND CAPITAL
BUDGETING FOR THE LEVERED FIRM
Answers to Concepts Review and Critical !in"in# Questions
1. )+X is e&ual to the ?+X of the pro:ect .i.e. the %alue of the pro:ect for an unle%ered firm/ plus the
?+X of financing side effects.
2. The W)CC is "ased on a target de"t le%el while the )+X is "ased on the amount of de"t.
3. ;TE uses le%ered cash flow and other methods use unle%ered cash flow.
4. The W)CC method does not e#plicitl! include the interest cash flows, "ut it does implicitl! include
the interest cost in the W)CC. If he insists that the interest pa!ments are e#plicitl! shown, !ou
should use the ;TE method.
5. \ou can estimate the unle%ered "eta from a le%ered "eta. The unle%ered "eta is the "eta of the assets
of the firm( as such, it is a measure of the "usiness ris,. ?ote that the unle%ered "eta will alwa!s "e
lower than the le%ered "eta .assuming the "etas are positi%e/. The difference is due to the le%erage of
the compan!. Thus, the second ris, factor measured "! a le%ered "eta is the financial ris, of the
compan!.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. The ma#imum price that the compan! should "e willing to pa! for the fleet of cars with all*
e&uit! funding is the price that ma,es the ?+X of the transaction e&ual to ero. The ?+X
e&uation for the pro:ect is0
?+X G @+urchase +rice L +XN.> @ tC /.EATE/O L +X.Eepreciation Ta# Shield/
If we let + e&ual the purchase price of the fleet, then the ?+X is0
?+X G @+ L .> @ .39/.2>64,444/+XI;)>6K,9 L ..39/.+-9/+XI;)>6K,9
SOLUTIONS
Setting the ?+X e&ual to ero and sol%ing for the purchase price, we find0
4 G @+ L .> @ .39/.2>64,444/+XI;)>6K,9 L ..39/.+-9/+XI;)>6K,9
+ G 268>,>I6.9D L .+/.4.39-9/+XI;)>6K,9
+ G 268>,>I6.9D L .69633D+
.IDIHI+ G 268>,>I6.9D
+ G 23IH,4HI.6>
b. The ad:usted present %alue .)+X/ of a pro:ect e&uals the net present %alue of the pro:ect if it
were funded completel! "! e&uit! plus the net present %alue of an! financing side effects. In
this case, the ?+X of financing side effects e&uals the after*ta# present %alue of the cash flows
resulting from the firms de"t, so0
)+X G ?+X.)ll*E&uit!/ L ?+X.;inancing Side Effects/
So, the ?+X of each part of the )+X e&uation is0
?+X.)ll*E&uit!/
?+X G @+urchase +rice L +XN.> @ tC /.EATE/O L +X.Eepreciation Ta# Shield/
The compan! paid 23I9,444 for the fleet of cars. Aecause this fleet will "e full! depreciated
o%er fi%e !ears using the straight*line method, annual depreciation e#pense e&uals0
Eepreciation G 23I9,444-9
Eepreciation G 2I9,444
So, the ?+X of an all*e&uit! pro:ect is0
?+X G @23I9,444 L .> @ 4.39/.2>64,444/+XI;)>6K,9 L .4.39/.2I9,444/+XI;)>6K,9
?+X G 2IJI.J6
?+X.;inancing Side Effects/
The net present %alue of financing side effects e&uals the after*ta# present %alue of cash flows
resulting from the firms de"t, so0
?+X G +roceeds @ )fterta# +X.Interest +a!ments/ @ +X.+rincipal +a!ments/
Ri%en a ,nown le%el of de"t, de"t cash flows should "e discounted at the pre*ta# cost of de"t
<A. So, the ?+X of the financing side effects are0
?+X G 2694,444 @ .> @ 4.39/.4.48/.2694,444/+XI;)8K,9 @ N2694,444-.>.48/
9
O
?+X G 26I,JD8.JI
So, the )+X of the pro:ect is0
)+X G ?+X.)ll*E&uit!/ L ?+X.;inancing Side Effects/
)+X G 2IJI.J6 L 6I,JD8.JI
)+X G 268,IDH.8J
B-354
CHAPTER 17 B-
2. The ad:usted present %alue .)+X/ of a pro:ect e&uals the net present %alue of the pro:ect if it were
funded completel! "! e&uit! plus the net present %alue of an! financing side effects. In this case, the
?+X of financing side effects e&uals the after*ta# present %alue of the cash flows resulting from the
firms de"t, so0
)+X G ?+X.)ll*E&uit!/ L ?+X.;inancing Side Effects/
So, the ?+X of each part of the )+X e&uation is0
?+X.)ll*E&uit!/
?+X G @+urchase +rice L +XN.> @ tC /.EATE/O L +X.Eepreciation Ta# Shield/
Since the initial in%estment of 26.D million will "e full! depreciated o%er four !ears using the
straight*line method, annual depreciation e#pense is0
Eepreciation G 26,D44,444-D
Eepreciation G 2H44,444
?+X G @26,>44,444 L .> @ 4.34/.2894,444/+XI;)D,8K L .4.34/.2H44,444/+XI;)D,8K
?+X .)ll*e&uit!/ G @ 2JD,I8D.I6
?+X.;inancing Side Effects/
The net present %alue of financing side effects e&uals the afterta# present %alue of cash flows
resulting from the firms de"t. So, the ?+X of the financing side effects are0
?+X G +roceeds.?et of flotation/ @ )fterta# +X.Interest +a!ments/ @ +X.+rincipal +a!ments/
L +X.;lotation Cost Ta# Shield/
Ri%en a ,nown le%el of de"t, de"t cash flows should "e discounted at the pre*ta# cost of de"t, <A.
Since the flotation costs will "e amortied o%er the life of the loan, the annual floatation costs that
will "e e#pensed each !ear are0
)nnual floatation e#pense G 26D,444-D
)nnual floatation e#pense G 2H,444
?+X G .26,>44,444 @ 6>,444/ @ .> @ 4.34/.4.4J9/.26,D44,444/+XI;)D,8K @ 26,>44,444-.>.4J9/
3

L 4.34.2H,444/ +XI;)D,8K
?+X G 2644,J9D.9I
So, the )+X of the pro:ect is0
)+X G ?+X.)ll*E&uit!/ L ?+X.;inancing Side Effects/
)+X G @2JD,I8D.I6 L 644,J9D.9I
)+X G 2>4H,>HJ.89
355
SOLUTIONS
3. a. In order to %alue a firms e&uit! using the flow*to*e&uit! approach, discount the cash flows
a%aila"le to e&uit! holders at the cost of the firms le%ered e&uit!. The cash flows to e&uit!
holders will "e the firms net income. Remem"ering that the compan! has three stores, we find0
Sales B3,444,444
C'RS >,394,444
R F ) costs JI9,444
Interest 88,944
EAT B98H,944
Ta#es >I9,J94
?I BD>4,994
Since this cash flow will remain the same fore%er, the present %alue of cash flows a%aila"le to
the firms e&uit! holders is a perpetuit!. We can discount at the le%ered cost of e&uit!, so, the
%alue of the compan!s e&uit! is0
+X.;low*to*e&uit!/ G BD>4,994 - 4.>J
+X.;low*to*e&uit!/ G B6,>H4,I8J.DI
b. The %alue of a firm is e&ual to the sum of the mar,et %alues of its de"t and e&uit!, or0
XC G A L S
We calculated the %alue of the compan!s e&uit! in part a, so now we need to calculate the
%alue of de"t. The compan! has a de"t*to*e&uit! ratio of 4.D4, which can "e written
alge"raicall! as0
A - S G 4.D4
We can su"stitute the %alue of e&uit! and sol%e for the %alue of de"t, doing so, we find0
A - B6,>H4,I8J.DI G 4.D4
A G B8HD,3>9.84
So, the %alue of the compan! is0
X G B6,>H4,I8J.DI L 8HD,3>9.84
X G B3,469,>49.6H
4. a. In order to determine the cost of the firms de"t, we need to find the !ield to maturit! on its
current "onds. With semiannual coupon pa!ments, the !ield to maturit! in the compan!s
"onds is0
2JI4 G 2D9.+XI;)<+,D4/ L 2>,444.+XI;<+,D4/
R G .4DHI or D.HIK
B-356
CHAPTER 17 B-
Since the coupon pa!ments are semiannual, the \T$ on the "onds is0
\T$ G D.HI Q 6
\T$ G J.33K
b. We can use the Capital )sset +ricing $odel to find the return on unle%ered e&uit!. )ccording
to the Capital )sset +ricing $odel0
R4 G R; L i<nle%ered.R$ @ R;/
R4 G IK L >.>.>3K @ IK/
R4 G >3.H4K
?ow we can find the cost of le%ered e&uit!. )ccording to $odigliani*$iller +roposition II with
corporate ta#es
RS G R4 L .A-S/.R4 @ RA/.> @ tC/
RS G .>3H4 L ..D4/..>3H4 @ .4J33/.> @ .D4/
RS G .>DHD or >D.HDK
c. In a world with corporate ta#es, a firms weighted a%erage cost of capital is e&ual to0
RW)CC G NA - .A L S/O.> @ tC/RA L NS - .A L S/ORS
The pro"lem does not pro%ide either the de"t*%alue ratio or e&uit!*%alue ratio. 5owe%er, the
firms de"t*e&uit! ratio of is0
A-S G 4.D4
Sol%ing for A0
A G 4.DS
Su"stituting this in the de"t*%alue ratio, we get0
A-X G .DS - ..DS L S/
A-X G .D - >.D
A-X G .6J
)nd the e&uit!*%alue ratio is one minus the de"t*%alue ratio, or0
S-X G > @ .6J
S-X G .I>
So, the W)CC for the compan! is0
RW)CC G .6J.> @ .D4/..4J33/ L .I>..>DHD/
RW)CC G .>644 or >6.49K
357
SOLUTIONS
5. a. The e&uit! "eta of a firm financed entirel! "! e&uit! is e&ual to its unle%ered "eta. Since each
firm has an unle%ered "eta of >.69, we can find the e&uit! "eta for each. Eoing so, we find0
?orth +ole
iE&uit! G N> L .> @ tC/.A-S/Oi<nle%ered
iE&uit! G N> L .> @ .39/.2>,D44,444-26,H44,444O.>.69/
iE&uit! G >.HJ
South +ole
iE&uit! G N> L .> @ tC/.A-S/Oi<nle%ered
iE&uit! G N> L .> @ .39/.26,H44,444-2>,D44,444O.>.69/
iE&uit! G 6.IH
b. We can use the Capital )sset +ricing $odel to find the re&uired return on each firms e&uit!.
Eoing so, we find0
?orth +ole0
RS G R; L iE&uit!.R$ @ R;/
RS G 9.34K L >.HJ.>6.69K @ 9.34K/
RS G >I.43K
South +ole0
RS G R; L iE&uit!.R$ @ R;/
RS G 9.34K L 6.IH.>6.69K @ 9.34K/
RS G 6D.DIK
6. a. If flotation costs are not ta,en into account, the net present %alue of a loan e&uals0
?+XCoan G Rross +roceeds @ )fterta# present %alue of interest and principal pa!ments
?+XCoan G 2>9,444,444 @ .4J.2>9,444,444/.> @ .D4/+XI;)JK,>4 @ 2>9,444,444->.4J
>4
?+XCoan G 23,DH9,939.>H
b. The floatation costs of the loan will "e0
;loatation costs G 2>9,444,444..4394/
;loatation costs G 2969,444
So, the annual floatation e#pense will "e0
)nnual floatation e#pense G 2969,444 - >4
)nnual floatation e#pense G 296,944
B-358
CHAPTER 17 B-
If flotation costs are ta,en into account, the net present %alue of a loan e&uals0
?+XCoan G +roceeds net of flotation costs @ )fterta# present %alue of interest and principal
pa!ments L +resent %alue of the flotation cost ta# shield
?+XCoan G .2>9,444,444 @ 969,444/ @ .4J.2>9,444,444/.> @ .D4/.+XI;)JK,>4/
@ 2D,694,444->.4J
>4
L 296,944.+XI;)JK,>4/
?+XCoan G 23,4I9,349.JI
7. ;irst we need to find the afterta# %alue of the re%enues minus e#penses. The afterta# %alue is0
)fterta# re%enue G 2D,D44,444.> @ .D4/
)fterta# re%enue G 26,HD4,444
?e#t, we need to find the depreciation ta# shield. The depreciation ta# shield each !ear is0
Eepreciation ta# shield G Eepreciation.tC/
Eepreciation ta# shield G .2>6,H44,444 - H/..D4/
Eepreciation ta# shield G 28D4,444
?ow we can find the ?+X of the pro:ect, which is0
?+X G Initial cost L +X of depreciation ta# shield L +X of afterta# re%enue
To find the present %alue of the depreciation ta# shield, we should discount at the ris,*free rate, and
we need to discount the afterta# re%enues at the cost of e&uit!, so0
?+X G @2>6,H44,444 L 28D4,444.+XI;)HK,H/ L 26,HD4,444.+XI;)>HK,H/
?+X G 2>,698,699.63
8. Whether the compan! issues stoc, or issues e&uit! to finance the pro:ect is irrele%ant. The
compan!s optimal capital structure determines the W)CC. In a world with corporate ta#es, a firms
weighted a%erage cost of capital e&uals0
RW)CC G NA - .A L S/O.> @ tC/RA L NS - .A L S/ORS
RW)CC G .84.> @ .39/..4I6/ L .64..>4J4/
RW)CC G .49J6 or 9.J6K
?ow we can use the weighted a%erage cost of capital to discount $ECs unle%ered cash flows.
Eoing so, we find the ?+X of the pro:ect is0
?+X G @294,444,444 L 23,944,444 - 4.49J6
?+X G 2J,48>,I4>.99
9. a. The compan! has a capital structure with three parts0 long*term de"t, short*term de"t, and
e&uit!. Since interest pa!ments on "oth long*term and short*term de"t are ta#*deducti"le,
multipl! the preta# costs "! .> @ tC/ to determine the afterta# costs to "e used in the weighted
a%erage cost of capital calculation. The W)CC using the "oo, %alue weights is0
RW)CC G .wSTE/.RSTE/.> @ tC/ L .wCTE/.RCTE/.> @ tC/ L .wE&uit!/.RE&uit!/
RW)CC G .IRR6 - IRR>I/..439/.> @ .39/ L .IRRJ - IRR>I/..4H8/.> @ .39/ L .IRRH - IRR>I/
..>D9/
359
SOLUTIONS
RW)CC G 4.4II3 or I.I3K
b. <sing the mar,et %alue weights, the compan!s W)CC is0
RW)CC G .wSTE/.RSTE/.> @ tC/ L .wCTE/.RCTE/.> @ tC/ L .wE&uit!/.RE&uit!/
RW)CC G .IRR6 - IRR36/..439/.> @ .39/ L .IRR8 - IRR36/..4H8/.> @ .39/ L .IRR66 - IRR36/
..>D9/
RW)CC G 4.>>66 or >>.66K
c. <sing the target de"t*e&uit! ratio, the target de"t*%alue ratio for the compan! is0
A-S G 4.H4
A G 4.HS
Su"stituting this in the de"t*%alue ratio, we get0
A-X G .HS - ..HS L S/
A-X G .H - >.H
A-X G .3I9
)nd the e&uit!*%alue ratio is one minus the de"t*%alue ratio, or0
S-X G > @ .3I9
S-X G .H69
We can use the ratio of short*term de"t to long*term de"t in a similar manner to find the short*
term de"t to total de"t and long*term de"t to total de"t. <sing the short*term de"t to long*term
de"t ratio, we get0
STE-CTE G 4.64
STE G 4.6CTE
Su"stituting this in the short*term de"t to total de"t ratio, we get0
STE-A G .6CTE - ..6CTE L CTE/
STE-A G .6 - >.6
STE-A G .>I
)nd the long*term de"t to total de"t ratio is one minus the short*term de"t to total de"t ratio, or0
CTE-A G > @ .>I
CTE-A G .83

?ow we can find the short*term de"t to %alue ratio and long*term de"t to %alue ratio "!
multipl!ing the respecti%e ratio "! the de"t*%alue ratio. So0
STE-X G .STE-A/.A-X/
STE-X G .>I..3I9/
STE-X G .4H
B-360
CHAPTER 17 B-
)nd the long*term de"t to %alue ratio is0
CTE-X G .CTE-A/.A-X/
CTE-X G .83..3I9/
CTE-X G .3>
So, using the target capital structure weights, the compan!s W)CC is0
RW)CC G .wSTE/.RSTE/.> @ tC/ L .wCTE/.RCTE/.> @ tC/ L .wE&uit!/.RE&uit!/
RW)CC G ..4H/..439/.> @ .39/ L ..3>/..4H8/.> @ .39/ L ..H69/..>D9/
RW)CC G 4.>49J or >4.9JK
d. The differences in the W)CCs are due to the different weighting schemes. The compan!s
W)CC will most closel! resem"le the W)CC calculated using target weights since future
pro:ects will "e financed at the target ratio. Therefore, the W)CC computed with target
weights should "e used for pro:ect e%aluation.
&ntermediate
10. The ad:usted present %alue of a pro:ect e&uals the net present %alue of the pro:ect under all*e&uit!
financing plus the net present %alue of an! financing side effects. In the :oint %entures case, the
?+X of financing side effects e&uals the afterta# present %alue of cash flows resulting from the
firms de"t. So, the )+X is0
)+X G ?+X.)ll*E&uit!/ L ?+X.;inancing Side Effects/
The ?+X for an all*e&uit! firm is0
?+X.)ll*E&uit!/
?+X G @Initial In%estment L +XN.> @ tC/.EAITE/O L +X.Eepreciation Ta# Shield/
Since the initial in%estment will "e full! depreciated o%er fi%e !ears using the straight*line method,
annual depreciation e#pense is0
)nnual depreciation G =69,444,444-9
)nnual depreciation G =9,444,444
?+X G @=69,444,444 L .> @ 4.39/.=3,D44,444/+XI;)64,>3K L .4.39/.=9,444,444/+XI;)9,>3K
?+X 4 @=3,364,>DD.34
?+X.;inancing Side Effects/
The ?+X of financing side effects e&uals the after*ta# present %alue of cash flows resulting from the
firms de"t. The coupon rate on the de"t is rele%ant to determine the interest pa!ments, "ut the
resulting cash flows should still "e discounted at the preta# cost of de"t. So, the ?+X of the
financing effects is0
?+X G +roceeds @ )fterta# +X.Interest +a!ments/ @ +X.+rincipal Repa!ments/
?+X G =>9,444,444 @ .> @ 4.39/.4.49/.=>9,444,444/+XI;)>9,8.9K @ =>9,444,444->.489
>9
?+X G =H,93J,98H.34
361
SOLUTIONS
So, the )+X of the pro:ect is0
)+X G ?+X.)ll*E&uit!/ L ?+X.;inancing Side Effects/
)+X G @=3,364,>DD.34 L =H,93J,98H.34
)+X G =3,6>J,DD6.44
11. If the compan! had to issue de"t under the terms it would normall! recei%e, the interest rate on the
de"t would increase to the compan!s normal cost of de"t. The ?+X of an all*e&uit! pro:ect would
remain unchanged, "ut the ?+X of the financing side effects would change. The ?+X of the
financing side effects would "e0
?+X G +roceeds @ )fterta# +X.Interest +a!ments/ @ +X.+rincipal Repa!ments/
?+X G =>9,444,444 @ .> @ 4.39/.4.489/.=>9,444,444/+XI;)>9,8.9K @ =>9,444,444-..>.489/
>9
?+X G =3,I49,IH9.9I
<sing the ?+X of an all*e&uit! pro:ect from the pre%ious pro"lem, the new )+X of the pro:ect
would "e0
)+X G ?+X.)ll*E&uit!/ L ?+X.;inancing Side Effects/
)+X G @=3,364,>DD.34 L =3,I49,IH9.9I
)+X G =389,H6>.6I
The gain to the compan! from issuing su"sidied de"t is the difference "etween the two )+Xs, so0
Rain from su"sidied de"t G =3,6>J,DD6.44 @ 389,H6>.6I
Rain from su"sidied de"t G =6,833,864.I3
$ost of the %alue of the pro:ect is in the form of the su"sidied interest rate on the de"t issue.
12. The ad:usted present %alue of a pro:ect e&uals the net present %alue of the pro:ect under all*e&uit!
financing plus the net present %alue of an! financing side effects. ;irst, we need to calculate the
unle%ered cost of e&uit!. )ccording to $odigliani*$iller +roposition II with corporate ta#es0
RS G R4 L .A-S/.R4 @ RA/.> @ tC/
.>H G R4 L .4.94/.R4 @ 4.4J/.> @ 4.D4/
R4 G 4.>D38 or >D.38K
?ow we can find the ?+X of an all*e&uit! pro:ect, which is0
?+X G +X.<nle%ered Cash ;lows/
?+X G @S)R6D,444,444 L S)R8,444,444->.>D38 L S)R>3,444,444-.>.>D38/
6
L S)R>4,444,444-
.>.>D38/
3

?+X G @S)R388,6I9.48
?e#t, we need to find the net present %alue of financing side effects. This is e&ual the afterta#
present %alue of cash flows resulting from the firms de"t. So0
?+X G +roceeds @ )fterta# +X.Interest +a!ments/ @ +X.+rincipal +a!ments/
B-362
CHAPTER 17 B-
Each !ear, and e&ual principal pa!ment will "e made, which will reduce the interest accrued during
the !ear. Ri%en a ,nown le%el of de"t, de"t cash flows should "e discounted at the pre*ta# cost of
de"t, so the ?+X of the financing effects are0
?+X G S)R>6,444,444 @ .> @ .D4/..4J/.S)R>6,444,444/ - .>.4J/ @ S)RD,444,444-.>.4J/
@ .> @ .D4/..4J/.S)R8,444,444/-.>.4J/
6
@ S)RD,444,444-.>.4J/
6

@ .> @ .D4/..4J/.S)RD,444,444/-.>.4J/
3
@ S)RD,444,444-.>.4J/
3
?+X G S)RIDJ,J68.93
So, the )+X of pro:ect is0
)+X G ?+X.)ll*e&uit!/ L ?+X.;inancing side effects/
)+X G @S)R388,6I9.48 L IDJ,J68.93
)+X G S)R3H>,H93.DH
13. a. To calculate the ?+X of the pro:ect, we first need to find the compan!s W)CC. In a world
with corporate ta#es, a firms weighted a%erage cost of capital e&uals0
RW)CC G NA - .A L S/O.> @ tC/RA L NS - .A L S/ORS
The mar,et %alue of the compan!s e&uit! is0
$ar,et %alue of e&uit! G 9,444,444.V64/
$ar,et %alue of e&uit! G V>44,444,444
So, the de"t*%alue ratio and e&uit!*%alue ratio are0
Ee"t*%alue G V34,444,444 - .V34,444,444 L >44,444,444/
Ee"t*%alue G .6348
E&uit!*%alue G V>44,444,444 - .V34,444,444 L >44,444,444/
E&uit!*%alue G .IHJ6
Since the CE' "elie%es its current capital structure is optimal, these %alues can "e used as the
target weights in the firms weighted a%erage cost of capital calculation. The !ield to maturit!
of the compan!s de"t is its preta# cost of de"t. To find the compan!s cost of e&uit!, we need
to calculate the stoc, "eta. The stoc, "eta can "e calculated as0
G S,$ -
6
$
G .4D8 - .64
6
G >.64
?ow we can use the Capital )sset +ricing $odel to determine the cost of e&uit!. The Capital
)sset +ricing $odel is0
RS G R; L i.R$ @ R;/
RS G HK L >.64.I.94K/
RS G >9.44K
363
SOLUTIONS
?ow, we can calculate the compan!s W)CC, which is0
RW)CC G NA - .A L S/O.> @ tC/RA L NS - .A L S/ORS
RW)CC G .6348.> @ .38/..48/ L .IHJ6..>9/
RW)CC G .>6H8 or >6.H8K
;inall!, we can use the W)CC to discount the unle%ered cash flows, which gi%es us an ?+X
of0
?+X G @VD4,444,444 L V>3,444,444.+XI;)>6.H8K,9/
?+X G VH,4IJ,849.83
b. The weighted a%erage cost of capital used in part a will not change if the firm chooses to fund
the pro:ect entirel! with de"t. The weighted a%erage cost of capital is "ased on optimal capital
structure weights. Since the current capital structure is optimal, all*de"t funding for the pro:ect
simpl! implies that the firm will ha%e to use more e&uit! in the future to "ring the capital
structure "ac, towards the target.
'hallenge
14. a. The compan! is currentl! an all*e&uit! firm, so the %alue as an all*e&uit! firm e&uals the
present %alue of afterta# cash flows, discounted at the cost of the firms unle%ered cost of
e&uit!. So, the current %alue of the compan! is0
X< G N.+reta# earnings/.> @ tC/O - R4
X< G N.239,444,444/.> @ .39/O - .64
X< G 2>>3,I94,444
The price per share is the total %alue of the compan! di%ided "! the shares outstanding, or0
+rice per share G 2>>3,I94,444 - >,944,444
+rice per share G 2I9.83
b. The ad:usted present %alue of a firm e&uals its %alue under all*e&uit! financing plus the net
present %alue of an! financing side effects. In this case, the ?+X of financing side effects
e&uals the afterta# present %alue of cash flows resulting from the firms de"t. Ri%en a ,nown
le%el of de"t, de"t cash flows can "e discounted at the preta# cost of de"t, so the ?+X of the
financing effects are0
?+X G +roceeds @ )fterta# +X.Interest +a!ments/
?+X G 2D4,444,444 @ .> @ .39/..4J/.2D4,444,444/ - .4J
?+X G 2>D,444,444
So, the %alue of the compan! after the recapitaliation using the )+X approach is0
X G 2>>3,I94,444 L >D,444,444
X G 2>6I,I94,444
B-364
CHAPTER 17 B-
Since the compan! has not !et issued the de"t, this is also the %alue of e&uit! after the
announcement. So, the new price per share will "e0
?ew share price G 2>6I,I94,444 - >,944,444
?ew share price G 289.>I
c. The compan! will use the entire proceeds to repurchase e&uit!. <sing the share price we
calculated in part b, the num"er of shares repurchased will "e0
Shares repurchased G 2D4,444,444 - 289.>I
Shares repurchased G DHJ,HHI
)nd the new num"er of shares outstanding will "e0
?ew shares outstanding G >,944,444 @ DHJ,HHI
?ew shares outstanding G >,434,333
The %alue of the compan! increased, "ut part of that increase will "e funded "! the new de"t.
The %alue of e&uit! after recapitaliation is the total %alue of the compan! minus the %alue of
de"t, or0
?ew %alue of e&uit! G 2>6I,I94,444 @ D4,444,444
?ew %alue of e&uit! G 28I,I94,444
So, the price per share of the compan! after recapitaliation will "e0
?ew share price G 28I,I94,444 - >,434,333
?ew share price G 289.>I
The price per share is unchanged.
d. In order to %alue a firms e&uit! using the flow*to*e&uit! approach, we must discount the cash
flows a%aila"le to e&uit! holders at the cost of the firms le%ered e&uit!. )ccording to
$odigliani*$iller +roposition II with corporate ta#es, the re&uired return of le%ered e&uit! is0
RS G R4 L .A-S/.R4 @ RA/.> @ tC/
RS G .64 L .2D4,444,444 - 28I,I94,444/..64 @ .4J/.> @ .39/
RS G .636H or 63.6HK
)fter the recapitaliation, the net income of the compan! will "e0
EAIT 239,444,444
Interest 3,H44,444
EAT 23>,D44,444
Ta#es >4,JJ4,444
?et income 264,D>4,444
365
SOLUTIONS
The firm pa!s all of its earnings as di%idends, so the entire net income is a%aila"le to
shareholders. <sing the flow*to*e&uit! approach, the %alue of the e&uit! is0
S G Cash flows a%aila"le to e&uit! holders - RS
S G 264,D>4,444 - .636H
S G 28I,I94,444
15. a. If the compan! were financed entirel! "! e&uit!, the %alue of the firm would "e e&ual to the
present %alue of its unle%ered after*ta# earnings, discounted at its unle%ered cost of capital.
;irst, we need to find the compan!s unle%ered cash flows, which are0
Sales 63,944,444
Xaria"le costs >D,>44,444
EAT J,D44,444
Ta# 3,IH4,444
?et income 9,HD4,444
So, the %alue of the unle%ered compan! is0
X< G 9,HD4,444 - .>I
X< G 33,>IH,DI4.9J
b. )ccording to $odigliani*$iller +roposition II with corporate ta#es, the %alue of le%ered e&uit!
is0
RS G R4 L .A-S/.R4 @ RA/.> @ tC/
RS G .>I L ..D9/..>I @ .4J/.> @ .D4/
RS G .>J>H or >J.>HK
c. In a world with corporate ta#es, a firms weighted a%erage cost of capital e&uals0
RW)CC G NA - .A L S/O.> @ tC/RA L NS - .A L S/ORS
So we need the de"t*%alue and e&uit!*%alue ratios for the compan!. The de"t*e&uit! ratio for
the compan! is0
A-S G 4.D9
A G 4.D9S
Su"stituting this in the de"t*%alue ratio, we get0
A-X G .D9S - ..D9S L S/
A-X G .D9 - >.D9
A-X G .3>
B-366
CHAPTER 17 B-
)nd the e&uit!*%alue ratio is one minus the de"t*%alue ratio, or0
S-X G > @ .3>
S-X G .HJ
So, using the capital structure weights, the compan!s W)CC is0
RW)CC G NA - .A L S/O.> @ tC/RA L NS - .A L S/ORS
RW)CC G .3>.> @ .D4/..4J/ L .HJ..>J>H/
RW)CC G .>D8J or >D.8JK
We can use the weighted a%erage cost of capital to discount the firms unle%ered afterta#
earnings to %alue the compan!. Eoing so, we find0
XC G 9,HD4,444 - .>D8J
XC G 3I,8I8,HDI.96
?ow we can use the de"t*%alue ratio and e&uit!*%alue ratio to find the %alue of de"t and e&uit!,
which are0
A G XC.Ee"t*%alue/
A G 3I,8I8,HDI.96..3>/
A G >>,I99,DD6.33
S G XC.E&uit!*%alue/
S G 3I,8I8,HDI.96..HJ/
S G 6H,>63,649.>J
d. In order to %alue a firms e&uit! using the flow*to*e&uit! approach, we can discount the cash
flows a%aila"le to e&uit! holders at the cost of the firms le%ered e&uit!. ;irst, we need to
calculate the le%ered cash flows a%aila"le to shareholders, which are0
Sales 63,944,444
Xaria"le costs >D,>44,444
EAIT J,D44,444
Interest >,49I,JJ4
EAT 8,3D6,4>4
Ta# 3,33H,84D
?et income 9,449,64H
So, the %alue of e&uit! with the flow*to*e&uit! method is0
S G Cash flows a%aila"le to e&uit! holders - RS
S G 9,449,64H - .>J>H
S G 6H,>63,649.>J
367
SOLUTIONS
16. a. Since the compan! is currentl! an all*e&uit! firm, its %alue e&uals the present %alue of its
unle%ered after*ta# earnings, discounted at its unle%ered cost of capital. The cash flows to
shareholders for the unle%ered firm are0
EAIT =I9,444
Ta# 34,444
?et income =D9,444
So, the %alue of the compan! is0
X< G =D9,444 - .>8
X< G =694,444
b. The ad:usted present %alue of a firm e&uals its %alue under all*e&uit! financing plus the net
present %alue of an! financing side effects. In this case, the ?+X of financing side effects
e&uals the after*ta# present %alue of cash flows resulting from de"t. Ri%en a ,nown le%el of
de"t, de"t cash flows should "e discounted at the pre*ta# cost of de"t, so0
?+X G +roceeds @ )fterta# +X.Interest pa!ments/
?+X G =>H4,444 @ .> @ .D4/..>4/.=>H4,444/ - 4.>4
?+X G =HD,444
So, using the )+X method, the %alue of the compan! is0
)+X G X< L ?+X.;inancing side effects/
)+X G =694,444 L HD,444
)+X G =3>D,444
The %alue of the de"t is gi%en, so the %alue of e&uit! is the %alue of the compan! minus the
%alue of the de"t, or0
S G X @ A
S G =3>D,444 @ >H4,444
S G =>9D,444
c. )ccording to $odigliani*$iller +roposition II with corporate ta#es, the re&uired return of
le%ered e&uit! is0
RS G R4 L .A-S/.R4 @ RA/.> @ tC/
RS G .>8 L .=>H4,444 - =>9D,444/..>8 @ .>4/.> @ .D4/
RS G .66JJ or 66.JJK
B-368
CHAPTER 17 B-
d. In order to %alue a firms e&uit! using the flow*to*e&uit! approach, we can discount the cash
flows a%aila"le to e&uit! holders at the cost of the firms le%ered e&uit!. ;irst, we need to
calculate the le%ered cash flows a%aila"le to shareholders, which are0
EAIT =I9,444
Interest >H,444
EAT =9J,444
Ta# 63,H44
?et income =39,D44
So, the %alue of e&uit! with the flow*to*e&uit! method is0
S G Cash flows a%aila"le to e&uit! holders - RS
S G =39,D44 - .66JJ
S G =>9D,444
17. Since the compan! is not pu"licl! traded, we need to use the industr! num"ers to calculate the
industr! le%ered return on e&uit!. We can then find the industr! unle%ered return on e&uit!, and re*
le%er the industr! return on e&uit! to account for the different use of le%erage. So, using the C)+$
to calculate the industr! le%ered return on e&uit!, we find0
RS G R; L i.$R+/
RS G IK L >.6.8K/
RS G >H.H4K
?e#t, to find the a%erage cost of unle%ered e&uit! in the holida! gift industr! we can use $odigliani*
$iller +roposition II with corporate ta#es, so0
RS G R4 L .A-S/.R4 @ RA/.> @ tC/
.>HH4 G R4 L ..D4/.R4 @ .4J/.> @ .D4/
R4 G .>DJ3 or >D.J3K
?ow, we can use the $odigliani*$iller +roposition II with corporate ta#es to re*le%er the return on
e&uit! to account for this compan!s de"t*e&uit! ratio. Eoing so, we find0
RS G R4 L .A-S/.R4 @ RA/.> @ tC/
RS G .>DJ3 L ..39/..>DJ3 @ .4J/.> @ .D4/
RS G .>H8D or >H.8DK
$ince t!e pro=ect is >inanced at t!e >ir'?s tar#et de&t@eAuitB ratio; it 'ust &e discounted at t!e
co'panB?s wei#!ted avera#e cost o> capital. *n a world wit! corporate taCes; a >ir'?s wei#!ted
avera#e cost o> capital eAuals<
RW)CC G NA - .A L S/O.> @ tC/RA L NS - .A L S/ORS
369
SOLUTIONS
So we need the de"t*%alue and e&uit!*%alue ratios for the compan!. The de"t*e&uit! ratio for the
compan! is0
A-S G 4.D4
A G 4.D4S
Su"stituting this in the de"t*%alue ratio, we get0
A-X G .D4S - ..D4S L S/
A-X G .D4 - >.D4
A-X G .6J
)nd the e&uit!*%alue ratio is one minus the de"t*%alue ratio, or0
S-X G > @ .6J
S-X G .I>
So, using the capital structure weights, the compan!s W)CC is0
RW)CC G NA - .A L S/O.> @ tC/RA L NS - .A L S/ORS
RW)CC G .6J.> @ .D4/..4J/ L .I>..>H8D/
RW)CC G .>363 or >3.63K
?ow we need the pro:ects cash flows. The cash flows increase for the first fi%e !ears "efore le%eling
off into perpetuit!. So, the cash flows from the pro:ect for the ne#t si# !ears are0
\ear > cash flow =I9,444.44
\ear 6 cash flow =I8,I94.44
\ear 3 cash flow =86,H8I.94
\ear D cash flow =8H,86>.88
\ear 9 cash flow =J>,>H6.JI
\ear H cash flow =J9,I6>.>6
So, the ?+X of the pro:ect is0
?+X G @=D94,444 L =I9,444->.>363 L =I8,I94->.>363
6
L =86,H8I.94->.>363
3
L =8H,86>.88->.>363
D

L =J>,>H6.JI->.>363
9
L .=J9,I6>.>6-.>363/->.>363
9
?+X G =669,6J4.86
B-370
CHAPTER 18
DIVIDENDS AND OTHER PAYOUTS
Answers to Concepts Review and Critical !in"in# Questions
1. Ei%idend polic! deals with the timing of di%idend pa!ments, not the amounts ultimatel! paid.
Ei%idend polic! is irrele%ant when the timing of di%idend pa!ments doesnt affect the present %alue
of all future di%idends.
2. ) stoc, repurchase reduces e&uit! while lea%ing de"t unchanged. The de"t ratio rises. ) firm could,
if desired, use e#cess cash to reduce de"t instead. This is a capital structure decision.
3. The chief draw"ac, to a strict di%idend polic! is the %aria"ilit! in di%idend pa!ments. This is a
pro"lem "ecause in%estors tend to want a somewhat predicta"le cash flow. )lso, if there is
information content to di%idend announcements, then the firm ma! "e inad%ertentl! telling the
mar,et that it is e#pecting a downturn in earnings prospects when it cuts a di%idend, when in realit!
its prospects are %er! good. In a compromise polic!, the firm maintains a relati%el! constant
di%idend. It increases di%idends onl! when it e#pects earnings to remain at a sufficientl! high le%el
to pa! the larger di%idends, and it lowers the di%idend onl! if it a"solutel! has to.
4. ;rida!, Eecem"er 6J is the e#*di%idend da!. Remem"er not to count Januar! > "ecause it is a
holida!, and the e#changes are closed. )n!one who "u!s the stoc, "efore Eecem"er 6J is entitled to
the di%idend, assuming the! do not sell it again "efore Eecem"er 6J.
5. ?o, "ecause the mone! could "e "etter in%ested in stoc,s that pa! di%idends in cash which "enefit
the fundholders directl!.
6. The change in price is due to the change in di%idends, not due to the change in di%idend polic.
Ei%idend polic! can still "e irrele%ant without a contradiction.
7. The stoc, price dropped "ecause of an e#pected drop in future di%idends. Since the stoc, price is the
present %alue of all future di%idend pa!ments, if the e#pected future di%idend pa!ments decrease,
then the stoc, price will decline.
8. The plan will pro"a"l! ha%e little effect on shareholder wealth. The shareholders can rein%est on
their own, and the shareholders must pa! the ta#es on the di%idends either wa!. 5owe%er, the
shareholders who ta,e the option ma! "enefit at the e#pense of the ones who dont ."ecause of the
discount/. )lso as a result of the plan, the firm will "e a"le to raise e&uit! "! pa!ing a >4K flotation
cost .the discount/, which ma! "e a smaller discount than the mar,et flotation costs of a new issue
for some companies.
9. If these firms :ust went pu"lic, the! pro"a"l! did so "ecause the! were growing and needed the
additional capital. Rrowth firms t!picall! pa! %er! small cash di%idends, if the! pa! a di%idend at
all. This is "ecause the! ha%e numerous pro:ects a%aila"le, and the! rein%est the earnings in the firm
instead of pa!ing cash di%idends.
SOLUTIONS
10. It would not "e irrational to find low*di%idend, high*growth stoc,s. The trust should "e indifferent
"etween recei%ing di%idends or capital gains since it does not pa! ta#es on either one .ignoring
possi"le restrictions on in%asion of principal, etc./. It would "e irrational, howe%er, to hold municipal
"onds. Since the trust does not pa! ta#es on the interest income it recei%es, it does not need the ta#
"rea, associated with the municipal "onds. Therefore, it should prefer to hold higher !ield, ta#a"le
"onds.
11. The stoc, price drop on the e#*di%idend date should "e lower. With ta#es, stoc, prices should drop
"! the amount of the di%idend, less the ta#es in%estors must pa! on the di%idends. ) lower ta# rate
lowers the in%estors ta# lia"ilit!.
12. With a high ta# on di%idends and a low ta# on capital gains, in%estors, in general, will prefer capital
gains. If the di%idend ta# rate declines, the attracti%eness of di%idends increases.
13. Mnowing that share price can "e e#pressed as the present %alue of e#pected future di%idends does not
ma,e di%idend polic! rele%ant. <nder the growing perpetuit! model, if o%erall corporate cash flows
are unchanged, then a change in di%idend polic! onl! changes the timing of the di%idends. The +X
of those di%idends is the same. This is true "ecause, gi%en that future earnings are held constant,
di%idend polic! simpl! represents a transfer "etween current and future stoc,holders.
In a more realistic conte#t and assuming a finite holding period, the %alue of the shares should
represent the future stoc, price as well as the di%idends. )n! cash flow not paid as a di%idend will "e
reflected in the future stoc, price. )s such, the +X of the cash flows will not change with shifts in
di%idend polic!( di%idend polic! is still irrele%ant.
14. The "ird*in*the*hand argument is "ased upon the erroneous assumption that increased di%idends
ma,e a firm less ris,!. If capital spending and in%estment spending are unchanged, the firms o%erall
cash flows are not affected "! the di%idend polic!.
15. This argument is theoreticall! correct. In the real world, with transaction costs of securit! trading,
home*made di%idends can "e more e#pensi%e than di%idends directl! paid out "! the firms.
5owe%er, the e#istence of financial intermediaries, such as mutual funds, reduces the transaction
costs for indi%iduals greatl!. Thus, as a whole, the desire for current income shouldnt "e a ma:or
factor fa%oring high*current*di%idend polic!.
16. a. Caps past "eha%ior suggests a preference for capital gains, while Widow Jones e#hi"its a
preference for current income.
b. Cap could show the Widow how to construct homemade di%idends through the sale of stoc,.
'f course, Cap will also ha%e to con%ince her that she li%es in an $$ world. Remem"er that
homemade di%idends can onl! "e constructed under the $$ assumptions.
c. Widow Jones ma! still not in%est in ?eotech "ecause of the transaction costs in%ol%ed in
constructing homemade di%idends. )lso, the Widow ma! desire the uncertaint! resolution
which comes with high di%idend stoc,s.
17. To minimie her ta# "urden, !our aunt should di%est herself of high di%idend !ield stoc,s and in%est
in low di%idend !ield stoc,. 'r, if possi"le, she should ,eep her high di%idend stoc,s, "orrow an
e&ui%alent amount of mone! and in%est that mone! in a ta#*deferred account.
B-372
CHAPTER 18 B-
18. The capital in%estment needs of small, growing companies are %er! high. Therefore, pa!ment of
di%idends could curtail their in%estment opportunities. Their other option is to issue stoc, to pa! the
di%idend, there"! incurring issuance costs. In either case, the companies and thus their in%estors are
"etter off with a ero di%idend polic! during the firms rapid growth phases. This fact ma,es these
firms attracti%e onl! to low di%idend clienteles.
This e#ample demonstrates that di%idend polic! is rele%ant when there are issuance costs. Indeed, it
ma! "e rele%ant whene%er the assumptions "ehind the $$ model are not met.
19. <nless there is an unsatisfied high di%idend clientele, a firm cannot impro%e its share price "!
switching policies. If the mar,et is in e&uili"rium, the num"er of people who desire high di%idend
pa!out stoc,s should e#actl! e&ual the num"er of such stoc,s a%aila"le. The supplies and demands
of each clientele will "e e#actl! met in e&uili"rium. If the mar,et is not in e&uili"rium, the suppl! of
high di%idend pa!out stoc,s ma! "e less than the demand. 'nl! in such a situation could a firm
"enefit from a polic! shift.
20. This finding implies that firms use initial di%idends to 1signal8 their potential growth and positi%e
?+X prospects to the stoc, mar,et. The initiation of regular cash di%idends also ser%es to con%ince
the mar,et that their high current earnings are not temporar!.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. The afterta# di%idend is the preta# di%idend times one minus the ta# rate, so0
)fterta# di%idend G 2H.44.> @ .>9/ G 29.>4
The stoc, price should drop "! the afterta# di%idend amount, or0
E#*di%idend price G 2J4 @ 9.>4 G 28D.J4
2. a. The shares outstanding increases "! >4 percent, so0
?ew shares outstanding G >4,444.>.>4/ G >>,444
?ew shares issued G >,444
Since the par %alue of the new shares is >, the capital surplus per share is 6D. The total
capital surplus is therefore0
373
SOLUTIONS
Capital surplus on new shares G >,444.6D/ G 6D,444
Common stoc, .> par %alue/ >>,444
Capital surplus 64D,444
Retained earnings 9H>,944
IIH,944
b. The shares outstanding increases "! 69 percent, so0
?ew shares outstanding G >4,444.>.69/ G >6,944
?ew shares issued G 6,944
Since the par %alue of the new shares is >, the capital surplus per share is 6D. The total
capital surplus is therefore0
Capital surplus on new shares G 6,944.6D/ G H4,444
Common stoc, .> par %alue/ >6,944
Capital surplus 6D4,444
Retained earnings 96D,444
IIH,944
3. a. To find the new shares outstanding, we multipl! the current shares outstanding times the ratio
of new shares to old shares, so0
?ew shares outstanding G >4,444.D->/ G D4,444
The e&uit! accounts are unchanged e#cept that the par %alue of the stoc, is changed "! the ratio
of new shares to old shares, so the new par %alue is0
?ew par %alue G >.>-D/ G 4.69 per share.
b. To find the new shares outstanding, we multipl! the current shares outstanding times the ratio
of new shares to old shares, so0
?ew shares outstanding G >4,444.>-D/ G 6,944.
The e&uit! accounts are unchanged e#cept that the par %alue of the stoc, is changed "! the ratio
of new shares to old shares, so the new par %alue is0
?ew par %alue G >.D->/ G 4.44 per share.
B-374
CHAPTER 18 B-
4. To find the new stoc, price, we multipl! the current stoc, price "! the ratio of old shares to new
shares, so0
a. M5RH9.3-9/ G M5R3J.44
b. M5RH9.>->.64/ G M5R9D.>I
c. M5RH9.>->.D69/ G M5RD9.H>
d. M5RH9.I-3/ G M5R>9>.HI
e. To find the new shares outstanding, we multipl! the current shares outstanding times the ratio
of new shares to old shares, so0
a: >94,444.9-3/ G 694,444
b: >94,444.>.64/ G >84,444
c: >94,444.>.D69/ G 6>3,I94
d: >94,444.3-I/ G HD,68H
5. The stoc, price is the total mar,et %alue of e&uit! di%ided "! the shares outstanding, so0
+4 G 2>I9,444 e&uit!->4,444 shares G 2>I.94 per share
Ignoring ta# effects, the stoc, price will drop "! the amount of the di%idend, so0
+U G 2>I.94 @ >.94 G 2>H.44
The total di%idends paid will "e0
2>.94 per share.>4,444 shares/ G 2>9,444
The e&uit! and cash accounts will "oth decline "! 2>9,444.
6. Repurchasing the shares will reduce shareholders e&uit! "! 2D,469. The shares repurchased will "e
the total purchase amount di%ided "! the stoc, price, so0
Shares "ought G 2D,469-2>I.94 G 634
)nd the new shares outstanding will "e0
?ew shares outstanding G >4,444 @ 634 G J,II4
375
SOLUTIONS
)fter repurchase, the new stoc, price is0
Share price G 2>I4,JI9-J,II4 shares G 2>I.94
The repurchase is effecti%el! the same as the cash di%idend "ecause !ou either hold a share worth
2>I.94, or a share worth 2>H.44 and 2>.94 in cash. Therefore, !ou participate in the repurchase
according to the di%idend pa!out percentage( !ou are unaffected.
7. The stoc, price is the total mar,et %alue of e&uit! di%ided "! the shares outstanding, so0
+4 G =3H4,444 e&uit!-64,444 shares G =>8 per share
The shares outstanding will increase "! 69 percent, so0
?ew shares outstanding G 64,444.>.69/ G 69,444
The new stoc, price is the mar,et %alue of e&uit! di%ided "! the new shares outstanding, so0
+U G =3H4,444-69,444 shares G =>D.D4
8. With a stoc, di%idend, the shares outstanding will increase "! one plus the di%idend amount, so0
?ew shares outstanding G 394,444.>.>6/ G 3J6,444
The capital surplus is the capital paid in e#cess of par %alue, which is =>, so0
Capital surplus for new shares G D6,444.=>J/ G =IJ8,444
The new capital surplus will "e the old capital surplus plus the additional capital surplus for the new
shares, so0
Capital surplus G =>,H94,444 L IJ8,444 G =6,DD8,444
The new e&uit! portion of the "alance sheet will loo, li,e this0
Common stoc, .=> par %alue/ = 3J6,444
Capital surplus 6,DD8,444
Retained earnings 6,>H4,444
=9,444,444
9. The onl! e&uit! account that will "e affected is the par %alue of the stoc,. The par %alue will change
"! the ratio of old shares to new shares, so0
?ew par %alue G =>.>-9/ G =4.64 per share.
B-376
CHAPTER 18 B-
The total di%idends paid this !ear will "e the di%idend amount times the num"er of shares
outstanding. The compan! had 394,444 shares outstanding "efore the split. We must remem"er to
ad:ust the shares outstanding for the stoc, split, so0
Total di%idends paid this !ear G =4.I4.394,444 shares/.9-> split/ G =>,669,444
The di%idends increased "! >4 percent, so the total di%idends paid last !ear were0
Cast !ears di%idends G =>,669,444->.>4 G =>,>>3,H3H.3H
)nd to find the di%idends per share, we simpl! di%ide this amount "! the shares outstanding last
!ear. Eoing so, we get0
Ei%idends per share last !ear G =>,>>3,H3H.3H-394,444 shares G =3.>8
10. The e&uit! portion of capital outla!s is the retained earnings. Su"tracting di%idends from net income,
we get0
E&uit! portion of capital outla!s G B>,644 @ D94 G BI94
Since the de"t*e&uit! ratio is .84, we can find the new "orrowings for the compan! "! multipl!ing
the e&uit! in%estment "! the de"t*e&uit! ratio, so0
?ew "orrowings G .84.BI94/ G BH44
)nd the total capital outla! will "e the sum of the new e&uit! and the new de"t, which is0
Total capital outla!s G BI94 L H44 GB>,394
11. a. The pa!out ratio is the di%idend per share di%ided "! the earnings per share, so0
+a!out ratio G Y)R4.84-Y)RI
+a!out ratio G .>>D3 or >>.D3K
b. <nder a residual di%idend polic!, the additions to retained earnings, which is the e&uit! portion
of the planned capital outla!s, is the retained earnings per share times the num"er of shares
outstanding, so0
E&uit! portion of capital outla!s G I$ shares .Y)RI @ .84/ G Y)RD3.D$
This means the total in%estment outla! will "e0
Total in%estment outla! G Y)RD3.D$ L >8$
Total in%estment outla! G Y)RH>.D$
377
SOLUTIONS
The de"t*e&uit! ratio is the new "orrowing di%ided "! the new e&uit!, so0
E-E ratio G Y)R>8$-Y)RD3.D$ G .D>DI
12. a. Since the compan! has a de"t*e&uit! ratio of 3, the! can raise 23 in de"t for e%er! 2> of e&uit!.
The ma#imum capital outla! with no outside e&uit! financing is0
$a#imum capital outla! G 2>84,444 L 3.2>84,444/ G 2I64,444.
b. If planned capital spending is 2I34,444, then no di%idend will "e paid and new e&uit! will "e
issued since this e#ceeds the amount calculated in a.
c. ?o, the! do not maintain a constant di%idend pa!out "ecause, with the strict residual polic!, the
di%idend will depend on the in%estment opportunities and earnings. )s these two things %ar!,
the di%idend pa!out will also %ar!.
13. a. We can find the new "orrowings for the compan! "! multipl!ing the e&uit! in%estment "! the
de"t*e&uit! ratio, so we get0
?ew de"t G 6.,r9H$/ G ,r>>6$
)dding the new retained earnings, we get0
$a#imum in%estment with no outside e&uit! financing G ,r9H$ L 6.,r9H$/ G ,r>H8$
b. ) de"t*e&uit! ratio of 6 implies capital structure is 6-3 de"t and >-3 e&uit!. The e&uit! portion
of the planned new in%estment will "e0
E&uit! portion of in%estment funds G >-3.,rI6$/ G ,r6D$
This is the addition to retained earnings, so the total a%aila"le for di%idend pa!ments is0
Residual G ,r9H$ @ 6D$ G ,r36$
This ma,es the di%idend per share0
Ei%idend per share G ,r36$->6$ shares G ,r6.HI
c. The "orrowing will "e0
Aorrowing G ,rI6$ @ 6D$ G ,rD8$
)lternati%el!, we could calculate the new "orrowing as the weight of de"t in the capital
structure times the planned capital outla!s, so0
Aorrowing G 6-3.,rI6$/ G ,rD8$
The addition to retained earnings is ,r6D$, which we calculated in part b.
B-378
CHAPTER 18 B-
d. If the compan! plans no capital outla!s, no new "orrowing will ta,e place. The di%idend per
share will "e0
Ei%idend per share G ,r9H$->6$ shares G ,rD.HI
14. a. If the di%idend is declared, the price of the stoc, will drop on the e#*di%idend date "! the %alue
of the di%idend, 29. It will then trade for 2J9.
b. If it is not declared, the price will remain at 2>44.
c. $anns outflows for in%estments are 26,444,444. These outflows occur immediatel!. 'ne !ear
from now, the firm will realie 2>,444,444 in net income and it will pa! 2944,444 in di%idends,
"ut the need for financing is immediate. $ann must finance 26,444,444 through the sale of
shares worth 2>44. It must sell 26,444,444 - 2>44 G 64,444 shares.
d. The $$ model is not realistic since it does not account for ta#es, "ro,erage fees, uncertaint!
o%er future cash flows, in%estors preferences, signaling effects, and agenc! costs.
&ntermediate
15. The price of the stoc, toda! is the +X of the di%idends, so0
+4 G =4.I4->.>9 L =D4->.>9
6
G =34.89
To find the e&ual two !ear di%idends with the same present %alue as the price of the stoc,, we set up
the following e&uation and sol%e for the di%idend .?ote0 The di%idend is a two !ear annuit!, so we
could sol%e with the annuit! factor as well/0
=34.89 G E->.>9 L E->.>9
6

E G =>8.J8
We now ,now the cash flow per share we want each of the ne#t two !ears. We can find the price of
stoc, in one !ear, which will "e0
+> G =D4->.>9 G =3D.I8
Since !ou own >,444 shares, in one !ear !ou want0
Cash flow in \ear one G >,444.=>8.J8/ G =>8,JIJ.4I
Aut !oull onl! get0
Ei%idends recei%ed in one !ear G >,444.=4.I4/ G =I44.44
379
SOLUTIONS
Thus, in one !ear !ou will need to sell additional shares in order to increase !our cash flow. The
num"er of shares to sell in !ear one is0
Shares to sell at time one G .=>8,JIJ.4I @ I44/-=3D.I8 G 969.96 shares
)t \ear 6, !ou cash flow will "e the di%idend pa!ment times the num"er of shares !ou still own, so
the \ear 6 cash flow is0
\ear 6 cash flow G =D4.>,444 @ 969.96/ G =>8,JIJ.4I
16. If !ou onl! want =644 in \ear >, !ou will "u!0
.=I44 @ 644/-=3D.I8 G >D.38 shares
at \ear >. \our di%idend pa!ment in \ear 6 will "e0
\ear 6 di%idend G .>,444 L >D.38/.=D4/ G =D4,9I9
?ote that the present %alue of each cash flow stream is the same. Aelow we show this "! finding the
present %alues as0
+X G =644->.>9 L =D4,9I9->.>9
6
G =34,89D.DD
+X G >,444.=4.I4/->.>9 L >,444.=D4/->.>9
6
G =34,89D.DD
17. a. If the compan! ma,es a di%idend pa!ment, we can calculate the wealth of a shareholder as0
Ei%idend per share G B9,444->,444 shares G B9.44
The stoc, price after the di%idend pa!ment will "e0
+U G BD4 @ 9 G B39 per share
The shareholder will ha%e a stoc, worth B39 and a B9 di%idend for a total wealth of BD4. If the
compan! ma,es a repurchase, the compan! will repurchase0
Shares repurchased G B9,444-BD4 G >69 shares
If the shareholder lets their shares "e repurchased, the! will ha%e BD4 in cash. If the shareholder
,eeps their shares, the!re still worth BD4.
b. If the compan! pa!s di%idends, the current E+S is B4.J9, and the +-E ratio is0
+-E G B39-B4.J9 G 3H.8D
B-380
CHAPTER 18 B-
If the compan! repurchases stoc,, the num"er of shares will decrease. The total net income is
the E+S times the current num"er of shares outstanding. Ei%iding net income "! the new
num"er of shares outstanding, we find the E+S under the repurchase is0
E+S G B4.J9.>,444/-.>,444 >69/ G B>.489I
The stoc, price will remain at BD4 per share, so the +-E ratio is0
+-E G BD4-B>.489I G 3H.8D
c. ) share repurchase would seem to "e the preferred course of action. 'nl! those
shareholders who wish to sell will do so, gi%ing the shareholder a ta# timing option
that he or she doesnt get with a di%idend pa!ment.
18. a. Since the firm has a >44 percent pa!out polic!, the entire net income, Rs.36,444 will "e paid as
a di%idend. The current %alue of the firm is the discounted %alue one !ear from now, plus the
current income, which is0
Xalue G Rs.36,444 L Rs.>,9D9,H44->.>6
Xalue G Rs.>,D>6,444
b. The current stoc, price is the %alue of the firm, di%ided "! the shares outstanding, which is0
Stoc, price G Rs.>,D>6,444->4,444
Stoc, price G Rs.>D>.64
Since the compan! has a >44 percent pa!out polic!, the current di%idend per share will "e the
compan!s net income, di%ided "! the shares outstanding, or0
Current di%idend G Rs.36,444->4,444
Current di%idend G Rs.3.64
The stoc, price will fall "! the %alue of the di%idend to0
E#*di%idend stoc, price G Rs.>D>.64 @ 3.64
E#*di%idend stoc, price G Rs.>38.44
c. i. )ccording to $$, it cannot "e true that the low di%idend is depressing the price. Since
di%idend polic! is irrele%ant, the le%el of the di%idend should not matter. )n! funds not
distri"uted as di%idends add to the %alue of the firm, hence the stoc, price. These directors
merel! want to change the timing of the di%idends .more now, less in the future/. )s the
calculations "elow indicate, the %alue of the firm is unchanged "! their proposal.
Therefore, the share price will "e unchanged.
381
SOLUTIONS
To show this, consider what would happen if the di%idend were increased to Rs.D.69.
Since onl! the e#isting shareholders will get the di%idend, the re&uired rupees amount to
pa! the di%idends is0
Total di%idends G Rs.D.69.>4,444/
Total di%idends G Rs.D6,944
To fund this di%idend pa!ment, the compan! must raise0
Rupee raised G Re&uired funds @ ?et income
Rupee raised G Rs.D6,944 @ 36,444
Rupee raised G Rs.>4,944
This mone! can onl! "e raised with the sale of new e&uit! to maintain the all*e&uit!
financing. Since those new shareholders must also earn >6 percent, their share of the firm
one !ear from now is0
?ew shareholder %alue in one !ear G Rs.>4,944.>.>6/
?ew shareholder %alue in one !ear G Rs.>>,IH4
This means that the old shareholdersT interest falls to0
'ld shareholder %alue in one !ear G Rs.>,9D9,H44 @ >>,IH4
'ld shareholder %alue in one !ear G Rs.>,933,8D4
<nder this scenario, the current %alue of the firm is0
Xalue G Rs.D6,944 L Rs.>,933,8D4->.>6
Xalue G Rs.>,D>6,444

Since the firm %alue is the same as in part a, the change in di%idend polic! had no effect.
ii. The new shareholders are not entitled to recei%e the current di%idend. The! will recei%e
onl! the %alue of the e&uit! one !ear hence. The present %alue of those flows is0
+resent %alue G Rs.>,933,8D4->.>6
+resent %alue G Rs.>,3HJ,944
)nd the current share price will "e0
Current share price G Rs.>,3HJ,944->4,444
Current share price G Rs.>3H.J9
So, the num"er of new shares the compan! must sell will "e0
Shares sold G Rs.>4,944-Rs.>3H.J9
Shares sold G IH.HI shares
B-382
CHAPTER 18 B-
19. a. The current price is the current cash flow of the compan! plus the present %alue of the e#pected
cash flows, di%ided "! the num"er of shares outstanding. So, the current stoc, price is0
Stoc, price G .=>,644,444 L >9,444,444/ - >,444,444
Stoc, price G =>H.64
b. To achie%e a ero di%idend pa!out polic!, he can in%est the di%idends "ac, into the compan!s
stoc,. The di%idends per share will "e0
Ei%idends per share G N.=>,644,444/..94/O->,444,444
Ei%idends per share G =4.H4
)nd the stoc,holder in &uestion will recei%e0
Ei%idends paid to shareholder G =4.H4.>,444/
Ei%idends paid to shareholder G =H44
The new stoc, price after the di%idends are paid will "e0
E#*di%idend stoc, price G =>H.64 @ 4.H4
E#*di%idend stoc, price G =>9.H4
So, the num"er of shares the in%estor will "u! is0
?um"er of shares to "u! G =H44 - =>9.H4
?um"er of shares to "u! G 38.DH
20. a. <sing the formula from the te#t proposed "! Cintner0
Ei%> G Ei%4 L s.t E+S> @ Ei%4/
Ei%> G 2>.69 L .3N..D/.2D.94/ @ 2>.69O
Ei%> G 2>.D>9
b. ?ow we use an ad:ustment rate of 4.94, so the di%idend ne#t !ear will "e0
Ei%> G Ei%4 L s.t E+S> @ Ei%4/
Ei%> G 2>.69 L .9N..D/.2D.94/ @ 2>.69O
Ei%> G 2>.969
c. The lower ad:ustment factor in part a is more conser%ati%e. The lower ad:ustment factor will
alwa!s result in a lower future di%idend.
383
SOLUTIONS
'hallenge
21. )ssuming no capital gains ta#, the afterta# return for the Rordon Compan! is the capital gains
growth rate, plus the di%idend !ield times one minus the ta# rate. <sing the constant growth
di%idend model, we get0
)fterta# return G g L E.> @ t/ G .>9
Sol%ing for g, we get0
.>9 G g L .4H.> @ .39/
g G .>>>4
The e&ui%alent preta# return for Rec,o Compan!, which pa!s no di%idend, is0
+reta# return G g L E G .>>>4 L .4H G >I.>4K
22. <sing the e&uation for the decline in the stoc, price e#*di%idend for each of the ta# rate
policies, we get0
.+4 @ +U/-E G .> @ T+/-.> @ TR/
a. +4 @ +U G E.> @ 4/-.> @ 4/
+4 @ +U G E
b. +4 @ +U G E.> @ .>9/-.> @ 4/
+4 @ +U G .89E
c. +4 @ +U G E.> @ .>9/-.> @ .64/
+4 @ +U G >.4H69E
d. With this ta# polic!, we simpl! need to multipl! the personal ta# rate times one minus the
di%idend e#emption percentage, so0
+4 @ +U G EN> @ ..39/..34/O-.> @ .39/
+4 @ +U G >.3IHJE
e. Since different in%estors ha%e widel! %ar!ing ta# rates on ordinar! income and capital gains,
di%idend pa!ments ha%e different after*ta# implications for different in%estors. This differential
ta#ation among in%estors is one aspect of what we ha%e called the clientele effect.
B-384
CHAPTER 18 B-
23. Since the 6,444,444 cash is after corporate ta#, the full amount will "e in%ested. So, the %alue of
each alternati%e is0
Alternative ) :
The firm in%ests in T*"ills or in preferred stoc,, and then pa!s out as special di%idend in 3 !ears
&f the firm invests in T-%ills0
If the firm in%ests in T*"ills, the afterta# !ield of the T*"ills will "e0
)fterta# corporate !ield G .4I.> @ .39/
)fterta# corporate !ield G .4D99 or D.99K
So, the future %alue of the corporate in%estment in T*"ills will "e0
;X of in%estment in T*"ills G 6,444,444.> L .4D99/
3
;X of in%estment in T*"ills G 6,689,H4J.8J
Since the future %alue will "e paid to shareholders as a di%idend, the afterta# cash flow will "e0
)fterta# cash flow to shareholders G 6,689,H4J.8J.> @ .>9/
)fterta# cash flow to shareholders G >,JD6,IH8.D>
&f the firm invests in preferred stoc(:
If the firm in%ests in preferred stoc,, the assumption would "e that the di%idends recei%ed will "e
rein%ested in the same preferred stoc,. The preferred stoc, will pa! a di%idend of0
+referred di%idend G .>>.6,444,444/
+referred di%idend G 664,444
Since I4 percent of the di%idends are e#cluded from ta#0
Ta#a"le preferred di%idends G .> @ .I4/.664,444/
Ta#a"le preferred di%idends G HH,444
)nd the ta#es the compan! must pa! on the preferred di%idends will "e0
Ta#es on preferred di%idends G .39.HH,444/
Ta#es on preferred di%idends G 63,>44
So, the afterta# di%idend for the corporation will "e0
)fterta# corporate di%idend G 664,444 @ 63,>44
)fterta# corporate di%idend G >JH,J44
385
SOLUTIONS
This means the afterta# corporate di%idend !ield is0
)fterta# corporate di%idend !ield G >JH,J44 - 6,444,444
)fterta# corporate di%idend !ield G .4J8D9 or J.8D9K
The future %alue of the compan!s in%estment in preferred stoc, will "e0
;X of in%estment in preferred stoc, G 6,444,444.> L .4J8D9/
3
;X of in%estment in preferred stoc, G 6,H94,IH6.89
Since the future %alue will "e paid to shareholders as a di%idend, the afterta# cash flow will "e0
)fterta# cash flow to shareholders G 6,H94,IH6.89.> @ .>9/
)fterta# cash flow to shareholders G 6,693,>D8.D6
Alternative .:
The firm pa!s out di%idend now, and indi%iduals in%est on their own. The afterta# cash recei%ed "!
shareholders now will "e0
)fterta# cash recei%ed toda! G 6,444,444.> @ .>9/
)fterta# cash recei%ed toda! G >,I44,444
The individuals invest in Treasur bills:
If the shareholders in%est the current afterta# di%idends in Treasur! "ills, the afterta# indi%idual !ield
will "e0
)fterta# indi%idual !ield on T*"ills G .4I.> @ .3>/
)fterta# indi%idual !ield on T*"ills G .4D83 or D.83K
So, the future %alue of the indi%idual in%estment in Treasur! "ills will "e0
;X of in%estment in T*"ills G >,I44,444.> L .4D83/
3
;X of in%estment in T*"ills G >,J98,D>J.6J
The individuals invest in preferred stoc(:
If the indi%idual in%ests in preferred stoc,, the assumption would "e that the di%idends recei%ed will
"e rein%ested in the same preferred stoc,. The preferred stoc, will pa! a di%idend of0
+referred di%idend G .>>.>,I44,444/
+referred di%idend G >8I,444
B-386
CHAPTER 18 B-
)nd the ta#es on the preferred di%idends will "e0
Ta#es on preferred di%idends G .3>.>8I,444/
Ta#es on preferred di%idends G 9I,JI4
So, the afterta# preferred di%idend will "e0
)fterta# preferred di%idend G >8I,444 @ 9I,JI4
)fterta# preferred di%idend G >6J,434
This means the afterta# indi%idual di%idend !ield is0
)fterta# corporate di%idend !ield G >6J,434 - >,I44,444
)fterta# corporate di%idend !ield G .4I9J or I.9JK
The future %alue of the indi%idual in%estment in preferred stoc, will "e0
;X of in%estment in preferred stoc, G >,I44,444.> L .4I9J/
3
;X of in%estment in preferred stoc, G 6,>>I,6>3.D9
The afterta# cash flow for the shareholders is ma#imied when the firm in%ests the cash in the
preferred stoc,s and pa!s a special di%idend later.
24. a. Cet 8 "e the ordinar! income ta# rate. The indi%idual recei%es an after*ta# di%idend of0
)fterta# di%idend G B>,444.> @ 8/
which she in%ests in Treasur! "onds. The Treasur! "ond will generate afterta# cash flows to the
in%estor of0
)fterta# cash flow from Treasur! "onds G B>,444.> @ 8/N> L .48.> @ 8/O
If the firm in%ests the mone!, its proceeds are0
;irm proceeds G B>,444N> L .48.> @ .39/O
)nd the proceeds to the in%estor when the firm pa!s a di%idend will "e0
+roceeds if firm in%ests first G .> @ 8/ZB>,444N> L .48.> @ .39/O[
387
SOLUTIONS
To "e indifferent, the in%estors proceeds must "e the same whether she in%ests the after*ta#
di%idend or recei%es the proceeds from the firms in%estment and pa!s ta#es on that amount. To
find the rate at which the in%estor would "e indifferent, we can set the two e&uations e&ual, and
sol%e for 8. Eoing so, we find0
B>,444.> @ 8/N> L .48.> @ 8/O G .> @ 8/ZB>,444N> L .48.> @ .39/O[
> L .48.> @ 8/ G > L .48.> @ .39/
8 G .39 or 39K
?ote that this argument does not depend upon the length of time the in%estment is held.
b. \es, this is a reasona"le answer. She is onl! indifferent if the after*ta# proceeds from the
B>,444 in%estment in identical securities are identical. That occurs onl! when the ta# rates are
identical.
c. Since "oth in%estors will recei%e the same pre*ta# return, !ou would e#pect the same answer as
in part a. \et, "ecause the compan! en:o!s a ta# "enefit from in%esting in stoc, .I4 percent of
income from stoc, is e#empt from corporate ta#es/, the ta# rate on ordinar! income which
induces indifference, is much lower. )gain, set the two e&uations e&ual and sol%e for 80
B>,444.> @ 8/N> L .>6.> @ 8/O G .> @ 8/.B>,444Z> L .>6N.I4 L .> @ .I4/.> @ .39/O[/
> L .>6.> @ 8/ G > L .>6N.I4 L .> @ .I4/.> @ .39/O
8 G .>494 or >4.94K
d. It is a compelling argument, "ut there are legal constraints, which deter firms from in%esting
large sums in stoc, of other companies.
B-388
CHAPTER 19
ISSUING SECURITIES TO THE PUBLIC
Answers to Concepts Review and Critical !in"in# Questions
1. ) compan!s internall! generated cash flow pro%ides a source of e&uit! financing. ;or a profita"le
compan!, outside e&uit! ma! ne%er "e needed. Ee"t issues are larger "ecause large companies ha%e
the greatest access to pu"lic de"t mar,ets .small companies tend to "orrow more from pri%ate
lenders/. E&uit! issuers are fre&uentl! small companies going pu"lic( such issues are often &uite
small.
2. ;rom the pre%ious &uestion, economies of scale are part of the answer. Ae!ond this, de"t issues are
simpl! easier and less ris,! to sell from an in%estment "an,s perspecti%e. The two main reasons are
that %er! large amounts of de"t securities can "e sold to a relati%el! small num"er of "u!ers,
particularl! large institutional "u!ers such as pension funds and insurance companies, and de"t
securities are much easier to price.
3. The! are ris,ier and harder to mar,et from an in%estment "an,s perspecti%e.
4. \ields on compara"le "onds can usuall! "e readil! o"ser%ed, so pricing a "ond issue accuratel! is
much less difficult.
5. It is clear that the stoc, was sold too cheapl!, so E!etech had reason to "e unhapp!.
6. ?o, "ut, in fairness, pricing the stoc, in such a situation is e#tremel! difficult.
7. Its an important factor. 'nl! 9 million of the shares were underpriced. The other 38 million were, in
effect, priced completel! correctl!.
8. The e%idence suggests that a non*underwritten rights offering might "e su"stantiall! cheaper than a
cash offer. 5owe%er, such offerings are rare, and there ma! "e hidden costs or other factors not !et
identified or well understood "! researchers.
9. 5e could ha%e done worse since his access to the o%ersu"scri"ed and, presuma"l!, underpriced
issues was restricted while the "ul, of his funds were allocated to stoc,s from the undersu"scri"ed
and, &uite possi"l!, o%erpriced issues.
10. a. The price will pro"a"l! go up "ecause I+'s are generall! underpriced. This is especiall! true
for smaller issues such as this one.
b. It is pro"a"l! safe to assume that the! are ha%ing trou"le mo%ing the issue, and it is li,el! that
the issue is not su"stantiall! underpriced.
11. Competiti%e offer and negotiated offer are two methods to select in%estment "an,ers for
underwriting. <nder the competiti%e offers, the issuing firm can award its securities to the
underwriter with the highest "id, which in turn implies the lowest cost. 'n the other hand, in
SOLUTIONS
negotiated deals, the underwriter gains much information a"out the issuing firm through negotiation,
which helps increase the possi"ilit! of a successful offering.
B-390
CHAPTER 19 B-
12. There are two possi"le reasons for stoc, price drops on the announcement of a new e&uit! issue0 >/
$anagement ma! attempt to issue new shares of stoc, when the stoc, is o%er*%alued, that is, the
intrinsic %alue is lower than the mar,et price. The price drop is the result of the downward
ad:ustment of the o%er%aluation. 6/ When there is an increase in the possi"ilit! of financial distress, a
firm is more li,el! to raise capital through e&uit! than de"t. The mar,et price drops "ecause the
mar,et interprets the e&uit! issue announcement as "ad news.
13. If the interest of management is to increase the wealth of the current shareholders, a rights offering
ma! "e prefera"le "ecause issuing costs as a percentage of capital raised are lower for rights
offerings. $anagement does not ha%e to worr! a"out underpricing "ecause shareholders get the
rights, which are worth something. Rights offerings also pre%ent e#isting shareholders from losing
proportionate ownership control. ;inall!, whether the shareholders e#ercise or sell their rights, the!
are the onl! "eneficiaries.
14. Reasons for shelf registration include0 >/ ;le#i"ilit! in raising mone! onl! when necessar! without
incurring additional issuance costs. 6/ )s Ahagat, $arr and Thompson showed, shelf registration is
less costl! than con%entional underwritten issues. 3/ Issuance of securities is greatl! simplified.
15. Aasic empirical regularities in I+'s include0 >/ underpricing of the offer price, 6/ "est*efforts
offerings are generall! used for small I+'s and firm*commitment offerings are generall! used for
large I+'s, 3/ the underwriter price sta"iliation of the after mar,et and, D/ that issuing costs are
higher in negotiated deals than in competiti%e ones.
$olutions to Questions and %ro&le's
NOTE: All end of chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. The new mar,et %alue will "e the current shares outstanding times the stoc, price plus the
rights offered times the rights price, so0
?ew mar,et %alue G D44,444.289/ L I4,444.2I4/ G 238,J44,444
b. The num"er of rights associated with the old shares is the num"er of shares outstanding di%ided
"! the rights offered, so0
?um"er of rights needed G D44,444 old shares-I4,444 new shares G 9.I> rights per new share
c. The new price of the stoc, will "e the new mar,et %alue of the compan! di%ided "! the total
num"er of shares outstanding after the rights offer, which will "e0
+U G 238,J44,444-.D44,444 L I4,444/ G 286.II
391
SOLUTIONS
d. The %alue of the right
Xalue of a right G 289.44 @ 86.II G 26.63
e. ) rights offering usuall! costs less, it protects the proportionate interests of e#isting share*
holders and also protects against underpricing.
2. a. The ma#imum su"scription price is the current stoc, price, or 2D4. The minimum price is
an!thing greater than 24.
b. The num"er of new shares will "e the amount raised di%ided "! the su"scription price, so0
?um"er of new shares G 294,444,444-239 G >,D68,9I> shares
)nd the num"er of rights needed to "u! one share will "e the current shares outstanding
di%ided "! the num"er of new share offered, so0
?um"er of rights needed G 9,644,444 shares outstanding->,D68,9I> new shares G 3.HD
c. ) shareholder can "u! 3.HD rights on shares for0
3.HD.2D4/ G 2>D9.H4
The shareholder can e#ercise these rights for 239, at a total cost of0
2>D9.H4 L 39.44 G 2>84.H4
The in%estor will then ha%e0
E#*rights shares G > L 3.HD
E#*rights shares G D.HD
The e#*rights price per share is0
+U G N3.HD.2D4/ L 239O-D.HD G 238.J6
So, the %alue of a right is0
Xalue of a right G 2D4 @ 38.J6 G 2>.48
d. Aefore the offer, a shareholder will ha%e the shares owned at the current mar,et price, or0
+ortfolio %alue G .>44 shares/.2D4/ G 2D,444
)fter the rights offer, the share price will fall, "ut the shareholder will also hold the rights, so0
+ortfolio %alue G .>44 shares/.238.J6/ L .>44 rights/.2>.48/ G 2D,444
B-392
CHAPTER 19 B-
3. <sing the e&uation we deri%ed in +ro"lem 6, part c to calculate the price of the stoc, e#*rights, we
can find the num"er of shares a shareholder will ha%e e#*rights, which is0
+U G BID.94 G N?.B84/ L BD4O-.? L >/
? G H.6I3
The num"er of new shares is the amount raised di%ided "! the per*share su"scription price, so0
?um"er of new shares G B>9,444,444-BD4 G 3I9,444
)nd the num"er of old shares is the num"er of new shares times the num"er of shares e#*rights, so0
?um"er of old shares G H.6I3.3I9,444/ G 6,396,6I3
4. If !ou recei%e >,444 shares of each, the profit is0
+rofit G >,444.+E?>>/ @ >,444.+E?H/ G +E?9,444
Since !ou will onl! recei%e one*half of the shares of the o%ersu"scri"ed issue, !our profit will "e0
E#pected profit G 944.+E?>>/ @ >,444.+E?H/ G @+E?944
This is an e#ample of the winners curse.
5. <sing U to stand for the re&uired sale proceeds, the e&uation to calculate the total sale proceeds,
including floatation costs is0
U.> @ .48/ G m89$
U G mJ6,3J>,34D re&uired total proceeds from sale.
So the num"er of shares offered is the total amount raised di%ided "! the offer price, which is0
?um"er of shares offered G mJ6,3J>,34D-mD94 G 649,3>D
6. This is "asicall! the same as the pre%ious pro"lem, e#cept we need to include the mJ44,444 of
e#penses in the amount the compan! needs to raise, so0
U.> @ .48/ G m89.J$
U G mJ3,3HJ,9H9 re&uired total proceeds from sale.
?um"er of shares offered G mJ3,3HJ,9H9-mD94 G 64I,D88
7. We need to calculate the net amount raised and the costs associated with the offer. The net amount
raised is the num"er of shares offered times the price recei%ed "! the compan!, minus the costs
associated with the offer, so0
?et amount raised G .9$ shares/.>J.I9/ @ 844,444 @ 694,444 G JI.I$
393
SOLUTIONS
The compan! recei%ed JI.I million from the stoc, offering. ?ow we can calculate the direct costs.
+art of the direct costs are gi%en in the pro"lem, "ut the compan! also had to pa! the underwriters.
The stoc, was offered at 6> per share, and the compan! recei%ed >J.I9 per share. The difference,
which is the underwriters spread, is also a direct cost. The total direct costs were0
Total direct costs G 844,444 L .6> @ >J.I9/.9$ shares/ G I.49$
We are gi%en part of the indirect costs in the pro"lem. )nother indirect cost is the immediate price
appreciation. The total indirect costs were0
Total indirect costs G 694,444 L .6H @ 6>/.9$ shares/ G 69.69$
This ma,es the total costs0
Total costs G I.49$ L 69.69$ G 36.3$
The floatation costs as a percentage of the amount raised is the total cost di%ided "! the amount
raised, so0
;lotation cost percentage G 36.3$-JI.I$ G .334H or 33.4HK
8. The num"er of rights needed per new share is0
?um"er of rights needed G >44,444 old shares-64,444 new shares G 9 rights per new share.
<sing +R' as the rights*on price, and +S as the su"scription price, we can e#press the price per share
of the stoc, e#*rights as0
+U G N?+R' L +SO-.? L >/
a. +U G N9.2J4/ L 2J4O-H G 2J4.44( ?o change.
b. +U G N9.2J4/ L 289O-H G 28J.>I( +rice drops "! 24.83 per share.
c. +U G N9.2J4/ L 2I4O-H G 28H.HI( +rice drops "! 23.33 per share.
9. In general, the new price per share after the offering will "e0
+ G
shares ?ew shares 'ld
offer from +roceeds ue mar,et %al Current
+
+
The current mar,et %alue of the compan! is the num"er of shares outstanding times the share price,
or0
$ar,et %alue of compan! G >4,444.D4/
$ar,et %alue of compan! G D44,444
B-394
CHAPTER 19 B-
If the new shares are issued at D4, the share price after the issue will "e0
+ G
9,444 >4,444
9,444.2D4/ 2D44,444
+
+
+ G D4.44
If the new shares are issued at 64, the share price after the issue will "e0
+ G
9,444 >4,444
9,444.264/ 2D44,444
+
+
+ G 33.33
If the new shares are issued at >4, the share price after the issue will "e0
+ G
9,444 >4,444
9,444.2>4/ 2D44,444
+
+
+ G 34.44
&ntermediate
10. a. The num"er of shares outstanding after the stoc, offer will "e the current shares outstanding,
plus the amount raised di%ided "! the current stoc, price, assuming the stoc, price doesnt
change. So0
?um"er of shares after offering G >4$ L 239$-294 G >4.I$
Since the par %alue per share is 2>, the old "oo, %alue of the shares is the current num"er of
shares outstanding. ;rom the pre%ious solution, we can see the compan! will sell I44,444
shares, and these will ha%e a "oo, %alue of 294 per share. The sum of these two %alues will
gi%e us the total "oo, %alue of the compan!. If we di%ide this "! the new num"er of shares
outstanding. Eoing so, we find the new "oo, %alue per share will "e0
?ew "oo, %alue per share G N>4$.2D4/ L .I$.294/O->4.I$ G 2D4.H9
The current E+S for the compan! is0
E+S4 G ?I4-Shares4 G 2>9$->4$ shares G 2>.94 per share
)nd the current +-E is0
.+-E/4 G 294-2>.94 G 33.33
If the net income increases "! 2944,444, the new E+S will "e0
E+S> G ?I>-shares> G 2>9.9$->4.I$ shares G 2>.D9 per share
395
SOLUTIONS
)ssuming the +-E remains constant, the new share price will "e0
+> G .+-E/4.E+S
>
/ G 33.33.2>.D9/ G 2D8.6J
The current mar,et*to*"oo, ratio is0
Current mar,et*to*"oo, G 294-2D4 G >.69
<sing the new share price and "oo, %alue per share, the new mar,et*to*"oo, ratio will "e0
?ew mar,et*to*"oo, G 2D8.6J-2D4.H9 G >.>8II
)ccounting dilution has occurred "ecause new shares were issued when the mar,et*to*"oo,
ratio was less than one( mar,et %alue dilution has occurred "ecause the firm financed a negati%e
?+X pro:ect. The cost of the pro:ect is gi%en at 239 million. The ?+X of the pro:ect is the new
mar,et %alue of the firm minus the current mar,et %alue of the firm, or0
?+X G @239$ L N>4.I$.2D8.6J/ @ >4$.294/O G @2>8,333,333
b. ;or the price to remain unchanged when the +-E ratio is constant, E+S must remain constant.
The new net income must "e the new num"er of shares outstanding times the current E+S,
which gi%es0
?I> G .>4.I$ shares/.2>.94 per share/ G 2>H.49$
11. The current R'E of the compan! is0
R'E4 G ?I4-TE4 G =H34,444-=3,H44,444 G .>I94 or >I.94K
The new net income will "e the R'E times the new total e&uit!, or0
?I> G .R'E4/.TE>/ G .>I94.=3,H44,444 L >,>44,444/ G =866,944
The compan!s current earnings per share are0
E+S4 G ?I4-Shares outstanding4 G =H34,444->D,444 shares G =D9.44
The num"er of shares the compan! will offer is the cost of the in%estment di%ided "! the current
share price, so0
?um"er of new shares G =>,>44,444-=J8 G >>,66D
The earnings per share after the stoc, offer will "e0
E+S> G=866,944-69,66D shares G =36.H>
The current +-E ratio is0
.+-E/4 G =J8-=D9.44 G 6.>I8
B-396
CHAPTER 19 B-
)ssuming the +-E remains constant, the new stoc, price will "e0

+> G 6.>I8.=36.H>/ G =I>.4>
The current "oo, %alue per share and the new "oo, %alue per share are0
AX+S4 G TE4-shares4 G =3,H44,444->D,444 shares G =69I.>D per share
AX+S> G TE>-shares> G .=3,H44,444 L >,>44,444/-69,66D shares G =>8H.33 per share
So the current and new mar,et*to*"oo, ratios are0
$ar,et*to*"oo,4 G =J8-=69I.>D G 4.38
$ar,et*to*"oo,> G =I>.4>-=>8H.33 G 4.38
The ?+X of the pro:ect is the new mar,et %alue of the firm minus the current mar,et %alue of the
firm, or0
?+X G @=>,>44,444 L N=I>.4>.69,66D/ @ =J8.>D,444/O G @=H84,II8
)ccounting dilution ta,es place here "ecause the mar,et*to*"oo, ratio is less than one. $ar,et %alue
dilution has occurred since the firm is in%esting in a negati%e ?+X pro:ect.
12. <sing the +-E ratio to find the necessar! E+S after the stoc, issue, we get0
+> G =J8 G 6.>I8.E+S>/
E+S> G =D9.44
The additional net income le%el must "e the E+S times the new shares outstanding, so0
?I G =D9.>>,66D shares/ G =949,>46
)nd the new R'E is0
R'E> G =949,>46-=>,>44,444 G .D9J6
?e#t, we need to find the ?+X of the pro:ect. The ?+X of the pro:ect is the new mar,et %alue of the
firm minus the current mar,et %alue of the firm, or0
?+X G @=>,>44,444 L N=J8.69,66D/ @ =J8.>D,444/O G =4
)ccounting dilution still ta,es place, as AX+S still falls from =69I.>D to =>8H.33, "ut no mar,et
dilution ta,es place "ecause the firm is in%esting in a ero ?+X pro:ect.
397
SOLUTIONS
13. a. )ssume !ou hold three shares of the compan!s stoc,. The %alue of !our holdings "efore !ou
e#ercise !our rights is0
Xalue of holdings G 3.VD,944/
Xalue of holdings G V>3,944
When !ou e#ercise, !ou must remit the three rights !ou recei%e for owning three shares, and
>,444 !ens. \ou ha%e increased !our e&uit! in%estment "! V>,444. The %alue of !our holdings
after surrendering !our rights is0
?ew %alue of holdings G V>3,944 L V>,444
?ew %alue of holdings G V>D,944
)fter e#ercise, !ou own four shares of stoc,. Thus, the price per share of !our stoc, is0
Stoc, price G V>D,944 - D
Stoc, price G V3,H69
b. The %alue of a right is the difference "etween the rights*on price of the stoc, and the e#*rights
price of the stoc,0
Xalue of rights G Rights*on price @ E#*rights price
Xalue of rights G VD,944 @ 3,H69
Xalue of rights G V8I9
c. The price drop will occur on the e#*rights date, e%en though the e#*rights date is neither the
e#piration date nor the date on which the rights are first e#ercisa"le. If !ou purchase the stoc,
"efore the e#*rights date, !ou will recei%e the rights. If !ou purchase the stoc, on or after the
e#*rights date, !ou will not recei%e the rights. Since rights ha%e %alue, the stoc,holder recei%ing
the rights must pa! for them. The stoc, price drop on the e#*rights da! is similar to the stoc,
price drop on an e#*di%idend da!.
14. a. The num"er of new shares offered through the rights offering is the e#isting shares di%ided "!
the rights per share, or0
?ew shares G >,444,444 - 6
?ew shares G 944,444
)nd the new price per share after the offering will "e0
+ G
shares ?ew shares 'ld
offer from +roceeds ue mar,et %al Current
+
+
+ G
944,444 >,444,444
26,444,444 2>3/ >,444,444.
+
+
+ G 2>4.44
B-398
CHAPTER 19 B-
The su"scription price is the amount raised di%ided "! the num"er of num"er of new shares
offered, or0
Su"scription price G 26,444,444 - 944,444
Su"scription price G 2D
)nd the %alue of a right is0
Xalue of a right G .E#*rights price @ Su"scription price/ - Rights needed to "u! a share of stoc,
Xalue of a right G .2>4 @ D/ - 6
Xalue of a right G 23
b. ;ollowing the same procedure, the num"er of new shares offered through the rights offering is0
?ew shares G >,444,444 - D
?ew shares G 694,444
)nd the new price per share after the offering will "e0
+ G
shares ?ew shares 'ld
offer from +roceeds ue mar,et %al Current
+
+
+ G
694,444 >,444,444
26,444,444 2>3/ >,444,444.
+
+
+ G 2>6.44
The su"scription price is the amount raised di%ided "! the num"er of num"er of new shares
offered, or0
Su"scription price G 26,444,444 - 694,444
Su"scription price G 28
)nd the %alue of a right is0
Xalue of a right G .E#*rights price @ Su"scription price/ - Rights needed to "u! a share of stoc,
Xalue of a right G .2>6 @ 8/ - D
Xalue of a right G 2>
c. Since rights issues are constructed so that e#isting shareholdersT proportionate share will remain
unchanged, we ,now that the stoc,holders wealth should "e the same "etween the two
arrangements. 5owe%er, a numerical e#ample ma,es this more clear. )ssume that an in%estor
holds D shares, and will e#ercise under either a or b. +rior to e#ercise, the in%estorTs portfolio
%alue is0
Current portfolio %alue G ?um"er of shares Q Stoc, price
Current portfolio %alue G D.2>6/
Current portfolio %alue G 296
399
SOLUTIONS
)fter e#ercise, the %alue of the portfolio will "e the new num"er of shares time the e#*rights
price, less the su"scription price paid. <nder a, the in%estor gets 6 new shares, so portfolio
%alue will "e0
?ew portfolio %alue G H.2>4/ @ 6.2D/
?ew portfolio %alue G 296
<nder b, the in%estor gets > new share, so portfolio %alue will "e0
?ew portfolio %alue G 9.2>6/ @ >.28/
?ew portfolio %alue G 296
So, the shareholderTs wealth position is unchanged either "! the rights issue itself, or the choice
of which rightTs issue the firm chooses.
15. The num"er of new shares is the amount raised di%ided "! the su"scription price, so0
?um"er of new shares G Rs.H4$-Rs.+S
)nd the e#*rights num"er of shares .?/ is e&ual to0
? G 'ld shares outstanding-?ew shares outstanding
? G 9$-.Rs.H4$-Rs.+S/
? G 4.4833+S
We ,now the e&uation for the e#*rights stoc, price is0
+U G N?+R' L +SO-.? L >/
We can su"stitute in the num"ers we are gi%en, and then su"stitute the two pre%ious results. Eoing
so, and sol%ing for the su"scription price, we get0
+U G Rs.96 G N?.Rs.99/ L Rs.+SO-.? L >/
Rs.96 G N99.4.4833+S/ L +SO-.4.4833+S L >/
Rs.96 G 9.98+S-.> L 4.4833+S/
+S G Rs.D>.H4
16. <sing +R' as the rights*on price, and +S as the su"scription price, we can e#press the price per share
of the stoc, e#*rights as0
+U G N?+R' L +SO-.? L >/
)nd the e&uation for the %alue of a right is0

Xalue of a right G +R' @ +U
B-400
CHAPTER 19 B-
Su"stituting the e#*rights price e&uation into the e&uation for the %alue of a right and rearranging, we
get0
Xalue of a right G +R' @ ZN?+R' L +SO-.? L >/[
Xalue of a right G N.? L >/+R' @ ?+R' @ +SO-.?L>/
Xalue of a right G N+R' @ +SO-.? L >/
17. The net proceeds to the compan! on a per share "asis is the su"scription price times one minus the
underwriter spread, so0
?et proceeds to the compan! G 266.> @ .4H/ G 264.H8 per share
So, to raise the re&uired funds, the compan! must sell0
?ew shares offered G 23.H9$-264.H8 G >IH,DJJ
The num"er of rights needed per share is the current num"er of shares outstanding di%ided "! the
new shares offered, or0
?um"er of rights needed G DJ4,444 old shares->IH,DJJ new shares
?um"er of rights needed G 6.I8 rights per share
The e#*rights stoc, price will "e0
+U G N?+R' L +SO-.? L >/
+U G N6.I8.234/ L 66O-3.I8 G 26I.88
So, the %alue of a right is0
Xalue of a right G 234 @ 6I.88 G 26.>6
)nd !our proceeds from selling !our rights will "e0
+roceeds from selling rights G H,444.26.>6/ G 2>6,I>>.>3
18. <sing the e&uation for %aluing a stoc, e#*rights, we find0
+U G N?+R' L +SO-.? L >/
+U G ND.'$R84/ L '$RD4O-9 G '$RI6
The stoc, is correctl! priced. Calculating the %alue of a right, we find0
Xalue of a right G +R' @ +U
Xalue of a right G '$R84 @ I6 G '$R8
So, the rights are underpriced. \ou can create an immediate profit on the e#*rights da! if the stoc, is
selling for '$RI6 and the rights are selling for '$RH "! e#ecuting the following transactions0
Au! D rights in the mar,et for D.'$RH/ G '$R6D. <se these rights to purchase a new share at the
su"scription price of '$RD4. Immediatel! sell this share in the mar,et for '$RI6, creating an
instant '$R8 profit.
401
CHAPTER 20
LONG-TERM DEBT
Answers to Concepts Review and Critical !in"in# Questions
1. There are two "enefits. ;irst, the compan! can ta,e ad%antage of interest rate declines "! calling in
an issue and replacing it with a lower coupon issue. Second, a compan! might wish to eliminate a
co%enant for some reason. Calling the issue does this. The cost to the compan! is a higher coupon. )
put pro%ision is desira"le from an in%estors standpoint, so it helps the compan! "! reducing the
coupon rate on the "ond. The cost to the compan! is that it ma! ha%e to "u! "ac, the "ond at an
unattracti%e price.
2. Aond issuers loo, at outstanding "onds of similar maturit! and ris,. The !ields on such "onds are
used to esta"lish the coupon rate necessar! for a particular issue to initiall! sell for par %alue. Aond
issuers also simpl! as, potential purchasers what coupon rate would "e necessar! to attract them.
The coupon rate is fi#ed and determines what the "onds coupon pa!ments will "e. The re&uired
return is what in%estors actuall! demand on the issue, and it will fluctuate through time. The coupon
rate and re&uired return are e&ual onl! if the "ond sells for e#actl! at par.
3. Companies pa! to ha%e their "onds rated simpl! "ecause unrated "onds can "e difficult to sell( man!
large in%estors are prohi"ited from in%esting in unrated issues.
4. Treasur! "onds ha%e no credit ris, since the! are "ac,ed "! the <.S. go%ernment, so a rating is not
necessar!. Jun, "onds often are not rated "ecause there would "e no point in an issuer pa!ing a
rating agenc! to assign its "onds a low rating .its li,e pa!ing someone to ,ic, !ou_/.
5. Aond ratings ha%e a su":ecti%e factor to them. Split ratings reflect a difference of opinion among
credit agencies.
6. Cac, of transparenc! means that a "u!er or seller cant see recent transactions, so it is much harder
to determine what the "est "id and as, prices are at an! point in time.
7. Companies charge that "ond rating agencies are pressuring them to pa! for "ond ratings. When a
compan! pa!s for a rating, it has the opportunit! to ma,e its case for a particular rating. With an
unsolicited rating, the compan! has no input.
8. ) >44*!ear "ond loo,s li,e a share of preferred stoc,. In particular, it is a loan with a life that almost
certainl! e#ceeds the life of the lender, assuming that the lender is an indi%idual. With a :un, "ond,
the credit ris, can "e so high that the "orrower is almost certain to default, meaning that the creditors
are %er! li,el! to end up as part owners of the "usiness. In "oth cases, the 1e&uit! in disguise8 has a
significant ta# ad%antage.
CHAPTER 20 B-
9. The statement is true. In an efficient mar,et, the calla"le "onds will "e sold at a lower price than that
of the non*calla"le "onds, other things "eing e&ual. This is "ecause the holder of calla"le "onds
effecti%el! sold a call option to the "ond issuer. Since the issuer holds the right to call the "onds, the
price of the "onds will reflect the disad%antage to the "ondholders and the ad%antage to the "ond
issuer .i.e., the "ondholder has the o"ligation to surrender their "onds when the call option is
e#ercised "! the "ond issuer./
10. )s the interest rate falls, the call option on the calla"le "onds is more li,el! to "e e#ercised "! the
"ond issuer. Since the non*calla"le "onds do not ha%e such a draw"ac,, the %alue of the "ond will go
up to reflect the decrease in the mar,et rate of interest. Thus, the price of non*calla"le "onds will
mo%e higher than that of the calla"le "onds.
11. Aonds with an SF+s rating of AA and "elow or a $ood!s rating of Aa and "elow are called :un,
"onds .or "elow*in%estment grade "onds/. Some contro%ersies surrounding :un, "onds are0 >/ Jun,
"onds increase the firms interest deduction. 6/ Jun, "onds increase the possi"ilit! of high le%erage,
which ma! lead to wholesale defaults in economic downturns. 3/ $ergers financed "! :un, "onds
ha%e fre&uentl! resulted in dislocations and loss of :o"s.
12. Sin,ing funds pro%ide additional securit! to "onds. If a firm is e#periencing financial difficult!, it is
li,el! to ha%e trou"le ma,ing its sin,ing fund pa!ments. Thus, the sin,ing fund pro%ides an earl!
warning s!stem to the "ondholders a"out the &ualit! of the "onds. ) draw"ac, to sin,ing funds is
that the! gi%e the firm an option that the "ondholders ma! find distasteful. If "ond prices are low, the
firm ma! satisf! its sin,ing fund o"ligation "! "u!ing "onds in the open mar,et. If "ond prices are
high though, the firm ma! satisf! its o"ligation "! purchasing "onds at face %alue .or other fi#ed
price, depending on the specific terms/. Those "onds "eing repurchased are chosen through a lotter!.
13. 'pen*end mortgage is ris,ier "ecause the firm can issue additional "onds on its propert!. The
additional "onds will cause an increase in interest pa!ments( this increases the ris, to the e#isting
"onds.
14. 'haracteristic =ublic &ssues "irect Financing
a. Re&uire SEC registration \es ?o
". 5igher interest cost ?o \es
c. 5igher fi#ed cost \es ?o
d. Yuic,er access to funds ?o \es
e. )cti%e secondar! mar,et \es ?o
f. Easil! renegotiated ?o \es
g. Cower floatation costs ?o \es
h. Re&uire regular amortiation \es ?o
i Ease of repurchase at fa%ora"le prices \es ?o
:. 5igh total cost to small "orrowers \es ?o
,. ;le#i"le terms ?o \es
l. Re&uire less intensi%e in%estigation \es ?o
15. $uch of the information used in a "ond rating is "ased on pu"licl! a%aila"le information and
therefore ma! not pro%ide information that the mar,et did not ha%e "efore the rating change.
403
SOLUTIONS
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. )ccrued interest is the coupon pa!ment for the period times the fraction of the period that has passed
since the last coupon pa!ment. Since we ha%e a semiannual coupon "ond, the coupon pa!ment per
si# months is one*half of the annual coupon pa!ment. There are four months until the ne#t coupon
pa!ment, so two months ha%e passed since the last coupon pa!ment. The accrued interest for the
"ond is0
)ccrued interest G 2I6-6 Q >-3 G 2>6
)nd we calculate the clean price as0
Clean price G Eirt! price @ )ccrued interest G 2>,>D4 @ >6 G 2>,>68
2. )ccrued interest is the coupon pa!ment for the period times the fraction of the period that has passed
since the last coupon pa!ment. Since we ha%e a semiannual coupon "ond, the coupon pa!ment per
si# months is one*half of the annual coupon pa!ment. There are three months until the ne#t coupon
pa!ment, so three months ha%e passed since the last coupon pa!ment. The accrued interest for the
"ond is0
)ccrued interest G =H9-6 Q 3-H G =>H.69
)nd we calculate the dirt! price as0
Eirt! price G Clean price L )ccrued interest G =8H9 L >H.69 G =88>.69
3. a. The price of the "ond toda! is the present %alue of the e#pected price in one !ear. So, the price
of the "ond in one !ear if interest rates increase will "e0
+> G 2H4.+XI;)IK,98/ L 2>,444.+XI;IK,98/
+> G 289J.JI
If interest rates fall, the price if the "ond in one !ear will "e0
+> G 2H4.+XI;)3.9K,98/ L 2>,444.+XI;3.9K,98/
+> G 2>,H>I.>H
?ow we can find the price of the "ond toda!, which will "e0
+4 G N.94.289J.JI/ L .94.2>,H>I.>H/O - >.499
6
+4 G 2>,>>6.IJ
;or students who ha%e studied term structure0 the assumption of ris,*neutralit! implies that the
forward rate is e&ual to the e#pected future spot rate.
B-404
CHAPTER 20 B-
b. If the "ond is calla"le, then the "ond %alue will "e less than the amount computed in part a. If
the "ond price rises a"o%e the call price, the compan! will call it. Therefore, "ondholders will
not pa! as much for a calla"le "ond.
4. The price of the "ond toda! is the present %alue of the e#pected price in one !ear. The "ond will "e
called whene%er the price of the "ond is greater than the call price of 2>,>94. ;irst, we need to find
the e#pected price in one !ear. If interest rates increase ne#t !ear, the price of the "ond will "e the
present %alue of the perpetual interest pa!ments, plus the interest pa!ment made in one !ear, so0
+> G .2>44 - .>6/ L 2>44
+> G 2J33.33
This is lower than the call price, so the "ond will not "e called. If the interest rates fall ne#t !ear, the
price of the "ond will "e0
+> G .2>44 - .4I/ L 2>44
+> G 2>,968.9I
This is greater than the call price, so the "ond will "e called. The present %alue of the e#pected %alue
of the "ond price in one !ear is0
+4 G N.D4.2J33.33/ L .H4.2>,>94/O - >.4J
+4 G 2JI9.9D
&ntermediate
5. If interest rates rise, the price of the "onds will fall. If the price of the "onds is low, the compan! will
not call them. The firm would "e foolish to pa! the call price for something worth less than the call
price. In this case, the "ondholders will recei%e the coupon pa!ment, C, plus the present %alue of the
remaining pa!ments. So, if interest rates rise, the price of the "onds in one !ear will "e0
+> G C L C - 4.>3
If interest rates fall, the assumption is that the "onds will "e called. In this case, the "ondholders will
recei%e the call price, plus the coupon pa!ment, C. So, the price of the "onds if interest rates fall will
"e0
+> G B>,694 L C
The selling price toda! of the "onds is the +X of the e#pected pa!offs to the "ondholders. To find
the coupon rate, we can set the desired issue price e&ual to present %alue of the e#pected %alue of end
of !ear pa!offs, and sol%e for C. Eoing so, we find0
+4 G B>,444 G N.H4.C L C - .>3/ L .D4.B>,694 L C/O - >.>>
C G B>48.H3
So the coupon rate necessar! to sell the "onds at par %alue will "e0
Coupon rate G B>48.H3 - B>,444
Coupon rate G .>48H or >4.8HK
405
SOLUTIONS
6. a. The price of the "ond toda! is the present %alue of the e#pected price in one !ear. So, the price
of the "ond in one !ear if interest rates increase will "e0
+> G 284 L 284 - .4J
+> G 2JH8.8J
If interest rates fall, the price if the "ond in one !ear will "e0
+> G 284 L 284 - .4H
+> G 2>,D>3.33
?ow we can find the price of the "ond toda!, which will "e0
+4 G N.39.2JH8.8J/ L .H9.2>,D>3.33/O - >.48
+4 G 2>,>HD.H>
b. If interest rates rise, the price of the "onds will fall. If the price of the "onds is low, the
compan! will not call them. The firm would "e foolish to pa! the call price for something
worth less than the call price. In this case, the "ondholders will recei%e the coupon pa!ment, C,
plus the present %alue of the remaining pa!ments. So, if interest rates rise, the price of the
"onds in one !ear will "e0
+> G C L C - .4J
If interest rates fall, the assumption is that the "onds will "e called. In this case, the
"ondholders will recei%e the call price, plus the coupon pa!ment, C. The call premium is not
fi#ed, "ut it is the same as the coupon rate, so the price of the "onds if interest rates fall will "e0
+> G .2>,444 L C/ L C
+> G 2>,444 L 6C
The selling price toda! of the "onds is the +X of the e#pected pa!offs to the "ondholders. To
find the coupon rate, we can set the desired issue price e&ual to present %alue of the e#pected
%alue of end of !ear pa!offs, and sol%e for C. Eoing so, we find0
+4 G 2>,444 G N.39.C L C - .4J/ L .H9.2>,444 L 6C/O - >.48
C G 2II.H3
So the coupon rate necessar! to sell the "onds at par %alue will "e0
Coupon rate G 2II.H33 - 2>,444
Coupon rate G .4IIH or I.IHK
B-406
CHAPTER 20 B-
c. To the compan!, the %alue of the call pro%ision will "e gi%en "! the difference "etween the
%alue of an outstanding, non*calla"le "ond and the call pro%ision. So, the %alue of a non*
calla"le "ond with the same coupon rate would "e0
?on*calla"le "ond %alue G 2II.H3 - 4.4H G 2>,6J3.88
So, the %alue of the call pro%ision to the compan! is0
Xalue G .H9.2>,6J3.88 @ >,4II.H3/ - >.48
Xalue G 2>34.>9
7. The compan! should refund when the ?+X of refunding is greater than ero, so we need to find the
interest rate that results in a ero ?+X. The ?+X of the refunding is the difference "etween the gain
from refunding and the refunding costs. The gain from refunding is the "ond %alue times the
difference in the interest rate, discounted to the present %alue. We must also consider that the interest
pa!ments are ta# deducti"le, so the afterta# gain is0
?+X G +X.Rain/ @ +X.Cost/
The present %alue of the gain will "e0
Rain G D94,444,444..48 @ R/ - R
Since refunding would cost mone! toda!, we must determine the afterta# cost of refunding, which
will "e0
)fterta# cost G D94,444,444..>6/.> @ .39/
)fterta# cost G 39,>44,444
So, setting the ?+X of refunding e&ual to ero, we find0
4 G @39,>44,444L D94,444,444..48 @ R/ - R
R G .4ID6 or I.D6K
)n! interest rate "elow this will result in a positi%e ?+X from refunding.
8. In this case, we need to find the ?+X of each alternati%e and choose the option with the highest
?+X, assuming either ?+X is positi%e. The ?+X of each decision is the gain minus the cost. So, the
?+X of refunding the 8 percent perpetual "ond is0
%ond A:
Rain G =I9,444,444..48 @ .4I/ - .4I
Rain G =>4,I>D,689.I>
)ssuming the call premium is ta# deducti"le, the afterta# cost of refunding this issue is0
Cost G =I9,444,444..489/.> @ .D4/ L =>4,444,444.> @ .D4/
Cost G =J,869,444.44
407
SOLUTIONS
?ote that the gain can "e calculated using the preta# or afterta# cost of de"t. If we calculate the gain
using the afterta# cost of de"t, we find0
)fterta# gain G =I9,444,444N.48.> @ .D4/ @ .4I.> @ .D4/O - N.4I.> @ .D4/O
)fterta# gain G =>4,I>D,689.I>
Thus, the inclusion of the ta# rate in the calculation of the gains from refunding is irrele%ant.
The ?+X of refunding this "ond is0
?+X G @=J,869,444 L >4,I>D,689.I>
?+X G =88J,689.I>
The ?+X of refunding the second "ond is0
%ond %:
Rain G =8I,944,444..4J @ .4I69/ - .4I69
Rain G =6>,>64,H8J.HH
)ssuming the call premium is ta# deducti"le, the afterta# cost of refunding this issue is0
Cost G .=8I,944,444/..4J9/.> @ .D4/ L =>6,444,444.> @ .D4/
Cost G =>6,>8I,944
The ?+X of refunding this "ond is0
?+X G @=>6,>8I,944 L 6>,>64,H8J.HH
?+X G =8,J33,>8J.HH
Since the ?+X of refunding "oth "onds is positi%e, "oth "ond issues should "e refunded.
'hallenge
9. To calculate this, we need to set up an e&uation with the calla"le "ond e&ual to a weighted a%erage
of the noncalla"le "onds. We will in%est U percent of our mone! in the first noncalla"le "ond, which
means our in%estment in Aond 3 .the other noncalla"le "ond/ will "e .> @ U/. The e&uation is0
C6 G C> U L C3.> @ U/
8.69 G H.94 U L >6.> @ U/
8.69 G H.94 U L >6 @ >6 U
U G 4.H8>86
B-408
CHAPTER 20 B-
So, we in%est a"out H8 percent of our mone! in Aond >, and a"out 36 percent in Aond 3. This
com"ination of "onds should ha%e the same %alue as the calla"le "ond, e#cluding the %alue of the
call. So0
+6 G 4.H8>86+> L 4.3>8>J+3
+6 G 4.H8>86.>4H.3I9/ L 4.3>8>J.>3D.JH8I9/
+6 G >>9.DI34
The call %alue is the difference "etween this implied "ond %alue and the actual "ond price. So, the
call %alue is0
Call %alue G >>9.DI34 @ >43.94 G >>.JI34
)ssuming 2>,444 par %alue, the call %alue is 2>>J.I3.
10. In general, this is not likely to happen, although it can (and did). The reason that this bond has a
negative YTM is that it is a callable U.S. Treasury bond. Market participants know this. Given the
high coupon rate of the bond, it is extremely likely to be called, which means the bondholder will not
receive all the cash flows promised. A better measure of the return on a callable bond is the yield to
call (YTC). The YTC calculation is the basically the same as the YTM calculation, but the number
of periods is the number of periods until the call date. If the YTC were calculated on this bond, it
would be positive.
409
CHAPTER 21
61A$*)3
Answers to Concepts Review and Critical !in"in# Questions
1. Some ,e! differences are0 .>/ Cease pa!ments are full! ta#*deducti"le, "ut onl! the interest portion
of the loan is( .6/ The lessee does not own the asset and cannot depreciate it for ta# purposes( .3/ In
the e%ent of a default, the lessor cannot force "an,ruptc!( and .D/ The lessee does not o"tain title to
the asset at the end of the lease .a"sent some additional arrangement/.
2. The less profita"le one "ecause leasing pro%ides, among other things, a mechanism for transferring
ta# "enefits from entities that %alue them less to entities that %alue them more.
3. +otential pro"lems include0 .>/ Care must "e ta,en in interpreting the IRR .a high or low IRR is
preferred depending on the setup of the anal!sis/( and .6/ Care must "e ta,en to ensure the IRR
under e#amination is not the implicit interest rate :ust "ased on the lease pa!ments.
4. a. Ceasing is a form of secured "orrowing. It reduces a firms cost of capital onl! if it is cheaper
than other forms of secured "orrowing. The reduction of uncertaint! is not particularl! rele%ant(
what matters is the ?)C.
b. The statement is not alwa!s true. ;or e#ample, a lease often re&uires an ad%ance lease pa!ment
or securit! deposit and ma! "e implicitl! secured "! other assets of the firm.
c. Ceasing would pro"a"l! not disappear, since it does reduce the uncertaint! a"out sal%age %alue
and the transactions costs of transferring ownership. 5owe%er, the use of leasing would "e
greatl! reduced.
5. ) lease must "e disclosed on the "alance sheet if one of the following criteria is met0
). The lease transfers ownership of the asset "! the end of the lease. In this case, the firm
essentiall! owns the asset and will ha%e access to its residual %alue.
.. The lessee can purchase the asset at a price "elow its fair mar,et %alue ."argain purchase
option/ when the lease ends. The firm essentiall! owns the asset and will ha%e access to most of
its residual %alue.
0. The lease term is for I9K or more of the estimated economic life of the asset. The firm
"asicall! has access to the ma:orit! of the "enefits of the asset, without an! responsi"ilit! for
the conse&uences of its disposal.
5. The present %alue of the lease pa!ments is J4K or more of the fair mar,et %alue of the asset at
the start of the lease. The firm is essentiall! purchasing the asset on an installment "asis.
6. The lease must meet the following IRS standards for the lease pa!ments to "e ta# deducti"le0
). The lease term must "e less than 84K of the economic life of the asset. If the term is longer, the
lease is considered to "e a conditional sale.
.. The lease should not contain a "argain purchase option, which the IRS interprets as an e&uit!
interest in the asset.
0. The lease pa!ment schedule should not pro%ide for %er! high pa!ments earl! and %er! low
pa!ments late in the life of the lease. This would indicate that the lease is "eing used simpl! to
a%oid ta#es.
CHAPTER 21 B-
5. Renewal options should "e reasona"le and "ased on the fair mar,et %alue of the asset at
renewal time. This indicates that the lease is for legitimate "usiness purposes, not ta#
a%oidance.
7. )s the term implies, off*"alance sheet financing in%ol%es financing arrangements that are not
re&uired to "e reported on the firms "alance sheet. Such acti%ities, if reported at all, appear onl! in
the footnotes to the statements. 'perating leases .those that do not meet the criteria in pro"lem 6/
pro%ide off*"alance sheet financing. ;or accounting purposes, total assets will "e lower and some
financial ratios ma! "e artificiall! high. ;inancial anal!sts are generall! not fooled "! such practices.
There are no economic conse&uences, since the cash flows of the firm are not affected "! how the
lease is treated for accounting purposes.
8. The lessee ma! not "e a"le to ta,e ad%antage of the depreciation ta# shield and ma! not "e a"le to
o"tain fa%ora"le lease arrangements for 1passing on8 the ta# shield "enefits. The lessee might also
need the cash flow from the sale to meet immediate needs, "ut will "e a"le to meet the lease
o"ligation cash flows in the future.
9. Since the rele%ant cash flows are all afterta#, the afterta# discount rate is appropriate.
10. S,!mar,s financial position was such that the pac,age of leasing and "u!ing pro"a"l! resulted in
the o%erall "est afterta# cost. In particular, S,!mar, ma! not ha%e "een in a position to use all of the
ta# credits and also ma! not ha%e had the credit strength to "orrow and "u! the plane without facing
a credit downgrade and-or su"stantiall! higher rates.
11. There is the ta# moti%e, "ut, "e!ond this, Ro!al Arunei ,nows that, in the e%ent of a default,
S,!mar, would relin&uish the planes, which would then "e re*leased. ;ungi"le assets, such as
planes, which can "e readil! reclaimed and redeplo!ed are good candidates for leasing.
12. The! will "e re*leased to S,!mar, or another air transportation firm, used "! Ro!al Arunei, or the!
will simpl! "e sold. There is an acti%e mar,et for used aircraft.
$olutions to Questions and %ro&le's
NOTE: All end of chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. We will calculate cash flows from the depreciation ta# shield first. The depreciation ta# shield is0
Eepreciation ta# shield G .B3,444,444-D/..39/ G B6H6,944
The afterta# cost of the lease pa!ments will "e0
)fterta# lease pa!ment G .B8J9,444/.> @ .39/ G B98>,I94
411
SOLUTIONS
So, the total cash flows from leasing are0
'C; G B6H6,944 L 98>,I94 G B8DD,694
The afterta# cost of de"t is0
)fterta# de"t cost G .4J.> @ .39/ G .4989
<sing all of this information, we can calculate the ?)C as0
?)C G B3,444,444 @ B8DD,694.+XI;)9.89K,D/ G BHD,948.3J
The ?)C is positi%e so !ou should lease.
2. If we assume the lessor has the same cost of de"t and the same ta# rate, the ?)C to the lessor is the
negati%e of our compan!s ?)C, so0
?)C G @ BHD,948.3J
3. To find the ma#imum lease pa!ment that would satisf! "oth the lessor and the lessee, we need to
find the pa!ment that ma,es the ?)C e&ual to ero. <sing the ?)C e&uation and sol%ing for the
'C;, we find0
?)C G 4 G B3,444,444 @ 'C;.+XI;)9.89K,D/
'C; G B8H6,846.HI
The 'C; for this lease is composed of the depreciation ta# shield cash flow, as well as the afterta#
lease pa!ment. Su"tracting out the depreciation ta# shield cash flow we calculated earlier, we find0
)fterta# lease pa!ment G B8H6,846.HI @ 6H6,944 G BH44,346.HI
Since this is the afterta# lease pa!ment, we can now calculate the "rea,e%en preta# lease pa!ment as0
Area,e%en lease pa!ment G BH44,346.HI-.> @ .39/ G BJ63,9D6.9I
4. If the ta# rate is ero, there is no depreciation ta# shield foregone. )lso, the afterta# lease pa!ment is
the same as the preta# pa!ment, and the afterta# cost of de"t is the same as the preta# cost. So0
Cost of de"t G .4J
)nnual cost of leasing G leasing pa!ment G B8J9,444
The ?)C to leasing with these assumptions is0
?)C G B3,444,444 @ B8J9,444.+XI;)JK,D/ G B>44,D94.I>
B-412
CHAPTER 21 B-
5. We alread! calculated the "rea,e%en lease pa!ment for the lessor in +ro"lem 3. Since the
assumption a"out the lessor concerning the ta# rate ha%e not changed. So, the lessor "rea,s e%en
with a pa!ment of BJ63,9D6.9I.
;or the lessee, we need to calculate the "rea,e%en lease pa!ment which results in a ero ?)C. <sing
the assumptions in +ro"lem D, we find0
?)C G 4 G B3,444,444 @ +$T.+XI;)JK,D/
+$T G BJ6H,449.JJ
So, the range of lease pa!ments that would satisf! "oth the lessee and the lessor are0
Total pa!ment range G BJ63,9D6.9I to BJ6H,449.JJ
6. The appropriate depreciation percentages for a 3*!ear $)CRS class asset can "e found in Chapter 8.
The depreciation percentages are .333, .DDD, .>D8, and 4.4ID. The cash flows from leasing are0
\ear >0 .B3,444,444/..333/..39/ L B98>,I94 G BJ3>,D44
\ear 60 .B3,444,444/..DDD/..39/ L B98>,I94 G B>,4DI,J94
\ear 30 .B3,444,444/..>D8/..39/ L B98>,I94 G BI3I,>94
\ear D0 .B3,444,444/..4ID/..39/ L B98>,I94 G BH9J,D94
?)C G B3,444,444 @ BJ3>,D44->.4989 @ B>,4DI,J94->.4989
6
@ BI3I,>94->.4989
3
@ BH9J,D94->.4989
D
?)C G B3I,88D.J4
The machine should "e leased. 5owe%er, notice that the ?+X is higher "ecause of the accelerated
ta# "enefits due to depreciation.
7. We will calculate cash flows from the depreciation ta# shield first. The depreciation ta# shield is0
Eepreciation ta# shield G .=394,444-9/..39/ G =6D,944
The afterta# cost of the lease pa!ments will "e0
)fterta# lease pa!ment G .=JD,644/.> @ .39/ G =H>,634
So, the total cash flows from leasing are0
'C; G =6D,944 L H>,634 G =89,I34
The afterta# cost of de"t is0
)fterta# de"t cost G .4J.> @ .39/ G .4989
<sing all of this information, we can calculate the ?)C as0
?)C G =394,444 @ =89,I34.+XI;)9.89K,9/ G @=>6,H4D.39
The ?)C is negati%e, so the compan! should "u!.
413
SOLUTIONS
8. a. Since the lessee has an effecti%e ta# rate of ero, there is no depreciation ta# shield foregone.
)lso, the afterta# lease pa!ment is the same as the preta# pa!ment, and the afterta# cost of de"t
is the same as the preta# cost. To find the most the lessee would pa!, we set the ?)C e&ual to
ero and sol%e for the pa!ment, doing so, we find the most the lessee will pa! is0
?)C G 4 G 2H94,444 @ +$T.+XI;)8K,9/
+$T G 2>H6,IJH.I4

b. We will calculate cash flows from the depreciation ta# shield first. The depreciation ta# shield is0
Eepreciation ta# shield G .2H94,444-9/..39/ G 2D9,944
The afterta# cost of de"t is0
)fterta# de"t cost G .48.> @ .39/ G .496
<sing all of this information, we can calculate the minimum lease pa!ment for the lessor as0
?)C G 4 G 2H94,444 @ +$T.> @ .39/.+XI;)9.6K,9/ L 2D9,944.+XI;)9.6K,9/
+$T G 2>H6,693.6D
c. ) lease pa!ment less than 2>H6,693.6D will gi%e the lessor a negati%e ?)C. ) pa!ment higher
than 2>H6,693.6D will gi%e the lessee a negati%e ?)C. In either case, no deal will "e struc,.
Therefore, these represent the lower and upper "ounds of possi"le lease prices during
negotiations.
&ntermediate
9. The preta# cost sa%ings are not rele%ant to the lease %ersus "u! decision, since the firm will
definitel! use the e&uipment and realie the sa%ings regardless of the financing choice made. The
depreciation ta# shield is0
Eepreciation ta# shield lost G .)u2H,444,444-9/..D4/ G )u2D84,444
)nd the afterta# lease pa!ment is0
)fterta# lease pa!ment G )u2>,D44,444.> @ .D4/ G )u28D4,444
The afterta# cost of de"t is0
)fterta# de"t cost G .4J.> @ .D4/ G .49D or 9.D4K
With these cash flows, the ?)C is0
?)C G )u2H,444,444 @ 8D4,444 @ )u28D4,444.+XI;)9.DK,D/ @ )u2D84,444.+XI;)9.DK,9/
G )u2>93,94>.>>
The e&uipment should "e leased.
B-414
CHAPTER 21 B-
To find the ma#imum pa!ment, we find where the ?)C is e&ual to ero, and sol%e for the pa!ment.
<sing U to represent the ma#imum pa!ment0
?)C G 4 G )u2H,444,444 @ U.>.49D/.+XI;)9.DK,9/ @ )u2D84,444.+XI;)9.DK,9/
U G )u28ID,4>>.66
So the ma#imum preta# lease pa!ment is0
+reta# lease pa!ment G )u28ID,4>>.66-.> @ .D4/ G )u2>,D9H,H89.3I
10. The afterta# residual %alue of the asset is an opportunit! cost to the leasing decision, occurring at the
end of the pro:ect life .!ear 9/. )lso, the residual %alue is not reall! a de"t*li,e cash flow, since there
is uncertaint! associated with it at !ear 4. ?e%ertheless, although a higher discount rate ma! "e
appropriate, well use the afterta# cost of de"t to discount the residual %alue as is common in
practice. Setting the ?)C e&ual to ero0
?)C G 4 G )u2H$ @ U.>.49D/.+XI;)9.DK,9/ @ D48,444.+XI;)9.DK,9/ @ 944,444->.49D
9
U G )u2I88,8D6.JJ
So, the ma#imum preta# lease pa!ment is0
+reta# lease pa!ment G )u2I88,8D6.JJ-.> @ .D4/ G )u2>,3>D,I38.3>
11. The securit! deposit is a cash outflow at the "eginning of the lease and a cash inflow at the end of
the lease when it is returned. The ?)C with these assumptions is0
?)C G )u2H$ @ 694,444 @ 8D4,444 @ )u28D4,444.+XI;)9.DK,D/ @ )u2D84,444.+XI;)9.DK,9/
L )u2694,444->.49D
9
?)C G )u2J9,HJ3.8D
With the securit! deposit, the firm should still lease the e&uipment rather than "u! it, "ecause the
?)C is greater than ero. We could also sol%e this pro"lem another wa!. ;rom +ro"lem J, we ,now
that the ?)C without the securit! deposit is )u2>93,94>.>>, so, if we find the present %alue of the
securit! deposit, we can simpl! add this to )u2>93,94>.>>. The present %alue of the securit! deposit
is0
+X of securit! deposit G @)u2694,444 L )u2694,444->.49D
9
G @)u29I,84I.6I
So, the ?)C with the securit! deposit is0
?)C G )u2>93,94>.>> @ 9I,84I.6IG )u2J9,HJ3.8D
12. The lessee is pa!ing ta#es, so will forego the depreciation ta# shield if it leases the e&uipment. The
depreciation ta# shield for the lessee is0
Eepreciation ta# shield G .Rs.>,944,444 - H/..69/
Eepreciation ta# shield G Rs.H6,944
415
SOLUTIONS
The afterta# cost of de"t for the lessee is0
)fterta# de"t cost G .4J.> @ .69/ G .4HI9
<sing all of this information, we can calculate the ma#imum preta# lease pa!ment for the lessee as0
?)C G 4 G Rs.>,944,444 @ +$T.> @ .69/.+XI;)H.I9K,H/ L Rs.H6,944.+XI;)H.I9K,H/
+$T G Rs.333,469.39
;or the lessor, the depreciation ta# shield is0
Eepreciation ta# shield G .Rs.>,944,444 - H/..D4/
Eepreciation ta# shield G Rs.>44,444
The afterta# cost of de"t for the lessor is0
)fterta# de"t cost G .4J.> @ .D4/ G .49D4
<sing all of this information, we can calculate the minimum preta# lease pa!ment for the lessor as0
?)C G 4 G Rs.>,944,444 @ +$T.> @ .D4/.+XI;)9.D4K,H/ L Rs.>44,444.+XI;)9.D4K,H/
+$T G Rs.336,>J9.9>
13. a. Since "oth companies ha%e the same ta# rate, there is onl! one lease pa!ment that will result in
a ero ?)C for each compan!. We will calculate cash flows from the depreciation ta# shield
first. The depreciation ta# shield is0
Eepreciation ta# shield G .3H4,444-3/..3D/ G D4,844
The afterta# cost of de"t is0
)fterta# de"t cost G .>4.> @ .3D/ G .4HH4
<sing all of this information, we can calculate the lease pa!ment as0
?)C G 4 G 3H4,444 @ +$T.> @ .3D/.+XI;)H.H4K,3/ L D4,844.+XI;)H.H4K,3/
+$T G >DD,9>4.JH
B-416
CHAPTER 21 B-
b. To generalie the result from part a0
Cet T> denote the lessors ta# rate.
Cet T6 denote the lessees ta# rate.
Cet + denote the purchase price of the asset.
Cet E e&ual the annual depreciation e#pense.
Cet ? denote the length of the lease in !ears.
Cet R e&ual the preta# cost of de"t.
The %alue to the lessor is0
XalueCessor G

+
+
+
?
> 6
> >
/O T R.> N>
/ E.T / T C.>
+
t
t
)nd the %alue to the lessee is0
XalueCessee G

+
+

?
> 6
6 6
/O T R.> N>
/ E.T / T C.>
+
t
t
Since all the %alues in "oth e&uations a"o%e are the same e#cept
>
T and
6
T , we can see that
the %alues of the lease to its two parties will "e opposite in sign onl! if T> G T6.
c. Since the lessors ta# "rac,et is unchanged, the ero ?)C lease pa!ment is the same as we
found in part a. The lessee will not realie the depreciation ta# shield, and the afterta# cost of
de"t will "e the same as the preta# cost of de"t. So, the lessees ma#imum lease pa!ment will
not "e0
?)C G 4 G @3H4,444 L +$T.+XI;)>4K,3/
+$T G >DD,IH>.33
Aoth parties ha%e positi%e ?)C for lease pa!ments "etween >DD,9>4.JH and >DD,IH>.33.
14. The decision to "u! or lease is made "! loo,ing at the incremental cash flows. The loan offered "!
the "an, merel! helps !ou to esta"lish the appropriate discount rate. Since the deal the! are offering
is the same as the mar,et*wide rate, !ou can ignore the offer and simpl! use >6 percent as the preta#
discount rate. In an! capital "udgeting pro:ect, !ou do not consider the financing which was to "e
applied to a specific pro:ect. The onl! e#ception would "e if a specific and special financing deal
were tied to a specific pro:ect .li,e a lower*than*mar,et interest rate loan if !ou "u! a particular car/.
417
SOLUTIONS
a. The incremental cash flows from leasing the machine are the lease pa!ments, the ta# sa%ings on
the lease, the lost depreciation ta# shield, and the sa%ed purchase price of the machine. The
lease pa!ments are due at the "eginning of each !ear, so the incremental cash flows are0
Aear / Aear ) Aear . Aear 0 Aear 5
Fease:
Cease pa!ment @,r>,644,444 @,r>,644,444 @,r>,644,444 @,r>,644,444
Ta# sa%ings on lease D64,444 D64,444 D64,444 D64,444
Cost dep. ta# shield @3HI,944 @3HI,944 @3HI,944 @,r3HI,944
E&uipment cost D,644,444
,r3,D64,444 @,r>,>DI,944 @,r>,>DI,944 @,r>,>DI,944 @,r3HI,944
The afterta# discount rate is0
)fterta# discount rate G .4J.> @ .39/
)fterta# discount rate G .4989 or 9.89K
So, the ?)C of leasing is0
?)C G ,r3,D64,444 @ ,r>,>DI,944.+XI;)9.89K,3/ @ ,r3HI,944 - >.4989
D
?)C G ,r9>,D38.D3
Since the ?)C is positi%e, the compan! should lease the e&uipment.
b. The compan! is indifferent at the lease pa!ment which ma,es the ?)C of the lease e&ual to
ero. The ?)C e&uation of the lease is0
4 G ,rD,644,444 @ +$T.> @ .39/ @ +$T.> @ .39/.+XI;)9.89K,3/ @ ,r3HI,944 - >.4989
D
+$T G ,r>,66>,94>.ID
15. The )+R of the loan is the lease factor times 6,D44, so0
)+R G 4.44389.6,D44/ G J.6DK
To calculate the lease pa!ment we first need the net capitaliation cost, which is the "ase capitalied
cost plus an! other costs, minus an! down pa!ment or re"ates. So, the net capitalied cost is0
?et capitalied cost G 2D4,444 L D94 @ 6,444
?et capitalied cost G 238,D94
The depreciation charge is the net capitalied cost minus the residual %alue, di%ided "! the term of
the lease, which is0
Eepreciation charge G .238,D94 @ 64,D44/ - 3H
Eepreciation charge G 294>.3J
B-418
CHAPTER 21 B-
?e#t, we can calculate the finance charge, which is the net capitalied cost plus the residual %alue,
times the lease factor, or0
;inance charge G .238,D94 L 64,D44/.4.44389/
;inance charge G 266H.9I
)nd the ta#es on each monthl! pa!ment will "e0
Ta#es G .294>.3J L 66H.9I/.4.48/
Ta#es G 298.6D
The monthl! lease pa!ment is the sum of the depreciation charge, the finance charge, and ta#es,
which will "e0
Cease pa!ment G 294>.3J L 66H.9I L 98.6D
Cease pa!ment G 2I8H.64
'hallenge
16. With a four*!ear loan, the annual loan pa!ment will "e
B3,444,444 G +$T.+XI;)JK,D/
+$T G BJ6H,449.JJ
The afterta# loan pa!ment is found "!0
)fterta# pa!ment G +reta# pa!ment @ Interest ta# shield
So, we need to find the interest ta# shield. To find this, we need a loan amortiation ta"le since the
interest pa!ment each !ear is the "eginning "alance times the loan interest rate of J percent. The
interest ta# shield is the interest pa!ment times the ta# rate. The amortiation ta"le for this loan is0
\ear
Aeginning
"alance
Total
pa!ment
Interest
pa!ment
+rincipal
pa!ment
Ending
"alance
>
B3,444,444.4
4
BJ6H,449.J
J
B6I4,444.4
4
BH9H,449.J
J
B6,3D3,JJD.4
>
6 6,3D3,JJD.4> J6H,449.JJ 6>4,J9J.DH I>9,4DH.93 >,H68,JDI.DJ
3 >,H68,JDI.DJ J6H,449.JJ >DH,H49.6I IIJ,D44.I> 8DJ,9DH.I8
D 8DJ,9DH.I8 J6H,449.JJ IH,D9J.6> 8DJ,9DH.I8 4.44
So, the total cash flows each !ear are0

)fterta# loan pa!ment 'C; Total
cash flow
\ear >0 BJ6H,449.JJ@ .B6I4,444/..39/ G B83>,949.JJ @ 8DD,694 G @B>6,IDD.4>
\ear 60 BJ6H,449.JJ@ .B6>4,J9J.DH/..39/ G B896,>I4.>I @ 8DD,694 G I,J64.>I
\ear 30 BJ6H,449.JJ@ .B>DH,H49.6I/..39/ G B8ID,HJD.>D @ 8DD,694 G 34,DDD.>D
\ear D0 BJ6H,449.JJ@ .BIH,D9J.6>/..39/ G B8JJ,6D9.6H @ 8DD,694 G 9D,JJ9.6H
419
SOLUTIONS
So, the ?)C with the loan pa!ments is0
?)C G 4 @ B>6,IDD.4>->.4989 L BI,J64.>I->.4989
6
L B34,DDD.>D->.4989
3
L B9D,JJ9.6H->.4989
D
?)C G BHD,948.3J
The ?)C is the same "ecause the present %alue of the afterta# loan pa!ments, discounted at the
afterta# cost of capital .which is the afterta# cost of de"t/ e&uals B3,444,444.
17. a. The decision to "u! or lease is made "! loo,ing at the incremental cash flows, so we need to
find the cash flows for each alternati%e. The cash flows if the compan! leases are0
Cash flows from leasing0
)fterta# cost sa%ings G BH,444.> @ .3D/
)fterta# cost sa%ings G B3,JH4
The ta# "enefit of the lease is the lease pa!ment times the ta# rate, so the ta# "enefit of the
lease is0
Cease ta# "enefit G B>D,444..3D/
Cease ta# "enefit G BD,IH4
We need to remem"er the lease pa!ments are due at the "eginning of the !ear. So, if the
compan! leases, the cash flows each !ear will "e0
Aear / Aear ) Aear . Aear 0 Aear 5 Aear *
)fterta# sa%ings B3,JH4 B3,JH4 B3,JH4 B3,JH4 B3,JH4
Cease pa!ment @>D,444 @>D,444 @>D,444 @>D,444 @>D,444
Ta# "enefit D,IH4 D,IH4 D,IH4 D,IH4 D,IH4
?et cash flows @BJ,6D4 @B9,684 @B9,684 @B9,684 @B9,684 B3,JH4
The amount the compan! "orrows and the repa!ment schedule are irrele%ant since the compan!
maintains a target de"t*e&uit! ratio. So, the cash flows from "u!ing the machine will "e0
Cash flows from purchasing0
)fterta# cost sa%ings G B>4,444.> @ .3D/
)fterta# cost sa%ings G BH,H44
)nd the deprecation ta# shield will "e0
Eepreciation ta# shield G .BI9,444 - 9/..3D/
Eepreciation ta# shield G B9,>44
B-420
CHAPTER 21 B-
Aear / Aear ) Aear . Aear 0 Aear 5 Aear *
)fterta# sa%ings BH,H44 BH,H44 BH,H44 BH,H44 BH,H44
+urchase @BI9,444
Eep. ta# shield B9,>44 B9,>44 B9,>44 B9,>44 B9,>44
?et cash flows @BI9,444 B>>,I44 B>>,I44 B>>,I44 B>>,I44 B>>,I44
?ow we can calculate the incremental cash flows from leasing %ersus "u!ing "! su"tracting the
net cash flows "u!ing from the net cash flows from leasing. The incremental cash flows from
leasing are0
Aear / Aear ) Aear . Aear 0 Aear 5 Aear *
Cease @ Au! BH9,IH4 @B>H,J84 @B>H,J84 @B>H,J84 @B>H,J84 @BI,ID4
The afterta# discount rate is0
)fterta# discount rate G .>4.> @ .3D/
)fterta# discount rate G .4HH4 or H.H4K
So, the ?)C of leasing is0
?)C G BH9,IH4 @ B>H,J84.+XI;)H.H4K,D/ @ BI,ID4 - >.4HH
9
?)C G B6,4JJ.>6
Since the ?)C is negati%e, the compan! should "u!, not lease the e&uipment.
b. )s long as the compan! maintains its target de"t*e&uit! ratio, the answer does not depend upon
the form of financing used for the direct purchase. ) financial lease will displace de"t
regardless of the form of financing.
c. The amount of displaced de"t is the +X of the incremental cash flows from !ear one through
fi%e.
+X G B>H,J84.+XI;)H.H4K,D/ L BI,ID4 - >.4HH4
9
+X G BH3,HH4.88
421
CHAPTER 22
OPTIONS AND CORPORATE FINANCE:
BASIC CONCEPTS
Answers to Concept Questions
1. ) call option confers the right, without the o"ligation, to "u! an asset at a gi%en price on or "efore a
gi%en date. ) put option confers the right, without the o"ligation, to sell an asset at a gi%en price on
or "efore a gi%en date. \ou would "u! a call option if !ou e#pect the price of the asset to increase.
\ou would "u! a put option if !ou e#pect the price of the asset to decrease. ) call option has
unlimited potential profit, while a put option has limited potential profit( the underl!ing assets price
cannot "e less than ero.
2. a. The "u!er of a call option pa!s mone! for the right to "u!....
b. The "u!er of a put option pa!s mone! for the right to sell....
c. The seller of a call option recei%es mone! for the o"ligation to sell....
d. The seller of a put option recei%es mone! for the o"ligation to "u!....
3. )n )merican option can "e e#ercised on an! date up to and including the e#piration date. )
European option can onl! "e e#ercised on the e#piration date. Since an )merican option gi%es its
owner the right to e#ercise on an! date up to and including the e#piration date, it must "e worth at
least as much as a European option, if not more.
4. The intrinsic %alue of a call is $a#NS @ E, 4O. The intrinsic %alue of a put is $a#NE @ S, 4O. The
intrinsic %alue of an option is the %alue at e#piration.
5. The call is selling for less than its intrinsic %alue( an ar"itrage opportunit! e#ists. Au! the call for
2>4, e#ercise the call "! pa!ing 239 in return for a share of stoc,, and sell the stoc, for 294. \ou%e
made a ris,less 29 profit.
6. The prices of "oth the call and the put option should increase. The higher le%el of downside ris, still
results in an option price of ero, "ut the upside potential is greater since there is a higher pro"a"ilit!
that the asset will finish in the mone!.
7. ;alse. The %alue of a call option depends on the total %ariance of the underl!ing asset, not :ust the
s!stematic %ariance.
8. The call option will sell for more since it pro%ides an unlimited profit opportunit!, while the
potential profit from the put is limited .the stoc, price cannot fall "elow ero/.
9. The %alue of a call option will increase, and the %alue of a put option will decrease.
CHAPTER 22 B-
10. The reason the! dont show up is that the <.S. go%ernment uses cash accounting( i.e., onl! actual
cash inflows and outflows are counted, not contingent cash flows. ;rom a political perspecti%e, the!
would ma,e the deficit larger, so that is another reason not to count them_ Whether the! should "e
included depends on whether we feel cash accounting is appropriate or not, "ut these contingent
lia"ilities should "e measured and reported. The! currentl! are not, at least not in a s!stematic
fashion.
11. Increasing the time to e#piration increases the %alue of an option. The reason is that the option gi%es
the holder the right to "u! or sell. The longer the holder has that right, the more time there is for the
option to increase .or decrease in the case of a put/ in %alue. ;or e#ample, imagine an out*of*the*
mone! option that is a"out to e#pire. Aecause the option is essentiall! worthless, increasing the time
to e#piration would o"%iousl! increase its %alue.
12. )n increase in %olatilit! acts to increase "oth call and put %alues "ecause the greater %olatilit!
increases the possi"ilit! of fa%ora"le in*the*mone! pa!offs.
13. ) put option is insurance since it guarantees the polic!holder will "e a"le to sell the asset for a
specific price. Consider homeowners insurance. If a house "urns down, it is essentiall! worthless. In
essence, the homeowner is selling the worthless house to the insurance compan! for the amount of
insurance.
14. The e&uit!holders of a firm financed partiall! with de"t can "e thought as holding a call option on
the assets of the firm with a stri,e price e&ual to the de"ts face %alue and a time to e#piration e&ual
to the de"ts time to maturit!. If the %alue of the firm e#ceeds the face %alue of the de"t when it
matures, the firm will pa! off the de"tholders in full, lea%ing the e&uit!holders with the firms
remaining assets. 5owe%er, if the %alue of the firm is less than the face %alue of de"t when it
matures, the firm must li&uidate all of its assets in order to pa! off the de"tholders, and the
e&uit!holders recei%e nothing. Consider the following0
Cet XC G the %alue of a firm financed with "oth de"t and e&uit!
;X.de"t/ G the face %alue of the firms outstanding de"t at maturit!
If XC d ;X.de"t/ If XC S ;X.de"t/
+a!off to de"tholders XC ;X.de"t/
+a!off to e&uit!holders 4 XC @ ;X.de"t/
XC XC
?otice that the pa!off to e&uit!holders is identical to a call option of the form $a#.4, ST @ M/, where
the stoc, price at e#piration .ST/ is e&ual to the %alue of the firm at the time of the de"ts maturit!
and the stri,e price .M/ is e&ual to the face %alue of outstanding de"t.
15. Since !ou ha%e a large num"er of stoc, options in the compan!, !ou ha%e an incenti%e to accept the
second pro:ect, which will increase the o%erall ris, of the compan! and reduce the %alue of the
firms de"t. 5owe%er, accepting the ris,! pro:ect will increase !our wealth, as the options are more
%alua"le when the ris, of the firm increases.
16. Rearranging the put*call parit! formula, we get0 S @ +X.E/ G C @ +. Since we ,now that the stoc,
price and e#ercise price are the same, assuming a positi%e interest rate, the left hand side of the
e&uation must "e greater than ero. This implies the price of the call must "e higher than the price of
the put in this situation.
423
SOLUTIONS
17. Rearranging the put*call parit! formula, we get0 S @ +X.E/ G C @ +. If the call and the put ha%e the
same price, we ,now C @ + G 4. This must mean the stoc, price is e&ual to the present %alue of the
e#ercise price, so the put is in*the*mone!.
18. ) stoc, can "e replicated using a long call .to capture the upside gains/, a short put .to reflect the
downside losses/ and a T*"ill .to reflect the time %alue component @ the 1wait8 factor/.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. The %alue of the call is the stoc, price minus the present %alue of the e#ercise price, so0
C4 G B99 @ NBD9->.4HO G B>6.99
The intrinsic %alue is the amount "! which the stoc, price e#ceeds the e#ercise price of the call,
so the intrinsic %alue is B>4.
b. The %alue of the call is the stoc, price minus the present %alue of the e#ercise price, so0
C4 G B99 @ NB39->.4HO G B6>.J8
The intrinsic %alue is the amount "! which the stoc, price e#ceeds the e#ercise price of the call,
so the intrinsic %alue is B64.
c. The %alue of the put option is B4 since there is no possi"ilit! that the put will finish in the
mone!. The intrinsic %alue is also B4.
2. a. The calls are in the mone!. The intrinsic %alue of the calls is 23.
b. The puts are out of the mone!. The intrinsic %alue of the puts is 24.
c. The $ar call and the 'ct put are mispriced. The call is mispriced "ecause it is selling for less
than its intrinsic %alue. If the option e#pired toda!, the ar"itrage strateg! would "e to "u! the
call for 26.84, e#ercise it and pa! 284 for a share of stoc,, and sell the stoc, for 283. ) ris,less
profit of 24.64 results. The 'cto"er put is mispriced "ecause it sells for less than the Jul! put.
To ta,e ad%antage of this, sell the Jul! put for 23.J4 and "u! the 'cto"er put for 23.H9, for a
cash inflow of 24.69. The e#posure of the short position is completel! co%ered "! the long
position in the 'cto"er put, with a positi%e cash inflow toda!.
3. a. Each contract is for >44 shares, so the total cost is0
Cost G >4.>44 shares-contract/.Rs.I.H4/
Cost G Rs.I,H44
B-424
CHAPTER 22 B-
b. If the stoc, price at e#piration is Rs.>D4, the pa!off is0
+a!off G >4.>44/.Rs.>D4 @ >>4/
+a!off G Rs.34,444
If the stoc, price at e#piration is Rs.>69, the pa!off is0
+a!off G >4.>44/.Rs.>69 @ >>4/
+a!off G Rs.>9,444
c. Remem"ering that each contract is for >44 shares of stoc,, the cost is0
Cost G >4.>44/.Rs.D.I4/
Cost G Rs.D,I44
The ma#imum gain on the put option would occur if the stoc, price goes to Rs.4. We also need
to su"tract the initial cost, so0
$a#imum gain G >4.>44/.Rs.>>4/ @ Rs.D,I44
$a#imum gain G Rs.>49,344
If the stoc, price at e#piration is Rs.>4D, the position will ha%e a profit of0
+rofit G >4.>44/.Rs.>>4 @ >4D/ @ Rs.D,I44
+rofit G Rs.>,344
d. )t a stoc, price of Rs.>43 the put is in the mone!. )s the writer, !ou will ma,e0
?et loss G Rs.D,I44 @ >4.>44/.Rs.>>4 @ >43/
?et loss G @Rs.6,344
)t a stoc, price of Rs.>36 the put is out of the mone!, so the writer will ma,e the initial cost0
?et gain G Rs.D,I44
)t the "rea,e%en, !ou would reco%er the initial cost of Rs.D,I44, so0
Rs.D,I44 G >4.>44/.Rs.>>4 @ ST/
ST G Rs.>49.34
;or terminal stoc, prices a"o%e Rs.>49.34, the writer of the put option ma,es a net profit
.ignoring transaction costs and the effects of the time %alue of mone!/.
4. a. The %alue of the call is the stoc, price minus the present %alue of the e#ercise price, so0
C4 G 84 @ I4->.4H
C4 G >3.JH
425
SOLUTIONS
b. <sing the e&uation presented in the te#t to pre%ent ar"itrage, we find the %alue of the call is0
84 G N.J9 @ I9/-.J9 @ J4/OC4 L I9->.4H
C4 G 6.3>
5. a. The %alue of the call is the stoc, price minus the present %alue of the e#ercise price, so0
C4 G 2I4 @ 2D9->.49
C4 G 26I.>D
b. <sing the e&uation presented in the te#t to pre%ent ar"itrage, we find the %alue of the call is0
2I4 G 6C4 L 2H4->.49
C4 G 2H.D3
6. <sing put*call parit! and sol%ing for the put price, we get0
VI,444 L + G VI,944e
@..46H/.3->6/
L VD94
+ G VJ4>.D>
7. <sing put*call parit! and sol%ing for the call price we get0
V9,344 L VD8J G V9,444e
@..43H/..9/
L C
C G V8I8.>J
8. <sing put*call parit! and sol%ing for the stoc, price we get0
S L B6.8I G BI4e
@..4D8/.3->6/
L BD.H8
S G BI4.J8
9. <sing put*call parit!, we can sol%e for the ris,*free rate as follows0
H9.84 L 6.8H G H9e
@R.6->6/
L D.48
HD.98 G H9e
@R.6->6/

4.JJ39 G e
@R.6->6/
ln.4.JJ39/ G ln.e
@R.6->6/
/
@4.44H9 G @R.6->6/
Rf G 3.8JK
10. <sing the Alac,*Scholes option pricing model to find the price of the call option, we find0
d> G Nln.Ca238-Ca239/ L ..4H L .9D
6
-6/ .3->6/O - ..9D >6 - 3 / G .DJ9>
d6 G .DJ9> @ ..9D >6 - 3 / G .669>
?.d>/ G .H8JI
?.d6/ G .98J>
B-426
CHAPTER 22 B-
+utting these %alues into the Alac,*Scholes model, we find the call price is0
C G Ca238..H8JI/ @ .Ca239e
@.4H..69/
/..98J>/ G Ca29.J4
<sing put*call parit!, the put price is0
+ut G Ca239e
@.4H..69/
L 9.J4 @ 38 G Ca26.38
11. <sing the Alac,*Scholes option pricing model to find the price of the call option, we find0
d> G Nln.P8H-PJ4/ L ..4D L .H6
6
-6/ .8->6/O - ..H6 >6 - 8 / G .6>H4
d6 G .6>H4 @ ..H6 >6 - 8 / G @.6J46
?.d>/ G .9899
?.d6/ G .3898
+utting these %alues into the Alac,*Scholes model, we find the call price is0
C G P8H..9899/ @ .PJ4e
@.4D.8->6/
/..3898/ G P>H.9D
<sing put*call parit!, the put price is0
+ut G PJ4e
@.4D.8->6/
L >H.9D @ 8H G P>8.>8
12. The delta of a call option is ?.d>/, so0
d> G Nln.8I-89/ L ..49 L .9H
6
-6/ .I9O - ..9H I9 . / G .3HI8
?.d>/ G .HD39
;or a call option the delta is .HD. ;or a put option, the delta is0
+ut delta G .HD @ > G @.3H
The delta tells us the change in the price of an option for a > change in the price of the underl!ing
asset.
13. <sing the Alac,*Scholes option pricing model, with a nstoc, price is Rs.64,444,444 and an e#ercise
price is Rs.66,444,444, the price !ou should recei%e is0
d> G Nln.Rs.64,444,444-Rs.66,444,444/ L ..49 L .64
6
-6/ .>6->6/O - ..64 >6 - >6 / G @.>6HH
d6 G @.>6HH @ ..64 >6 - >6 / G @.36HH
?.d>/ G .DDJH
?.d6/ G .3I64
427
SOLUTIONS
+utting these %alues into the Alac,*Scholes model, we find the call price is0
C G Rs.64,444,444..DDJH/ @ .Rs.66,444,444e
@.49.>/
/..3I64/ G Rs.>,648,4>I.H3
14. <sing the call price we found in the pre%ious pro"lem and put*call parit!, !ou would need to pa!0
+ut G Rs.66,444,444e
@.49.>/
L >,648,4>I.H3 @ 64,444,444 G Rs.6,>39,4HD.JH
\ou would ha%e to pa! Rs.6,>39,4HD.JH in order to guarantee the right to sell the land for
Rs.66,444,444.
15. <sing the Alac,*Scholes option pricing model to find the price of the call option, we find0
d> G Nln.28H-2J4/ L ..>6 L .93
6
-6/ .H->6/O - ..93
/ >6 - H .
/ G .66H6
d6 G .66H6 @ ..93 >6 - H / G @.>D8H
?.d>/ G .98J9
?.d6/ G .DD4J
+utting these %alues into the Alac,*Scholes model, we find the call price is0
C G 28H..98J9/ @ .2J4e
@.>6..94/
/..DD4J/ G 2>3.36
<sing put*call parit!, we find the put price is0
+ut G 2J4e
@.>6..94/
L >3.36 @ 8H G 2>6.48
a. The intrinsic %alue of each option is0
Call intrinsic %alue G $a#NS @ E, 4O G 24
+ut intrinsic %alue G $a#NE @ S, 4O G 2D
b. 'ption %alue consists of time %alue and intrinsic %alue, so0
Call option %alue G Intrinsic %alue L Time %alue
2>3.36 G 24 L TX
TX G 2>3.36
+ut option %alue G Intrinsic %alue L Time %alue
2>6.48 G 2D L TX
TX G 28.48
c. The time premium .theta/ is more important for a call option than a put option( therefore, the time
premium is, in general, larger for a call option.
B-428
CHAPTER 22 B-
16. The stoc, price can either increase >9 percent, or decrease >9 percent. The stoc, price at e#piration
will either "e0
Stoc, price increase G 2I9.> L .>9/ G 28H.69
Stoc, price decrease G 2I9.> @ .>9/ G 2H3.I9
The pa!off in either state will "e the ma#imum stoc, price minus the e#ercise price, or ero, which
is0
+a!off if stoc, price increases G $a#N28H.69 @ I4, 4O G 2>H.69
+a!off if stoc, price decreases G $a#N293.I9 @ I4, 4O G 24
The ris, neutral pro"a"ilit! of a stoc, price increase is0
+ro"a"ilit! of stoc, price increase G ..>9 L .>6/ - ..>9 L .>9/ G .J4
)nd the pro"a"ilit! of a stoc, price decrease is0
+ro"a"ilit! of stoc, price decrease G > @ .J4 G .>4
So, the ris, neutral %alue of a call option will "e0
Call %alue G N..J4 Q 2>H.69/ L ..>4 Q 24/O - .> L .48/
Call %alue G 2>3.4H
17. The stoc, price increase, decrease, and option pa!offs will remain unchanged since the stoc, price
change is the same. The new ris, neutral pro"a"ilit! of a stoc, price increase is0
+ro"a"ilit! of stoc, price increase G ..48 L .>9/ - ..>9 L .>9/ G .IHHI
)nd the pro"a"ilit! of a stoc, price decrease is0
+ro"a"ilit! of stoc, price decrease G > @ .IHHI G .6333
So, the ris, neutral %alue of a call option will "e0
Call %alue G N..IHHI Q 2>H.69/ L ..6333 Q 24/O - .> L .>9/
Call %alue G 2>>.9D
&ntermediate
18. If the e#ercise price is e&ual to ero, the call price will e&ual the stoc, price, which is =89.
19. If the standard de%iation is ero, d> and d6 go to L, so ?.d>/ and ?.d6/ go to >. This is the no ris,
call option formula, which is0
C G S @ Ee
@rt

C G B8D @ B84e
@.49.H->6/
G B9.J8
429
SOLUTIONS
20. If the standard de%iation is infinite, d> goes to positi%e infinit! so ?.d>/ goes to >, and d6 goes to
negati%e infinit! so ?.d6/ goes to 4. In this case, the call price is e&ual to the stoc, price, which is
Rs.39.
21. We can use the Alac,*Scholes model to %alue the e&uit! of a firm. <sing the asset %alue of
V>4,944,444 as the stoc, price, and the face %alue of de"t of V>4,444,444 as the e#ercise price, the
%alue of the firms e&uit! is0
d> G Nln.V>4,944,444-V>4,444,444/ L ..49 L .38
6
-6/ >O - ..38 > / G .D944
d6 G .D944 @ ..38 > / G .4I44
?.d>/ G .HI3H
?.d6/ G .96IJ
+utting these %alues into the Alac,*Scholes model, we find the e&uit! %alue is0
E&uit! G V>4,944,444..HI3H/ @ .V>4,444,444e
@.49.>/
/..96IJ/ G V6,49>,HJJ.J4
The %alue of the de"t is the firm %alue minus the %alue of the e&uit!, so0
E G V>4,944,444 @ 6,49>,HJJ.J4 G V8,DD8,344.>4
22. a. We can use the Alac,*Scholes model to %alue the e&uit! of a firm. <sing the asset %alue of
V>>,644,444 as the stoc, price, and the face %alue of de"t of V>4,444,444 as the e#ercise price,
the %alue of the firm if it accepts pro:ect ) is0
d> G Nln.V>>,644,444-V>4,444,444/ L ..49 L .99
6
-6/ >O - ..99 > / G .9I64
d6 G .9I64 @ ..99 > / G .4664
?.d>/ G .I>H3
?.d6/ G .9488
+utting these %alues into the Alac,*Scholes model, we find the e&uit! %alue is0
E) G V>>,644,444..I>H3/ @ .V>4,444,444e
@.49.>/
/..9488/ G V3,>83,3HJ.I6
The %alue of the de"t is the firm %alue minus the %alue of the e&uit!, so0
E) G V>>,644,444 @ 3,>83,3HJ.I6 G V8,4>H,H34.68
B-430
CHAPTER 22 B-
)nd the %alue of the firm if it accepts +ro:ect A is0
d> G Nln.V>>,944,444-V>4,444,444/ L ..49 L .3D
6
-6/ >O - ..3D > / G .I68>
d6 G .I68> @ ..3D > / G .388>
?.d>/ G .IHHI
?.d6/ G .H9>4
+utting these %alues into the Alac,*Scholes model, we find the e&uit! %alue is0
EA G V>>,944,444..IHHI/ @ .V>4,444,444e
@.49.>/
/..H9>4/ G V6,H6D,9DD.9J
The %alue of the de"t is the firm %alue minus the %alue of the e&uit!, so0
EA G V>>,944,444 @ 6,H6D,9DD.9J G V8,8I9,D99.D>
b. )lthough the ?+X of pro:ect A is higher, the e&uit! %alue with pro:ect ) is higher. While ?+X
represents the increase in the %alue of the assets of the firm, in this case, the increase in the %alue
of the firms assets resulting from pro:ect A is mostl! allocated to the de"tholders, resulting in a
smaller increase in the %alue of the e&uit!. Stoc,holders would, therefore, prefer pro:ect ) e%en
though it has a lower ?+X.
c. \es. If the same group of in%estors ha%e e&ual sta,es in the firm as "ondholders and stoc,*
holders, then total firm %alue matters and pro:ect A should "e chosen, since it increases the %alue
of the firm to V>>,944,444 instead of V>>,644,444.
d. Stoc,holders ma! ha%e an incenti%e to ta,e on ris,ier, less profita"le pro:ects if the firm is
le%eraged( the higher the firms de"t load, all else the same, the greater is this incenti%e.
23. We can use the Alac,*Scholes model to %alue the e&uit! of a firm. <sing the asset %alue of
V66,444,444 as the stoc, price, and the face %alue of de"t of V64,444,444 as the e#ercise price, the
%alue of the firms e&uit! is0
d> G Nln.V66,444,444-V64,444,444/ L ..49 L .93
6
-6/ >O - ..93 > / G .93J6
d6 G .93J6 @ ..93 > / G .44J6
?.d>/ G .I49>
?.d6/ G .943I
+utting these %alues into the Alac,*Scholes model, we find the e&uit! %alue is0
E&uit! G V66,444,444..I49>6/ @ .V64,444,444e
@.49.>/
/..943I/ G V9,J34,HD3.J6
431
SOLUTIONS
The %alue of the de"t is the firm %alue minus the %alue of the e&uit!, so0
E G V66,444,444 @ 9,J34,HD3.J6 G V>H,4HJ,39H.48
The return on the compan!s de"t is0
V>H,4HJ,39H.48 G V64,444,444e
@R.>/

.843DH8 G e
@R

RE G @ln..843DH8/ G 6>.88K
24. a. The com"ined %alue of e&uit! and de"t of the two firms is0
E&uit! G V6,49>,HJJ.J L 9,J34,HD3.J6 G VI,J86,3D3.86
Ee"t G V8,DD8,344.>4 L >H,4HJ,39H.48 G V6D,9>I,H9H.>8
b. ;or the new firm, the com"ined mar,et %alue of assets is V36,944,444 and the com"ined face
%alue of de"t is V34,444,444. <sing Alac,*Scholes to find the %alue of e&uit! for the new firm,
we find0
d> G Nln.V36,944,444-V34,444,444/ L ..49 L .3>
6
-6/ >O - ..3> > / G .9ID9
d6 G .9ID9 @ ..3> > / G .6HD9
?.d>/ G .I>I6
?.d6/ G .H4D3
+utting these %alues into the Alac,*Scholes model, we find the e&uit! %alue is0
E G V36,944,444..I>I6/ @ .V34,444,444e
@.49.>/
/..H4D3/ G VH,4H3,H4H.69
The %alue of the de"t is the firm %alue minus the %alue of the e&uit!, so0
E G V36,944,444 @ H,4H3,H4H.69 G V6H,D3H,3J3.I9
c. The change in the %alue of the firms e&uit! is0
E&uit! %alue change G VH,4H3,H4H.69 @ I,J86,3D3.86 G @V>,J>8,I3I.9I
The change in the %alue of the firms de"t is0
Ee"t G V6H,D3H,3J3.I9 @ 6D,9>I,H9H.>8 G V>,J>8,I3I.9I
d. In a purel! financial merger, when the standard de%iation of the assets declines, the %alue of the
e&uit! declines as well. The shareholders will lose e#actl! the amount the "ondholders gain. The
"ondholders gain as a result of the coinsurance effect. That is, it is less li,el! that the new
compan! will default on the de"t.
B-432
CHAPTER 22 B-
25. a. <sing Alac,*Scholes model to %alue the e&uit!, we get0
d> G Nln.266,444,444-234,444,444/ L ..4H L .3J
6
-6/ >4O - ..3J 4 > / G .89>I
d6 G .89>I @ ..3J 4 > / G @.38>H
?.d>/ G .8468
?.d6/ G .39>D
+utting these %alues into Alac,*Scholes0
E G 266,444,444..8468/ @ .234,444,444e
@.4H.>4/
/..39>D/ G 2>>,8IH,9>D.HJ
b. The %alue of the de"t is the firm %alue minus the %alue of the e&uit!, so0
E G 266,444,444 @ >>,8IH,9>D.HJ G 2>4,>63,D89.3>
c. <sing the e&uation for the +X of a continuousl! compounded lump sum, we get0
2>4,>63,D89.3> G 234,444,444e
@R.>4/

.33ID9 G e
@R>4

RE G @.>->4/ln..33ID9/ G >4.8HK
d. <sing Alac,*Scholes model to %alue the e&uit!, we get0
d> G Nln.266,844,444-234,444,444/ L ..4H L .3J
6
-6/ >4O - ..3J 4 > / G .884H
d6 G .884H @ ..3J 4 > / G @.38>H
?.d>/ G .8>4I
?.d6/ G .3H66
+utting these %alues into Alac,*Scholes0
E G 266,844,444..8>4I/ @ .234,444,444e
@.4H.>4/
/..3H66/ G 2>6,96>,JH6.46
e. The %alue of the de"t is the firm %alue minus the %alue of the e&uit!, so0
E G 266,844,444 @ >6,96>,JH6.46 G 2>4,6I8,43I.J8
<sing the e&uation for the +X of a continuousl! compounded lump sum, we get0
2>4,6I8,43I.J8G 234,444,444e
@R.>4/

.3D6H4 G e
@R>4

RE G @.>->4/ln..3D6H4/ G >4.I>K
433
SOLUTIONS
When the firm accepts the new pro:ect, part of the ?+X accrues to "ondholders. This increases
the present %alue of the "ond, thus reducing the return on the "ond. )dditionall!, the new pro:ect
ma,es the firm safer in the sense that it increases the %alue of assets, thus increasing the
pro"a"ilit! the call will end in*the*mone! and the "ondholders will recei%e their pa!ment.
26. a. In order to sol%e a pro"lem using the two*state option model, we first need to draw a stoc,
price tree containing "oth the current stoc, price and the stoc,s possi"le %alues at the time of
the options e#piration. ?e#t, we can draw a similar tree for the option, designating what its
%alue will "e at e#piration gi%en either of the 6 possi"le stoc, price mo%ements.
+rice of stoc, Call option price with a stri,e of >>4
Toda! > !ear Toda! > !ear
>69 >9 G$a#.4, >69 @ >>4/
>44 7
84 4 G$a#.4, 84 @ >>4/
The stoc, price toda! is >44. It will either increase to >69 or decrease to 84 in one
!ear. If the stoc, price rises to >69, the call will "e e#ercised for >>4 and a pa!off of
>9 will "e recei%ed at e#piration. If the stoc, price falls to 84, the option will not "e
e#ercised, and the pa!off at e#piration will "e ero.
If the stoc, price rises, its return o%er the period is 69 percent NG .>69->44/ @ >O. If the
stoc, price falls, its return o%er the period is @64 percent NG .84->44/ @>O. We can use the
following e#pression to determine the ris,*neutral pro"a"ilit! of a rise in the price of the stoc,0
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .+ro"a"ilit!;all/.Return;all/
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .> @ +ro"a"ilit!Rise/.Return;all/
.469 G .+ro"a"ilit!Rise/.4.69/ L .> @ +ro"a"ilit!Rise/.@4.64/
+ro"a"ilit!Rise G .94 or 94K
This means the ris, neutral pro"a"ilit! of a stoc, price decrease is0
+ro"a"ilit!;all G > @ +ro"a"ilit!Rise
+ro"a"ilit!;all G > @ .94
+ro"a"ilit!;all G .94 or 94K
<sing these ris,*neutral pro"a"ilities, we can now determine the e#pected pa!off of the call
option at e#piration. The e#pected pa!off at e#piration is0
E#pected pa!off at e#piration G ..94/.>9/ L ..94/.4/
E#pected pa!off at e#piration G I.94
Since this pa!off occurs > !ear from now, we must discount it "ac, to the %alue toda!. Since
we are using ris,*neutral pro"a"ilities, we can use the ris,*free rate, so0
+X.E#pected pa!off at e#piration/ G I.94 - >.469
+X.E#pected pa!off at e#piration/ G I.36
B-434
CHAPTER 22 B-
Therefore, gi%en the information a"out the stoc, price mo%ements o%er the ne#t !ear, a
European call option with a stri,e price of >>4 and one !ear until e#piration is worth I.36
toda!.
b. \es, there is a wa! to create a s!nthetic call option with identical pa!offs to the call option
descri"ed a"o%e. In order to do this, we will need to "u! shares of stoc, and "orrow at the ris,*
free rate. The num"er of shares to "u! is "ased on the delta of the option, where delta is defined
as0
Eelta G .Swing of option/ - .Swing of stoc,/
Since the call option will "e worth >9 if the stoc, price rises and 4 if it falls, the delta of
the option is >9 .G >9 @ 4/. Since the stoc, price will either "e >69 or 84 at the time of
the options e#piration, the swing of the stoc, is D9 .G >69 @ 84/. With this information,
the delta of the option is0
Eelta G >9 - D9
Eelta G >-3 or .3333
Therefore, the first step in creating a s!nthetic call option is to "u! >-3 of a share of the stoc,.
Since the stoc, is currentl! trading at >44 per share, this will cost 33.33 NG .>-3/.>44/O.
In order to determine the amount that we should "orrow, compare the pa!off of the actual call
option to the pa!off of delta shares at e#piration.
Call 'ption
If the stoc, price rises to >690 +a!off G >9
If the stoc, price falls to 840 +a!off G 4
Eelta Shares
If the stoc, price rises to >690 +a!off G .>-3/.>69/ G D>.HH
If the stoc, price falls to 840 +a!off G .>-3/.84/ G 6H.HH
The pa!off of his s!nthetic call position should "e identical to the pa!off of an actual call
option. 5owe%er, owning >-3 of a share lea%es us e#actl! 6H.HH a"o%e the pa!off at
e#piration, regardless of whether the stoc, price rises or falls. In order to reduce the pa!off at
e#piration "! 6H.HH, we should "orrow the present %alue of 6H.HH now. In one !ear, the
o"ligation to pa! 6H.HH will reduce the pa!offs so that the! e#actl! match those of an actual
call option. So, purchase >-3 of a share of stoc, and "orrow 6H.46 .G 6H.HH - >.469/ in
order to create a s!nthetic call option with a stri,e price of >>4 and > !ear until e#piration.
c. Since the cost of the stoc, purchase is 33.33 to purchase >-3 of a share and 6H.46 is
"orrowed, the total cost of the s!nthetic call option is0
Cost of s!nthetic option G 33.33 @ 6H.46
Cost of s!nthetic option G I.36
This is e#actl! the same price as an actual call option. Since an actual call option and a
s!nthetic call option pro%ide identical pa!off structures, we should not e#pect to pa! more for
one than for the other.
435
SOLUTIONS
27. a. In order to sol%e a pro"lem using the two*state option model, we first draw a stoc, price tree
containing "oth the current stoc, price and the stoc,s possi"le %alues at the time of the
options e#piration. ?e#t, we can draw a similar tree for the option, designating what its %alue
will "e at e#piration gi%en either of the 6 possi"le stoc, price mo%ements.
+rice of stoc, +ut option price with a stri,e of 2D4
Toda! H months Toda! H months
2H4 24 G$a#.4, 234 @ D4/
234 7
2>9 269 G$a#.4, 2>9 @ D4/
The stoc, price toda! is 234. It will either decrease to 2>9 or increase to 2H4 in si# months. If
the stoc, price falls to 2>9, the put will "e e#ercised and the pa!off will "e 269. If the stoc,
price rises to 2H4, the put will not "e e#ercised, so the pa!off will "e ero.
If the stoc, price rises, its return o%er the period is >44K NG .H4-34/ @ >O. If the stoc, price falls,
its return o%er the period is @94K NG .>9-34/ @>O. <se the following e#pression to determine the
ris,*neutral pro"a"ilit! of a rise in the price of the stoc,0
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .+ro"a"ilit!;all/.Return;all/
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .> @ +ro"a"ilit!Rise/.Return;all/
The ris,*free rate o%er the ne#t si# months must "e used in the order to match the timing of the
e#pected stoc, price change. Since the ris,*free rate per annum is 6> percent, the ris,*free rate
o%er the ne#t si# months is >4 percent NG .>.6>/
>-6
@>O, so.
4.>4 G .+ro"a"ilit!Rise/.>/ L .> @ +ro"a"ilit!Rise/.@.94/
+ro"a"ilit!Rise G .D4 or D4K
Which means the ris,*neutral pro"a"ilit! of a decrease in the stoc, price is0
+ro"a"ilit!;all G > @ +ro"a"ilit!Rise
+ro"a"ilit!;all G > @ .D4
+ro"a"ilit!;all G .H4 or H4K
<sing these ris,*neutral pro"a"ilities, we can determine the e#pected pa!off to put option at
e#piration as0
E#pected pa!off at e#piration G ..D4/.24/ L ..H4/.269/
E#pected pa!off at e#piration G 2>9.44
Since this pa!off occurs H months from now, we must discount it at the ris,*free rate in order to
find its present %alue, which is0
+X.E#pected pa!off at e#piration/ G 2>9.44 - .>.6>/
>-6

B-436
CHAPTER 22 B-
+X.E#pected pa!off at e#piration/ G 2>3.HD
Therefore, gi%en the information a"out the stoc, price mo%ements o%er the ne#t si# months, a
European put option with a stri,e price of 2D4 and si# months until e#piration is worth 2>3.HD
toda!.
c. \es, there is a wa! to create a s!nthetic put option with identical pa!offs to the put option
descri"ed a"o%e. In order to do this, we need to short shares of the stoc, and lend at the ris,*
free rate. The num"er of shares that should "e shorted sell is "ased on the delta of the option,
where delta is defined as0
Eelta G .Swing of option/ - .Swing of stoc,/
Since the put option will "e worth 24 if the stoc, price rises and 269 if it falls, the swing of the
call option is @269 .G 24 @ 69/. Since the stoc, price will either "e 2H4 or 2>9 at the time of the
options e#piration, the swing of the stoc, is 2D9 .G 2H4 @ >9/. Ri%en this information, the delta
of the put option is0
Eelta G .Swing of option/ - .Swing of stoc,/
Eelta G .@269 - 2D9/
Eelta G @9-J
Therefore, the first step in creating a s!nthetic put option is to short 9-J of a share of stoc,.
Since the stoc, is currentl! trading at 234 per share, the amount recei%ed will "e 2>H.HI .G 9-J
Q 234/ as a result of the short sale. In order to determine the amount to lend, compare the
pa!off of the actual put option to the pa!off of delta shares at e#piration.
+ut option
If the stoc, price rises to 2H40 +a!off G 24
If the stoc, price falls to 2>90 +a!off G 269
Eelta shares
If the stoc, price rises to 2H40 +a!off G .@9-J/.2H4/ G @233.33
If the stoc, price falls to 2840 +a!off G .@9-J/.2>9/ G @28.33
437
SOLUTIONS
The pa!off of the s!nthetic put position should "e identical to the pa!off of an actual put
option. 5owe%er, shorting 9-J of a share lea%es us e#actl! 233.33 "elow the pa!off at
e#piration, whether the stoc, price rises or falls. In order to increase the pa!off at e#piration "!
233.33, we should lend the present %alue of 233.33 now. In si# months, we will recei%e 233.33,
which will increase the pa!offs so that the! e#actl! match those of an actual put option. So, the
amount to lend is0
)mount to lend G 233.33 - >.6>
>-6
)mount to lend G 234.34
c. Since the short sale results in a positi%e cash flow of 2>H.HI and we will lend 234.34, the total
cost of the s!nthetic put option is0
Cost of s!nthetic put G 234.34 @ >H.HI
Cost of s!nthetic put G 2>3.HD
This is e#actl! the same price as an actual put option. Since an actual put option and a s!nthetic
put option pro%ide identical pa!off structures, we should not e#pect to pa! more for one than
for the other.
28. a. The compan! would "e interested in purchasing a call option on the price of gold with a stri,e
price of 3,I94 per ounce and 3 months until e#piration. This option will compensate the
compan! for an! increases in the price of gold a"o%e the stri,e price and places a cap on the
amount the firm must pa! for gold at 3,I94 per ounce.
b. In order to sol%e a pro"lem using the two*state option model, first draw a price tree containing
"oth the current price of the underl!ing asset and the underl!ing assets possi"le %alues at the
time of the options e#piration. ?e#t, draw a similar tree for the option, designating what its
%alue will "e at e#piration gi%en either of the 6 possi"le stoc, price mo%ements.
+rice of gold Call option price with a stri,e of 3,I94
Toda! 3 months Toda! 3 months
D,444 694 G$a#.4, D,444 @
3,I94/
3,944 7
3,694 4 G$a#.4, 3,694 @
3,I94/
B-438
CHAPTER 22 B-
The price of gold is 3,944 per ounce toda!. If the price rises to D,444, the compan! will
e#ercise its call option for 3,I94 and recei%e a pa!off of 694 at e#piration. If the price of
gold falls to 3,694, the compan! will not e#ercise its call option, and the firm will recei%e no
pa!off at e#piration. If the price of gold rises, its return o%er the period is >D.6J percent NG .
D,444 - 3,944/ @ >O. If the price of gold falls, its return o%er the period is @I.>D percent NG .
3,694 - 3,944/ @>O. <se the following e#pression to determine the ris,*neutral pro"a"ilit! of
a rise in the price of gold0
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .+ro"a"ilit!;all/.Return;all/
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .> * +ro"a"ilit!Rise/.Return;all/
The ris,*free rate o%er the ne#t three months must "e used in the order to match the timing of
the e#pected price change. Since the ris,*free rate per annum is >H.JJ percent, the ris,*free rate
o%er the ne#t three months is D percent NG .>.>HJJ/
>-D
@ >O, so0
.4D G .+ro"a"ilit!Rise/..>D6J/ L .> @ +ro"a"ilit!Rise/.@.4I>D/
+ro"a"ilit!Rise G .9644 or 96.44K
)nd the ris,*neutral pro"a"ilit! of a price decline is0
+ro"a"ilit!;all G > @ +ro"a"ilit!Rise
+ro"a"ilit!;all G > @.9644
+ro"a"ilit!;all G .D844 or D8.44K
<sing these ris,*neutral pro"a"ilities, we can determine the e#pected pa!off to of the call
option at e#piration, which will "e.
E#pected pa!off at e#piration G ..9644/.694/ L ..D844/.4/
E#pected pa!off at e#piration G >34.44
Since this pa!off occurs 3 months from now, it must "e discounted at the ris,*free rate in order
to find its present %alue. Eoing so, we find0
+X.E#pected pa!off at e#piration/ G N>34.44 - .>.>HJJ/
>-D
O
+X.E#pected pa!off at e#piration/ G >69.44
Therefore, gi%en the information a"out golds price mo%ements o%er the ne#t three months, a
European call option with a stri,e price of 3,I94 and three months until e#piration is worth
>69.44 toda!.
c. \es, there is a wa! to create a s!nthetic call option with identical pa!offs to the call option
descri"ed a"o%e. In order to do this, the compan! will need to "u! gold and "orrow at the ris,*
free rate. The amount of gold to "u! is "ased on the delta of the option, where delta is defined
as0
Eelta G .Swing of option/ - .Swing of price of gold/
Since the call option will "e worth 694 if the price of gold rises and 4 if it falls, the swing
of the call option is 694 .G 694 @ 4/. Since the price of gold will either "e D,444 or
3,694 at the time of the options e#piration, the swing of the price of gold is I94 .G ,D444
@ 3,694/. Ri%en this information the delta of the call option is0
439
SOLUTIONS
Eelta G .Swing of option/ - .Swing of price of gold/
Eelta G .694 - I94/
Eelta G >-3 or .3333
Therefore, the first step in creating a s!nthetic call option is to "u! >-3 of an ounce of gold.
Since gold currentl! sells for 3,944 per ounce, the compan! will pa! >>HH.HI .G >-3 Q
3,944/ to purchase >-3 of an ounce of gold. In order to determine the amount that should "e
"orrowed, compare the pa!off of the actual call option to the pa!off of delta shares at
e#piration0
Call 'ption
If the price of gold rises to D,4440 +a!off G 694
If the price of gold falls to 3,6940 +a!off G 4
Eelta Shares
If the price of gold rises to D,4440 +a!off G .>-3/.D,444/ G >,333.3
If the price of gold falls to 3,6940 +a!off G .>-3/.3,694/ G >,483.3
The pa!off of this s!nthetic call position should "e identical to the pa!off of an actual call
option. 5owe%er, "u!ing >-3 of a share lea%es us e#actl! >,483.3 a"o%e the pa!off at
e#piration, whether the price of gold rises or falls. In order to decrease the compan!s pa!off at
e#piration "! >,483.3, it should "orrow the present %alue of >,483.3 now. In three
months, the compan! must pa! >,483.3, which will decrease its pa!offs so that the! e#actl!
match those of an actual call option. So, the amount to "orrow toda! is0
)mount to "orrow toda! G >,483.3 - >.>HJJ
>-D
)mount to "orrow toda! G >,4D>.I
d. Since the compan! pa!s >,>HH.HI in order to purchase gold and "orrows >,4D>.I, the total
cost of the s!nthetic call option is >69.44 .G >,>HH.HI @ >,4D>.I/. This is e#actl! the same
price for an actual call option. Since an actual call option and a s!nthetic call option pro%ide
identical pa!off structures, the compan! should not e#pect to pa! more for one than for the
other.
29. To construct the collar, the in%estor must purchase the stoc,, sell a call option with a high stri,e
price, and "u! a put option with a low stri,e price. So, to find the cost of the collar, we need to find
the price of the call option and the price of the put option. We can use Alac,*Scholes to find the
price of the call option, which will "e0
=rice of call option with G)./ stri(e price:
d> G Nln.=84-=>64/ L ..>4 L .94
6
-6/ .H->6/O - ..94
/ >6 - H .
/ G @.868H
d6 G @.868H @ ..94 >6 - H / G @>.>866
?.d>/ G .643I
?.d6/ G .>>8H
+utting these %alues into the Alac,*Scholes model, we find the call price is0
B-440
CHAPTER 22 B-
C G =84..643I/ @ .=>64e
@.>4.H->6/
/..>>8H/ G =6.IH
?ow we can use Alac,*Scholes and put*call parit! to find the price of the put option with a stri,e
price of =94. Eoing so, we find0
=rice of put option with G*/ stri(e price:
d> G Nln.=84-=94/ L ..>4 L .94
6
-6/ .H->6/O - ..94
/ >6 - H .
/ G >.HDIH
d6 G >.HDIH @ ..94 >6 - H / G >.6JD4
?.d>/ G .J943
?.d6/ G .J466
+utting these %alues into the Alac,*Scholes model, we find the call price is0
C = 80(.9503) (50e
.10(6/12)
)(.9022) = 33.11
Rearranging the put*call parit! e&uation, we get0
+ G C @ S L Ue
@Rt
+ G =33.>> @ 84 L 94e
@.>4.H->6/
+ G =4.H8
So, the in%estor will "u! the stoc,, sell the call option, and "u! the put option, so the total cost is0
Total cost of collar G =84 @ 6.IH L .H8
Total cost of collar G =II.J6
'hallenge
30. a. <sing the e&uation for the +X of a continuousl! compounded lump sum, we get0
+X G 234,444 e
@.49.6/
G 26I,>D9.>6
b. <sing Alac,*Scholes model to %alue the e&uit!, we get0
d> G Nln.2>3,444-234,444/ L ..49 L .H4
6
-6/ 6O - ..H4 6 / G @.DD3D
d6 G @.DD3D @ ..H4 6 / G @>.6J>J
?.d>/ G .368I
?.d6/ G .4J86
+utting these %alues into Alac,*Scholes0
E G 2>3,444..368I/ @ .234,444e
@.49.6/
/..4J86/ G 2>,H48.>J
441
SOLUTIONS
)nd using put*call parit!, the price of the put option is0
+ut G 234,444e
@.49.6/
L >,H48.>J @ >3,444 G 2>9,I93.3>
c. The %alue of a ris,! "ond is the %alue of a ris,*free "ond minus the %alue of a put option on the
firms e&uit!, so0
Xalue of ris,! "ond G 26I,>D9.>6 @ >9,I93.3> G 2>>,3J>.8>
<sing the e&uation for the +X of a continuousl! compounded lump sum to find the return on
de"t, we get0
2>>,3J>.8> G 234,444e
@R.6/

.3IJI3 G e
@R6

RE G @.>-6/ln..3IJI3/ G .D8D6 or D8.D6K
d. The %alue of the de"t with fi%e !ears to maturit! at the ris,*free rate is0
+X G 234,444 e
@.49.9/
G 263,3HD.46
<sing Alac,*Scholes model to %alue the e&uit!, we get0
d> G Nln.2>3,444-234,444/ L ..49 L .H4
6
-6/ 9O - ..H4 9 / G .633J
d6 G .633J @ ..H4 9 / G @>.>4I8
?.d>/ G .9J69
?.d6/ G .>3D4
+utting these %alues into Alac,*Scholes0
E G 2>3,444..9J69/ @ .234,444e
@.49.9/
/..>3D4/ G 2D,9I>.H6
)nd using put*call parit!, the price of the put option is0
+ut G 234,444e
@.49.9/
L 2D,9I>.H6 @ 2>3,444 G 2>D,J39.HD
The %alue of a ris,! "ond is the %alue of a ris,*free "ond minus the %alue of a put option on the
firms e&uit!, so0
Xalue of ris,! "ond G 263,3HD.46 @ >D,J39.HD G 28,D68.38
<sing the e&uation for the +X of a continuousl! compounded lump sum to find the return on
de"t, we get0
Return on de"t0 28,D68.38 G 234,444e
@R.9/

.684J9 G e
@R9

RE G @.>-9/ln..684J9/ G 69.3JK
B-442
CHAPTER 22 B-
The %alue of the de"t declines "ecause of the time %alue of mone!, i.e., it will "e longer until
shareholders recei%e their pa!ment. 5owe%er, the re&uired return on the de"t declines. <nder the
current situation, it is not li,el! the compan! will ha%e the assets to pa! off "ondholders. <nder
the new plan where the compan! operates for fi%e more !ears, the pro"a"ilit! of increasing the
%alue of assets to meet or e#ceed the face %alue of de"t is higher than if the compan! onl!
operates for two more !ears.
31. a. <sing the e&uation for the +X of a continuousl! compounded lump sum, we get0
+X G 2H4,444 e
@.4H.9/
G 2DD,DDJ.4J
b. <sing Alac,*Scholes model to %alue the e&uit!, we get0
d> G Nln.29I,444-2H4,444/ L ..4H L .94
6
-6/ 9O - ..94 9 / G .I8>9
d6 G .I8>9 @ ..94 9 / G @.33HH
?.d>/ G .I86I
?.d6/ G .3H86
+utting these %alues into Alac,*Scholes0
E G 29I,444..I86I/ @ .2H4,444e
@.4H.9/
/..3H86/ G 268,6D8.8D
)nd using put*call parit!, the price of the put option is0
+ut G 2H4,444e
@.4H.9/
L 68,6D8.8D @ 9I,444 G 2>9,HJI.J3
c. The %alue of a ris,! "ond is the %alue of a ris,*free "ond minus the %alue of a put option on the
firms e&uit!, so0
Xalue of ris,! "ond G 2DD,DDJ.4J @ >9,HJI.J3 G 268,I9>.>H
<sing the e&uation for the +X of a continuousl! compounded lump sum to find the return on
de"t, we get0
Return on de"t0 268,I9>.>H G 2H4,444e
@R.9/

.DIJ>J G e
@R.9/

RE G @.>-9/ln..DIJ>J/ G >D.I>K
d. <sing the e&uation for the +X of a continuousl! compounded lump sum, we get0
+X G 2H4,444 e
@.4H.9/
G 2DD,DDJ.4J
<sing Alac,*Scholes model to %alue the e&uit!, we get0
d> G Nln.29I,444-2H4,444/ L ..4H L .H4
6
-6/ 9O - ..H4 9 / G .89H6
d6 G .89H6 @ ..H4 9 / G @.D89D
443
SOLUTIONS
?.d>/ G .84D>
?.d6/ G .3>3I
+utting these %alues into Alac,*Scholes0
E G 29I,444..84D>/ @ .2H4,444e
@.4H.9/
/..3>3I/ G 23>,888.3D
)nd using put*call parit!, the price of the put option is0
+ut G 2H4,444e
@.4H.9/
L 3>,888.3D @ 9I,444 G 2>J,33I.DD
The %alue of a ris,! "ond is the %alue of a ris,*free "ond minus the %alue of a put option on the
firms e&uit!, so0
Xalue of ris,! "ond G 2DD,DDJ.4J @ >J,33I.DD G 269,>>>.HH
<sing the e&uation for the +X of a continuousl! compounded lump sum to find the return on
de"t, we get0
Return on de"t0 269,>>>.HH G 2H4,444e
@R.9/

.D>893 G e
@R.9/

RE G @.>-9/ln..D>893/ G >I.D6K
The %alue of the de"t declines. Since the standard de%iation of the compan!s assets increases, the
%alue of the put option on the face %alue of the "ond increases, which decreases the "onds
current %alue.
B-444
CHAPTER 22 B-
e. ;rom c and d, "ondholders lose0 269,>>>.HH @ 68,I9>.>H G @23,H3J.9>
;rom c and d, stoc,holders gain0 23>,888.3D @ 68,6D8.8D G 23,H3J.9>
This is an agenc! pro"lem for "ondholders. $anagement, acting to increase shareholder wealth in
this manner, will reduce "ondholder wealth "! the e#act amount "! which shareholder wealth is
increased.

32. a. Since the e&uit!holders of a firm financed partiall! with de"t can "e thought of as holding a call
option on the assets of the firm with a stri,e price e&ual to the de"ts face %alue and a time to
e#piration e&ual to the de"ts time to maturit!, the %alue of the compan!s e&uit! e&uals a call
option with a stri,e price of V384 "illion and > !ear until e#piration.
In order to %alue this option using the two*state option model, first draw a tree containing "oth
the current %alue of the firm and the firms possi"le %alues at the time of the options
e#piration. ?e#t, draw a similar tree for the option, designating what its %alue will "e at
e#piration gi%en either of the 6 possi"le changes in the firms %alue.
The %alue of the compan! toda! is VD44 "illion. It will either increase to V944 "illion or
decrease to V364 "illion in one !ear as a result of its new pro:ect. If the firms %alue increases
to V944 "illion, the e&uit!holders will e#ercise their call option, and the! will recei%e a pa!off
of V>64 "illion at e#piration. 5owe%er, if the firms %alue decreases to V364 "illion, the
e&uit!holders will not e#ercise their call option, and the! will recei%e no pa!off at e#piration.
Xalue of compan! .in "illions/
E&uit!holders call option price with a stri,e of V384
.in "illions/
Toda! > !ear Toda! > !ear
V944 V>64 G$a#.4, V944 @ 384/
VD44 7
V364 V4 G$a#.4, V364 @ 384/
If the pro:ect is successful and the compan!s %alue rises, the percentage increase in %alue o%er
the period is 69 percent NG .V944 - VD44/ @ >O. If the pro:ect is unsuccessful and the compan!s
%alue falls, the percentage decrease in %alue o%er the period is @64 percent NG .V364 - VD44/ @>O.
We can determine the ris,*neutral pro"a"ilit! of an increase in the %alue of the compan! as0
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .+ro"a"ilit!;all/.Return;all/
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .> @ +ro"a"ilit!Rise/.Return;all/
4.4I G .+ro"a"ilit!Rise/..69/ L .> @ +ro"a"ilit!Rise/.@.64/
+ro"a"ilit!Rise G .H4 or H4K
)nd the ris,*neutral pro"a"ilit! of a decline in the compan! %alue is0
+ro"a"ilit!;all G > @ +ro"a"ilit!Rise
+ro"a"ilit!;all G > @.H4
+ro"a"ilit!;all G .D4 or D4K
445
SOLUTIONS
<sing these ris,*neutral pro"a"ilities, we can determine the e#pected pa!off to the
e&uit!holders call option at e#piration, which will "e0
E#pected pa!off at e#piration G ..H4/.V>64,444,444/ L ..D4/.V4/
E#pected pa!off at e#piration G VI6,444,444
Since this pa!off occurs > !ear from now, we must discount it at the ris,*free rate in order to
find its present %alue. So0
+X.E#pected pa!off at e#piration/ G .VI6,444,444 - >.4I/
+X.E#pected pa!off at e#piration/ G VHI,68J,I64
Therefore, the current %alue of the compan!s e&uit! is VHI,68J,I64. The current %alue of the
compan! is e&ual to the %alue of its e&uit! plus the %alue of its de"t. In order to find the %alue
of compan!s de"t, su"tract the %alue of the compan!s e&uit! from the total %alue of the
compan!0
XC G Ee"t L E&uit!
VD44,444,444 G Ee"t L VHI,68J,I64
Ee"t G V336,I>4,684
b. To find the price per share, we can di%ide the total %alue of the e&uit! "! the num"er of shares
outstanding. So, the price per share is0
+rice per share G Total e&uit! %alue - Shares outstanding
+rice per share G VHI,68J,I64 - 944,444
+rice per share G V>3D.98
c. The mar,et %alue of the firms de"t is V336,I>4,684. The present %alue of the same face
amount of ris,less de"t is V399,>D4,>8I .G V384,444,444 - >.4I/. The firms de"t is worth less
than the present %alue of ris,less de"t since there is a ris, that it will not "e repaid in full. In
other words, the mar,et %alue of the de"t ta,es into account the ris, of default. The %alue of
ris,less de"t is V399,>D4,>8I. Since there is a chance that the compan! might not repa! its
de"tholders in full, the de"t is worth less than V399,>D4,>8I.
d. The %alue of Strudler toda! is VD44 "illion. It will either increase to V844 "illion or decrease to
V644 "illion in one !ear as a result of the new pro:ect. If the firms %alue increases to V844
"illion, the e&uit!holders will e#ercise their call option, and the! will recei%e a pa!off of VD64
"illion at e#piration. 5owe%er, if the firms %alue decreases to V644 "illion, the e&uit!holders
will not e#ercise their call option, and the! will recei%e no pa!off at e#piration.
Xalue of compan! .in "illions/
E&uit!holders call option price with a stri,e of V384
.in "illions/
Toda! > !ear Toda! > !ear
V844 VD64 G$a#.4, V844 @ 384/
VD44 7
V644 V4 G$a#.4, V644 @ 384/
B-446
CHAPTER 22 B-
If the pro:ect is successful and the compan!s %alue rises, the increase in the %alue of the
compan! o%er the period is >44 percent NG .V844 - VD44/ @ >O. If the pro:ect is unsuccessful and
the compan!s %alue falls, decrease in the %alue of the compan! o%er the period is @94 percent
NG .V644 - VD44/ @>O. We can use the following e#pression to determine the ris,*neutral
pro"a"ilit! of an increase in the %alue of the compan!0
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .+ro"a"ilit!;all/.Return;all/
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .> * +ro"a"ilit!Rise/.Return;all/
4.4I G .+ro"a"ilit!Rise/.>/ L .> @ +ro"a"ilit!Rise/.@.94/
+ro"a"ilit!Rise G .38 or 38 percent
So the ris,*neutral pro"a"ilit! of a decrease in the compan! %alue is0
+ro"a"ilit!;all G > @ +ro"a"ilit!Rise
+ro"a"ilit!;all G > @ .38
+ro"a"ilit!;all G .H6 or H6K
<sing these ris,*neutral pro"a"ilities, we can determine the e#pected pa!off to the
e&uit!holders call option at e#piration, which is0
E#pected pa!off at e#piration G ..38/.VD64,444,444/ L ..H6/.V4/
E#pected pa!off at e#piration G V>9J,H44,444
Since this pa!off occurs > !ear from now, we must discount it at the ris,*free rate in order to
find its present %alue. So0
+X.E#pected pa!off at e#piration/ G .V>9J,H44,444 - >.4I/
+X.E#pected pa!off at e#piration/ G V>DJ,>98,8IJ
Therefore, the current %alue of the firms e&uit! is V>DJ,>98,8IJ.
The current %alue of the compan! is e&ual to the %alue of its e&uit! plus the %alue of its de"t. In
order to find the %alue of the compan!s de"t, we can su"tract the %alue of the compan!s
e&uit! from the total %alue of the compan!, which !ields0
XC G Ee"t L E&uit!
VD44,444,444 G Ee"t L V>DJ,>98,8IJ
Ee"t G V694,8D>,>6>
The ris,ier pro:ect increases the %alue of the compan!s e&uit! and decreases the %alue of the
compan!s de"t. If the compan! ta,es on the ris,ier pro:ect, the compan! is less li,el! to "e
a"le to pa! off its "ondholders. Since the ris, of default increases if the new pro:ect is
underta,en, the %alue of the compan!s de"t decreases. Aondholders would prefer the compan!
to underta,e the more conser%ati%e pro:ect.

33. a. Roing "ac, to the chapter on di%idends, the price of the stoc, will decline "! the amount of the
di%idend .less an! ta# effects/. Therefore, we would e#pect the price of the stoc, to drop when a
di%idend is paid, reducing the upside potential of the call "! the amount of the di%idend. The
price of a call option will decrease when the di%idend !ield increases.
447
SOLUTIONS
b. <sing the Alac,*Scholes model with di%idends, we get0
d> G Nln.=8D-=84/ L ..49 @ .46 L .94
6
-6/ .9O - ..94 9 . / G .39I6
d6 G .39I6 @ ..94 9 . / G .443H
?.d>/ G .H3J9
?.d6/ G .94>9
C G =8De
@..46/..9/
..H3J9/ @ .=84e
@.49..9/
/..94>9/ G =>D.4H

34. a. Roing "ac, to the chapter on di%idends, the price of the stoc, will decline "! the amount of the
di%idend .less an! ta# effects/. Therefore, we would e#pect the price of the stoc, to drop when a
di%idend is paid. The price of put option will increase when the di%idend !ield increases.
b. <sing put*call parit! to find the price of the put option, we get0
28De
@.46..9/
L + G 284e
@.49..9/
L >D.4H
+ G 28.J6
35. ?.d>/ is the pro"a"ilit! that 1H8 is less than or e&ual to ?.d>/, so > @ ?.d>/ is the pro"a"ilit! that 1H8
is greater than ?.d>/. Aecause of the s!mmetr! of the normal distri"ution, this is the same thing as
the pro"a"ilit! that 1H8 is less than ?.@d>/. So0
?.d>/ @ > G @?.@d>/.
36. ;rom put*call parit!0
= G E Q e
*<t
I ' 7 ,
Su"stituting the Alac,*Scholes call option formula for ' and using the result in the pre%ious &uestion
produces the put option formula0
= G E Q e
*<t
I ' 7 ,
= 1 E Q e
*<t
I , J?.d>/ @ E Q e
*<t
J?.d6/ @ ,
= 1 , J.?.d>/ @ >/ L E Q e
*<t
J.> @ ?.d6//
= 1 E Q e
*<t
J?.@d6/ @ , J ?.@d>/
37. Aased on Alac,*Scholes, the call option is worth B94_ The reason is that present %alue of the e#ercise
price is ero, so the second term disappears. )lso, d> is infinite, so ?.d>/ is e&ual to one. The
pro"lem is that the call option is European with an infinite e#piration, so wh! would !ou pa!
an!thing for it since !ou can never e#ercise it7 The parado# can "e resol%ed "! e#amining the price
of the stoc,. Remem"er that the call option formula onl! applies to a non*di%idend pa!ing stoc,. If
the stoc, will ne%er pa! a di%idend, it .and a call option to "u! it at an! price/ must "e worthless.
38. The delta of the call option is N(d1) and the delta of the put option is N(d1) 1. Since you are selling
a put option, the delta of the portfolio is N(d1) [N(d1) 1]. This leaves the overall delta of your
B-448
CHAPTER 22 B-
position as 1. This position will change dollar for dollar in value with the underlying asset. This
position replicates the dollar action on the underlying asset.
449
CHAPTER 23
OPTIONS AND CORPORATE FINANCE:
EXTENSIONS AND APPLICATIONS
Answers to Concepts Review and Critical !in"in# Questions
1. 'ne of the purposes to gi%e stoc, options to CE's .instead of cash/ is to tie the performance of the
firms stoc, with the compensation of the CE'. In this wa!, the CE' has an incenti%e to increase
shareholder %alue.
2. $ost "usinesses ha%e the option to a"andon under "ad conditions and the option to e#pand under
good conditions.
3. Xirtuall! all pro:ects ha%e em"edded options, which are ignored in ?+X calculations and li,el!
leads to under%aluation.
4. )s the %olatilit! increases, the %alue of an option increases. )s the %olatilit! of coal and oil
increases, the option to "urn either increases. 5owe%er, if the prices of coal and oil are highl!
correlated, the %alue of the option would decline. If coal and oil prices "oth increase at the same
time, the option to switch "ecomes less %alua"le since the compan! will li,el! sa%e less mone!.
5. The ad%antage is that the %alue of the land ma! increase if !ou wait. )dditionall!, if !ou wait, the
"est use of the land other than sale ma! "ecome more %alua"le.
6. The compan! has an option to a"andon the mine temporaril!, which is an )merican put. If the
option is e#ercised, which the compan! is doing "! not operating the mine, it has an option to reopen
the mine when it is profita"le, which is an )merican call. 'f course, if the compan! does reopen the
mine, it has another option to a"andon the mine again, which is an )merican put.
7. \our colleague is correct, "ut the fact that an increased %olatilit! increases the %alue of an option is
an important part of option %aluation. )ll else the same, a call option on a %enture that has a higher
%olatilit! will "e worth more since the upside potential is greater. E%en though the downside is also
greater, with an option, the downside is irrele%ant since the option will not "e e#ercised and will
e#pire worthless no matter how low the asset falls. With a put option, the re%erse is true in that the
option "ecomes more %alua"le the further the asset falls, and if the asset increases in %alue, the
option is allowed to e#pire.
8. Real option anal!sis is not a techni&ue that can "e applied in isolation. The %alue of the asset in real
option anal!sis is calculated using traditional cash flow techni&ues, and then real options are applied
to the resulting cash flows.
CHAPTER 23 B-
9. Insurance is a put option. Consider !our homeowners insurance. If !our house were to "urn down,
!ou would recei%e the %alue of the polic! from !our insurer. In essence, !ou are selling !our "urned
house .1putting8/ to the insurance compan! for the %alue of the polic! .the stri,e price/.
451
SOLUTIONS
10. In a mar,et with competitors, !ou must realie that the competitors ha%e real options as well. The
decisions made "! these competitors ma! often change the pa!offs for !our compan!s options. ;or
e#ample, the first entrant into a mar,et can often "e rewarded with a larger mar,et share "ecause the
name can "ecome s!non!mous with the product .thin, of Y*tips and Mleene#/. Thus, the option to
"ecome the first entrant can "e %alua"le. 5owe%er, we must also consider that it ma! "e "etter to "e
a later entrant in the mar,et. Either wa!, we must realie that the competitors actions will affect our
options as well.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. The inputs to the Alac,*Scholes model are the current price of the underl!ing asset .S/, the
stri,e price of the option .M/, the time to e#piration of the option in fractions of a !ear .t/, the
%ariance of the underl!ing asset, and the continuousl!*compounded ris,*free interest rate .R/.
Since these options were granted at*the*mone!, the stri,e price of each option is e&ual to the
current %alue of one share, or B94. We can use Alac,*Scholes to sol%e for the option price.
Eoing so, we find0
d> G Nln.S-M/ L .R L
6
-6/.t/ O - .
6
t/
>-6
d> G Nln.B94-B94/ L ..4H L .99
6
-6/ .D/O - ..99 D / G .IH86
d6 G .IH86 @ ..99 D / G @.33>8
;ind ?.d>/ and ?.d6/, the area under the normal cur%e from negati%e infinit! to d> and negati%e
infinit! to d6, respecti%el!. Eoing so0
?.d>/ G ?.4.IH86/ G 4.II88
?.d6/ G ?.@4.33>8/ G 4.3I44
?ow we can find the %alue of each option, which will "e0

C G S?.d>/ @ Me
*@Rt
?.d6/
C G B94.4.II88/ @ .B94e
@.4H.D/
/.4.3I44/
C G B6D.3J
Since the option grant is for 64,444 options, the %alue of the grant is0
Rrant %alue G 64,444.B6D.3J/
Rrant %alue G BD8I,IDI.HH
B-452
CHAPTER 23 B-
b. Aecause he is ris,*neutral, !ou should recommend the alternati%e with the highest net present
%alue. Since the e#pected %alue of the stoc, option pac,age is worth more than BD94,444, he
would prefer to "e compensated with the options rather than with the immediate "onus.
c. If he is ris,*a%erse, he ma! or ma! not prefer the stoc, option pac,age to the immediate "onus.
E%en though the stoc, option pac,age has a higher net present %alue, he ma! not prefer it
"ecause it is undi%ersified. The fact that he cannot sell his options prematurel! ma,es it much
more ris,! than the immediate "onus. Therefore, we cannot sa! which alternati%e he would
prefer.
2. The total compensation pac,age consists of an annual salar! in addition to >4,444 at*the*mone!
stoc, options. ;irst, we will find the present %alue of the salar! pa!ments. Since the pa!ments occur
at the end of the !ear, the pa!ments can "e %alued as a three*!ear annuit!, which will "e0

+X.Salar!/ G Rs.D44,444.+XI;)JK,3/
+X.Salar!/ G Rs.>,4>6,9>I.8I
?e#t, we can use the Alac,*Scholes model to determine the %alue of the stoc, options. Eoing so, we
find0
d> G Nln.S-M/ L .R L
6
-6/.t/ O - .
6
t/
>-6
d> G Nln.Rs.D4-Rs.D4/ L ..49 L .H8
6
-6/ .3/O - ..H8 3 / G .I>H3
d6 G .I>H3 @ ..H8 3 / G @.DH>9
;ind ?.d>/ and ?.d6/, the area under the normal cur%e from negati%e infinit! to d> and negati%e
infinit! to d6, respecti%el!. Eoing so0
?.d>/ G ?.4.I>H3/ G 4.IH3>
?.d6/ G ?.@4.DH>9/ G 4.3666
?ow we can find the %alue of each option, which will "e0

C G S?.d>/ @ Me
*@Rt
?.d6/
C G Rs.D4.4.IH3>/ @ .Rs.D4e
@.49.3/
/.4.3666/
C G Rs.>J.D3
Since the option grant is for >4,444 options, the %alue of the grant is0
Rrant %alue G >4,444.Rs.>J.D3/
Rrant %alue G Rs.>JD,343.DJ
The total %alue of the contract is the sum of the present %alue of the salar!, plus the option %alue, or0
Contract %alue G Rs.>,4>6,9>I.8I L >JD,343.>J
Contract %alue G Rs.>,64H,86>.49
453
SOLUTIONS
3. Since the contract is to sell up to 9 million gallons, it is a call option, so we need to %alue the
contract accordingl!. <sing the "inomial mode, we will find the %alue of u and d, which are0
u G e

-
n
u G e
.DH- >6-3
u G >.6H
d G > - u
d G > - >.6H
d G 4.IJ
This implies the percentage increase if gasoline increases will "e 6H percent, and the percentage
decrease if prices fall will "e 6> percent. So, the price in three months with an up or down mo%e will
"e0
+<p G 2>.H9.>.6H/
+<p G 26.48
+Eown G 2>.H9.4.IJ/
+Eown G 2>.3>
The option is worthless if the price decreases. If the price increases, the %alue of the option per
gallon is0
Xalue with price increase G 26.48 @ >.89
Xalue with price increase G 24.63
?e#t, we need to find the ris, neutral pro"a"ilit! of a price increase or decrease, which will "e0
.4H - .>6-3/ G 4.6H.+ro"a"ilit! of rise/ L @4.6>.> @ +ro"a"ilit! of rise/
+ro"a"ilit! of rise G 4.DI9>
)nd the pro"a"ilit! of a price decrease is0
+ro"a"ilit! of decrease G > @ 4.DI9>
+ro"a"ilit! of decrease G 4.96DJ
The contract will not "e e#ercised if gasoline prices fall, so the %alue of the contract with a price
decrease is ero. So, the %alue per gallon of the call option contract will "e0
C G N4.DI9>.24.63/ L 4.96DJ.4/O - N> L 4.4H-.>6 - 3/O
C G 24.>4H
This means the %alue of the entire contract is0
Xalue of contract G 24.>4H.9,444,444/
Xalue of contract G 2934,9>H.>I
B-454
CHAPTER 23 B-
4. When sol%ing a &uestion dealing with real options, "egin "! identif!ing the option*li,e features of
the situation. ;irst, since the compan! will e#ercise its option to "uild if the %alue of an office
"uilding rises, the right to "uild the office "uilding is similar to a call option. Second, an office
"uilding would "e worth Ca2>4 million toda!. This amount can "e %iewed as the current price of the
underl!ing asset .S/. Third, it will cost Ca2>4.9 million to construct such an office "uilding. This
amount can "e %iewed as the stri,e price of a call option .M/, since it is the amount that the firm
must pa! in order to ne#ercise its right to erect an office "uilding. ;inall!, since the firms right to
"uild on the land lasts onl! > !ear, the time to e#piration .t/ of the real option is one !ear. We can
use the two*state model to %alue the option to "uild on the land. ;irst, we need to find the return of
the land if the %alue rises or falls. The return will "e0
RRise G .Ca2>H,844,444 @ >3,944,444/ - Ca2>3,944,444
RRise G .6DDD or 6D.DDK
R;all G .Ca2>>,844,444 @ >3,944,444/ - Ca2>3,944,444
R;all G @.>69J or @>6.9JK
?ow we can find the ris,*neutral pro"a"ilit! of a rise in the %alue of the "uilding as0
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .+ro"a"ilit!;all/.Return;all/
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .> * +ro"a"ilit!Rise/.Return;all/
4.49 G .+ro"a"ilit!Rise/.4.6DDD/ L .> @ +ro"a"ilit!Rise/.@.>69J/
+ro"a"ilit!Rise G 4.DHJH
So, a pro"a"ilit! of a fall is0
+ro"a"ilit!;all G > @ +ro"a"ilit!Rise
+ro"a"ilit!;all G > @ 4.DHJH
+ro"a"ilit!;all G 4.934D
<sing these ris,*neutral pro"a"ilities, we can determine the e#pected pa!off of the real option at
e#piration.
E#pected pa!off at e#piration G ..DHJH/.Ca2>,844,444/ L ..94/.Ca24/
E#pected pa!off at e#piration G Ca28D9,684
455
Xalue of an 'ffice Auilding .in millions/ Calgar!Ts Real Call 'ption with a Stri,e of 2>4.9 .in millions/
Toda! > \ear Toda! > \ear
>6.9 6 G ma#.4, >6.9*>4.9/
>4 7
8 4 G ma#.4, 8*>4.9/
SOLUTIONS
Since this pa!off will occur > !ear from now, it must "e discounted at the ris,*free rate in order to
find its present %alue, which is0
+X G .Ca28D9,684 - >.49/
+X G Ca284H,9HD.8J
Therefore, the right to "uild an office "uilding o%er the ne#t !ear is worth Ca284H,9HD.8J toda!.
Since the offer to purchase the land is less than the %alue of the real option to "uild, the compan!
should not accept the offer
5. When sol%ing a &uestion dealing with real options, "egin "! identif!ing the option*li,e features of
the situation. ;irst, since the compan! will onl! choose to drill and e#ca%ate if the price of oil rises,
the right to drill on the land can "e %iewed as a call option. Second, since the land contains >69,444
"arrels of oil and the current price of oil is 299 per "arrel, the current price of the underl!ing asset
.S/ to "e used in the Alac,*Scholes model is0
1Stoc,8 price G >69,444.299/
1Stoc,8 price G 2H,8I9,444
Third, since the compan! will not drill unless the price of oil in one !ear will compensate its
e#ca%ation costs, these costs can "e %iewed as the real options stri,e price .M/. ;inall!, since the
winner of the auction has the right to drill for oil in one !ear, the real option can "e %iewed as ha%ing
a time to e#piration .t/ of one !ear. <sing the Alac,*Scholes model to determine the %alue of the
option, we find0
d> G Nln.S-M/ L .R L
6
-6/.t/ O - .
6
t/
>-6
d> G Nln.2H,8I9,444-2>4,444,444/ L ..4H9 L .94
6
-6/ .>/O - ..94 > / G @.3HJD
d6 G @.3HJD @ ..94 > / G @.8HJD
;ind ?.d>/ and ?.d6/, the area under the normal cur%e from negati%e infinit! to d> and negati%e
infinit! to d6, respecti%el!. Eoing so0
?.d>/ G ?.@4.3HJD/ G 4.399J
?.d6/ G ?.@4.8HJD/ G 4.>J63
?ow we can find the %alue of call option, which will "e0

C G S?.d>/ @ Me
*@Rt
?.d6/
C G 2H,8I9,444.4.399J/ @ .2>4,444,444e
@.4H9.>/
/.4.>J63/
C G 2HDD,844.93
This is the ma#imum "id the compan! should "e willing to ma,e at auction.
B-456
CHAPTER 23 B-
&ntermediate
6. When sol%ing a &uestion dealing with real options, "egin "! identif!ing the option*li,e features of
the situation. ;irst, since A:eorn Smelters will onl! choose to manufacture the steel rods if the price
of steel falls, the lease, which gi%es the firm the a"ilit! to manufacture steel, can "e %iewed as a put
option. Second, since the firm will recei%e a fi#ed amount of mone! if it chooses to manufacture the
rods0
)mount recei%ed G D,844 steel rods.B3H4 @ >64/
)mount recei%ed G B>,>96,444
The amount recei%ed can "e %iewed as the put options stri,e price .M/. Third, since the pro:ect
re&uires A:eorn Smelters to purchase D44 tons of steel and the current price of steel is B3,H44 per ton,
the current price of the underl!ing asset .S/ to "e used in the Alac,*Scholes formula is0
1Stoc,8 price G D44 tons.B3,H44 per ton/
1Stoc,8 price G B>,DD4,444
;inall!, since A:eorn Smelters must decide whether to purchase the steel or not in si# months, the
firms real option to manufacture steel rods can "e %iewed as ha%ing a time to e#piration .t/ of si#
months. In order to calculate the %alue of this real put option, we can use the Alac,*Scholes model to
determine the %alue of an otherwise identical call option then infer the %alue of the put using put*call
parit!. <sing the Alac,*Scholes model to determine the %alue of the option, we find0
d> G Nln.S-M/ L .R L
6
-6/.t/ O - .
6
t/
>-6
d> G Nln.B>,DD4,444-B>,>96,444/ L ..4D9 L .D9
6
-6/ .H->6/O - ..D9 >6 H 2 / G .J3>>
d6 G .J3>> @ ..D9 >6 H 2 / G .H>6J
;ind ?.d>/ and ?.d6/, the area under the normal cur%e from negati%e infinit! to d> and negati%e
infinit! to d6, respecti%el!. Eoing so0
?.d>/ G ?.4.J3>>/ G 4.86D>
?.d6/ G ?.4.H>6J/ G 4.I344
?ow we can find the %alue of call option, which will "e0

C G S?.d>/ @ Me
*@Rt
?.d6/
C G B>,DD4,444.4.86D>/ @ .B>,>96,444e
@.4D9.H->6/
/.4.I344/
C G B3HD,D>J.8I
?ow we can use put*call parit! to find the price of the put option, which is0
C G + L S @ Me
@Rt
B3HD,D>J.8I G + L B>,DD4,444 @ B>,>96,444e
@.4D9.H->6/
+ G B94,I8J.6J
This is the most the compan! should "e willing to pa! for the lease.
457
SOLUTIONS
7. In one !ear, the compan! will a"andon the technolog! if the demand is low since the %alue of
a"andonment is higher than the %alue of continuing operations. Since the compan! is selling the
technolog! in this case, the option is a put option. The %alue of the put option in one !ear if demand
is low will "e0
Xalue of put with low demand G 2I,444,444 @ H,444,444
Xalue of put with low demand G 2>,444,444
'f course, if demand is high, the compan! will not sell the technolog!, so the put will e#pire
worthless. We can %alue the put with the "inomial model. In one !ear, the percentage gain on the
pro:ect if the demand is high will "e0
+ercentage increase with high demand G .2>4,944,444 @ J,>44,444/ - 2J,>44,444
+ercentage increase with high demand G .>938 or >9.38K
)nd the percentage decrease in the %alue of the technolog! with low demand is0
+ercentage decrease with high demand G .2H,444,444 @ J,>44,444/ - 2J,>44,444
+ercentage decrease with high demand G @.3D4I or @3D.4IK
?ow we can find the ris,*neutral pro"a"ilit! of a rise in the %alue of the technolog! as0
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .+ro"a"ilit!;all/.Return;all/
Ris,*free rate G .+ro"a"ilit!Rise/.ReturnRise/ L .> @ +ro"a"ilit!Rise/.Return;all/
4.4H G .+ro"a"ilit!Rise/.4.>938/ L .> @ +ro"a"ilit!Rise/.@.3D4I/
+ro"a"ilit!Rise G 4.8>46
So, a pro"a"ilit! of a fall is0
+ro"a"ilit!;all G > @ +ro"a"ilit!Rise
+ro"a"ilit!;all G > @ 4.8>46
+ro"a"ilit!;all G 4.>8J8
<sing these ris,*neutral pro"a"ilities, we can determine the e#pected pa!off of the real option at
e#piration. With high demand, the option is worthless since the technolog! will not "e sold, and the
%alue of the technolog! with low demand is the 2> million we calculated pre%iousl!. So, the %alue of
the option to a"andon is0
Xalue of option to a"andon G N..8>46/.4/ L ..>8J8/.2>,444,444/O - .> L .4H/
Xalue of option to a"andon G 2>IJ,439.HD
B-458
CHAPTER 23 B-
'hallenge
8. <sing the "inomial mode, we will find the %alue of u and d, which are0
u G e

-
n
u G e
.H9-
>6
u G >.6>
d G > - u
d G > - >.6>
d G 4.83
This implies the percentage increase is if the stoc, price increases will "e 6> percent, and the
percentage decrease if the stoc, price falls will "e >I percent. The monthl! interest rate is0
$onthl! interest rate G 4.49->6
$onthl! interest rate G 4.44D6
?e#t, we need to find the ris, neutral pro"a"ilit! of a price increase or decrease, which will "e0
4.44D6 G 4.6>.+ro"a"ilit! of rise/ L @4.>I.> @ +ro"a"ilit! of rise/
+ro"a"ilit! of rise G 4.DHD3
)nd the pro"a"ilit! of a price decrease is0
+ro"a"ilit! of decrease G > @ 4.DHD3
+ro"a"ilit! of decrease G 4.939I
The following figure shows the stoc, price and put price for each possi"le mo%e o%er the ne#t two
months0

Stoc, price .E/ = J>.HJ
+ut price = *

Stoc, price .A/ = IH.44
+ut price = 3.I3

Stoc, price.)/ = H3.44 Stoc, price .E/ = H3.44
+ut price = >>.6> +ut price = I.44

Stoc, price .C/ = 96.66
+ut price = >I.I8

Stoc, price .;/ = D3.6J
+ut price = 6H.I>
459
SOLUTIONS
The stoc, price at node .)/ is the current stoc, price. The stoc, price at node .A/ is from an up
mo%e, which means0
Stoc, price .A/ G =H3.>.64HD/
Stoc, price .A/ G =IH.44
)nd the stoc, price at node .E/ is two up mo%es, or0
Stoc, price .E/ G =H3.>.64HD/.>.64HD/
Stoc, price .E/ G =J>.HJ
The stoc, price at node .C/ is from a down mo%e, or0
Stoc, price .C/ G =H3.4.868J/
Stoc, price .C/ G =96.66
)nd the stoc, price at node .;/ is two down mo%es, or0
Stoc, price .E/ G =H3.4.868J/.4.868J/
Stoc, price .E/ G =D3.6J
;inall!, the stoc, price at node .E/ is from an up mo%e followed "! a down mo%e, or a down mo%e
followed "! an up mo%e. Since the "inomial tree recom"ines, "oth calculations !ield the same result,
which is0
Stoc, price .E/ G =H3.>.64HD/.4.868J/ G =H3.4.868J/.>.64HD/
Stoc, price .E/ G =H3.44
?ow we can %alue the put option at the e#piration nodes, namel! .E/, .E/, and .;/. The %alue of the
put option at these nodes is the ma#imum of the stri,e price minus the stoc, price, or ero. So0
+ut %alue .E/ G $a#.=I4 @ J>.HJ, =4/
+ut %alue .E/ G =4
+ut %alue .E/ G $a#.=I4 @ H3, =4/
+ut %alue .E/ G =I
+ut %alue .;/ G $a#.=I4 @ D3.6J, =4/
+ut %alue .;/ G =6H.I>
The %alue of the put at node .A/ is the present %alue of the e#pected %alue. We find the e#pected
%alue "! using the %alue of the put at nodes .E/ and .E/ since those are the onl! two possi"le stoc,
prices after node .A/. So, the %alue of the put at node .A/ is0
+ut %alue .A/ G N.DHD3.=4/ L .939I.=I/O - >.44D6
+ut %alue .A/ G =3.I3
B-460
CHAPTER 23 B-
Similarl!, the %alue of the put at node .C/ is the present %alue of the e#pected %alue of the put at
nodes .E/ and .;/ since those are the onl! two possi"le stoc, prices after node .C/. So, the %alue of
the put at node .C/ is0
+ut %alue .C/ G N.DHD3.=I/ L .939I.=6H.I>/O - >.44D6
+ut %alue .C/ G =>I.DJ
?otice, howe%er, that the put option is an )merican option. Aecause it is an )merican option, it can
"e e#ercised an! time prior to e#piration. If the stoc, price falls ne#t month, the %alue of the put
option if e#ercised is0
Xalue if e#ercised G =I4 @ 96.66
Xalue if e#ercised G =>I.I8
This is greater then the present %alue of waiting one month, so the option will "e e#ercised earl! in
one month if the stoc, price falls. This is the %alue of the put option at node .C/. <sing this put
%alue, we can now find the %alue of the put toda!, which is0
+ut %alue .)/ G N.DHD3.=3.I3/ L .939I.=>I.I8/O - >.44D6
+ut %alue .)/ G =>>.6>
9. <sing the "inomial mode, we will find the %alue of u and d, which are0
u G e

-
n
u G e
.69- >-6
u G >.>J
d G > - u
d G > - >.>J
d G 4.8D
This implies the percentage increase is if the stoc, price increases will "e >J percent, and the
percentage decrease if the stoc, price falls will "e >H percent. The si# month interest rate is0
Si# month interest rate G 4.48-6
Si# month interest rate G 4.4D
?e#t, we need to find the ris, neutral pro"a"ilit! of a price increase or decrease, which will "e0
4.4D G 4.>J.+ro"a"ilit! of rise/ L @4.>H.> @ +ro"a"ilit! of rise/
+ro"a"ilit! of rise G 4.9H89
)nd the pro"a"ilit! of a price decrease is0
+ro"a"ilit! of decrease G > @ 4.9H89
+ro"a"ilit! of decrease G 4.D3>9
461
SOLUTIONS
The following figure shows the stoc, price and call price for each possi"le mo%e o%er the each of the
si# month steps0
.%alues in
"illions/ Xalue .E/ VHD,489.39H
Call price V>I,489.39H

Xalue pre*pa!ment V93,I4>.D4H
Xalue post*pa!ment .A/ V93,64>.D4H
Call price VJ,338.JH3

Xalue .E/ VDD,98>.4>I
Call price V4

Stoc, price.)/ VD9,444.44
Call price V9,>4D.I3H


Xalue .;/ VDD,D43.3>8
Call price V4

Xalue pre*pa!ment V3I,I48.9>4
Xalue post*pa!ment .C/ V3I,648.9>4
Call price V4


Xalue .R/ V3>,>IJ.DJJ
Call price V4
;irst, we need to find the "uilding %alue at e%er! step along the "inomial tree. The "uilding %alue at
node .)/ is the current "uilding %alue. The "uilding %alue at node .A/ is from an up mo%e, which
means0
Auilding %alue .A/ G VD9,444,444,444.>.>J3D/
Auilding %alue .A/ G V93,I4>,D4H,444
)t node .A/, the accrued rent pa!ment will "e made, so the %alue of the "uilding after the pa!ment
will "e reduced "! the amount of the pa!ment, which means the "uilding %alue at node .A/ is0
Auilding %alue .A/ after pa!ment G V93,I4>,D4H,444 @ 944,444,444
Auilding %alue .A/ after pa!ment G V93,64>,D4H,444
B-462
CHAPTER 23 B-
To find the "uilding %alue at node .E/, we multipl! the after*pa!ment "uilding %alue at node .A/ "!
the up mo%e, or0
Auilding %alue .E/ G V93,64>,D4H,444.>.>J3D/
Auilding %alue .E/ G VHD,489,39H,444
To find the "uilding %alue at node .E/, we multipl! the after*pa!ment "uilding %alue at node .A/ "!
the down mo%e, or0
Auilding %alue .E/ G V93,64>,D4H,444.4.8384/
Auilding %alue .E/ G VDD,98>,4>I,444
The "uilding %alue at node .C/ is from a down mo%e, which means the "uilding %alue will "e0
Auilding %alue .E/ G VD9,444,444,444.4.8384/
Auilding %alue .E/ G V3I,I48,9>4,444
)t node .C/, the accrued rent pa!ment will "e made, so the %alue of the "uilding after the pa!ment
will "e reduced "! the amount of the pa!ment, which means the "uilding %alue at node .C/ is0
Auilding %alue .C/ after pa!ment G V3I,I48,9>4,444 @ 944,444,444
Auilding %alue .C/ after pa!ment G V3I,648,9>4,444
To find the "uilding %alue at node .;/, we multipl! the after*pa!ment "uilding %alue at node .C/ "!
the down mo%e, or0
Auilding %alue .;/ G V3I,648,9>4,444.>.>J3D/
Auilding %alue .;/ G VDD,D43,3>8,444
;inall!, the "uilding %alue at node .R/ is from a down mo%e from node .C/, so the "uilding %alue is0
Auilding %alue .R/ G V3I,648,9>4,444.4.8384/
Auilding %alue .R/ G V3>,>IJ,DJJ,444
?ote that "ecause of the accrued rent pa!ment in si# months, the "inomial tree does not recom"ine
during the ne#t step. This occurs whene%er a fi#ed pa!ment is made during a "inomial tree. ;or
e#ample, when using a "inomial tree for a stoc, option, a fi#ed di%idend pa!ment will mean that the
tree does not recom"ine. With the e#piration %alues, we can %alue the call option at the e#piration
nodes, namel! .E/, .E/, .;/, and .R/. The %alue of the call option at these nodes is the ma#imum of
the "uilding %alue minus the stri,e price, or ero. We do not need to account for the %alue of the
"uilding after the accrued rent pa!ments in this case since if the option is e#ercised, !ou will recei%e
the rent pa!ment. So0
Call %alue .E/ G $a#.VHD,489,39H,444 @ DI,444,444,444, V4/
Call %alue .E/ G V>I,489,39H,444
Call %alue .E/ G $a#.VDD,98>,4>I,444 @ DI,444,444,444, V4/
Call %alue .E/ G V4
463
SOLUTIONS
Call %alue .;/ G $a#.VDD,D43,3>8,444 @ DI,444,444,444, V4/
Call %alue .;/ G V4
Call %alue .R/ G $a#.V3>,>IJ,DJJ,444 @ DI,444,444,444, V4/
Call %alue .R/ G V4
The %alue of the call at node .A/ is the present %alue of the e#pected %alue. We find the e#pected
%alue "! using the %alue of the call at nodes .E/ and .E/ since those are the onl! two possi"le
"uilding %alues after node .A/. So, the %alue of the call at node .A/ is0
Call %alue .A/ G N.9H89.V>I,489,39H,444/ L .D3>9.V4/O - >.4D
Call %alue .A/ G VJ,338,JH3,444
?ote that !ou would not want to e#ercise the option earl! at node .A/. The %alue of the option at
node .A/ is e#ercised if the %alue of the "uilding including the accrued rent pa!ment minus the stri,e
price, or0
'ption %alue at node .A/ if e#ercised G V93,I4>,D4H,444 @ D9,444,444,444
'ption %alue at node .A/ if e#ercised G V8,I4>,D4H,444
Since this is less than the %alue of the option if it left 1ali%e8, the option will not "e e#ercised. With a
call option, unless a large cash pa!ment .di%idend/ is made, it is generall! not %alua"le to e#ercise
the call option earl!. The reason is that the potential gain is unlimited. In contrast, the potential gain
on a put option is limited "! the stri,e price, so it ma! "e %alua"le to e#ercise an )merican put
option earl! if it is deep in the mone!.
We can %alue the call at node .C/, which will "e the present %alue of the e#pected %alue of the call at
nodes .;/ and .R/ since those are the onl! two possi"le "uilding %alues after node .C/. Since neither
node has a %alue greater than ero, o"%iousl! the %alue of the option at node .C/ will also "e ero.
?ow we need to find the %alue of the option toda!, which is0
Call %alue .)/ G N.9H89.VJ,338,JH3,444/ L .D3>9.V4/O - >.4D
Call %alue .)/ G V9,>4D,I3H,444
B-464
CHAPTER 24
DARRA)$ A)8 C0)-1R*261$
Answers to Concepts Review and Critical !in"in# Questions
1. When a warrant is issued "! the compan!, and when a warrant is e#ercised, the num"er of shares
increases. ) call option is a contract "etween in%estors and does not affect the num"er of shares of
the firm.
2. a. If the stoc, price is less than the e#ercise price of the warrant at e#piration, the warrant is
worthless. +rior to e#piration, howe%er, the warrant will ha%e %alue as long as there is some
pro"a"ilit! that the stoc, price will rise a"o%e the e#ercise price in the time remaining until
e#piration. Therefore, if the stoc, price is "elow the e#ercise price of the warrant, the lower
"ound on the price of the warrant is ero.
b. If the stoc, price is a"o%e the e#ercise price of the warrant, the warrant must "e worth at least
the difference "etween these two prices. If warrants were selling for less than the difference
"etween the current stoc, price and the e#ercise price, an in%estor could earn an ar"itrage profit
.i.e. an immediate cash inflow/ "! purchasing warrants, e#ercising them immediatel!, and
selling the stoc,.
c. If the warrant is selling for more than the stoc,, it would "e cheaper to purchase the stoc, than
to purchase the warrant, which gi%es its owner the right to "u! the stoc,. Therefore, an upper
"ound on the price of an! warrant is the firms current stoc, price.
3. )n increase in the stoc, price %olatilit! increases the "ond price. If the stoc, price "ecomes more
%olatile, the con%ersion option on the stoc, "ecomes more %alua"le.
4. The two components of the %alue of a con%erti"le "ond are the straight "ond %alue and the option
%alue. )n increase in interest rates decreases the straight %alue component of the con%erti"le "ond.
Con%ersel!, an increase in interest rates increases the %alue of the e&uit! call option. Renerall!, the
effect on the straight "ond %alue will "e much greater, so we would e#pect the "ond %alue to fall,
although not as much as the decrease in a compara"le straight "ond.
5. When warrants are e#ercised, howe%er, the num"er of shares outstanding increases. This results in
the %alue of the firm "eing spread out o%er a larger num"er of shares, often leading to a decrease in
%alue of each indi%idual share. The decrease in the per*share price of a compan!s stoc, due to a
greater num"er of shares outstanding is ,nown as dilution.
6. In an efficient capital mar,et the difference "etween the mar,et %alue of a con%erti"le "ond and the
%alue of straight "ond is the fair price in%estors pa! for the call option that the con%erti"le or the
warrant pro%ides.
7. There are three potential reasons0 >/ To match cash flows, that is, the! issue securities whose cash
flows match those of the firm. 6/ To "!pass assessing the ris, of the compan! .ris, s!nerg!/. ;or
SOLUTIONS
e#ample, the ris, of compan! start*ups is hard to e%aluate. 3/ To reduce agenc! costs associated with
raising mone! "! pro%iding a pac,age that reduces "ondholder*stoc,holder conflicts.
B-466
CHAPTER 24 B-
8. Aecause the holder of the con%erti"le has the option to wait and perhaps do "etter than what is
implied "! current stoc, prices.
9. Theoreticall! con%ersion should "e forced as soon as the con%ersion %alue reaches the call price
"ecause other con%ersion policies will reduce shareholder %alue. If con%ersion is forced when
con%ersion %alues are a"o%e the call price, "ondholders will "e allowed to e#change less %alua"le
"onds for more %alua"le common stoc,. In the opposite situation, shareholders are gi%ing
"ondholders the e#cess %alue.
10. ?o, the mar,et price of the warrant will not e&ual ero. Since there is a chance that the mar,et price
of the stoc, will rise a"o%e the 26> per share e#ercise price "efore e#piration, the warrant still has
some %alue. Its mar,et price will "e greater than ero. )s a practical matter, warrants that are far out*
of*the*mone! ma! sell at 4, due to transaction costs.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. The con%ersion price is the par %alue di%ided "! the con%ersion ratio, or0
Con%ersion price G 2>,444 - 63.6
Con%ersion price G 2D3.>4
2. The con%ersion ratio is the par %alue di%ided "! the con%ersion price, or0
Con%ersion ratio G =>,444 - =ID.69
Con%ersion ratio G >3.DI
3. The con%ersion %alue is the num"er of shares that the "ond can "e con%erted to times the stoc, price.
So, the con%ersion %alue for this "ond is0
Con%ersion %alue G 2H6.>4.9/
Con%ersion %alue G 2H9>
4. ;irst, we need to find the con%ersion price, which is the par %alue di%ided "! the con%ersion ratio, or0
Con%ersion price G B>,444 - >D.94
Con%ersion price G BH8.JI
The con%ersion premium is the necessar! increase in stoc, price to ma,e the "ond con%erti"le. So,
the con%ersion premium is0
Con%ersion premium G .BH8.JI @ DH.6D/ -BDH.6D
Con%ersion premium G 4.DJ>9 or DJ.>9K
467
SOLUTIONS
5. a. The con%ersion ratio is defined as the num"er of shares that will "e issued upon con%ersion.
Since each "ond is con%erti"le into 6D.69 shares of 5annons common stoc,, the con%ersion
ratio of the con%erti"le "onds is 6D.69.
b. The con%ersion price is defined as the face amount of a con%erti"le "ond that the holder must
surrender in order to recei%e a single share. Since the con%ersion ratio indicates that each "ond
is con%erti"le into 6D.69 shares, the con%ersion price is0
Con%ersion price G >,444 - 6D.69
Con%ersion price G D>.6D
c. The con%ersion premium is defined as the percentage difference "etween the con%ersion price of
the con%erti"le "onds and the current stoc, price. So, the con%ersion premium is0
Con%ersion premium G .D>.6D @ 3>.69/ -3>.69
Con%ersion premium G 4.3>JH or 3>.JHK
d. The con%ersion %alue is defined as the amount that each con%erti"le "ond would "e worth if it
were immediatel! con%erted into common stoc,. So, the con%ersion %alue is0
Con%ersion %alue G3>.69.6D.69/
Con%ersion %alue G I9I.8>
e. If the stoc, price increases "! 6, the new con%ersion %alue will "e0
Con%ersion %alue G33.69.6D.69/
Con%ersion %alue G 84H.3>
6. The total e#ercise price of each warrant is shares each warrant can purchase times the e#ercise price,
which in this case will "e0
E#ercise price G 3.236/
E#ercise price G 2JH
Since the shares of stoc, are selling at 238, the %alue of three shares is0
Xalue of shares G 3.238/
Xalue of shares G 2>>D
Therefore, the warrant effecti%el! gi%es its owner the right to "u! 2>>D worth of stoc, for 2JH. It
follows that the minimum %alue of the warrant is the difference "etween these num"ers, or0
$inimum warrant %alue G 2>>D @ JH
$inimum warrant %alue G 2>8
If the warrant were selling for less than 2>8, an in%estor could earn an ar"itrage profit "! purchasing
the warrant, e#ercising it immediatel!, and selling the stoc,. 5ere, the warrant holder pa!s less than
2>8 while recei%ing the 2>8 difference "etween the price of three shares and the e#ercise price.
B-468
CHAPTER 24 B-
7. Since a con%erti"le "ond gi%es its holder the right to a fi#ed pa!ment plus the right to con%ert, it
must "e worth at least as much as its straight %alue. Therefore, if the mar,et %alue of a con%erti"le
"ond is less than its straight %alue, there is an opportunit! to ma,e an ar"itrage profit "! purchasing
the "ond and holding it until e#piration. In Scenario ), the mar,et %alue of the con%erti"le "ond is
>,444. Since this amount is greater than the con%erti"les straight %alue . J44/, Scenario ) is
feasi"le. In Scenario A, the mar,et %alue of the con%erti"le "ond is J44. Since this amount is less
than the con%erti"les straight %alue .J94/, Scenario A is not feasi"le.
8. a. <sing the con%ersion price, we can determine the con%ersion ratio, which is0
Con%ersion ratio G 2>,444 - 269
Con%ersion ratio G D4
So, each "ond can "e e#changed for D4 shares of stoc,. This means the con%ersion price of the
"ond is0
Con%ersion price G D4.26>/
Con%ersion price G 28D4
Therefore, the minimum price the "ond should sell for is 28D4. Since the "ond price is higher
than this price, the "ond is selling at the straight %alue, plus a premium for the con%ersion
feature.
b. ) con%erti"le "ond gi%es its owner the right to con%ert his "ond into a fi#ed num"er of shares.
The mar,et price of a con%erti"le "ond includes a premium o%er the %alue of immediate
con%ersion that accounts for the possi"ilit! of increases in the price of the firms stoc, "efore
the maturit! of the "ond. If the stoc, price rises, a con%erti"le "ondholder will con%ert and
recei%e %alua"le shares of e&uit!. If the stoc, price decreases, the con%erti"le "ondholder holds
the "ond and retains his right to a fi#ed interest and principal pa!ments.
9. \ou can con%ert or tender the "ond .i.e., surrender the "ond in e#change for the call price/. If !ou
con%ert, !ou get stoc, worth 39 Q D4 G >,D44. If !ou tender, !ou get >,>44 .>>4 percent of par/.
Its a no*"rainer0 con%ert.
10. a. Since the stoc, price is currentl! "elow the e#ercise price of the warrant, the lower "ound on
the price of the warrant is ero. If there is onl! a small pro"a"ilit! that the firms stoc, price
will rise a"o%e the e#ercise price of the warrant, the warrant has little %alue. )n upper "ound on
the price of the warrant is 233, the current price of the common stoc,. 'ne would ne%er pa!
more than 233 to recei%e the right to purchase a share of the compan!s stoc, if the firms stoc,
were onl! worth 233.
b. If the stoc, is trading for 23J per share, the lower "ound on the price of the warrant is 2D, the
difference "etween the current stoc, price and the warrants e#ercise price. If warrants were
selling for less than this amount, an in%estor could earn an ar"itrage profit "! purchasing
warrants, e#ercising them immediatel!, and selling the stoc,. )s alwa!s, the upper "ound on
the price of a warrant is the current stoc, price. In this case, one would ne%er pa! more than
23J for the right to "u! a single share of stoc, when he could purchase a share outright for 23J.
469
SOLUTIONS
&ntermediate
11. a. The minimum con%erti"le "ond %alue is the greater of the con%ersion price or the straight "ond
price. To find the con%ersion price of the "ond, we need to determine the con%ersion ratio,
which is0
Con%ersion ratio G P>,444 - P>69
Con%ersion ratio G 8
So, each "ond can "e e#changed for 8 shares of stoc,. This means the con%ersion price of the
"ond is0
Con%ersion price G 8.P39/
Con%ersion price G P684
)nd the straight "ond %alue is0
+ G P39.Z> @ N>-.> L .4H/O
H4
[ - .4H/ L P>,444N> - .> L .4H/
H4
O
+ G P9J9.JH
So, the minimum price of the "ond is P9J9.JH
c. If the stoc, price were growing "! >9 percent per !ear fore%er, each share of its stoc, would "e
worth appro#imatel! P36.>.>9/
t
after t !ears. Since each "ond is con%erti"le into 8 shares, the
con%ersion %alue of the "ond e&uals .P36/.8/.>.>9/
t
after t !ears. In order to calculate the
num"er of !ears that it will ta,e for the con%ersion %alue to e&ual P>,>44, set up the following
e&uation0
.P36/.8/.>.>9/
t
G P>,>44
t G >4.D3 !ears
12. a. The percentage of the compan! stoc, currentl! owned "! the CE' is0
+ercentage of stoc, G 944,444 - D,444,444
+ercentage of stoc, G .>694 or >6.94K
b. The con%ersion price indicates that for e%er! 269 of face %alue of con%erti"le "onds
outstanding, the compan! will "e o"ligated to issue a new share upon con%ersion. So, the new
num"er of shares the compan! must issue will "e0
?ew shares issued G 264,444,444 - 269
?ew shares issued G 844,444
So, the new num"er of shares of compan! stoc, outstanding will "e0
?ew total shares G D,444,444 L 844,444
?ew total shares G D,844,444
B-470
CHAPTER 24 B-
)fter the con%ersion, the percentage of compan! stoc, owned "! the CE' will "e0
?ew percentage of stoc, G 944,444 - D,844,444
?ew percentage of stoc, G .>4D6 or >4.D6K
13. a. Aefore the warrant was issued, the firms assets were worth0
Xalue of assets G 9 o of platinum.B>,444 per o/
Xalue of assets G B9,444
So, the price per share is0
+rice per share G B9,444 - 3
+rice per share G B>,HHH.HI
b. When the warrant was issued, the firm recei%ed B>,444, increasing the total %alue of the firms
assets to BH,444 .G B9,444 L >,444/. If the two shares of common stoc, were the onl!
outstanding claims on the firms assets, each share would "e worth B6,444 .G BH,444 - 3
shares/. 5owe%er, since the warrant gi%es warrant holder a claim on the firms assets worth
B>,444, the %alue of the firms assets a%aila"le to stoc,holders is onl! B9,444 .G BH,444 @
>,444/. Since there are three shares outstanding, the %alue per share remains at B>,HHH.HI .G
B9,444 - 3 shares/ after the warrant issue. ?ote that the firm uses warrant price of B>,444 to
purchase one more ounce of platinum.
c. If the price of platinum is B>,>44 per ounce, the total %alue of the firms assets is BH,H44 .G H o
of platinum Q B>,>44 per o/. If the warrant is not e#ercised, the %alue of the firms assets
would remain at BH,H44 and there would "e three shares of common stoc, outstanding. If the
warrant is e#ercised, the firm would recei%e the warrants B6,>44 stri,e price and issue one
share of stoc,. The total %alue of the firms assets would increase to B8,I44 .G BH,H44 L 6,>44/.
Since there would now "e D shares outstanding and no warrants, the price per share would "e
B6,>I9.44 .G B8,I44 - D shares/. Since the B6,644 %alue of the share that the warrant holder will
recei%e is greater than the B6,>44 e#ercise price of the warrant, in%estors will e#pect the
warrant to "e e#ercised. The firms stoc, price will reflect this information and will "e priced at
B6,>I9 per share on the warrants e#piration date.
14. The %alue of the compan!s assets is the com"ined %alue of the stoc, and the warrants. So, the %alue
of the compan!s assets "efore the warrants are e#ercised is0
Compan! %alue G >4,444,444.2>I/ L >,444,444.23/
Compan! %alue G 2>I3,444,444
When the warrants are e#ercised, the %alue of the compan! will increase "! the num"er of warrants
times the e#ercise price, or0
Xalue increase G >,444,444.2>9/
Xalue increase G 2>9,444,444
471
SOLUTIONS
So, the new %alue of the compan! is0
?ew compan! %alue G 2>I3,444,444 L >9,444,444
?ew compan! %alue G 2>88,444,444
This means the new stoc, price is0
?ew stoc, price G 2>88,444,444 - >>,444,444
?ew stoc, price G 2>I.4J
?ote that since the warrants were e#ercised when the price per warrant .23/ was a"o%e the e#ercise
%alue of each warrant .26 G 2>I @ >9/, the stoc,holders gain and the warrant holders lose.
'hallenge
15. The straight "ond %alue toda! is0
Straight "ond %alue G =H8.+XI;)>4K,69/ L =>,444->.>4
69

Straight "ond %alue G =I4J.93
)nd the con%ersion %alue of the "ond toda! is0
Con%ersion %alue G =DD.I9.=>,444-=>94/
Con%ersion %alue G =6J8.33
We e#pect the "ond to "e called when the con%ersion %alue increases to =>,344, so we need to find
the num"er of periods it will ta,e for the current con%ersion %alue to reach the e#pected %alue at
which the "ond will "e con%erted. Eoing so, we find0
=6J8.33.>.>6/
t
G =>,344
t G >6.JJ !ears.
The "ond will "e called in >6.JJ !ears.
The "ond %alue is the present %alue of the e#pected cash flows. The cash flows will "e the annual
coupon pa!ments plus the con%ersion price. The present %alue of these cash flows is0
Aond %alue G =H8.+XI;)>4K,>6.JJ/ L =>,344->.>4
>6.JJ
G =89J.84
16. The %alue of a single warrant .W/ e&uals0
W G Ne - .e L eW/O Q CallZS G .X- e/, M G MW[
where0
e G the num"er of shares of common stoc, outstanding
eW G the num"er of warrants outstanding
CallZS, M[ G a call option on an underl!ing asset worth , with a stri,e price K
X G the firms %alue net of de"t
MW G the stri,e price of each warrant
B-472
CHAPTER 24 B-
Therefore, the %alue of a single warrant .W/ e&uals0
W G Ne - .e L eW/O Q CallZS G .X- e/, M G MW[
G ND,444,444 - .D,444,444 L 944,444/ Q CallZS G .288,444,444 - D,444,444/, M G 264[
G .8-J/ Q Call.S G 266, M G 264/
In order to %alue the call option, use the Alac,*Scholes formula. Sol%ing for d> and d6, we find
d> G Nln.S-M/ L .R L o
6
/.t/ O - .
6
t/
>-6
d> G Nln.266-64/ L Z4.4I L o.4.4D/[.>/ O - .4.4DQ>/
>-6
d> G 4.J6HH
d6 G d> @ .
6
t/
>-6
d6 G 4.J6HH @ .4.4D Q >/
>-6
d6 G 4.I6HH
?e#t, we need to find ?.d>/ and ?.d6/, the area under the normal cur%e from negati%e infinit! to d>
and negati%e infinit! to d6, respecti%el!.
?.d>/ G ?.4.J6HH/ G 4.866J
?.d6/ G ?.4.I6HH/ G 4.IHH3
)ccording to the Alac,*Scholes formula, the price of a European call option .C/ on a non*di%idend
pa!ing common stoc, is0
C G S?.d>/ @ Me
@Rt
?.d6/
C G .266/.4.866J/ @ .64/e
@4.4I.>/
.4.IHH3/
C G 23.8>
Therefore, the price of a single warrant .W/ e&uals0
W G .8-J/ Q Call.S G 266, M G 264/
W G .8-J/.23.8>/
W G 23.3J
17. To calculate the num"er of warrants that the compan! should issue in order to pa! off Rs.>4 million
in si# months, we can use the Alac,*Scholes model to find the price of a single warrant, then di%ide
this amount into the present %alue of Rs.>4 million to find the num"er of warrants to "e issued. So,
the %alue of the lia"ilit! toda! is0
+X of lia"ilit! G Rs.>4,444,444e
@.4H.H->6/
+X of lia"ilit! G Rs.J,I4D,D99.3D
The compan! must raise this amount from the warrant issue.
473
SOLUTIONS
The %alue of compan!s assets will increase "! the amount of the warrant issue after the issue, "ut
this increase in %alue from the warrant issue is e#actl! offset "! the "ond issue. Since the cash
inflow from the warrants offsets the firms de"t, the %alue of the warrants will "e e#actl! the same as
if the cash from the warrants were used to immediatel! pa! off the de"t. We can use the mar,et
%alue of the compan!s assets to find the current stoc, price, which is0
Stoc, price G Rs.>H4,444,444 - >,944,444
Stoc, price G Rs.>4H.HI
The %alue of a single warrant .W/ e&uals0
W G Ne - .e L eW/O Q Call.S, M/
W G N>,944,444 - .>,944,444 L eW/O Q Call.Rs.>4H.HI, Rs.J9/
Since the firm must raise Rs.J,I4D,D99 as a result of the warrant issue, we ,now eW Q W must e&ual
Rs.J,I4D,D99.
Therefore, it can "e stated that0
Rs.J,I4D,D99 G .eW/.W/
Rs.J,I4D,D99 G .eW/.N>,944,444 - .>,944,444 LeW/O Q Call.Rs.>4H.HI, Rs.J9/
<sing the Alac,*Scholes formula to %alue the warrant, which is a call option, we find0
d> G Nln.S-M/ L .R L o
6
/.t/ O - .
6
t/
>-6
d> G Nln.Rs.>4H.HI - Rs.J9/ L Z.4H L o..H9
6
/[.H - >6/ O - ..H9
6
Q H - >6/
>-6
d> G 4.9DI>
d6 G d> @ .
6
t/
>-6
d6 G 4.9DI> @ ..H9
6
Q H - >6/
>-6
d6 G 4.48I9
?e#t, we need to find ?.d>/ and ?.d6/, the area under the normal cur%e from negati%e infinit! to d>
and negati%e infinit! to d6, respecti%el!.
?.d>/ G ?.4.9DI>/ G 4.I4I8
?.d6/ G ?.4.48I9/ G 4.93DJ
)ccording to the Alac,*Scholes formula, the price of a European call option .C/ on a non*di%idend
pa!ing common stoc, is0
C G S?.d>/ @ Me
@Rt
?.d6/
C G .Rs.>4H.HI/.4.I4I8/ @ .Rs.J9/e
@4.4H.H->6/
.4.93DJ/
C G Rs.6H.>J
<sing this %alue in the e&uation a"o%e, we find the num"er of warrants the compan! must sell is0
Rs.J,I4D,D99 G .eW/.N>,944,444 - .>,944,444 LeW/O Q Call.Rs.>4H.HI, Rs.J9/
Rs.J,I4D,D99 G .eW/ N>,944,444 - .>,944,444 LeW/O Q Rs.6H.>J
eW G DJ6,44H
B-474
CHAPTER 25
DERIVATIVES AND HEDGING RISK
Answers to Concepts Review and Critical !in"in# Questions
1. Since the firm is selling futures, it wants to "e a"le to deli%er the lum"er( therefore, it is a supplier.
Since a decline in lum"er prices would reduce the income of a lum"er supplier, it has hedged its
price ris, "! selling lum"er futures. Cosses in the spot mar,et due to a fall in lum"er prices are offset
"! gains on the short position in lum"er futures.
2. Au!ing call options gi%es the firm the right to purchase por, "ellies( therefore, it must "e a consumer
of por, "ellies. While a rise in por, "ell! prices is "ad for the consumer, this ris, is offset "! the
gain on the call options( if por, "ell! prices actuall! decline, the consumer en:o!s lower costs, while
the call option e#pires worthless.
3. ;orward contracts are usuall! designed "! the parties in%ol%ed for their specific needs and are rarel!
sold in the secondar! mar,et, so forwards are somewhat customied financial contracts. )ll gains
and losses on the forward position are settled at the maturit! date. ;utures contracts are standardied
to facilitate li&uidit! and to allow them to "e traded on organied futures e#changes. Rains and
losses on futures are mar,ed*to*mar,et dail!. Eefault ris, is greatl! reduced with futures since the
e#change acts as an intermediar! "etween the two parties, guaranteeing performance. Eefault ris, is
also reduced "ecause the dail! settlement procedure ,eeps large loss positions from accumulating.
\ou might prefer to use forwards instead of futures if !our hedging needs were different from the
standard contract sie and maturit! dates offered "! the futures contract.
4. The firm is hurt "! declining oil prices, so it should sell oil futures contracts. The firm ma! not "e
a"le to create a perfect hedge "ecause the &uantit! of oil it needs to hedge doesnt match the standard
contract sie on crude oil futures, or perhaps the e#act settlement date the compan! re&uires isnt
a%aila"le on these futures. )lso, the firm ma! produce a different grade of crude oil than that
specified for deli%er! in the futures contract.
5. The firm is directl! e#posed to fluctuations in the price of natural gas since it is a natural gas user. In
addition, the firm is indirectl! e#posed to fluctuations in the price of oil. If oil "ecomes less
e#pensi%e relati%e to natural gas, its competitors will en:o! a cost ad%antage relati%e to the firm.
6. Au!ing the call options is a form of insurance polic! for the firm. If cotton prices rise, the firm is
protected "! the call, while if prices actuall! decline, the! can :ust allow the call to e#pire worthless.
5owe%er, options hedges are costl! "ecause of the initial premium that must "e paid. The futures
contract can "e entered into at no initial cost, with the disad%antage that the firm is loc,ing in one
price for cotton( it cant profit from cotton price declines.
SOLUTIONS
7. The put option on the "ond gi%es the owner the right to sell the "ond at the options stri,e price. If
"ond prices decline, the owner of the put option profits. 5owe%er, since "ond prices and interest
rates mo%e in opposite directions, if the put owner profits from a decline in "ond prices, he would
also profit from a rise in interest rates. 5ence, a call option on interest rates is conceptuall! the same
thing as a put option on "ond prices.
8. The compan! would li,e to loc, in the current low rates, or at least "e protected from a rise in rates,
allowing for the possi"ilit! of "enefit if rates actuall! fall. The former hedge could "e implemented
"! selling "ond futures( the latter could "e implemented "! "u!ing put options on "ond prices or
"u!ing call options on interest rates.
9. ) swap contract is an agreement "etween parties to e#change assets o%er se%eral time inter%als in the
future. The swap contract is usuall! an e#change of cash flows, "ut not necessaril! so. Since a
forward contract is also an agreement "etween parties to e#change assets in the future, "ut at a single
point in time, a swap can "e %iewed as a series of forward contracts with different settlement dates.
The firm participating in the swap agreement is e#posed to the default ris, of the dealer, in that the
dealer ma! not ma,e the cash flow pa!ments called for in the contract. The dealer faces the same
ris, from the contracting part!, "ut can more easil! hedge its default ris, "! entering into an
offsetting swap agreement with another part!.
10. The firm will "orrow at a fi#ed rate of interest, recei%e fi#ed rate pa!ments from the dealer as part of
the swap agreement, and ma,e floating rate pa!ments "ac, to the dealer( the net position of the firm
is that it has effecti%el! "orrowed at floating rates.
11. Transaction e#posure is the short*term e#posure due to uncertain prices in the near future. Economic
e#posure is the long*term e#posure due to changes in o%erall economic conditions. There are a
%ariet! of instruments a%aila"le to hedge transaction e#posure, "ut %er! few long*term hedging
instruments e#ist. It is much more difficult to hedge against economic e#posure, since fundamental
changes in the "usiness generall! must "e made to offset long*run changes in the economic
en%ironment.
12. The ris, is that the dollar will strengthen relati%e to the !en, since the fi#ed !en pa!ments in the
future will "e worth fewer dollars. Since this implies a decline in the 2-V e#change rate, the firm
should sell !en futures. The wa! the interest rate is &uoted will affect the calculation of which
currenc! is strengthening.
13. a. Au! oil and natural gas futures contracts, since these are pro"a"l! !our primar! resource costs.
If it is a coal*fired plant, a cross*hedge might "e implemented "! selling natural gas futures,
since coal and natural gas prices are somewhat negati%el! related in the mar,et( coal and
natural gas are somewhat su"stituta"le.
b. Au! sugar and cocoa futures, since these are pro"a"l! !our primar! commodit! inputs.
c. Sell corn futures, since a record har%est implies low corn prices.
d. Au! sil%er and platinum futures, since these are primar! commodit! inputs re&uired in the
manufacture of photographic e&uipment.
e. Sell natural gas futures, since e#cess suppl! in the mar,et implies low prices.
f. )ssuming the "an, doesnt resell its mortgage portfolio in the secondar! mar,et, "u! "ond
futures.
g. Sell stoc, inde# futures, using an inde# most closel! associated with the stoc,s in !our fund,
such as the SF+ >44 or the $a:or $ar,et Inde# for large "lue*chip stoc,s.
B-476
CHAPTER 25 B-
h. Au! Swiss franc futures, since the ris, is that the dollar will wea,en relati%e to the franc o%er
the ne#t si# months, which implies a rise in the 2-S;r e#change rate.
i. Sell euro futures, since the ris, is that the dollar will strengthen relati%e to the Euro o%er the
ne#t three months, which implies a decline in the 2-B e#change rate.
14. S!sco must ha%e felt that the com"ination of fi#ed plus swap would result in an o%erall "etter rate. In
other words, the %aria"le rate a%aila"le %ia a swap ma! ha%e "een more attracti%e than the rate
a%aila"le from issuing a floating*rate "ond.
15. 5e is a little nap%e a"out the capa"ilities of hedging. While hedging can significantl! reduce the ris,
of changes in foreign e#change mar,ets, it cannot completel! eliminate it. Aasis ris, is the primar!
reason that hedging cannot reduce >44K of an! firms e#posure to price fluctuations. Aasis ris,
arises when the price mo%ements of the hedging instrument do not perfectl! match the price
mo%ements of the asset "eing hedged.
16. Me%in will "e hurt if the !en loses %alue relati%e to the dollar o%er the ne#t eight months.
Eepreciation in the !en relati%e to the dollar results in a decrease in the V-2 e#change rate. Since
Me%in is hurt "! a decrease in the e#change rate, he should ta,e on a short position in !en per dollar
futures contracts to hedge his ris,.
$olutions to Questions and %ro&le's
NOTE: All end of chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. The initial price is 2>,D39 per metric ton and each contract is for >4 metric tons, so the initial
contract %alue is0
Initial contract %alue G .2>,D39 per ton/.>4 tons per contract/ G 2>D,394
)nd the final contract %alue is0
;inal contract %alue G .2>,D46 per ton/.>4 tons per contract/ G 2>D,464
\ou will ha%e a loss on this futures position of0
Coss on futures contract G 2>D,394 @ >D,464 G 2334
477
SOLUTIONS
2. The price &uote is 2>4.>4I per ounce and each contract is for 9,444 ounces, so the initial contract
%alue is0
Initial contract %alue G .2>4.>4I per o./.9,444 o. per contract/ G 294,939
)t a final price of 2>>.>9 per ounce, the %alue of the position is0
;inal contract %alue G .2>>.>9 per o./.9,444 o. per contract/ G 299,I94
Since this is a short position, there is a net loss of0
299,I94 @ 94,939 G 29,6>9 per contract
Since !ou sold fi%e contracts, the net loss is0
?et loss G 9.29,6>9/ G 26H,4I9
)t a final price of 2J.49 per ounce, the %alue of the position is0
;inal contract %alue G .2J.49 per o./.9,444 o. per contract/ G 2D9,694
Since this is a short position, there is a net gain of 294,939 @ D9,694 G 29,689
Since !ou sold fi%e contracts, the net gain is0
?et gain G 9.29,689/ G 26D,D69
With a short position, !ou ma,e a profit when the price falls, and incur a loss when the price rises.
3. The call options gi%e the manager the right to purchase oil futures contracts at a futures price of B39
per "arrel. The manager will e#ercise the option if the price rises a"o%e B39. Selling put options
o"ligates the manager to "u! oil futures contracts at a futures price of B39 per "arrel. The put holder
will e#ercise the option if the price falls "elow B39. The pa!offs per "arrel are0
'il futures price0 B34 B36 B39 B38 BD4
Xalue of call option position0 4 4 4 3 9
Xalue of put option position0 @9 @3 4 4 4
Total %alue0 @B9 @B3 B4 B3 B9
The pa!off profile is identical to that of a forward contract with a B39 stri,e price.
B-478
CHAPTER 25 B-
4. When !ou purchase the contracts, the initial %alue is0
Initial %alue G >4.>44/.=D84/
Initial %alue G =D84,444
)t the end of the first da!, the %alue of !ou account is0
Ea! > account %alue G >4.>44/.=DI3/
Ea! > account %alue G =DI3,444
So, !our cash flow is0
Ea! > cash flow G =DI3,444 @ D84,444
Ea! > cash flow G @=I,444
The da! 6 account %alue is0
Ea! 6 account %alue G >4.>44/.=DIJ/
Ea! 6 account %alue G =DIJ,444
So, !our cash flow is0
Ea! 6 cash flow G =DIJ,444 @ DI3,444
Ea! 6 cash flow G =H,444
The da! 3 account %alue is0
Ea! 3 account %alue G >4.>44/.=D86/
Ea! 3 account %alue G =D86,444
So, !our cash flow is0
Ea! 3 cash flow G =D86,444 @ DIJ,444
Ea! 3 cash flow G =3,444
The da! D account %alue is0
Ea! D account %alue G >4.>44/.=D8H/
Ea! D account %alue G =D8H,444
So, !our cash flow is0
Ea! D cash flow G =D8H,444 @ D86,444
Ea! D cash flow G =D,444
\ou total profit for the transaction is0
+rofit G =D8H,444 @ D84,444
+rofit G =H,444
479
SOLUTIONS
5. When !ou purchase the contracts, !our cash outflow is0
Cash outflow G 69.D4,444/.R>.96/
Cash outflow G R>,964,444
)t the end of the first da!, the %alue of !ou account is0
Ea! > account %alue G 69.D4,444/.R>.DH/
Ea! > account %alue G R>,DH4,444
Remem"er, on a short position !ou gain when the price declines, and lose when the price increase.
So, !our cash flow is0
Ea! > cash flow G R>,964,444 @ >,DH4,444
Ea! > cash flow G RH4,444
The da! 6 account %alue is0
Ea! 6 account %alue G 69.D4,444/.R>.99/
Ea! 6 account %alue G R>,994,444
So, !our cash flow is0
Ea! 6 cash flow G R>,DH4,444 @ >,994,444
Ea! 6 cash flow G @RJ4,444
The da! 3 account %alue is0
Ea! 3 account %alue G 69.D4,444/.R>.9J/
Ea! 3 account %alue G R>,9J4,444
So, !our cash flow is0
Ea! 3 cash flow G R>,994,444 @ >,9J4,444
Ea! 3 cash flow G @RD4,444
The da! D account %alue is0
Ea! D account %alue G 69.D4,444/.R>.H6/
Ea! D account %alue G R>,H64,444
So, !our cash flow is0
Ea! D cash flow G R>,9J4,444 @ >,H64,444
Ea! D cash flow G @R34,444
\ou total profit for the transaction is0
+rofit G R>,964,444 @ >,H64,444
+rofit G @R>44,444
B-480
CHAPTER 25 B-
6. The duration of a "ond is the a%erage time to pa!ment of the "onds cash flows, weighted "! the
ratio of the present %alue of each pa!ment to the price of the "ond. Since the "ond is selling at par,
the mar,et interest rate must e&ual 8 percent, the annual coupon rate on the "ond. The price of a
"ond selling at par is e&ual to its face %alue. Therefore, the price of this "ond is 2>,444. The relati%e
%alue of each pa!ment is the present %alue of the pa!ment di%ided "! the price of the "ond. The
contri"ution of each pa!ment to the duration of the "ond is the relati%e %alue of the pa!ment
multiplied "! the amount of time .in !ears/ until the pa!ment occurs. So, the duration of the "ond is0
\ear +X of pa!ment Relati%e %alue +a!ment weight
> 2ID.4I 4.4ID4I 4.4ID4I
6 H8.9J 4.4H89J 4.>3I>I
3 89I.3D 4.89I3D 6.9I646
+rice of "ond 2>,444 Euration G 6.I836H
7. The duration of a "ond is the a%erage time to pa!ment of the "onds cash flows, weighted "! the
ratio of the present %alue of each pa!ment to the price of the "ond. Since the "ond is selling at par,
the mar,et interest rate must e&ual 8 percent, the annual coupon rate on the "ond. The price of a
"ond selling at par is e&ual to its face %alue. Therefore, the price of this "ond is 2>,444. The relati%e
%alue of each pa!ment is the present %alue of the pa!ment di%ided "! the price of the "ond. The
contri"ution of each pa!ment to the duration of the "ond is the relati%e %alue of the pa!ment
multiplied "! the amount of time .in !ears/ until the pa!ment occurs. So, the duration of the "ond is0
\ear +X of pa!ment Relati%e %alue +a!ment weight
> 2ID.4I 4.4ID4I 4.4ID4I
6 H8.9J 4.4H89J 4.>3I>I
3 H3.9> 4.4H39> 4.>J496
D IJ3.83 4.IJ383 3.>I933
+rice of "ond 2>,444 Euration G 3.9II>4
8. The duration of a portfolio of assets or lia"ilities is the weighted a%erage of the duration of the
portfolios indi%idual items, weighted "! their relati%e mar,et %alues.
a. The total mar,et %alue of assets in millions is0
$ar,et %alue of assets G =68 L 984 L 3J4 L 8D L 3>9
$ar,et %alue of assets G =>,3JI
481
SOLUTIONS
So, the mar,et %alue weight of each asset is0
;ederal funds deposits G =68 - =>,3JI G 4.464
)ccounts recei%a"le G =984 - =>,3JI G 4.D>9
Short*term loans G =3J4 - =>,3JI G 4.6IJ
Cong*term loans G =8D - =>,3JI G 4.4H4
$ortgages G =3>9 - =>,3JI G 4.669

Since the duration of a group of assets is the weighted a%erage of the durations of each
indi%idual asset in the group, the duration of assets is0
Euration of assets G 4.464.4/ L 4.D>9.4.64/ L 4.6IJ.4.H9/ L 4.4H4.9.69/ L 4.669.>D.69/
Euration of assets G 3.IJ !ears
b. The total mar,et %alue of lia"ilities in millions is0
$ar,et %alue of lia"ilities G =964 L 3D4 L 6H4
$ar,et %alue of lia"ilities G =>,>64
?ote that e&uit! is not included in this calculation since it is not a lia"ilit!. So, the mar,et %alue
weight of each asset is0
Chec,ing and sa%ings deposits G =964 - =>,>64 G 4.DHD
Certificates of deposit G =3D4 - =>,>64 G 4.34D
Cong*term financing G =6H4 - =>,>64 G 4.636

Since the duration of a group of lia"ilities is the weighted a%erage of the durations of each
indi%idual asset in the group, the duration of lia"ilities is0
Euration of lia"ilities G 4.DHD.4/ L 4.34D.>.H4/ L 4.636.>>.6/
Euration of lia"ilities G 3.4J !ears
c. Since the duration of assets does not e&ual the duration of its lia"ilities, the "an, is not immune
from interest rate ris,.
&ntermediate
9. a. \oure concerned a"out a rise in corn prices, so !ou would "u! $a! contracts. Since each
contract is for 9,444 "ushels, the num"er of contracts !ou would need to "u! is0
?um"er of contracts to "u! G I9,444-9,444 G >9
A! doing so, !oure effecti%el! loc,ing in the settle price in $a!, 644H of 26.349 per "ushel of
corn, or0
Total price for I9,444 "ushels G >9.26.349/.9,444/ G 2>I6,8I9
B-482
CHAPTER 25 B-
b. If the price of corn at e#piration is 26.DH per "ushel, the %alue of !ou futures position is0
Xalue of future position G .26.DH per "u./.9,444 "u. per contract/.>9 contracts/ G 2>8D,944
Ignoring an! transaction costs, !our gain on the futures position will "e0
Rain G 2>8D,944 @ >I6,8I9 G 2>>,H69
While the price of the corn !our firm needs has "ecome 2>>,H69 more e#pensi%e since $arch,
!our profit from the futures position has netted out this higher cost.
10. a. S<?IC has a comparati%e ad%antage relati%e to )?IC in "orrowing at fi#ed interest rates, while
)?IC has a comparati%e ad%antage relati%e to S<?IC in "orrowing at floating interest rates.
Since the spread "etween )?IC and S<?ICs fi#ed rate costs is onl! >K, while their
differential is 6K in floating rate mar,ets, there is an opportunit! for a 3K total gain "!
entering into a fi#ed for floating rate swap agreement.
b. If the swap dealer must capture 6K of the a%aila"le gain, there is >K left for )?IC and S<?IC.
)n! di%ision of that gain is feasi"le( in an actual swap deal, the di%isions would pro"a"l! "e
negotiated "! the dealer. 'ne possi"le com"ination is K for )?IC and K for S<?IC0


)?IC


Eealer
CIA'R L>K
>4.9K

S<?IC
CIA'R L6.9K
L6.9K
>4.4K
Ee"t $ar,et
CIA'R
L>K
Ee"t $ar,et
>4K
11. The duration of a lia"ilit! is the a%erage time to pa!ment of the cash flows re&uired to retire the
lia"ilit!, weighted "! the ratio of the present %alue of each pa!ment to the present %alue of all
pa!ments related to the lia"ilit!. In order to determine the duration of a lia"ilit!, first calculate the
present %alue of all the pa!ments re&uired to retire it. Since the cost is 234,444 at the "eginning of
each !ear for four !ears, we can find the present %alue of each pa!ment using the +X e&uation0
+X G ;X - .> L R/
t
So, the +X each !ear of college is0
\ear > +X G 234,444 - .>.48/
I
G 2>I,94D.I>
\ear 6 +X G 234,444 - .>.48/
8
G 2>H,648.4I
\ear 3 +X G 234,444 - .>.48/
J
G 2>9,44I.DI
\ear D +X G 234,444 - .>.48/
>4
G 2>3,8J9.84
483
SOLUTIONS
So, the total +X of the college cost is0
+X of college G 2>I,94D.I>L >H,648.4I L >9,44I.DI L >3,8J9.84
+X of college G 2H6,H>H.49
?ow, we can set up the following ta"le to calculate the lia"ilit!s duration. The relati%e %alue of
each pa!ment is the present %alue of the pa!ment di%ided "! the present %alue of the entire lia"ilit!.
The contri"ution of each pa!ment to the duration of the entire lia"ilit! is the relati%e %alue of the
pa!ment multiplied "! the amount of time .in !ears/ until the pa!ment occurs.
\ear +X of pa!ment Relati%e %alue +a!ment weight
I 2>I,94D.I> 4.6IJ9H >.J9H8J
8 >H,648.4I 4.69889 6.4I4IJ
J >9,44I.DI 4.63JHI 6.>9I4I
>4 >3,8J9.84 4.66>J6 6.6>J6>
+X of college 2H6,H>H.49 Euration G 8.D43JH
12. The duration of a "ond is the a%erage time to pa!ment of the "onds cash flows, weighted "! the
ratio of the present %alue of each pa!ment to the price of the "ond. We need to find the present %alue
of the "onds pa!ments at the mar,et rate. The relati%e %alue of each pa!ment is the present %alue of
the pa!ment di%ided "! the price of the "ond. The contri"ution of each pa!ment to the duration of
the "ond is the relati%e %alue of the pa!ment multiplied "! the amount of time .in !ears/ until the
pa!ment occurs. Since this "ond has semiannual coupons, the !ears will include half*!ears. So, the
duration of the "ond is0
\ear +X of pa!ment Relati%e %alue +a!ment weight
4.9 2D3.D8 4.4D>JD 4.464JI
>.4 D6.4> 4.4D496 4.4D496
>.9 D4.9J 4.43J>9 4.498I6
6.4 J>4.HH 4.8I83J >.I9HIJ
+rice of "ond 2>,43H.I3 Euration G >.8II44
13. Cet < e&ual the interest rate change "etween the initiation of the contract and the deli%er! of the asset.
'ash flows from ,trateg ):
Toda ) Aear
+urchase sil%er @S4 4
Aorrow LS4 @S4.> L </
Total cash flow 4 @S4.> L </

'ash flows from ,trateg .:
Toda ) Aear
+urchase sil%er 4 @;
Total cash flow 4 @;
B-484
CHAPTER 25 B-
?otice that each strateg! results in the ownership of sil%er in one !ear for no cash outflow toda!.
Since the pa!offs from "oth the strategies are identical, the two strategies must cost the same in
order to preclude ar"itrage.
The forward price .;/ of a contract on an asset with no carr!ing costs or con%enience %alue e&uals
the current spot price of the asset .S4/ multiplied "! > plus the appropriate interest rate change
"etween the initiation of the contract and the deli%er! date of the asset.
14. a. The forward price of an asset with no carr!ing costs or con%enience %alue is0
;orward price G S4.> L R/
Since !ou will recei%e the "onds face %alue of =>,444 in >> !ears and the >> !ear spot interest
rate is currentl! J percent, the current price of the "ond is0
Current "ond price G =>,444 - .>.4J/
>>
Current "ond price G =38I.93
Since the forward contract defers deli%er! of the "ond for one !ear, the appropriate interest rate
to use in the forward pricing e&uation is the one*!ear spot interest rate of 9 percent0
;orward price G =38I.93.>.49/
;orward price G =D4H.J>
b. If "oth the >*!ear and >>*!ear spot interest rates une#pectedl! shift downward "! 6 percent, the
appropriate interest rates to use when pricing the "ond is I percent, and the appropriate interest
rate to use in the forward pricing e&uation is 3 percent. Ri%en these changes, the new price of
the "ond will "e0
?ew "ond price G =>,444 - .>.4I/
>>
?ew "ond price G =DI9.4J
)nd the new forward price of the contract is0
;orward price G =DI9.4J.>.43/
;orward price G =D8J.39
15. a. The forward price of an asset with no carr!ing costs or con%enience %alue is0
;orward price G S4.> L R/
Since !ou will recei%e the "onds face %alue of V>,444 in >8 months, we can find the price of
the "ond toda!, which will "e0
Current "ond price G V>,444 - .>.48IJ/
3-6
Current "ond price G V88>.6J
485
SOLUTIONS
Since the forward contract defers deli%er! of the "ond for si# months, the appropriate interest
rate to use in the forward pricing e&uation is the si# month E)R, so the forward price will "e0
;orward price G V88>.6J.>.4ID6/
>-6

;orward price G VJ>3.D4
b. It is important to remem"er that >44 "asis points e&uals > percent and one "asis point e&uals
4.4>K. Therefore, if all rates increase "! 34 "asis points, each rate increases "! 4.443. So, the
new price of the "ond toda! will "e0
?ew "ond price G V>,444 - .> L .48IJ L .443/
3-6
?ew "ond price G V8II.H9
Since the forward contract defers deli%er! of the "ond for si# months, the appropriate interest
rate to use in the forward pricing e&uation is the si# month E)R, increased "! the interest rate
change. So the new forward price will "e0
;orward price G V8II.H9.> L .4ID6 L .443/
>-6

;orward price G VJ>4.J4
'hallenge
16. The financial engineer can replicate the pa!offs of owning a put option "! selling a forward contract
and "u!ing a call. ;or e#ample, suppose the forward contract has a settle price of 294 and the
e#ercise price of the call is also 294. The pa!offs "elow show that the position is the same as owning
a put with an e#ercise price of 2940
+rice of coal0 2D4 2D9 294 299 2H4
Xalue of call option position0 4 4 4 9 >4
Xalue of forward position0 >4 9 4 @9 @>4
Total %alue0 2>4 29 24 24 24
Xalue of put position0 2>4 29 24 24 24
The pa!offs for the com"ined position are e#actl! the same as those of owning a put. This means
that, in general, the relationship "etween puts, calls, and forwards must "e such that the cost of the
two strategies will "e the same, or an ar"itrage opportunit! e#ists. In general, gi%en an! two of the
instruments, the third can "e s!nthesied.
B-486
CHAPTER 26
$90R@1R. /*)A)C1 A)8
%6A))*)3
Answers to Concepts Review and Critical !in"in# Questions
1. These are firms with relati%el! long in%entor! periods and-or relati%el! long recei%a"les periods.
Thus, such firms tend to ,eep in%entor! on hand, and the! allow customers to purchase on credit and
ta,e a relati%el! long time to pa!.
2. These are firms that ha%e a relati%el! long time "etween the time that purchased in%entor! is paid for
and the time that in%entor! is sold and pa!ment recei%ed. Thus, these are firms that ha%e relati%el!
short pa!a"les periods and-or relati%el! long recei%a"le c!cles.
3. a. <se0 The cash "alance declined "! Ca2644 to pa! the di%idend.
b. Source0 The cash "alance increased "! Ca2944, assuming the goods "ought on pa!a"les
credit were sold for cash.
c. <se0 The cash "alance declined "! Ca2J44 to pa! for the fi#ed assets.
d. <se0 The cash "alance declined "! Ca2H69 to pa! for the higher le%el of in%entor!.
e. <se0 The cash "alance declined "! Ca2>,644 to pa! for the redemption of de"t.
4. Carr!ing costs will decrease "ecause the! are not holding goods in in%entor!. Shortage costs will
pro"a"l! increase depending on how close the suppliers are and how well the! can estimate need.
The operating c!cle will decrease "ecause the in%entor! period is decreased.
5. Since the cash c!cle e&uals the operating c!cle minus the accounts pa!a"le period, it is not possi"le
for the cash c!cle to "e longer than the operating c!cle if the accounts pa!a"le is positi%e. $oreo%er,
it is unli,el! that the accounts pa!a"le period would e%er "e negati%e since that implies the firm pa!s
its "ills "efore the! are incurred.
6. Shortage costs are those costs incurred "! a firm when its in%estment in current assets is low. There
are two "asic t!pes of shortage costs. >/ Trading or order costs. 'rder costs are the costs of placing
an order for more cash or more in%entor!. 6/ Costs related to safet! reser%es. These costs include
lost sales, lost customer goodwill, and disruption of production schedules.
7. ) long*term growth trend in sales will re&uire some permanent in%estment in current assets. Thus, in
the real world, net wor,ing capital is not ero. )lso, the %ariation across time for assets means that
net wor,ing capital is unli,el! to "e ero at an! point in time. This is a li&uidit! reason.
8. It lengthened its pa!a"les period, there"! shortening its cash c!cle.
SOLUTIONS B-488
CHAPTER 26 B-
9. Their recei%a"les period increased, there"! increasing their operating and cash c!cles.
10. It is sometimes argued that large firms 1ta,e ad%antage of8 smaller firms "! threatening to ta,e their
"usiness elsewhere. 5owe%er, considering a mo%e to another supplier to get "etter terms is the
nature of competiti%e free enterprise.
11. The! would li,e to_ The pa!a"les period is a su":ect of much negotiation, and it is one aspect of the
price a firm pa!s its suppliers. ) firm will generall! negotiate the "est possi"le com"ination of
pa!a"les period and price. T!picall!, suppliers pro%ide strong financial incenti%es for rapid pa!ment.
This issue is discussed in detail in a later chapter on credit polic!.
12. AlueS,! will need less financing "ecause it is essentiall! "orrowing more from its suppliers. )mong
other things, AlueS,! will li,el! need less short*term "orrowing from other sources, so it will sa%e
on interest e#pense.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. ?o change. ) di%idend paid for "! the sale of de"t will not change cash since the cash raised
from the de"t offer goes immediatel! to shareholders.
b. ?o change. The real estate is paid for "! the cash raised from the de"t, so this will not change
the cash "alance.
c. ?o change. In%entor! and accounts pa!a"le will increase, "ut neither will impact the cash
account.
d. Eecrease. The short*term "an, loan is repaid with cash, which will reduce the cash "alance.
e. Eecrease. The pa!ment of ta#es is a cash transaction.
f. Eecrease. The preferred stoc, will "e repurchased with cash.
g. ?o change. )ccounts recei%a"le will increase, "ut cash will not increase until the sales are paid
off.
h. Eecrease. The interest is paid with cash, which will reduce the cash "alance.
i. Increase. When pa!ments for pre%ious sales, or accounts recei%a"le, are paid off, the cash
"alance increases since the pa!ment must "e made in cash.
>. Eecrease. The accounts pa!a"le are reduced through cash pa!ments to suppliers.
489
SOLUTIONS
(. Eecrease. 5ere the di%idend pa!ments are made with cash, which is generall! the case. This is
different from part a, where de"t was raised to ma,e the di%idend pa!ment.
l. ?o change. The short*term note will not change the cash "alance.
m. Eecrease. The utilit! "ills must "e paid in cash.
n. Eecrease. ) cash pa!ment will reduce cash.
o. Increase. If mar,eta"le securities are sold, the compan! will recei%e cash from the sale.
2. The total lia"ilities and e&uit! of the compan! are the net "oo, worth, or mar,et %alue of e&uit!, plus
the long*term de"t, so0
Total lia"ilities and e&uit! G =J,344 L >,J44
Total lia"ilities and e&uit! G =>>,644
This is also e&ual to the total assets of the compan!. Since total assets are the sum of all assets, and
cash is an asset, the cash account must "e e&ual to total assets minus all other assets, so0
Cash G =>>,644 @ 6,344 @ 6,D94
Cash G =H,D94
We ha%e ?WC other than cash, so the total ?WC is0
?WC G =6,D94 L H,D94
?WC G =8,J44
We can find total current assets "! using the ?WC e&uation. ?WC is e&ual to0
?WC G C) @ CC
=8,J44 G C) @ =>,694
C) G =>4,>94
3. a. Increase. If recei%a"les go up, the time to collect the recei%a"les would increase, which
increases the operating c!cle.
b. Increase. If credit repa!ment times are increased, customers will ta,e longer to pa! their "ills,
which will lead to an increase in the operating c!cle.
c. Eecrease. If the in%entor! turno%er increases, the in%entor! period decreases.
d. ?o change. The accounts pa!a"le period is part of the cash c!cle, not the operating c!cle.
B-490
CHAPTER 26 B-
e. Eecrease. If the recei%a"les turno%er increases, the recei%a"les period decreases.
f. ?o change. +a!ments to suppliers affects the accounts pa!a"le period, which is part of the cash
c!cle, not the operating c!cle.
4. a. Increase( Increase. If the terms of the cash discount are made less fa%ora"le to customers, the
accounts recei%a"le period will lengthen. This will increase "oth the cash c!cle and the
operating c!cle.
b. Increase( ?o change. This will shorten the accounts pa!a"le period, which will increase the
cash c!cle. It will ha%e no effect on the operating c!cle since the accounts pa!a"le period is not
part of the operating c!cle.
c. Eecrease( Eecrease. If more customers pa! in cash, the accounts recei%a"le period will
decrease. This will decrease "oth the cash c!cle and the operating c!cle.
d. Eecrease( Eecrease. )ssume the accounts pa!a"le period and in%entor! period do not change.
;ewer raw materials purchased will reduce the in%entor! period, which will decrease "oth the
cash c!cle and the operating c!cle.
e. Eecrease( ?o change. If more raw materials are purchased on credit, the accounts pa!a"le
period will tend to increase, which would decrease the cash c!cle. We should sa! that this ma!
not "e the case. The accounts pa!a"le period is a decision made "! the compan!s
management. The compan! could increase the accounts pa!a"le account and still ma,e the
pa!ments in the same num"er of da!s. This would lea%e the accounts pa!a"le period
unchanged, which would lea%e the cash c!cle unchanged. The change in credit purchases made
on credit will not affect the in%entor! period or the accounts pa!a"le period, so the operating
c!cle will not change.
f. Increase( Increase. If more goods are produced for in%entor!, the in%entor! period will
increase. This will increase "oth the cash c!cle and operating c!cle.
5. a. ) D9*da! collection period implies all recei%a"les outstanding from the pre%ious &uarter are
collected in the current &uarter, and0
.J4 @ D9/-J4 G >-6 of current sales are collected. So0
L) L. L0 L5
Aeginning recei%a"les B344 BD44 B384 BDI4
Sales 844 IH4 JD4 8I4
Cash collections .I44/ .I84/ .894/ .J49/
Ending recei%a"les BD44 B384 BDI4 BD39
491
SOLUTIONS
b. ) H4*da! collection period implies all recei%a"les outstanding from the pre%ious &uarter are
collected in the current &uarter, and0
.J4*H4/-J4 G >-3 of current sales are collected. So0
L) L. L0 L5
Aeginning recei%a"les B344 B933 B94I BH6I
Sales 844 IH4 JD4 8I4
Cash collections .9HI/ .I8I/ .864/ .J>I/
Ending recei%a"les B933 B94I BH6I B984
c. ) 34*da! collection period implies all recei%a"les outstanding from the pre%ious &uarter are
collected in the current &uarter, and0
.J4*34/-J4 G 6-3 of current sales are collected. So0
L) L. L0 L5
Aeginning recei%a"les B344 B6HI B693 B3>3
Sales 844 IH4 JD4 8I4
Cash collections .833/ .II3/ .884/ .8J3/
Ending recei%a"les B6HI B693 B3>3 B6J4
6. The operating c!cle is the in%entor! period plus the recei%a"les period. The in%entor! turno%er and
in%entor! period are0
In%entor! turno%er G C'RS-)%erage in%entor!
In%entor! turno%er G 29>,44D-ZN28,D>3 L >4,>98O-6[
In%entor! turno%er G 9.DJ6J times
In%entor! period G 3H9 da!s-In%entor! turno%er
In%entor! period G 3H9 da!s-9.DJ6J
In%entor! period G HH.D9 da!s
)nd the recei%a"les turno%er and recei%a"les period are0
Recei%a"les turno%er G Credit sales-)%erage recei%a"les
Recei%a"les turno%er G 2HI,3>6-ZN29,>48 L 9,D3JO-6[
Recei%a"les turno%er G >6.IHD6 times
Recei%a"les period G 3H9 da!s-Recei%a"les turno%er
Recei%a"les period G 3H9 da!s->6.IHD6
Recei%a"les period G 68.H4 da!s
So, the operating c!cle is0
'perating c!cle G HH.D9 da!s L 68.H4 da!s
'perating c!cle G J9.49 da!s
B-492
CHAPTER 26 B-
The cash c!cle is the operating c!cle minus the pa!a"les period. The pa!a"les turno%er and pa!a"les
period are0
+a!a"les turno%er G C'RS-)%erage pa!a"les
+a!a"les turno%er G 29>,44D-ZN2H,J6I L I,H69O-6[
+a!a"les turno%er G I.44JJ times
+a!a"les period G 3H9 da!s-+a!a"les turno%er
+a!a"les period G 3H9 da!s-I.44JJ
+a!a"les period G 96.4I da!s
So, the cash c!cle is0
Cash c!cle G J9.49 da!s @ 96.4I da!s
Cash c!cle G D6.J8 da!s
The firm is recei%ing cash on a%erage D6.J8 da!s after it pa!s its "ills.
7. a. The pa!a"les period is ero since the compan! pa!s immediatel!. Sales in the !ear following
this one are pro:ected to "e >9K greater in each &uarter. Therefore, Y> sales for the ne#t !ear
will "e 9D4.>.>9/ G H6>. The pa!ment in each period is 34 percent of ne#t periods sales,
so0
L) L. L0 L5
+a!ment of accounts >8J.44 6>3.44 639.94 >8H.34
b. Since the pa!a"les period is J4 da!s, the pa!ment in each period is 34 percent of the current
period sales, so0
L) L. L0 L5
+a!ment of accounts >H6.44 >8J.44 6>3.44 639.94
c. Since the pa!a"les period is H4 da!s, the pa!ment in each period is 6-3 of last &uarters orders,
plus >-3 of this &uarters orders, or0
Yuarterl! pa!ments G 6-3..34/ times current sales L >-3..34/ ne#t period sales.
L) L. L0 L5
+a!ment of accounts >I>.44 >JI.44 664.94 6>J.>4
493
SOLUTIONS
8. Since the pa!a"les period is H4 da!s, the pa!a"les in each period will "e0
+a!a"les each period G 6-3 of last &uarters orders L >-3 of this &uarters orders
+a!a"les each period G 6-3..I9/ times current sales L >-3..I9/ ne#t period sales
L) L. L0 L5
+a!ment of accounts Rs.H49.44 Rs.H86.94 Rs.HD6.94 Rs.H3I.94
Wages, ta#es, other e#penses >94.44 >8D.44 >I8.44 >98.44
Cong*term financing e#penses H4.44 H4.44 H4.44 H4.44
Total Rs.8>9.44 Rs.J6H.94 Rs.884.94 Rs.899.94
9. a. The ?o%em"er sales must ha%e "een the total uncollected sales minus the uncollected sales
from Eecem"er, di%ided "! the collection rate two months after the sale, so0
?o%em"er sales G .B9I,444 @ D>,444/-4.>9
?o%em"er sales G B>4H,HHH.HI
b. The Eecem"er sales are the uncollected sales from Eecem"er di%ided "! the collection rate of
the pre%ious months sales, so0
Eecem"er sales G BD>,444-4.39
Eecem"er sales G B>>I,>D6.8H
c. The collections each month for this compan! are0
Collections G .>9.Sales from 6 months ago/ L .64.Cast months sales/ L .H9 .Current sales/
Januar! collections G .>9.B>4H,HHH.HI/ L .64.B>>I,>D6.8H/ L .H9.B>94,444/
Januar! collections G B>3H,J68.9I
;e"ruar! collections G .>9.B>>I,>D6.8H/ L .64.B>94,444/ L .H9.B>I3,444/
;e"ruar! collections G B>H4,46>.D3
$arch collections G .>9.B>94,444/ L .64.B>I3,444/ L .H9.B>J4,444/
$arch collections G B>84,H44.44
B-494
CHAPTER 26 B-
10. The sales collections each month will "e0
Sales collections G .39.current month sales/ L .H4.pre%ious month sales/
Ri%en this collection, the cash "udget will "e0
)pril $a! June
Aeginning cash "alance 2684,444 26D8,894 23>I,8D4
Cash receipts
Cash collections from
credit sales 69J,444 3HH,H44 3J4,J44
Total cash a%aila"le 293J,444 2H>9,D94 2I48,ID4
Cash dis"ursements
+urchases >9H,444 >DI,444 >I9,944
Wages, ta#es, and e#penses 3J,I94 D8,6>4 94,344
Interest >>,D44 >>,D44 >>,D44
E&uipment purchases 83,444 J>,444 4
Total cash dis"ursements 6J4,>94 6JI,H>4 63I,644
Ending cash "alance 26D8,894 23>I,8D4 2DI>,9D4
11. Item Source-<se )mount
Cash <se @VI,444,444
)ccounts recei%a"le <se @VJ,I94,444
In%entories <se @V3,I94,444
+ropert!, plant, and e&uipment <se @V>6,I69,444
)ccounts pa!a"le Source V9,944,444
)ccrued e#penses <se @V3,344,444
Cong*term de"t <se @V>9,444,444
Common stoc, Source V3,444,444
)ccumulated retained earnings Source V3I,844,444
&ntermediate
12. ;irst, we need to calculate the sales from the last &uarter of the pre%ious !ear. Since 94 percent of the
sales were collected in that &uarter, the sales figure must ha%e "een0
Sales last &uarter of per%ious !ear G 8>,444,444 - .> @ .94/
Sales last &uarter of per%ious !ear G >H6,444,444
?ow we can estimate the sales growth each &uarter, and calculate the net sales including the seasonal
ad:ustments. The sales figures for each &uarter will "e0
Luarter ) Luarter . Luarter 5 Luarter 5
Sales ."asic trend/ >44,444,444 >64,444,444 >DD,444,444 >I6,844,444
Seasonal ad:ustment 4 @>4,444,444 @9,444,444 >9,444,444
Sales pro:ection >44,444,444 >>4,444,444 >3J,444,444 >8I,844,444
495
SOLUTIONS
Since 94 percent of sales are collected in the &uarter the sales are made, and D9 percent of sales are
collected in the &uarter after the sales are made, the cash "udget is0
Luarter ) Luarter . Luarter 5 Luarter 5

Collected within
&uarter 94,444,444 99,444,444 HJ,944,444 J3,J44,444

Collection from
pre%ious &uarter I6,J44,444 D9,444,444 DJ,944,444 H6,994,444

Cash collections from
sales >66,J44,444 >44,444,444 >>J,444,444 >9H,D94,444
13. a. ) D9*da! collection period means sales collections each &uarter are0
Collections G >-6 current sales L >-6 old sales
) 3H*da! pa!a"les period means pa!a"les each &uarter are0
+a!a"les G 3-9 current orders L 6-9 old orders
So, the cash inflows each &uarter are0
Y> G IJ L >-6.634/ @ 6-9..D9/.634/ @ 3-9..D9/.>J9/ @ .34.634/ @ >9
Y> G >9.J9
Y6 G >-6.634/ L >-6.>J9/ @ 6-9..D9/.>J9/ @ 3-9..D9/.6I4/ @ .34.>J9/ @ >9 @ J4
Y6 G @9J.44
Y3 G >-6.>J9/ L >-6.6I4/ @ 6-9..D9/.6I4/ @ 3-9..D9/.6J9/ @ .34.6I4/ @ >9
Y3 G 8.69
YD G >-6.6I4/ L >-6.6J9/ @ 6-9..D9/.6J9/ @ 3-9..D9/.694/ @ .34.6J9/ @ >9
YD G 98.D4
The compan!s cash "udget will "e0
5I$ J<? S' C'.
Cash Audget
.in millions/
L) L. L0 L5
Aeginning cash "alance I3.44 88.J9 6J.J9 38.64
?et cash inflow >9.J9 .9J.44/ 8.69 98.D4
Ending cash "alance 88.J9 6J.J9 38.64 JH.H4
$inimum cash "alance .34.44/ .34.44/ .34.44/ .34.44/
Cumulati%e surplus .deficit/ 98.J9 .4.49/ 8.64 HH.H4
B-496
CHAPTER 26 B-
With a 34$ minimum cash "alance, the short*term financial plan will "e0
5I$ J<? S' C'.
Short*Term ;inancial +lan
.in millions/
b. L) L. L0 L5
Aeginning cash "alance 34.44 34.44 34.44 34.44
?et cash inflow >9.J9 @9J.44 8.69 98.D4
?ew short*term in%estments @>H.8> 4 @8.6J @98.H>
Income on short*term in%estments 4.8H >.64 4.4D 4.6>
Short*term in%estments sold 4 9I.84 4 4
?ew short*term "orrowing 4 4 4 4
Interest on short*term "orrowing 4 4 4 4
Short*term "orrowing repaid 4 4 4 4
Ending cash "alance 34.44 34.44 34.44 34.44
$inimum cash "alance @34.44 @34.44 @34.44 @34.44
Cumulati%e surplus .deficit/ 4 4 4 4
Aeginning short*term in%estments D3.44 9J.8> 6.4> >4.34
Ending short*term in%estments 9J.8> 6.4> 14.34 H8.J4
Aeginning short*term de"t 4 4 4 4
Ending short*term de"t 4 4 4 4
Aelow !ou will find the interest paid .or recei%ed/ for each &uarter0
Y>0 e#cess funds at start of &uarter of D3 in%ested for > &uarter earns .46.D3/ G 4.8H
income
Y60 e#cess funds of 9J.8> in%ested for > &uarter earns .46.9J.8>/ G >.64 in income
Y30 e#cess funds of 6.4> in%ested for > &uarter earns .46.6.4>/ G 4.4D in income
YD0 e#cess funds of >4.34 in%ested for > &uarter earns .46.>4.34/ G 4.6> in income
497
SOLUTIONS
14. a. With a minimum cash "alance of D9$, the short*term financial plan will "e0
5I$ J<? S' C'.
Short*Term ;inancial +lan
.in millions/
L) L. L0 L5
Aeginning cash "alance D9.44 D9.44 D9.44 D9.44
?et cash inflow >9.J9 .9J.44/ 8.69 98.D4
?ew short*term in%estments .>H.9>/ 4 4 .96.DI/
Income on short*term in%estments .9H .8J 4 4
Short*term in%estments sold 4 DD.9> 4 4
?ew short*term "orrowing 4 >3.H4 4 4
Interest on short*term "orrowing 4 4 .4.D>/ .4.>I/
Short*term "orrowing repaid 4 4 .I.8D/ .9.IH/
Ending cash "alance D9.44 D9.44 D9.44 D9.44
$inimum cash "alance .D9.44/ .D9.44/ D9.44/ .D9.44/
Cumulati%e surplus .deficit/ 4 4 4 4
Aeginning short*term in%estments 68.44 DD.9> 4 4
Ending short*term in%estments DD.9> 4 4 93.IH
Aeginning short*term de"t 4 4 >3.H4 9.IH
Ending short*term de"t 4 >3.H4 9.IH 4
b. )nd with a minimum cash "alance of >9$, the short*term financial plan will "e0
5I$ J<? S' C'.
Short*Term ;inancial +lan
.in millions/
L) L. L0 L5
Aeginning cash "alance >9.44 >9.44 >9.44 >9.44
?et cash inflow >9.J9 .9J.44/ 8.69 98.D4
?ew short*term in%estments .>I.>>/ 4 .8.H4/ .98.J6/
Income on short*term in%estments >.>H >.94 .39 4.96
Short*term in%estments sold 4 9I.94 4 4
?ew short*term "orrowing 4 4 4 4
Interest on short*term "orrowing 4 4 4 4
Short*term "orrowing repaid 4 4 4 4
Ending cash "alance >9.44 >9.44 >9.44 >9.44
$inimum cash "alance .>9.44/ .>9.44/ .>9.44/ .>9.44/
Cumulati%e surplus .deficit/ 4 4 4 4
Aeginning short*term in%estments 98.44 I9.>> >I.H> 6H.6>
Ending short*term in%estments I9.>> >I.H> 6H.6> 89.>D
Aeginning short*term de"t 4 4 4 4
Ending short*term de"t 4 4 4 4
Since cash has an opportunit! cost, the firm can "oost its profit if it ,eeps its minimum cash "alance
low and in%ests the cash instead. 5owe%er, the tradeoff is that in the e%ent of unforeseen
circumstances, the firm ma! not "e a"le to meet its short*run o"ligations if enough cash is not
a%aila"le.
B-498
CHAPTER 26 B-
15. a. The current assets of Cle%eland Compressor are financed largel! "! retained earnings. ;rom
644H to 644I, total current assets grew "! =I,6>6. 'nl! =6,>6H of this increase was financed "!
the growth of current lia"ilities. +new \or, +neumatics current assets are largel! financed "!
current lia"ilities. Aan, loans are the most important of these current lia"ilities. The! grew
=3,4II to finance an increase in current assets of =8,333.
b. Cle%eland Compressor holds the larger in%estment in current assets. It has current assets of
=J6,H>H while +new \or, +neumatic has =I8,D3D in current assets. The main reason for the
difference is the larger sales of Cle%eland Compressor.
c. Cle%eland Compressor is more li,el! to incur shortage costs "ecause the ratio of current assets
to sales is 4.9I. That ratio for +new \or, +neumatic is 4.8H. Similarl!, +new \or, +neumatic
is incurring more carr!ing costs for the same reason, a higher ratio of current assets to sales.
499
CHAPTER 27
CA$9 .A)A31.1)
Answers to Concepts Review and Critical !in"in# Questions
1. \es. 'nce a firm has more cash than it needs for operations and planned e#penditures, the e#cess
cash has an opportunit! cost. It could "e in%ested ."! shareholders/ in potentiall! more profita"le
wa!s. Yuestion >4 discusses another reason.
2. If it has too much cash it can simpl! pa! a di%idend, or, more li,el! in the current financial
en%ironment, "u! "ac, stoc,. It can also reduce de"t. If it has insufficient cash, then it must either
"orrow, sell stoc,, or impro%e profita"ilit!.
3. +ro"a"l! not. Creditors would pro"a"l! want su"stantiall! more.
4. In the case of $icrosoft, the compan!s reason gi%en for holding cash was to pa! for potential
settlements in its monopol! cases "rought "! the <.S. go%ernment and the European <nion. R$
generall! argued that it held cash to guard against future economic downturns.
5. Cash management is associated more with the collection and dis"ursement of cash. Ci&uidit!
management is "roader and concerns the optimal le%el of li&uid assets needed "! a firm. Thus, for
e#ample, ;ord and Chr!slers stoc,piling of cash was li&uidit! management( whereas, e%aluating a
loc,"o# s!stem is cash management.
6. Such instruments go "! a %ariet! of names, "ut the ,e! feature is that the di%idend ad:usts, ,eeping
the price relati%el! sta"le. This price sta"ilit!, along with the di%idend ta# e#emption, ma,es so*
called ad:usta"le rate preferred stoc, %er! attracti%e relati%e to interest*"earing instruments.
7. ?et dis"ursement float is more desira"le "ecause the "an, thin,s the firm has more mone! than it
actuall! does, and the firm is, therefore, recei%ing interest on funds it has alread! spent.
8. The firm has a net dis"ursement float of =944,444. If this is an ongoing situation, the firm ma! "e
tempted to write chec,s for more than it actuall! has in its account.
9. a. )"out the onl! disad%antage to holding T*"ills are the generall! lower !ields compared to
alternati%e mone! mar,et in%estments.
b. Some ordinar! preferred stoc, issues pose "oth credit and price ris,s that are not consistent
with most short*term cash management plans.
c. The primar! disad%antage of ?CEs is the normall! large transactions sies, which ma! not "e
feasi"le for the short*term in%estment plans of man! smaller to medium*sied corporations.
CHAPTER 27 B-
d. The primar! disad%antages of the commercial paper mar,et are the higher default ris,
characteristics of the securit! and the lac, of an acti%e secondar! mar,et which ma!
e#cessi%el! restrict the fle#i"ilit! of corporations to meet their li&uidit! ad:ustment needs.
501
SOLUTIONS
e. The primar! disad%antages of R)?s is that some possess non*tri%ial le%els of default ris,, and
also, corporations are somewhat restricted in the t!pe and amount of these ta#*e#empts that
the! can hold in their portfolios.
f. The primar! disad%antage of the repo mar,et is the generall! %er! short maturities a%aila"le.
10. The concern is that e#cess cash on hand can lead to poorl! thought*out in%estments. The thought is
that ,eeping cash le%els relati%el! low forces management to pa! careful attention to cash flow and
capital spending.
11. ) potential ad%antage is that the &uic,er pa!ment often means a "etter price. The disad%antage is
that doing so increases the firms cash c!cle.
12. This is reall! a capital structure decision. If the firm has an optimal capital structure, pa!ing off de"t
mo%es it to an under*le%eraged position. 5owe%er, a com"ination of de"t reduction and stoc, "u!*
"ac,s could "e structured to lea%e capital structure unchanged.
13. It is unethical "ecause !ou ha%e essentiall! tric,ed the grocer! store into ma,ing !ou an interest*free
loan, and the grocer! store is harmed "ecause it could ha%e earned interest on the mone! instead of
loaning it to !ou.
14. )s %ariance increases, the upper limit and the spread will increase, while the lower limit remains
unchanged. The lower limit does not change "ecause it is an e#ogenous %aria"le set "! management.
)s the %ariance increases, howe%er, the amount of uncertaint! increases. When this happens, the
target cash "alance, and therefore the upper limit and the spread, will need to "e higher. If the
%ariance drops to ero, then the lower limit, the target "alance, and the upper limit will all "e the
same.
$olutions to Questions and %ro&le's
NOTE: All end of chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. Eecrease. This will lower the trading costs, which will cause a decrease in the target cash
"alance.
b. Eecrease. This will increase the holding cost, which will cause a decrease in the target cash
"alance.
c. Increase. This will increase the amount of cash that the firm has to hold in non*interest "earing
accounts, so the! will ha%e to raise the target cash "alance to meet this re&uirement.
d. Eecrease. If the credit rating impro%es, then the firm can "orrow more easil!, allowing it to
lower the target cash "alance and "orrow if a cash shortfall occurs.
B-502
CHAPTER 27 B-
e. Increase. If the cost of "orrowing increases, the firm will need to hold more cash to protect
against cash shortfalls as its "orrowing costs "ecome more prohi"iti%e.
f. Eecrease. This depends somewhat on what the fees appl! to, "ut if direct fees are esta"lished,
then the compensating "alance ma! "e lowered, thus lowering the target cash "alance. If, on the
other hand, fees are charged on the num"er of transactions, then the firm ma! wish to hold a
higher cash "alance so the! are not transferring mone! into the account as often.
2. The target cash "alance using the Aaumol model is0
b
c
G N.6T Q ;/-RO
>-6

b
c
G N6.)u2>4,444/.)u2>4/-.4IO
>-6

b
c
G )u2>,HJ4.3>
The initial "alance should "e )u2>,HJ4.3>, and whene%er the "alance drops to )u24, another
)u2>,HJ4.3> should "e transferred in.
3. The holding cost is the a%erage dail! cash "alance times the interest rate, so0
5olding cost G .2D44/..49/
5olding cost G 264.44
The trading costs are the total cash needed times the replenishing costs, di%ided "! the a%erage dail!
"alance times two, so0
Trading cost G N.269,444/.2I/O-N.2D44/.6/O
Trading cost G 26>8.I9
The total cost is the sum of the holding cost and the trading cost, so0
Total cost G 264.44 L 6>8.I9
Total cost G 2638.I9
The target cash "alance using the Aaumol model is0
b
c
G N.6T Q ;/-RO
>-6

b
c
G N6.269,444/.2I/-.49O
>-6

b
c
G 26,HD9.I9
The! should increase their a%erage dail! cash "alance to0
?ew a%erage cash "alance G 26,HD9.I9-6
?ew a%erage cash "alance G 2>,366.88
This would minimie the costs. The new total cost would "e0
?ew total cost G .2>,366.88/..49/ L N.269,444/.2I/O-N6.2>,366.88/O
?ew total cost G 2>36.6J
503
SOLUTIONS
4. a. The opportunit! costs are the amount transferred times the interest rate, di%ided "! two, so0
'pportunit! cost G .2344/..4I/-6
'pportunit! cost G 2>4.94
The trading costs are the total cash "alance times the trading cost per transaction, di%ided "! the
amount transferred, so0
Trading cost G .2D,444/.269/-2344
Trading cost G 2333.33
The firm ,eeps too little in cash "ecause the trading costs are much higher than the opportunit!
costs.
b. The target cash "alance using the Aaumol model is0
b
c
G N.6T Q ;/-RO
>-6

b
c
G N6.2D,444/.269/-.4IO
>-6

b
c
G 2>,HJ4.3>
5. a. The dis"ursement float is the a%erage monthl! chec,s written times the a%erage num"er of da!s
for the chec,s to clear, so0
Eis"ursement float G D.B69,444/
Eis"ursement float G B>44,444
The collection float is the a%erage monthl! chec,s recei%ed times the a%erage num"er of da!s
for the chec,s to clear, so0
Collection float G 6.@BD4,444/
Collection float G @B84,444
The net float is the dis"ursement float plus the collection float, so0
?et float G B>44,444 @ 84,444
?et float G B64,444
b. The new collection float will "e0
Collection float G >.@BD4,444/
Collection float G @BD4,444
)nd the new net float will "e0
?et float G B>44,444 @ D4,444
?et float G BH4,444
B-504
CHAPTER 27 B-
6. a. The collection float is the a%erage dail! chec,s recei%ed times the a%erage num"er of da!s for
the chec,s to clear, so0
Collection float G D.Rs.J,444/
Collection float G Rs.3H,444
b. The firm should pa! no more than the amount of the float, or Rs.3H,444, to eliminate the float.
c. The ma#imum dail! charge the firm should "e willing to pa! is the collection float times the
dail! interest rate, so0
$a#imum dail! charge G Rs.3H,444..44469/
Maximum daily charge = Rs.9.00
7. a. Total float G D.2>H,444/ L 9.26,944/
Total float G 2IH,944
b. The a%erage dail! float is the total float di%ided "! the num"er of da!s in a month. )ssuming
34 da!s in a month, the a%erage dail! float is0
)%erage dail! float G 2IH,944-34
)%erage dail! float G 26,994
c. The a%erage dail! receipts are the a%erage monthl! chec,s recei%ed di%ided "! the num"er of
da!s in a month. )ssuming a 34 da! month0
)%erage dail! receipts G .2>H,444 L 6,944/-34
)%erage dail! receipts G 2H>H.HI
The weighted a%erage dela! is the sum of the da!s to clear a chec,, times the amount of the
chec, di%ided "! the a%erage monthl! receipts, so0
Weighted a%erage dela! G D.2>H,444-2>8,944/ L 9.26,944-2>8,944/
Weighted a%erage dela! G D.>D da!s
8. The a%erage dail! collections are the num"er of chec,s recei%ed times the a%erage %alue of a chec,,
so0
)%erage dail! collections G B84.>6,444/
)%erage dail! collections G BJH4,444
The present %alue of the loc,"o# ser%ice is the a%erage dail! receipts times the num"er of da!s the
collection is reduced, so0
+X G .6 da! reduction/.BJH4,444/
+X G B>,J64,444
505
SOLUTIONS
The dail! cost is a perpetuit!. The present %alue of the cost is the dail! cost di%ided "! the dail!
interest rate. So0
+X of cost G B>J4-.444>H
+X of cost G B>,>8I,944
The firm should ta,e the loc,"o# ser%ice. The ?+X of the loc,"o# is the cost plus the present %alue
of the reduction in collection time, so0
?+X G @B>,>8I,944 L >,J64,444
?+X G BI36,944
The annual net sa%ings e#cluding the cost would "e the future %alue of the sa%ings minus the
sa%ings, so0
)nnual sa%ings G B>,J64,444.>.444>H/
3H9
@ >,J64,444
)nnual sa%ings G B>>9,D9I.3>
)nd the annual cost would "e the future %alue of the dail! cost, which is an annuit!, so0
)nnual cost G B>J4.;XI;)3H9,.4>HK/
)nnual cost G BI>,D4J.>D
So, the annual net sa%ings would "e0
)nnual net sa%ings G B>>9,D9I.3> @ I>,D4J.>D
)nnual net sa%ings G BDD,4D8.>I
9. a. The a%erage dail! float is the sum of the percentage each chec, times the num"er of chec,s
recei%ed times the amount of the chec, times the num"er of da!s until the chec, clears, di%ided
"! the num"er of da!s in a month. )ssuming a 34 da! month, we get0
)%erage dail! float G N.H9.9,444/.=94/.6/ L .39.9,444/.=I4/.3/O-34
)%erage dail! float G =63,483
'n a%erage, there is =63,483 that is uncollected and not a%aila"le to the firm.
b. The total collections are the sum of the percentage of each chec, amount recei%ed times the
total chec,s recei%ed times the amount of the chec,, so0
Total collections G .H9.9,444/.=94/ L .39.9,444/.=I4/
Total collections G =689,444
B-506
CHAPTER 27 B-
The weighted a%erage dela! is the sum of the a%erage num"er of da!s a chec, of a specific
amount is dela!ed, times the percentage that chec, amount ma,es up of the total chec,s
recei%ed, so0
Weighted a%erage dela! G 6.=>H6,944-=689,444/ L 3.=>66,944-=689,444/
Weighted a%erage dela! G 6.D3 da!s
The a%erage dail! float is the weighted a%erage dela! times the a%erage chec,s recei%ed per
da!. )ssuming a 34 da! month, we get0
)%erage dail! float G 6.D3.=689,444-34 da!s/
)%erage dail! float G =63,483
c. The most the firm should pa! is the total amount of the a%erage float, or =63,483.
d. The a%erage dail! interest rate is0
>.48 G .> L R/
3H9

R G .46>4JK per da!
The dail! cost of float is the a%erage dail! float times the dail! interest rate, so0
Eail! cost of the float G =63,483..4446>4J/
Eail! cost of the float G =D.8I
e. The most the firm should pa! is still the a%erage dail! float. <nder the reduced collection time
assumption, we get0
?ew a%erage dail! float G 6.=689,444-34/
?ew a%erage dail! float G =>J,444
10. a. The present %alue of adopting the s!stem is the num"er of da!s collections are reduced times
the a%erage dail! collections, so0
+X G 3.D44/.>,D44/
+X G >,H84,444
b. The ?+X of adopting the s!stem is the present %alue of the sa%ings minus the cost of adopting
the s!stem. The cost of adopting the s!stem is the present %alue of the fee per transaction times
the num"er of transactions. This is a perpetuit!, so0
?+X G >,H84,444 @ N4.I9.D44/-.4446O
?+X G >84,444
507
SOLUTIONS
c. The net cash flows is the present %alue of the a%erage dail! collections times the dail! interest
rate, minus the transaction cost per da!, so0
?et cash flow per da! G >,H84,444..4446/ @ 4.I9.D44/
?et cash flow per da! G 3H
The net cash flow per chec, is the net cash flow per da! di%ided "! the num"er of chec,s
recei%ed per da!, or0
?et cash flow per chec, G 3H-D44
?et cash flow per chec, G 4.4J
)lternati%el!, we could find the net cash flow per chec, as the num"er of da!s the s!stem
reduces collection time times the a%erage chec, amount times the dail! interest rate, minus the
transaction cost per chec,. Eoing so, we confirm our pre%ious answer as0

?et cash flow per chec, G 3.>,D44/..4446/ @ 4.I9
?et cash flow per chec, G 4.4J per chec,
11. a. The reduction in cash "alance from adopting the loc,"o# is the num"er of da!s the s!stem
reduces collection time times the a%erage dail! collections, so0
Cash "alance reduction G 3.2>D4,444/
Cash "alance reduction G 2D64,444
b. The dollar return that can "e earned is the a%erage dail! interest rate times the cash "alance
reduction. The a%erage dail! interest rate is0
)%erage dail! rate G >.4J
>-3H9
@ >
)%erage dail! rate G .463HK per da!
The dail! return that can "e earned from the reduction in da!s to clear the chec,s is0
Eail! return G 2D64,444..44463H/
Eail! return G 2JJ.>8
c. If the compan! ta,es the loc,"o#, it will recei%e three pa!ments earl!, with the first pa!ment
occurring toda!. We can use the dail! interest rate from part b, so the sa%ings are0
Sa%ings G 2>D4,444 L 2>D4,444.+XI;).463HK,6/
Sa%ings G 2D>J,J44.8H
If the loc,"o# pa!ments occur at the end of the month, we need the effecti%e monthl! interest
rate, which is0
$onthl! interest rate G >.4J
>->6
@ >
$onthl! interest rate G 4.I64IK
B-508
CHAPTER 27 B-
)ssuming the loc,"o# pa!ments occur at the end of the month, the loc,"o# pa!ments, which
are a perpetuit!, will "e0
+X G C-R
2D>J,J44.8H G C - .44I64I
C G 23,46H.3H
It could also "e assumed that the loc,"o# pa!ments occur at the "eginning of the month. If so,
we would need to use the +X of a perpetuit! due, which is0
+X G C L C - R
Sol%ing for C0
C G .+X Q R/ - .> L R/
C G .2D>J,J44.8H Q .44I64I/ - .> L .44I64I/
C G 23,44D.I>
12. The interest that the compan! could earn will "e the amount of the chec,s times the num"er of da!s
it will dela! pa!ment times the num"er of wee,s that chec,s will "e dis"ursed times the dail!
interest rate, so0
Interest G V64,444,444.I/.96-6/..4446/
Interest G VI68,444
13. The "enefit of the new arrangement is the B8 million in accelerated collections since the new s!stem
will speed up collections "! one da!. The cost is the new compensating "alance, "ut the compan!
will reco%er the e#isting compensating "alance, so0
?+X G B8,444,444 @ .BH44,444 @ 944,444/
?+X G BI,J44,444
The compan! should proceed with the new s!stem. The sa%ings are the ?+X times the annual
interest rate, so0
?et sa%ings G BI,J44,444..49/
?et sa%ings G B3J9,444
&ntermediate
14. The total cash needed is the cash shortage per month times twel%e months, so0
Total cash G >6.23H4,444/
Total cash G 2D,364,444
The target cash "alance using the Aaumol model is0
b
c
G N.6T Q ;/-RO
>-6

b
c
G N6.2D,364,444/.2944/-.4H9O
>-6

b
c
G 269I,84>.39
509
SOLUTIONS
The compan! should in%est0
In%est G 2I44,444 @ 69I,84>.39
In%est G 2DD6,>J8.H9
of its current cash holdings in mar,eta"le securities to "ring the cash "alance down to the optimal
le%el. '%er the rest of the !ear, sell securities0
Sell securities G 2D,364,444-269I,84>.39
Sell securities G >H.IH >I times.
15. The target cash "alance using the $iller*'rr model is0
b
c
G C L .3-D Q ; Q
6
- RO
>-3

b
c
G >,>44 L N3-D.>44/.I9/
6
-.4446>O
>-3

b
c
G 6,3H>.IJ
The upper limit is0
<
c
G 3 Q b
c
@ 6 Q C
<
c
G 3.6,3H>.IJ/ @ 6.>,>44/
<
c
G D,889.38
When the "alance in the cash account drops to >,>44, the firm sells0
Sell G 6,3H>.IJ @ >,>44
Sell G >,6H>.IJ
of mar,eta"le securities. The proceeds from the sale are used to replenish the account "ac, to the
optimal target le%el of b
c
. Con%ersel!, when the upper limit is reached, the firm "u!s0
Au! G D,889.38 @ 6,3H>.IJ
Au! G 6,963.9J
of mar,eta"le securities. This e#penditure lowers the cash le%el "ac, down to the optimal le%el of
6,3H>.IJ.
16. The a%erage dail! interest rate is0
Eail! rate G >.4I
>-3H9
@ >
Eail! rate G .444>89 or .4>89K per da!
The target cash "alance using the $iller*'rr model is0
b
c
G C L .3-D Q ; Q
6
- RO
>-3

b
c
G R2>94,444 L N3-D.R2JH4,444/.R2944/-.444>89O
>-3

b
c
G R2>H6,DIH.49
B-510
CHAPTER 27 B-
The upper limit is0
<
c
G 3 Q b
c
@ 6 Q C
<
c
G 3.R2>H6,DIH.49/ @ 6.R2>94,444/
<
c
G R2>8I,D68.>H
17. <sing the Aaumol model and sol%ing for R, we get0
b
c
G N.6T Q ;/-RO
>-6
Rs.6,644 G N6.Rs.6>,444/.Rs.>4/-RO
>-6

R G N6.Rs.6>,444/.Rs.>4/O-Rs.6,644
6
R G .48H8 or 8.H8K
18. To find the ?+X of ta,ing the loc,"o#, we first need to calculate the present %alue of the sa%ings.
The present %alue of the sa%ings will "e the reduction in collection time times the a%erage dail!
collections, so0
+X G 6.H44/.2>,>44/
+X G 2>,364,444
)nd the dail! interest rate is0
Eail! interest rate G >.4H4
>-3H9
@ >
Eail! interest rate G .444>H4 or .4>H4K per da!
The transaction costs are a perpetuit!. The cost per da! is the cost per transaction times the num"er
of transactions per da!, so the ?+X of ta,ing the loc,"o# is0
?+X G 2>,364,444 @ N24.39.H44/-.444>HO
?+X G 2D,H96.>I
Without the fee, the loc,"o# s!stem should "e accepted. To calculate the ?+X of the loc,"o# with
the annual fee, we can simpl! use the ?+X of the loc,"o# without the annual fee and su"tract the
addition cost. The annual fee is a perpetuit!, so, with the fee, the ?+X of ta,ing the loc,"o# is0
?+X G 2D,H96.>I @ N2>,444-.4HO
?+X G @2>6,4>D.94
With the fee, the loc,"o# s!stem should not "e accepted.
19. To find the minimum num"er of pa!ments per da! needed to ma,e the loc,"o# s!stem feasi"le is the
num"er of chec,s that ma,es the ?+X of the decision e&ual to ero. The a%erage dail! interest rate
is0
Eail! interest rate G >.49
>-3H9
@ >
Eail! interest rate G .4>3DK per da!
511
SOLUTIONS
The present %alue of the sa%ings is the a%erage pa!ment amount times the da!s the collection period
is reduced times the num"er of customers. The costs are the transaction fee and the annual fee. Aoth
are perpetuities. The total transaction costs are the transaction costs per chec, times the num"er of
chec,s. The e&uation for the ?+X of the pro:ect, where ? is the num"er of chec,s transacted per
da!, is0
?+X G 4 G .Rs.9,944/.>/? @ NRs.4.>4.?/-.444>3DO @ NRs.69,444-.49O
Rs.944,444 G Rs.9,944? @ Rs.ID8.49?
Rs.D,I9>.J9? G Rs.944,444
? G >49.66 >49 customers per da!
20. <sing the Aaumol model and sol%ing for T, we get0
b
c
G N.6T Q ;/-RO
>-6
V>4,444,444 G N6.T/.V9,444/-.498O
>-6

T G N.V>4,444,444/
6
..498/O - N6.V9,444/O
T G V984,444,444
So, the a%erage wee,l! dis"ursement is0
)%erage wee,l! dis"ursement G V984,444,444 - 96
)%erage wee,l! dis"ursement G V>>,>93,8DH.>9
21. a. Since the upper limit, <, is set "! the firms, use that to find b0
< G 3b @ 6C
b G .< L 6C/ - 3
So for Rold Star, the target cash "alance is0
b G N2649,444 L 6.2J9,444/O - 3
b G 2>3>,HHH.HI
)nd for Sil%er Star, the target cash "alance is0
b G N2634,444 L 6.2>64,444/O - 3
b G 2>9H,HHH.HI
B-512
CHAPTER 27 B-
b. We can use the $iller*'rr model to sol%e for the %ariance of the cash flows for each firm.
Sol%ing the $iller*'rr model for the %ariance, we find0
b G C
DR
3;j
3
6
+
b @ C G C
DR
3;j
3
6
+
.b @ C/
3
G
DR
3;j
6

6
G
3;
R D C/ .b
3
-
To find the %ariance of Rold Stars cash flows, we first need to find the dail! interest rate,
which is0
R G .>.498/
>-3H9
@ >
R G 4.444>9D
)nd the %ariance of Rold Stars cash flows is0

6
G
26,844 3
.444>9D D J9,444/ HI .2>3>,HHH.
3

6
G 23,H6H,6JH.93
The dail! interest rate for Sil%er Star is0
R G .>.4H>/
>-3H9
@ >
R G 4.444>H6
)nd the %ariance of Rold Stars cash flows is0

6
G
26,944 3
.444>H6 D >64,444/ HI .2>9H,HHH.
3

6
G 2D,6H9,DD6.D>
513
CHAPTER 28
CR18* .A)A31.1)
Answers to Concepts Review and Critical !in"in# Questions
1. a. ) sight draft is a commercial draft that is pa!a"le immediatel!.
b. ) time draft is a commercial draft that does not re&uire immediate pa!ment.
c. ) "an,ers acceptance is when a "an, guarantees the future pa!ment of a commercial draft.
d. ) promissor! note is an I'< that the customer signs.
e. ) trade acceptance is when the "u!er accepts the commercial draft and promises to pa! it in the
future.
2. Trade credit is usuall! granted on open account. The in%oice is the credit instrument.
3. Credit costs0 cost of de"t, pro"a"ilit! of default, and the cash discount
?o*credit costs0 lost sales
The sum of these are the carr!ing costs.
4. ). Character0 determines if a customer is willing to pa! his or her de"ts.
.. Capacit!0 determines if a customer is a"le to pa! de"ts out of operating cash flow.
0. Capital0 determines the customers financial reser%es in case pro"lems occur with opera*
ting cash flow.
5. Collateral0 assets that can "e li&uidated to pa! off the loan in case of default.
*. Conditions0 customers a"ilit! to weather an economic downturn and whether such a down*
turn is li,el!.
5. ). +erisha"ilit! and collateral %alue
.. Consumer demand
0. Cost, profita"ilit!, and standardiation
5. Credit ris,
*. The sie of the account
M. Competition
4. Customer t!pe
If the credit period e#ceeds a customers operating c!cle, then the firm is financing the recei%a"les
and other aspects of the customers "usiness that go "e!ond the purchase of the selling firms
merchandise.
6. a. A0 ) is li,el! to sell for cash onl!, unless the product reall! wor,s. If it does, then the! might
grant longer credit periods to entice "u!ers.
b. )0 Candlords ha%e significantl! greater collateral, and that collateral is not mo"ile.
c. )0 Since )s customers turn o%er in%entor! less fre&uentl!, the! ha%e a longer in%entor!
period, and thus, will most li,el! ha%e a longer credit period as well.
d. A0 Since )s merchandise is perisha"le and As is not, A will pro"a"l! ha%e a longer credit
period.
CHAPTER 28 B-
e. )0 Rugs are fairl! standardied and the! are transporta"le, while carpets are custom fit and
are not particularl! transporta"le.
7. In practice, the cost of short*term de"t for the compan! granting credit is most often used( howe%er,
this is not necessaril! correct. Whene%er we are e#amining an in%estment, the re&uired return
depends on the ris, of the in%estment, not the source of financing. The buerNs cost of short*term
de"t is closer in spirit to the correct rate since it more accuratel! reflects the ris, of non*pa!ment. A!
using the sellers cost of de"t, the implicit assumption is that the "u!er and seller ha%e an e&ui%alent
cost of short*term de"t. 'f course, we should also remem"er that the cost of short*term de"t is li,el!
to "e similar for most companies, so using the sellers cost of short*term de"t will onl! result in a
small error.
8. If we grant credit to a new customer, the most we ris, losing is the %aria"le cost of the product.
Aecause of this low potential cost, the decision to grant credit is %er! often 1\es.8 When we
e#amine the default pro"a"ilit! of granting credit to a pre%ious cash pa!ing customer, the default
pro"a"ilit! of the decision to grant credit is lower than the decision to grant credit to a new
customer. The reason is simple0 If we grant credit to a pre%ious cash pa!ing customer, we ris, losing
the purchase price of the product "ecause that is what we collect if we dont grant credit.
9. The default rate for a repeat customer will definitel! "e higher. 'ften, the "est wa! to do credit
anal!sis, especiall! for repeat "usiness, is to grant credit to almost an!one. The reason is that all we
can lose is the %aria"le cost of the product, "ut stand to gain a large amount "ecause of the repeat
"usiness. 'ne of the "est predictors of the a"ilit! and capacit! to repa! is whether or not the
customer has paid in the past. In such cases, it is important to control the amount of credit granted
initiall! to an! one customer. If the customer "ecomes a good customer, the credit limit can alwa!s
"e increased at a later date.
10. ;or a product with a higher gross margin, the default rate will "e higher than a product with a low
default rate. Consider an e#treme e#ample with a %aria"le cost of that sells for 2>44. Since we are
onl! ris,ing the %aria"le cost "! granting credit, the most we can lose on each credit sale is 2>.
Therefore as long as the default rate is not greater than JJ percent, credit should "e granted. 'n the
other hand, if the %aria"le cost is 2JJ, we stand to lose much more for a lot less potential profit.
$olutions to Questions and %ro&le's
NOTE: All end of chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. a. There are 34 da!s until account is o%erdue. If !ou ta,e the full period, !ou must remit0
Remittance G 644.289/
Remittance G 2>I,444
515
SOLUTIONS
b. There is a 6 percent discount offered, with a >4 da! discount period. If !ou ta,e the discount,
!ou will onl! ha%e to remit0
Remittance G .> @ .46/.2>I,444/
Remittance G 2>H,HH4
c. The implicit interest is the difference "etween the two remittance amounts, or0
Implicit interest G 2>I,444 @ >H,HH4
Implicit interest G 23D4
The num"er of da!s credit offered is0
Ea!s credit G 34 @ >4
Ea!s credit G 64 da!s
2. The recei%a"les turno%er is0
Recei%a"les turno%er G 3H9-)%erage collection period
Recei%a"les turno%er G 3H9-D8
Recei%a"les turno%er G I.H4D times
)nd the a%erage recei%a"les are0
)%erage recei%a"les G Sales-Recei%a"les period
)%erage recei%a"les G VH9 million-I.H4D
)%erage recei%a"les G V8,9DI,JD9
3. a. The a%erage collection period is the percentage of accounts ta,ing the discount times the
discount period, plus the percentage of accounts not ta,ing the discount times the da!s until full
pa!ment is re&uired, so0
)%erage collection period G .H9.>4 da!s/ L .39.34 da!s/
)%erage collection period G >I da!s
b. )nd the a%erage dail! "alance is0
)%erage "alance G >,644.V6,644/.>I/.>6-3H9/
)%erage "alance G V>,DI9,94H.89
4. The daily sales are:
Daily sales = 18,000 / 7
Daily sales = 2,571.43
Since the a%erage collection period is 6J da!s, the a%erage accounts recei%a"le is0
)%erage accounts recei%a"le G B6,9I>.D3.6J/
)%erage accounts recei%a"le G BID,9I>.D3

B-516
CHAPTER 28 B-
5. The interest rate for the term of the discount is0
Interest rate G .46-.J8
Interest rate G .464D or 6.4DK
)nd the interest is for0
D4 @ J G 3> da!s
So, using the E)R e&uation, the effecti%e annual interest rate is0
E)R G .> L +eriodic rate/
m
@ >
E)R G .>.464D/
3H9-3>
@ >
E)R G .6H89 or 6H.89K
a. The periodic interest rate is0
Interest rate G .43-.JI
Interest rate G .434J or 3.4JK
)nd the E)R is0
E)R G .>.434J/
3H9-3>
@ >
E)R G .D3>D or D3.>DK
b. The E)R is0
E)R G .>.464D/
3H9-9>
@ >
E)R G .>99H or G >9.9HK
c. The E)R is0
E)R G .>.464D/
3H9-69
@ >
E)R G .3D3> or 3D.3>K
6. The recei%a"les turno%er is0
Recei%a"les turno%er G 3H9-)%erage collection period
Recei%a"les turno%er G 3H9-96
Recei%a"les turno%er G I.46 times
)nd the annual credit sales are0
)nnual credit sales G Recei%a"les turno%er Q )%erage dail! recei%a"les
)nnual credit sales G I.46.2DH,444/
)nnual credit sales G 2366,88D.H6
517
SOLUTIONS
7. The total sales of the firm are e&ual to the total credit sales since all sales are on credit, so0
Total credit sales G D,444.RD44/
Total credit sales G R>,H44,444
The a%erage collection period is the percentage of accounts ta,ing the discount times the discount
period, plus the percentage of accounts not ta,ing the discount times the da!s until full pa!ment is
re&uired, so0
)%erage collection period G .H4.>9/ L .D4.D4/
)%erage collection period G 69 da!s
The recei%a"les turno%er is 3H9 di%ided "! the a%erage collection period, so0
Recei%a"les turno%er G 3H9-69
Recei%a"les turno%er G >D.H4 times
)nd the a%erage recei%a"les are the credit sales di%ided "! the recei%a"les turno%er so0
)%erage recei%a"les G R>,H44,444->D.H4
)%erage recei%a"les G R>4J,98J.4D
If the firm increases the cash discount, more people will pa! sooner, thus lowering the a%erage
collection period. If the )C+ declines, the recei%a"les turno%er increases, which will lead to a
decrease in the a%erage recei%a"les.
8. The a%erage collection period is the net credit terms plus the da!s o%erdue, so0
)%erage collection period G 69 L J
)%erage collection period G 3D da!s
The recei%a"les turno%er is 3H9 di%ided "! the a%erage collection period, so0
Recei%a"les turno%er G 3H9-3D
Recei%a"les turno%er G >4.I393 times
)nd the a%erage recei%a"les are the credit sales di%ided "! the recei%a"les turno%er so0
)%erage recei%a"les G J,444,444->4.I393
)%erage recei%a"les G 838,39H.>H
9. a. The cash outla! for the credit decision is the %aria"le cost of the engine. If this is a one*time
order, the cash inflow is the present %alue of the sales price of the engine times one minus the
default pro"a"ilit!. So, the ?+X per unit is0
?+X G @Ca2>,944,444 L .> @ .449/.Ca2>,844,444/->.469
?+X G Ca26DI,3>I.4I per unit
The compan! should fill the order.
B-518
CHAPTER 28 B-
b. To find the "rea,e%en pro"a"ilit! of default, , we simpl! use the ?+X e&uation from part a,
set it e&ual to ero, and sol%e for . Eoing so, we get0
?+X G 4 G @Ca2>,944,444 L .> @ /.Ca2>,844,444/->.469
G .>D98 or >D.98K
We would not accept the order if the default pro"a"ilit! was higher than >D.98 percent.
c. If the customer will "ecome a repeat customer, the cash inflow changes. The cash inflow is now
one minus the default pro"a"ilit!, times the sales price minus the %aria"le cost. We need to use
the sales price minus the %aria"le cost since we will ha%e to "uild another engine for the
customer in one period. )dditionall!, this cash inflow is now a perpetuit!, so the ?+X under
these assumptions is0
?+X G @Ca2>,944,444 L .> @ .449/.Ca2>,844,444 @ >,944,444/-.469
?+X G Ca2>4,DD4,444.44 per unit
The compan! should fill the order. The "rea,e%en default pro"a"ilit! under these assumptions
is0
?+X G 4 G @Ca2>,944,444 L .> @ /.Ca2>,844,444 @ >,944,444/-.469
G .8I94 or 8I.94K
We would not accept the order if the default pro"a"ilit! was higher than 8I.94 percent. This
default pro"a"ilit! is much higher than in part b "ecause the customer ma! "ecome a repeat
customer.
d. It is assumed that if a person has paid his or her "ills in the past, the! will pa! their "ills in the
future. This implies that if someone doesnt default when credit is first granted, then the! will
"e a good customer far into the future, and the possi"le gains from the future "usiness outweigh
the possi"le losses from granting credit the first time.
10. The cost of switching is the lost sales from the e#isting polic! plus the incremental %aria"le costs
under the new polic!, so0
Cost of switching G 2844.>,>34/ L 2DI9.>,>J9 @ >,>34/
Cost of switching G 2J3D,8I9
The "enefit of switching is the new sales price minus the %aria"le costs per unit, times the
incremental units sold, so0
Aenefit of switching G .2844 @ DI9/.>,>J9 @ >,>34/
Aenefit of switching G 26>,>69
519
SOLUTIONS
The "enefit of switching is a perpetuit!, so the ?+X of the decision to switch is0
?+X G @2J3D,8I9 L 26>,>69-.46
?+X G 2>6>,3I9.44
The firm will ha%e to "ear the cost of sales for one month "efore the! recei%e an! re%enue from
credit sales, which is wh! the initial cost is for one month. Recei%a"les will grow o%er the one month
credit period and will then remain sta"le with pa!ments and new sales offsetting one another.
11. The cash flow from the old polic! is the &uantit! sold times the price, so0
Cash flow from old polic! G I4,444.)u2934/
Cash flow from old polic! G )u23I,>44,444
The cash flow from the new polic! is the &uantit! sold times the new price, all times one minus the
default rate, so0
Cash flow from new polic! G I4,444.)u2996/.> @ .46/
Cash flow from new polic! G )u23I,8HI,644
The incremental cash flow is the difference in the two cash flows, so0
Incremental cash flow G )u23I,8HI,644 @ 3I,>44,444
Incremental cash flow G )u2IHI,644
The cash flows from the new polic! are a perpetuit!. The cost is the old cash flow, so the ?+X of the
decision to switch is0
?+X G @)u23I,>44,444 L )u2IHI,644-.46
?+X G )u2>,6H4,444
12. a. The old price as a percentage of the new price is0
2J4-2J>.8D G .J8
So the discount is0
Eiscount G > @ .J8 G .46 or 6K
The credit terms will "e0
Credit terms0 6->4, net 34
b. We are una"le to determine for certain since no information is gi%en concerning the percentage
of customers who will ta,e the discount. 5owe%er, the ma#imum recei%a"les would occur if all
customers too, the credit, so0
Recei%a"les G 3,444.2J4/
Recei%a"les G 26I4,444 .at a ma#imum/
c. Since the &uantit! sold does not change, %aria"le cost is the same under either plan.
B-520
CHAPTER 28 B-
d. ?o, "ecause0
d @ G .46 @ .>6
d @ G @.>4 or @>4K
Therefore the ?+X will "e negati%e. The ?+X is0
?+X G @3,444.2J4/ L .3,444/.2J>.8D/..46 @ .>6/-..4>/
?+X G @23,46D,6D4
The "rea,e%en credit price is0
+.> L r/-.> @ / G 2J4.>.4>/-..88/
+ G 2>43.6J9
This implies that the "rea,e%en discount is0
Area,e%en discount G > @ .2J4-2>43.6J9/
Area,e%en discount G .>68I or >6.8IK
The ?+X at this discount rate is0

?+X G @3,444.2J4/ L .3,444/.2>43.6J9/..>68I @ .>6/-..4>/
?+X 4
13. We must first find the e#pected profit per in%oice since there is a pro"a"ilit! of default. The
e#pected profit per in%oice is the in%oice price times one minus the pro"a"ilit! of default, or0
E#pected profit per in%oice G 2>,944.> @ .46/
E#pected profit per in%oice G 2>,DI4
The cost per in%oice is the price paid, or0
Cost per in%oice G 2>,944.> @ .439/
Cost per in%oice G 2>,DDI.94
The EAIT is the re%enue minus e#penses, or0
EAIT G Re%enue @ Xaria"le costs @ ;i#ed costs
EAIT G >44,444.2>,DI4/ @ >44,444.2>,DDI.94/ @ 2D44,444
EAIT G 2>,894,444
521
SOLUTIONS
14. If we factor immediatel!, we recei%e cash on an a%erage of 39 da!s sooner. The num"er of periods
in a !ear are0
?um"er of periods G 3H9-39
?um"er of periods G >4.D689I
The E)R of this arrangement is0
E)R G .> L +eriodic rate/
m
@ >
E)R G .> L 6-J8/
>4.D689I
@ >
E)R G .63D9 or 63.D9K
&ntermediate
15. a. The cost of the credit polic! switch is the &uantit! sold times the %aria"le cost. The cash inflow
is the price times the &uantit! sold, times one minus the default rate. This is a one*time, lump
sum, so we need to discount this %alue one period. Eoing so, we find the ?+X is0
?+X G @>6.2>,644/ L .> @ .6/.>6/.2>,894/->.46
?+X G 23,4>>.IH
The order should "e ta,en since the ?+X is positi%e.
b. To find the "rea,e%en default rate, , we :ust need to set the ?+X e&ual to ero and sol%e for
the "rea,e%en default rate. Eoing so, we get0
?+X G 4 G @>6.2>,644/ L .> @ /.>6/.2>,894/->.46
G .338D or 33.8DK
c. Effecti%el!, the cash discount is0
Cash discount G .2>,894 @ >,I94/-2>,894
Cash discount G .49D> or 9.D>K
Since the discount rate is less than the default rate, credit should not "e granted. The firm would
"e "etter off ta,ing the 2>,I94 up*front than ta,ing an 84K chance of ma,ing 2>,894.
16. a. The cash discount is0
Cash discount G .B99 @ 9>/-B99
Cash discount G .4I6I or I.6IK
The default pro"a"ilit! is one minus the pro"a"ilit! of pa!ment, or0
Eefault pro"a"ilit! G > @ .J4
Eefault pro"a"ilit! G .>4
Since the default pro"a"ilit! is greater than the cash discount, credit should not "e granted( the
?+X of doing so is negati%e.
B-522
CHAPTER 28 B-
b. Eue to the increase in "oth &uantit! sold and credit price when credit is granted, an additional
incremental cost is incurred of0
)dditional cost G .3,344/.B3> @ 6J/ L .3,944 @ 3,344/.B3>/
)dditional cost G B>6,844
The "rea,e%en price under these assumptions is0
?+X G 4 G @B>6,844 @ .3,344/.B9>/ L Z3,944N.> @ .>4/+ @ B3>O @ 3,344.B9> @ 6J/[-.>.44I9
3
@ >/
?+X G @B>6,844 @ >H8,344 L >38,J99.63+ @ I,J88,866.J3
B8,>HJ,J66.J3 G B>38,J99.63+
+ G B98.84
c. The credit report is an additional cost, so we ha%e to include it in our anal!sis. The ?+X when
using the credit reports is0
?+X G 3,344.6J/ @ .J4.3,944/3> @ 3,344.9>/ @ I,444 L Z3,944N4.J4.99 @ 3>/ @ 6O
@ 3,344.9> @ 6J/[-.>.44I9
3
@ >/
?+X G BJ9,I44 @ JI,H94 @ >H8,344 @ I,444 @ >IH,D9>.4J
?+X G @B393,I4>.4J
So, credit should not "e e#tended.
17. We can e#press the old cash flow as0
'ld cash flow G .+ @ %/Y
)nd the new cash flow will "e0
?ew cash flow G .+ @ %/.> @ /Y L Y N.> @ /+ @ %O
So, the incremental cash flow is
Incremental cash flow G @.+ @ %/Y L .+ @ %/.> @ /Y L Y N.> @ /+ @ %O
Incremental cash flowG .+ @ %/.Y @ Y/ L Y N.> @ /+ @ +O
Thus0
?+X G .+ @ %/.Y @ Y/ @ +Y L
1
]
1

R
+ * + / * Z . > Y Y / * Y % / . * . +
18. a. The firm should offer credit if the ?+X of offering credit is greater than the ?+X of the firms
current, no*credit polic!. The ?+X under the current polic! is0
?+X G .+ @ XC/Y
?+X G .39 @ 69/.6,444/
523
SOLUTIONS
?+X G 64,444
B-524
CHAPTER 28 B-
If h is the pro"a"ilit! of pa!ment under the proposed credit polic!, the ?+X is0
?+X G +X of pa!ments recei%ed @ Cost
?+X G ZNh.+/.Y/O - .> L R/[ @ C.Y/
?+X G ZN4.89.3I/.6,944/O - >.46[ @ 6I.6,944/
?+X G J,983.33
The compan! should not grant credit since the ?+X is lower.
b. The compan! will "e indifferent if the ?+X of the current polic! e&uals the ?+X of the credit
polic!. If we set the ?+X of the two pre%ious solutions e&ual to each other and sol%e the the
pro"a"ilit! of pa!ment, we find0
64,444 G ZN.> @ /.3I/.6,944/O - >.46[ @ 6I.6,944/
G .JHDJ or JH.DJK
19. If the cost of su"scri"ing to the credit agenc! is less than the sa%ings from collection of the "ad
de"ts, the compan! should su"scri"e. The cost of the su"scription is0
Cost of the su"scription G =944 L =D.D44/
Cost of the su"scription G =6,>44
)nd the sa%ings from ha%ing no "ad de"ts will "e0
Sa%ings from not selling to "ad credit ris,s G .=684/.D44/.4.43/
Sa%ings from not selling to "ad credit ris,s G =3,3H4
So, the compan!s net sa%ings will "e0
?et sa%ings G =3,3H4 @ 6,>44
?et sa%ings G =>,6H4
The compan! should su"scri"e to the credit agenc!.
20. The cash flow from either polic! is0
Cash flow G .+ @ %/Y
So, the cash flows from the old polic! are0
Cash flow from old polic! G .BI9 @ D3/.3,644/
Cash flow from old polic! G B>46,D44
)nd the cash flow from the new polic! would "e0
Cash flow from new polic! G .B84 @ D3/.3,944/
Cash flow from new polic!G B>6J,944
525
SOLUTIONS
So, the incremental cash flow would "e0
Incremental cash flow G B>6J,944 @ >46,D44
Incremental cash flow G B6I,>44
The incremental cash flow is a perpetuit!. The cost of initiating the new polic! is0
Cost of new polic! G @N+Y L %.Y @ Y/O
So, the ?+X of the decision to change credit policies is0
?+X G @N.BI9/.3,644/ L .BD3/.3,944 @ 3,644/O L B6I,>44-.469
?+X G B83>,>44.44
21. The cash flow from the old polic! is0
Cash flow from old polic! G .23D4 @ 6H4/.>,844/
Cash flow from old polic! G 2>DD,444
)nd the cash flow from the new polic! will "e0
Cash flow from new polic! G .23D9 @ 6H9/.>,894/
Cash flow from new polic!G 2>D8,444
The incremental cash flow, which is a perpetuit!, is the difference "etween the old polic! cash flows
and the new polic! cash flows, so0
Incremental cash flow G 2>D8,444 @ >DD,444
Incremental cash flow G 2D,444
The cost of switching credit policies is0
Cost of new polic! G @N+Y L Y.% @ %/ L % .Y @ Y/O
In this cost e&uation, we need to account for the increased %aria"le cost for all units produced. This
includes the units we alread! sell, plus the increased %aria"le costs for the incremental units. So, the
?+X of switching credit policies is0
?+X G @N.23D4/.>,844/ L .>,844/.26H9 @ 6H4/ L .26H9/.>,894 @ >,844/O L .2D,444-.469/
?+X G @2DID,694
B-526
CHAPTER 28 B-
'hallenge
22. The cost of switching credit policies is0
Cost of new polic! G @N+Y L Y.% @ %/ L % .Y @ Y/O
)nd the cash flow from switching, which is a perpetuit!, is0
Cash flow from new polic! G NY .+ @ %/ @ Y.+ @ %/O
To find the "rea,e%en &uantit! sold for switching credit policies, we set the ?+X e&ual to ero and
sol%e for Y . Eoing so, we find0
?+X G 4 G @N.BI9/.3,644/ L .BD3/.Y @ 3,644/O L N.Y /.B84 @ D3/ @ .3,644/.BI9 @ D3/O-.469
4 G @B6D4,444 @ BD3Y L B>3I,H44 L B>,D84Y @ BD,4JH,444
B>,D3IY G BD,>J8,D44
Y G 6,J6>.HD
23. We can use the e&uation for the ?+X we constructed in +ro"lem >H. <sing the sales figure of 3,344
units and sol%ing for + , we get0
?+X G 4 G N@.BI9/.3,644/ @ .BD3/.3,344 @ 3,644/O L N.+ @ D3/.3,344/ @ .BI9 @ D3/.3,644/O-.469
4 G @B6D4,444 @ D,344 L B>36,444+ *9,HIH,444@ BD,4JH,444
B>36,444+ G B>4,4>H,344
+ G BI9.88
24. ;rom +ro"lem 6>, the incremental cash flow from the new credit polic! will "e0
Incremental cash flow G Y .+ @ % / @ Y.+ @ %/
)nd the cost of the new polic! is0
Cost of new polic! G @N+Y L Y.% @ %/ L % .Y @ Y/O
Setting the ?+X e&ual to ero and sol%ing for + , we get0
?+X G 4 G @N.23D4/.>,844/ L .26H9 @ 6H4/.>,844/ L .26H9/.>,894 @ >,844/O L N.>,894/.+ @ 6H9/ @
.>,844/.23D4 @ 6H4/O-.469
4 G @2H>6,444 @ J,444 @ >3,694 L 2ID,444+ @ 269,3I4,444
2ID,444+ G 26H,44D,694
+ G 239>.D>
527
SOLUTIONS
25. The compan! should adopt the new credit polic! if its +X, +X?ew, is greater than the +X of the
current polic!, +X'ld. ?ote that we can write the general formula as0
+X G
1
]
1

,
_

+
3H9
pa! to da!s )%g.
rate/ .Eiscount >
Eiscount/ sales/.> .)%g. -
So, the +X of the current polic! is0
+X'ld G .V94,444,444-3H9/ - N> L 4.4H.D9-3H9/O
+X'ld G V>39,J84.D6
?ow, find we can find the +X of the new polic!. <nder the new polic!, we e#pect 6 groups of
customers0 >/ those that ta,e the discount and pa! earl!, and 6/ those that do not ta,e the discount
and pa! qlateq. Since we are onl! gi%en the a%erage collection for all customers, we need to find the
a%erage collection period for each group. ;or those who ta,e the discount, we will assume the! pa!
on da! >4. Cet T G the a%erage num"er of da!s until pa!ment for those customers who do not ta,e
the discount. This means the a%erage collection period for those customers who do not ta,e the
discount will "e0
4.I.>4 da!s/ L 4.3T G 68 da!s
T G I4 da!s
?ow appl! this to our general formula for +X, allowing for the fact that we ha%e two ,inds of
customers, the +X of the new polic! will "e0
+X?ew G +X of customers who ta,e discount L +X of customers who do not ta,e discount
+X?ew G
[ ] 3H9/ .4.4H/.>4- >
4.4D/ .> 4,444-3H9/ 4.I.294,44
+
-
L
[ ] 3H9/ .4.4H/.I4- >
4,444-3H9/ 4.3.294,44
+
+X?ew G V>3D,DDH.II
Aecause +X of the current polic! is greater than the +X of the new polic!, the compan! should not
adopt the new polic!.
?otice that the decision is independent of the le%el of credit sales, since !ou can factor out the le%el
of sales. We can rewrite the +X e&uation of each polic! as0
+X'ld G .V94,444,444-3H9/Z> - N> L 4.4H.D9-3H9/O[
+X?ew G .V94,444,444-3H9/
[ ] [ ]

'

+
+
+ 3H9/ .4.4H/.I4- >
4.3

3H9/ .4.4H/.>4- >
4.4D/ 4.I.> -
B-528
CHAPTER 28 B-
Since we are onl! interested in the comparative value of these +Xs and we ha%e the same constant as
the first term in "oth e&uations, we can remo%e it and rewrite them as0
+X'ld G > - N> L 4.4H.D9-3H9/O
+X'ld G 4.JJ6I
+X?ew G
[ ] [ ] 3H9/ .4.4H/.I4- >
4.3

3H9/ .4.4H/.>4- >
4.4D/ 4.I.>
+
+
+
-
+X?ew G 4.J8>9
)lthough the +X num"ers are different, we still ha%e +X of the current polic! is still greater than the
+X of the proposed polic! and we get the same decision ** choose the current polic!.
529
CHAPTER 29
.1R31R$ A)8 ACQ7*$**0)$
Answers to Concepts Review and Critical !in"in# Questions
1. In the purchase method, assets are recorded at mar,et %alue, and goodwill is created to account for
the e#cess of the purchase price o%er this recorded %alue. In the pooling of interests method, the
"alance sheets of the two firms are simpl! com"ined( no goodwill is created. The choice of
accounting method has no direct impact on the cash flows of the firms. E+S will pro"a"l! "e lower
under the purchase method "ecause reported income is usuall! lower due to the re&uired
amortiation of the goodwill created in the purchase.
2. a. ;alse. )lthough the reasoning seems correct, in general, the new firms do not ha%e monopol!
power. This is especiall! true since man! countries ha%e laws limiting mergers when it would
create a monopol!.
b. True. When managers act in their own interest, ac&uisitions are an important control de%ice for
shareholders. It appears that some ac&uisitions and ta,eo%ers are the conse&uence of underl!ing
conflicts "etween managers and shareholders.
c. ;alse. E%en if mar,ets are efficient, the presence of s!nerg! will ma,e the %alue of the
com"ined firm different from the sum of the %alues of the separate firms. Incremental cash
flows pro%ide the positi%e ?+X of the transaction.
d. ;alse. In an efficient mar,et, traders will %alue ta,eo%ers "ased on 1fundamental factors8
regardless of the time horion. Recall that the e%idence as a whole suggests efficienc! in the
mar,ets. $ergers should "e no different.
e. ;alse. The ta# effect of an ac&uisition depends on whether the merger is ta#a"le or non*ta#a"le.
In a ta#a"le merger, there are two opposing factors to consider, the capital gains effect and the
write*up effect. The net effect is the sum of these two effects.
f. True. Aecause of the coinsurance effect, wealth might "e transferred from the stoc,holders to
the "ondholders. )c&uisition anal!sis usuall! disregards this effect and considers onl! the total
%alue.
3. Ei%ersification doesnt create %alue in and of itself "ecause di%ersification reduces uns!stematic, not
s!stematic, ris,. )s discussed in the chapter on options, there is a more su"tle issue as well.
Reducing uns!stematic ris, "enefits "ondholders "! ma,ing default less li,el!. 5owe%er, if a
merger is done purel! to di%ersif! .i.e., no operating s!nerg!/, then the ?+X of the merger is ero. If
the ?+X is ero, and the "ondholders are "etter off, then stoc,holders must "e worse off.
4. ) firm might choose to split up "ecause the newer, smaller firms ma! "e "etter a"le to focus on their
particular mar,ets. Thus, re%erse s!nerg! is a possi"ilit!. )n added ad%antage is that performance
CHAPTER 29 B-
e%aluation "ecomes much easier once the split is made "ecause the new firms financial results .and
stoc, prices/ are no longer commingled.
531
SOLUTIONS
5. It depends on how the! are used. If the! are used to protect management, then the! are not good for
stoc,holders. If the! are used "! management to negotiate the "est possi"le terms of a merger, then
the! are good for stoc,holders.
6. 'ne of the primar! ad%antages of a ta#a"le merger is the write*up in the "asis of the target firms
assets, while one of the primar! disad%antages is the capital gains ta# that is pa!a"le. The situation is
the re%erse for a ta#*free merger.
The "asic determinant of ta# status is whether or not the old stoc,holders will continue to participate
in the new compan!, which is usuall! determined "! whether the! get an! shares in the "idding firm.
)n CA' is usuall! ta#a"le "ecause the ac&uiring group pa!s off the current stoc,holders in full,
usuall! in cash.
7. Economies of scale occur when a%erage cost declines as output le%els increase. ) merger in this
particular case might ma,e sense "ecause Eastern and Western ma! need less total capital
in%estment to handle the pea, power needs, there"! reducing a%erage generation costs.
8. )mong the defensi%e tactics often emplo!ed "! management are see,ing white ,nights, threatening
to sell the crown :ewels, appealing to regulator! agencies and the courts .if possi"le/, and targeted
share repurchases. ;re&uentl!, anti*ta,eo%er charter amendments are a%aila"le as well, such as
poison pills, poison puts, golden parachutes, loc,up agreements, and superma:orit! amendments, "ut
these re&uire shareholder appro%al, so the! cant "e immediatel! used if time is short. While target
firm shareholders ma! "enefit from management acti%el! fighting ac&uisition "ids, in that it
encourages higher "idding and ma! solicit "ids from other parties as well, there is also the danger
that such defensi%e tactics will discourage potential "idders from see,ing the firm in the first place,
which harms the shareholders.
9. In a cash offer, it almost surel! does not ma,e sense. In a stoc, offer, management ma! feel that one
suitor is a "etter long*run in%estment than the other, "ut this is onl! %alid if the mar,et is not
efficient. In general, the highest offer is the "est one.
10. Xarious reasons include0 .>/ )nticipated gains ma! "e smaller than thought( .6/ Aidding firms are
t!picall! much larger, so an! gains are spread thinl! across shares( .3/ $anagement ma! not "e
acting in the shareholders "est interest with man! ac&uisitions( .D/ Competition in the mar,et for
ta,eo%ers ma! force prices for target firms up to the ero ?+X le%el( and .9/ $ar,et participants
ma! ha%e alread! discounted the gains from the merger "efore it is announced.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. ;or the merger to ma,e economic sense, the ac&uirer must feel the ac&uisition will increase %alue "!
at least the amount of the premium o%er the mar,et %alue, so0
$inimum economic %alue G C'+ID4,444,444 @ HD4,444,444 G C'+>44,444,444
B-532
CHAPTER 29 B-
2. a6 Since neither compan! has an! de"t, using the pooling method, the asset %alue of the com"ined
must e&ual the %alue of the e&uit!, so0
)ssets G E&uit! G 64,444.=64/ L 64,444.=I/ G =9D4,444
b6 With the purchase method, the assets of the com"ined firm will "e the "oo, %alue of ;irm U,
the ac&uiring compan!, plus the mar,et %alue of ;irm \, the target compan!, so0

)ssets from U G 64,444.=64/ G =D44,444 ."oo, %alue/
)ssets from \ G 64,444.=>8/ G =3H4,444 .mar,et %alue/
The purchase price of ;irm \ is the num"er of shares outstanding times the sum of the current
stoc, price per share plus the premium per share, so0
+urchase price of \ G 64,444.=>8 L 9/ G =DH4,444
The goodwill created will "e0
Roodwill G =DH4,444 @ 3H4,444 G =>44,444.
)nd the total asset of the com"ined compan! will "e0
Total assets U\ G Total e&uit! U\ G =D44,444 L 3H4,444 L >44,444 G =8H4,444
3. In the pooling method, all accounts of "oth companies are added together to total the accounts in the
new compan!, so the post*merger "alance sheet will "e0

Fas Tunas "(es# post-merger
Current assets C<+>3,D44 Current lia"ilities C<+ D,I44
;i#ed assets >J,H44 Cong*term de"t 6,844
rr. E&uit! 69,944
Total C<+33,444 C<+33,444
4. Since the ac&uisition is funded "! long*term de"t, the post*merger "alance sheet will ha%e long*term
de"t e&ual to the original long*term de"t of Cas Tunas "alance sheet plus the new long*term de"t
issue, so0
+ost*merger long*term de"t G C<+>,J44 L >I,444 G C<+>8,J44
Roodwill will "e created since the ac&uisition price is greater than the mar,et %alue. The goodwill
amount is e&ual to the purchase price minus the mar,et %alue of assets. Renerall!, the mar,et %alue
of current assets is e&ual to the "oo, %alue, so0
Roodwill created G C<+>I,444 @C<+>6,444 .mar,et %alue ;)/ @ C<+3,D44 .mar,et %alue C)/ G
C<+>,H44
Current lia"ilities and e&uit! will remain the same as the pre*merger "alance sheet of the ac&uiring
firm. Current assets will "e the sum of the two firms pre*merger "alance sheet accounts, and the
533
SOLUTIONS
fi#ed assets will "e the sum of the pre*merger fi#ed assets of the ac&uirer and the mar,et %alue of
fi#ed assets of the target firm. The post*merger "alance sheet will "e0
Fas Tunas "(es# post-merger
Current assets C<+>3,D44 Current lia"ilities C<+ 3,>44
;i#ed assets 6H,444 Cong*term de"t >8,J44
Roodwill >,H44 E&uit! >J,444
Total C<+D>,444 C<+D>,444
5. In the pooling method, all accounts of "oth companies are added together to total the accounts in the
new compan!, so the post*merger "alance sheet will "e0
,ilver Enterprises# post-merger
Current assets \ER 3,I44 Current lia"ilities \ER 6,I44
'ther assets >,>94 Cong*term de"t J44
?et fi#ed assets H,I44 E&uit! I,J94
Total \ER>>,994 \ER>>,994
6. Since the ac&uisition is funded "! long*term de"t, the post*merger "alance sheet will ha%e long*term
de"t e&ual to the original long*term de"t of Sil%ers "alance sheet plus the new long*term de"t issue,
so0
+ost*merger long*term de"t G \ERJ44 L 8,D44 G \ERJ,344
Roodwill will "e created since the ac&uisition price is greater than the mar,et %alue. The goodwill
amount is e&ual to the purchase price minus the mar,et %alue of assets. Since the mar,et %alue of
fi#ed assets of the target firm is e&ual to the "oo, %alue, and the "oo, %alue of all other assets is
e&ual to mar,et %alue, we can su"tract the total assets from the purchase price, so0
Roodwill created G \ER8,D44 @ .\ERD,694 mar,et %alue T)/ G \ERD,>94
Current lia"ilities and e&uit! will remain the same as the pre*merger "alance sheet of the ac&uiring
firm. Current assets and other assets will "e the sum of the two firms pre*merger "alance sheet
accounts, and the fi#ed assets will "e the sum of the pre*merger fi#ed assets of the ac&uirer and the
mar,et %alue of fi#ed assets of the target firm. ?ote, in this case, the mar,et %alue and the "oo,
%alue of fi#ed assets are the same. The post*merger "alance sheet will "e0
,ilver Enterprises# post-merger
Current assets \ER 3,I44 Current lia"ilities \ER >,844
'ther assets >,>94 Cong*term de"t J,344
?et fi#ed assets H,I44 E&uit! D,H44
Roodwill D,>94
Total \ER>9,I44 \ER>9,I44
B-534
CHAPTER 29 B-
7. a. The cash cost is the amount of cash offered, so the cash cost is VJD million.
To calculate the cost of the stoc, offer, we first need to calculate the %alue of the target to the
ac&uirer. The %alue of the target firm to the ac&uiring firm will "e the mar,et %alue of the target
plus the +X of the incremental cash flows generated "! the target firm. The cash flows are a
perpetuit!, so
X
c
G VI8,444,444 L V3,>44,444-.>4 G V>4J,444,444
The cost of the stoc, offer is the percentage of the ac&uiring firm gi%en up times the sum of the
mar,et %alue of the ac&uiring firm and the %alue of the target firm to the ac&uiring firm. So, the
e&uit! cost will "e0
E&uit! cost G .D4.V>39$ L >4J,444,444/ G VJI,H44,444
b. The ?+X of each offer is the %alue of the target firm to the ac&uiring firm minus the cost of
ac&uisition, so0
?+X cash G V>4J,444,444 @ JD,444,444 G V>9,444,444
?+X stoc, G V>4J,444,444 @ JI,H44,444 G V>>,D44,444
c. Since the ?+X is greater with the cash offer, the ac&uisition should "e in cash.
8. a. The E+S of the com"ined compan! will "e the sum of the earnings of "oth companies di%ided
"! the shares in the com"ined compan!. Since the stoc, offer is one share of the ac&uiring firm
for three shares of the target firm, new shares in the ac&uiring firm will increase "! one*third.
So, the new E+S will "e0
E+S G .B344,444 L HI9,444/-N>84,444 L .>-3/.H4,444/O G BD.8I9
The mar,et price of Stult will remain unchanged if it is a ero ?+X ac&uisition. <sing the +E
ratio, we find the current mar,et price of Stult stoc,, which is0
+ G 6>.BHI9,444/->84,444 G BI8.I9
If the ac&uisition has a ero ?+X, the stoc, price should remain unchanged. Therefore, the new
+E will "e0
+-E G BI8.I9-BD.8I9 G >H.>9
b. The %alue of ;lanner! to Stult must "e the mar,et %alue of the compan! since the ?+X of the
ac&uisition is ero. Therefore, the %alue is0
X
c
G B344,444.9.69/ G B>,9I9,444
535
SOLUTIONS
The cost of the ac&uisition is the num"er of shares offered times the share price, so the cost is0
Cost G .>-3/.H4,444/.BI8.I9/ G B>,9I9,444
So, the ?+X of the ac&uisition is0
?+X G 4 G X
c
L X @ Cost G B>,9I9,444 L X @ >,9I9,444
X G B4
)lthough there is no economic %alue to the ta,eo%er, it is possi"le that Stult is moti%ated to
purchase ;lanner! for other than financial reasons.
9. The decision hinges upon the ris, of sur%i%ing. That is, consider the wealth transfer from
"ondholders to stoc,holders when ris,! pro:ects are underta,en. 5igh*ris, pro:ects will reduce the
e#pected %alue of the "ondholders claims on the firm. The telecommunications "usiness is ris,ier
than the utilities "usiness.
If the total %alue of the firm does not change, the increase in ris, should fa%or the stoc,holder.
5ence, management should appro%e this transaction.
If the total %alue of the firm drops "ecause of the transaction, and the wealth effect is lower than the
reduction in total %alue, management should re:ect the pro:ect.
10. a. The ?+X of the merger is the mar,et %alue of the target firm, plus the %alue of the s!nerg!,
minus the ac&uisition costs, so0
?+X G J44.=6D/ L =3,444 @ J44.=6I/ G =344
b. Since the ?+X goes directl! to stoc,holders, the share price of the merged firm will "e the
mar,et %alue of the ac&uiring firm plus the ?+X of the ac&uisition, di%ided "! the num"er of
shares outstanding, so0
Share price G N>,944.=3D/ L =344O->,944 G =3D.64
c. The merger premium is the premium per share times the num"er of shares of the target firm
outstanding, so the merger premium is0
$erger premium G J44.=6I @ 6D/ G =6,I44
d. The num"er of new shares will "e the num"er of shares of the target times the e#change ratio,
so0
?ew shares created G J44.3-9/ G 9D4 new shares
The %alue of the merged firm will "e the mar,et %alue of the ac&uirer plus the mar,et %alue of
the target plus the s!nerg! "enefits, so0
XAT G >,944.=3D/ L J44.=6D/ L 3,444 G =I9,H44
B-536
CHAPTER 29 B-
The price per share of the merged firm will "e the %alue of the merged firm di%ided "! the total
shares of the new firm, which is0
+ G =I9,H44-.>,944 L 9D4/ G =3I.4H
e. The ?+X of the ac&uisition using a share e#change is the mar,et %alue of the target firm plus
s!nerg! "enefits, minus the cost. The cost is the %alue per share of the merged firm times the
num"er of shares offered to the target firm shareholders, so0
?+X G J44.=6D/ L =3,444 @ 9D4.=3I.4H/ G =D,988.6D
&ntermediate
11. The cash offer is "etter for target firm shareholders since the! recei%e =6I per share. In the share
offer, the target firms shareholders will recei%e0
E&uit! offer %alue G .3-9/.=6D/ G =>D.D4 per share
The shareholders of the target firm would prefer the cash offer. The e#change ratio which would
ma,e the target firm shareholders indifferent "etween the two offers is the cash offer price di%ided
"! the new share price of the firm under the cash offer scenario, so0
E#change ratio G =6I-=3D.64 G .I8J9
12. The cost of the ac&uisition is0
Cost G 664.,r64/ G ,rD,D44
Since the stoc, price of the ac&uiring firm is ,rD4, the firm will ha%e to gi%e up0
Shares offered G ,rD,D44-,rD4 G >>4 shares
a. The E+S of the merged firm will "e the com"ined E+S of the e#isting firms di%ided "! the new
shares outstanding, so0
E+S G .,rJ44 L H44/-.994 L >>4/ G ,r6.6I
b. The +E of the ac&uiring firm is0

'riginal +-E G ,rD4-.,rJ44-994/ G 6D.DD times
)ssuming the +E ratio does not change, the new stoc, price will "e0
?ew + G ,r6.6I.6D.DD/ G ,r99.9H
c. If the mar,et correctl! anal!es the earnings, the stoc, price will remain unchanged since this is
a ero ?+X ac&uisition, so0
?ew +-E G ,rD4-,r6.6I G >I.H4 times
537
SOLUTIONS
d. The new share price will "e the com"ined mar,et %alue of the two e#isting companies di%ided
"! the num"er of shares outstanding in the merged compan!. So0
+ G N.994/.,rD4/ L 664.,r>9/O-.994 L >>4/ G ,r38.33
)nd the +E ratio of the merged compan! will "e0
+-E G ,r38.33-,r6.6I G >H.8I times
)t the proposed "id price, this is a negati%e ?+X ac&uisition for ) since the share price
declines. The! should re%ise their "id downward until the ?+X is ero.
13. Aeginning with the fact that the ?+X of a merger is the %alue of the target minus the cost, we get0
?+X G
c
A
X @ Cost
?+X G X L XA @ Cost
?+X G X @ .Cost @ XA/
?+X G X @ $erger premium
14. a. The s!nerg! will "e the present %alue of the incremental cash flows of the proposed purchase.
Since the cash flows are perpetual, the s!nerg! %alue is0
S!nerg! %alue G H44,444 - .48
S!nerg! %alue G I,944,444
b. The %alue of ;lash*in*the*+an to ;l!*"!*?ight is the s!nerg! plus the current mar,et %alue of
;lash*in*the*+an, which is0
Xalue G I,944,444 L 64,444,444
Xalue G 6I,944,444
c. The %alue of the cash option is the amount of cash paid, or 69 million. The %alue of the stoc,
ac&uisition is the percentage of ownership in the merged compan!, times the %alue of the
merged compan!, so0
Stoc, ac&uisition %alue G .69.6I,944,444 L 39,444,444/
Stoc, ac&uisition %alue G >9,H69,444
d. The ?+X is the %alue of the ac&uisition minus the cost, so the ?+X of each alternati%e is0
?+X of cash offer G 6I,944,444 @ 69,444,444
?+X of cash offer G 6,944,444
?+X of stoc, offer G 6I,944,444 @ >9,H69,444
?+X of stoc, offer G >>,8I9,444
e. The ac&uirer should ma,e the stoc, offer since its ?+X is greater.
B-538
CHAPTER 29 B-
15. a. The num"er of shares after the ac&uisition will "e the current num"er of shares outstanding for
the ac&uiring firm, plus the num"er of new shares created for the ac&uisition, which is0
?um"er of shares after ac&uisition G 34,444,444 L >9,444,444
?um"er of shares after ac&uisition G D9,444,444
)nd the share price will "e the %alue of the com"ined compan! di%ided "! the shares
outstanding, which will "e0
?ew stoc, price G =>,444,444,444 - D9,444,444
?ew stoc, price G =66.66
b. Cet

e&ual the fraction of ownership for the target shareholders in the new firm. We can set
the percentage of ownership in the new firm e&ual to the %alue of the cash offer, so0
.=>,444,444,444/ G =684,444,444
G .68 or 68K
So, the shareholders of the target firm would "e e&uall! as well off if the! recei%ed 68 percent
of the stoc, in the new compan! as if the! recei%ed the cash offer. The ownership percentage of
the target firm shareholders in the new firm can "e e#pressed as0
'wnership G ?ew shares issued - .?ew shares issued L Current shares of ac&uiring firm/
.68 G ?ew shares issued - .?ew shares issued L 34,444,444/
?ew shares issued G >>,HHH,HHI
To find the e#change ratio, we di%ide the new shares issued to the shareholders of the target
firm "! the e#isting num"er of shares in the target firm, so0
E#change ratio G ?ew shares - E#isting shares in target firm
E#change ratio G >>,HHH,HHI - 64,444,444
E#change ratio G .9833
)n e#change ratio of .9833 shares of the merged compan! for each share of the target compan!
owned would ma,e the %alue of the stoc, offer e&ui%alent to the %alue of the cash offer.
16. a. The %alue of each compan! is the sum of the pro"a"ilit! of each state of the econom! times the
%alue of the compan! in that state of the econom!, so0
XalueAentle! G .I4.2344,444/ L .34.2>>4,444/
XalueAentle! G 26D3,444

XalueRolls G .I4.26H4,444/ L .34.284,444/
XalueRolls G 264H,444
539
SOLUTIONS
b. The %alue of each compan!s e&uit! is sum of the pro"a"ilit! of each state of the econom!
times the %alue of the e&uit! in that state of the econom!. The %alue of e&uit! in each state of
the econom! is the ma#imum of total compan! %alue minus the %alue of de"t, or ero. Since
Rolls is an all e&uit! compan!, the %alue of its e&uit! is simpl! the total %alue of the firm, or
264H,444. The %alue of Aentle!s e&uit! in a "oom is 2>H4,444 .2344,444 compan! %alue
minus 2>D4,444 de"t %alue/, and the %alue of Aentle!s e&uit! in a recession is ero since the
%alue of its de"t is greater than the %alue of the compan! in that state of the econom!. So, the
%alue of Aentle!s e&uit! is0
E&uit!Aentle! G .I4.2>H4,444/ L .34.24/
E&uit!Aentle! G 2>>6,444
The %alue of Aentle!s de"t in a "oom is the full face %alue of 2>D4,444. In a recession, the
%alue of the compan!s de"t is 2>>4,444 since the %alue of the de"t cannot e#ceed the %alue of
the compan!. So, the %alue of Aentle!s de"t toda! is0
Ee"tAentle! G .I4.2>D4,444/ L .34.2>>4,444/
Ee"tAentle! G 2>3>,444
?ote, this is also the %alue of the compan! minus the %alue of the e&uit!, or0
Ee"tAentle! G 26D3,444 @ >>6,444
Ee"tAentle! G 2>3>,444
c. The com"ined %alue of the companies, the com"ined e&uit! %alue, and com"ined de"t %alue is0
Com"ined %alue G 26D3,444 L 64H,444
Com"ined %alue G 2DDJ,444
Com"ined e&uit! %alue G 2>>6,444 L 64H,444
Com"ined e&uit! %alue G 23>8,444
Com"ined de"t %alue G 2>3>,444
d. To find the %alue of the merged compan!, we need to find the %alue of the merged compan! in
each state of the econom!, which is0
Aoom merged %alue G 2344,444 L 6H4,444
Aoom merged %alue G 29H4,444
Recession merged %alue G 2>>4,444 L 84,444
Recession merged %alue G 2>J4,444
So, the %alue of the merged compan! toda! is0
$erged compan! %alue G .I4.29H4,444/ L .34.2>J4,444/
$erged compan! %alue G 2DDJ,444
B-540
CHAPTER 29 B-
Since the merged compan! will still ha%e 2>D4,444 in de"t, the %alue of the e&uit! in a "oom is
2D64,444, and the %alue of e&uit! in a recession is 294,444. So, the %alue of the merged
compan!s e&uit! is0
$erged e&uit! %alue G .I4.2D64,444/ L .34.294,444/
$erged e&uit! %alue G 234J,444
The merged compan! will ha%e a %alue greater than the face %alue of de"t in "oth states of the
econom!, so the %alue of the compan!s de"t is 2>D4,444.
e. There is a wealth transfer in this case. The com"ined e&uit! %alue "efore the merger was
23>8,444, "ut the %alue of the e&uit! in the merged compan! is onl! 234J,444, a loss of 2J,444
for stoc,holders. The %alue of the de"t in the com"ined companies was onl! 2>3>,444, "ut the
%alue of de"t in the merged compan! is 2>D4,444 since there is no chance of default. The
"ondholders gained 2J,444, e#actl! the amount the stoc,holders lost.
f. If the %alue of Aentle!s de"t "efore the merger is less than the lowest firm %alue, there is no
coinsurance effect. Since there is no possi"ilit! of default "efore the merger, "ondholders do
not gain after the merger.
'hallenge
17. a. To find the %alue of the target to the ac&uirer, we need to find the share price with the new
growth rate. We "egin "! finding the re&uired return for shareholders of the target firm. The
earnings per share of the target are0
E+S+ G 2984,444-994,444 G 2>.49 per share
The price per share is0
++ G J.2>.49/ G 2J.DJ
)nd the di%idends per share are0
E+S+ G 26J4M-994M G 24.96I
The current re&uired return for +almer shareholders, which incorporates the ris, of the
compan! is0
RE G N24.96I.>.49/-2J.DJO L .49 G .>483
The price per share of +almer with the new growth rate is0
++ G 24.96I.>.4I/-..>483 @ .4I/ G 2>D.I6
The %alue of the target firm to the ac&uiring firm is the num"er of shares outstanding times the
price per share under the new growth rate assumptions, so0
c
T
X G 994,444.2>D.I6/ G 28,4JD,I86.H>
541
SOLUTIONS
b. The gain to the ac&uiring firm will "e the %alue of the target firm to the ac&uiring firm minus
the mar,et %alue of the target, so0
Rain G 28,4JD,I86.H> @ 994,444.2J.DJ/ G 26,8ID,I86.H>
c. The ?+X of the ac&uisition is the %alue of the target firm to the ac&uiring firm minus the cost
of the ac&uisition, so0
?+X G 28,4JD,I86.H> @ 994,444.2>8/ G @2>,849,6>I.3J
d. The most the ac&uiring firm should "e willing to pa! per share is the offer price per share plus
the ?+X per share, so0
$a#imum "id price G 2>8 L .@2>,849,6>I.3J-994,444/ G 2>D.I6
?otice that this is the same %alue we calculated earlier in part a as the %alue of the target to the
ac&uirer.
e. The price of the stoc, in the merged firm would "e the mar,et %alue of the ac&uiring firm plus
the %alue of the target to the ac&uirer, di%ided "! the num"er of shares in the merged firm, so0
+;+ G .269,444,444 L 8,4JD,I86.H>/-.>,444,444 L >>4,444/ G 26J.86
The ?+X of the stoc, offer is the %alue of the target to the ac&uirer minus the %alue offered to
the target shareholders. The %alue offered to the target shareholders is the stoc, price of the
merged firm times the num"er of shares offered, so0
?+X G 28,4JD,I86.H> @ >>4,444.26J.86/ G 2D,8>9,>>J.DI
f. \es, the ac&uisition should go forward, and +lant should offer the >>4,444 shares since the
?+X is higher.
g. <sing the new growth rate in the di%idend growth model, along with the di%idend and re&uired
return we calculated earlier, the price of the target under these assumptions is0
++ G 24.96I.>.4H/-..>483 @ .4H/ G 2>>.9H
)nd the %alue of the target firm to the ac&uiring firm is0
c
+
X G 994,444.2>>.9H/ G 2H,3H4,444.44
The gain to the ac&uiring firm will "e0
Rain G 2H,3H4,444 @ 994,444.2J.DJ/ G 2>,>D4,444.44
The ?+X of the cash offer is now0
?+X cash G 2H,3H4,444 @ 994,444.2>8/ G @23,9D4,444
B-542
CHAPTER 29 B-
)nd the new price per share of the merged firm will "e0
+;+ G N269$ L H,3H4,444O-.>,444,444 L >>4,444/ G 268.69
)nd the ?+X of the stoc, offer under the new assumption will "e0
?+X stoc, G 2H,3H4,444 @ >>4,444.268.69/ G 23,696,696.69
E%en with the lower pro:ected growth rate, the stoc, offer still has a positi%e ?+X. +lant should
purchase +almer with a stoc, offer of >>4,444 shares.
18. a. To find the distri"ution of :oint %alues, we first must find the :oint pro"a"ilities. To do this, we
need to find the :oint pro"a"ilities for each possi"le com"ination of weather in the two towns.
The weather conditions are independent( therefore, the :oint pro"a"ilities are the products of the
indi%idual pro"a"ilities.
+ossi"le states Joint pro"a"ilit!
Rain*Rain .>..>/ G .4>
Rain*Warm .>..D/ G .4D
Rain*5ot .>..9/ G .49
Warm*Rain .D..>/ G .4D
Warm*Warm .D..D/ G .>H
Warm*5ot .D..9/ G .64
5ot*Rain .9..>/ G .49
5ot*Warm .9..D/ G .64
5ot*5ot .9..9/ G .69
?e#t, note that the re%enue when rain! is the same regardless of which town. So, since the state
qRain*Warmq has the same outcome .re%enue/ as qWarm*Rainq, their pro"a"ilities can "e
added. The same is true of qRain*5otq - q5ot*Rainq and qWarm*5otq - q5ot*Warmq. Thus the
:oint pro"a"ilities are0
+ossi"le states Joint pro"a"ilit!
Rain*Rain .4>
Rain*Warm .48
Rain*5ot .>4
Warm*Warm .>H
Warm*5ot .D4
5ot*5ot .69
;inall!, the :oint %alues are the sums of the %alues of the two companies for the particular state.
+ossi"le states Joint %alue
Rain*Rain B>44,444 L >44,444 G B644,444
Rain*Warm B>44,444 L 644,444 G 344,444
Rain*5ot B>44,444 L D44,444 G 944,444
Warm*Warm B644,444 L 644,444 G D44,444
Warm*5ot B644,444 L D44,444 G H44,444
5ot*5ot BD44,444 L D44,444 G 844,444
543
SOLUTIONS
b. Recall that if a firm cannot ser%ice its de"t, the "ondholders recei%e the %alue of the assets.
Thus, the %alue of the de"t is the %alue of the compan! if the face %alue of the de"t is greater
than the %alue of the compan!. If the %alue of the compan! is greater than the %alue of the de"t,
the %alue of the de"t is its face %alue. 5ere, the %alue of the common stoc, is alwa!s the
residual %alue of the firm o%er the %alue of the de"t. So, the %alue of the de"t and the %alue of
the stoc, in each state is0
+ossi"le states Joint +ro". Joint Xalue Ee"t Xalue Stoc, Xalue
Rain*Rain .4> B644,444 B644,444 B4
Rain*Warm .48 344,444 344,444 4
Rain*5ot .>4 944,444 D44,444 >44,444
Warm*Warm .>H D44,444 D44,444 4
Warm*5ot .D4 H44,444 D44,444 644,444
5ot*5ot .69 844,444 D44,444 D44,444
c. The "ondholders are "etter off if the %alue of the de"t after the merger is greater than the %alue
of the de"t "efore the merger. The %alue of the de"t is the smaller of the de"t %alue or the
compan! %alue. So, the %alue of the de"t of each indi%idual compan! "efore the merger in each
state is0
+ossi"le states +ro"a"ilit! Ee"t Xalue
Rain .>4 B>44,444
Warm .D4 644,444
5ot .94 644,444
Indi%idual de"t %alue G .>.B>44,444/ L .D.B644,444/ L .9.B644,444/
Indi%idual de"t %alue G B>J4,444
This means the total %alue of the de"t for "oth companies pre*merger must "e0
Total de"t %alue pre*merger G 6.B>J4,444/
Total de"t %alue pre*merger G B384,444
To get the e#pected de"t %alue, post*merger, we can use the :oint pro"a"ilities for each possi"le
state and the de"t %alues corresponding to each state we found in part c. <sing this information
to find the %alue of the de"t in the post*merger firm, we get0
Total de"t %alue post*merger G .4>.B644,444/ L .48.B344,444/ L .>4.BD44,444/
L .>H.BD44,444/ L .D4.BD44,444/ L .69.BD44,444/
Total de"t %alue post*merger G B3J4,444
The "ondholders are "etter off "! B>4,444. Since we ha%e alread! shown that the total %alue of
the com"ined compan! is the same as the sum of the %alue of the indi%idual companies, the
implication is that the stoc,holders are worse off "! B>4,444.
B-544
CHAPTER 30
/*)A)C*A6 8*$R1$$
Answers to Concepts Review and Critical !in"in# Questions
1. ;inancial distress is often lin,ed to insol%enc!. Stoc,*"ased insol%enc! occurs when a firm has a
negati%e net worth. ;low*"ased insol%enc! occurs when operating cash flow is insufficient to meet
current o"ligations.
2. ;inancial distress fre&uentl! can ser%e as a firms 1earl! warning8 sign for trou"le. Thus, it can "e
"eneficial since it ma! "ring a"out new organiational forms and new operating strategies.
3. ) prepac,aged "an,ruptc! is where the firm and most creditors agree to a pri%ate reorganiation
"efore "an,ruptc! ta,es place. )fter the pri%ate agreement, the firm files for formal "an,ruptc!. The
"iggest ad%antage is that a prepac,aged "an,ruptc! is usuall! cheaper and faster than a traditional
"an,ruptc!.
4. Just "ecause a firm is e#periencing financial distress doesnt necessaril! impl! the firm is worth
more dead than ali%e.
5. Ci&uidation occurs when the assets of a firm are sold and pa!ments are made to creditors .usuall!
"ased upon the )+R/. Reorganiation is the restructuring of the firmTs finances.
6. The a"solute priorit! rule is the priorit! rule of the distri"ution of the proceeds of the li&uidation. It
"egins with the first claim to the last, in the order0 administrati%e e#penses, unsecured claims after a
filing of in%oluntar! "an,ruptc! petition, wages, emplo!ee "enefit plans, consumer claims, ta#es,
secured and unsecured loans, preferred stoc,s and common stoc,s.
7. Aan,ruptc! allows firms to issue new de"t that is senior to all pre%iousl! incurred de"t. This new
de"t is called EI+ .de"tor in possession/ de"t. If EI+ loans were not senior to all other de"t, a firm in
"an,ruptc! would "e una"le to o"tain financing necessar! to continue operations while in
"an,ruptc! since the lender would "e unli,el! to ma,e the loan.
8. 'ne answer is that the right to file for "an,ruptc! is a %alua"le asset, and the financial manager acts
in shareholders "est interest "! managing this asset in wa!s that ma#imie its %alue. To the e#tent
that a "an,ruptc! filing pre%ents 1a race to the courthouse steps,8 it would seem to "e a reasona"le
use of the process.
9. As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be
the best use of the asset. Creditors are aware at the time a loan is made of the possibility of
bankruptcy, and the interest charged incorporates it. If the only way a firm can continue to operate is
to reduce labor costs, it may be a benefit to everyone, including employees.
SOLUTIONS
10. There are four possi"le reasons wh! firms ma! choose legal "an,ruptc! o%er pri%ate wor,out0 >/ It
ma! "e less e#pensi%e .although legal "an,ruptc! is usuall! more e#pensi%e/. 6/ E&uit! in%estors
can use legal "an,ruptc! to 1hold out.8 3/ ) complicated capital structure ma,es pri%ate wor,outs
more difficult. D/ Conflicts of interest "etween creditors, e&uit! in%estors and management can ma,e
pri%ate wor,outs impossi"le.
$olutions to Questions and %ro&le's
NOTE: All end of chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. <nder the a"solute priorit! rule .)+R/, claims are paid out in full to the e#tent there are assets. In
this case, assets are 2>9,944, so !ou should propose the follows.
Original claim
"istribution of
li!uidating value
Trade credit 23,444 23,444
Secured mortgage notes H,444 H,444
Senior de"entures 9,444 9,444
Junior de"entures J,444 >,944
E&uit! 4 4
2. There are man! possi"le reorganiation plans, so we will ma,e an assumption that the mortgage
"onds are full! recognied as senior de"entures, the senior de"entures will recei%e :unior de"entures
in the %alue of H9 cents on the dollar, and the :unior de"entures will recei%e an! remaining %alue as
e&uit!. With these assumptions, the reorganiation plan will loo, li,e this0
Original claim <eorganiHed claim
$ortgage "onds 2>4,444 Senior de"enture 2>4,444
Senior de"entures 2H,444 Junior de"enture 23,J44
Junior de"entures 2D,444 E&uit! 2>,>44
B-546
CHAPTER 31
INTERNATIONAL CORPORATE
FINANCE
Answers to Concepts Review and Critical !in"in# Questions
1. a. The dollar is selling at a premium "ecause it is more e#pensi%e in the forward mar,et than in
the spot mar,et .S;r >.93 %ersus S;r >.94/.
b. The franc is e#pected to depreciate relati%e to the dollar "ecause it will ta,e more francs to "u!
one dollar in the future than it does toda!.
c. Inflation in Switerland is higher than in the <nited States, as are nominal interest rates.
2. The e#change rate will increase, as it will ta,e progressi%el! more pesos to purchase a dollar. This is
the relati%e +++ relationship.
3. a. The )ustralian dollar is e#pected to wea,en relati%e to the dollar, "ecause it will ta,e more )2
in the future to "u! one dollar than it does toda!.
b. The inflation rate in )ustralia is higher.
c. ?ominal interest rates in )ustralia are higher( relati%e real rates in the two countries are the
same.
4. ) \an,ee "ond is most accuratel! descri"ed "! d.
5. ?o. ;or e#ample, if a countr!s currenc! strengthens, imports "ecome cheaper .good/, "ut its e#ports
"ecome more e#pensi%e for others to "u! ."ad/. The re%erse is true for currenc! depreciation.
6. )dditional ad%antages include "eing closer to the final consumer and, there"!, sa%ing on
transportation, significantl! lower wages, and less e#posure to e#change rate ris,. Eisad%antages
include political ris, and costs of super%ising distant operations.
7. 'ne ,e! thing to remem"er is that di%idend pa!ments are made in the home currenc!. $ore
generall!, it ma! "e that the owners of the multinational are primaril! domestic and are ultimatel!
concerned a"out their wealth denominated in their home currenc! "ecause, unli,e a multinational,
the! are not internationall! di%ersified.
8. a. ;alse. If prices are rising faster in Rreat Aritain, it will ta,e more pounds to "u! the same
amount of goods that one dollar can "u!( the pound will depreciate relati%e to the dollar.
b. ;alse. The forward mar,et would alread! reflect the pro:ected deterioration of the euro relati%e
to the dollar. 'nl! if !ou feel that there might "e additional, unanticipated wea,ening of the
SOLUTIONS
euro that isnt reflected in forward rates toda!, will the forward hedge protect !ou against
additional declines.
B-548
CHAPTER 31 B-
c. True. The mar,et would onl! "e correct on a%erage, while !ou would "e correct all the time.
9. a. )merican e#porters0 their situation in general impro%es "ecause a sale of the e#ported goods for
a fi#ed num"er of euros will "e worth more dollars.
)merican importers0 their situation in general worsens "ecause the purchase of the imported
goods for a fi#ed num"er of euros will cost more in dollars.
b. )merican e#porters0 the! would generall! "e "etter off if the Aritish go%ernments intentions
result in a strengthened pound.
)merican importers0 the! would generall! "e worse off if the pound strengthens.
c. )merican e#porters0 the! would generall! "e much worse off, "ecause an e#treme case of fiscal
e#pansion li,e this one will ma,e )merican goods prohi"iti%el! e#pensi%e to "u!, or else
Arailian sales, if fi#ed in crueiros, would "ecome worth an unaccepta"l! low num"er of
dollars.
)merican importers0 the! would generall! "e much "etter off, "ecause Arailian goods will
"ecome much cheaper to purchase in dollars.
10. IR+ is the most li,el! to hold "ecause it presents the easiest and least costl! means to e#ploit an!
ar"itrage opportunities. Relati%e +++ is least li,el! to hold since it depends on the a"sence of mar,et
imperfections and frictions in order to hold strictl!.
11. It all depends on whether the forward mar,et e#pects the same appreciation o%er the period and
whether the e#pectation is accurate. )ssuming that the e#pectation is correct and that other traders
do not ha%e the same information, there will "e %alue to hedging the currenc! e#posure.
12. 'ne possi"le reason in%estment in the foreign su"sidiar! might "e preferred is if this in%estment
pro%ides direct di%ersification that shareholders could not attain "! in%esting on their own. )nother
reason could "e if the political climate in the foreign countr! was more sta"le than in the home
countr!. Increased political ris, can also "e a reason !ou might prefer the home su"sidiar!
in%estment. Indonesia can ser%e as a great e#ample of political ris,. If it cannot "e di%ersified awa!,
in%esting in this t!pe of foreign countr! will increase the s!stematic ris,. )s a result, it will raise the
cost of the capital, and could actuall! decrease the ?+X of the in%estment.
13. \es, the firm should underta,e the foreign in%estment. If, after ta,ing into consideration all ris,s, a
pro:ect in a foreign countr! has a positi%e ?+X, the firm should underta,e it. ?ote that in practice,
the stated assumption .that the ad:ustment to the discount rate has ta,en into consideration all
political and di%ersification issues/ is a huge tas,. Aut once that has "een addressed, the net present
%alue principle holds for foreign operations, :ust as for domestic.
14. If the foreign currenc! depreciates, the <.S. parent will e#perience an e#change rate loss when the
foreign cash flow is remitted to the <.S. This pro"lem could "e o%ercome "! selling forward
contracts. )nother wa! of o%ercoming this pro"lem would "e to "orrow in the countr! where the
pro:ect is located.
15. ;alse. If the financial mar,ets are perfectl! competiti%e, the difference "etween the Eurodollar rate
and the <.S. rate will "e due to differences in ris, and go%ernment regulation. Therefore, speculating
in those mar,ets will not "e "eneficial.
549
SOLUTIONS
16. The difference "etween a Euro"ond and a foreign "ond is that the foreign "ond is denominated in the
currenc! of the countr! of origin of the issuing compan!. Euro"onds are more popular than foreign
"onds "ecause of registration differences. Euro"onds are unregistered securities.
$olutions to Questions and %ro&le's
NOTE: All end-of-chapter problems were solved using a spreadsheet. Man problems re!uire multiple
steps. "ue to space and readabilit constraints# when these intermediate steps are included in this
solutions manual# rounding ma appear to have occurred. $owever# the final answer for each problem is
found without rounding during an step in the problem.
%asic
1. <sing the &uotes from the ta"le, we get0
a. 2>44.B4.83J4-2>/ G B83.J4
b. 2>.>J>J
c. B>4$.2>.>J>J-B/ G 2>>,J>8,J9>
d. ?ew bealand dollar
e. $e#ican peso
f. .+>4.D899-2>/.2>.>J>J-B>/ G +>6.DJIH-B
This is a cross rate.
g. The most valuable is the Kuwait dinar. The least valuable is the Indonesian rupiah.

2. a. \ou would prefer =>44, since0
.=>44/.2.9I4J-=>/ G 29I.4J
b. \ou would still prefer =>44. <sing the 2-= e#change rate and the S;-= e#change rate to find the
amount of Swiss francs =>44 will "u!, we get0
.=>44/.2>.I9>H-=>/.S; .IH3J/ G S; 66J.6JI4
c. <sing the &uotes in the "oo, to find the S;-= cross rate, we find0
.S; >.34J>-2>/.24.9I4J-=>/ G S; 6.6J34-=>
The =-S; e#change rate is the in%erse of the S;-= e#change rate, so0
=>-S; .D3H> G =4.D3H>-S; >
B-550
CHAPTER 31 B-
3. a. ;>84 G V>>D.39 .per 2/. The !en is selling at a premium "ecause it is more e#pensi%e in the
forward mar,et than in the spot mar,et .24.4489393 %ersus 24.448ID9>/.
b. ;J4 G 24.9I4J-=. The pound is selling at a premium "ecause it is less e#pensi%e in the forward
mar,et than in the spot mar,et .24.9I49 %ersus 24.9I4J/.
c. The %alue of the dollar will fall relati%e to the !en, since it ta,es more dollars to "u! one !en in
the future than it does toda!. The %alue of the dollar will fall relati%e to the pound, "ecause it
will ta,e more dollars to "u! one pound in the future than it does toda!.
4. a. The <.S. dollar, since one Canadian dollar will "u!0
.Can2>/-.Can2>.6H-2>/ G 24.IJ3I
b. The cost in <.S. dollars is0
.Can26.>J/-.Can2>.6H-2>/ G 2>.ID
)mong the reasons that a"solute +++ doesnt hold are tariffs and other "arriers to trade,
transactions costs, ta#es, and different tastes.
c. The <.S. dollar is selling at a discount, "ecause it is less e#pensi%e in the forward mar,et than
in the spot mar,et .Can2>.66 %ersus Can2>.6H/.
d. The Canadian dollar is e#pected to appreciate in %alue relati%e to the dollar, "ecause it ta,es
fewer Canadian dollars to "u! one <.S. dollar in the future than it does toda!.
e. Interest rates in the <nited States are pro"a"l! higher than the! are in Canada.
5. a. The cross rate in V-= terms is0
.V>>9-2>/.2>.I4-=>/ G V>J9.9-=>
b. The !en is &uoted too low relati%e to the pound. Ta,e out a loan for 2> and "u! V>>9. <se the
V>>9 to purchase pounds at the cross*rate, which will gi%e !ou0
V>>9.=>-V>84/ G =4.H38J
<se the pounds to "u! "ac, dollars and repa! the loan. The cost to repa! the loan will "e0
=4.H38J.2>.I4-=>/ G 2>.48H>
\ou ar"itrage profit is 24.48H> per dollar used.
551
SOLUTIONS
6. We can rearrange the interest rate parit! condition to answer this &uestion. The e&uation we will use
is0
R;C G .;T @ S4/-S4 L R<S
<sing this relationship, we find0
Rreat Aritain0 R;C G .=4.9HJH @ =4.9I4J/-=4.9I4J L .438 G 3.9IK
Japan0 R;C G .V>>D.39 @ V>>I.>H/-V>>I.>H L .438 G >.D4K
Switerland0 R;C G .S;r >.6896 @ S;r >.34J>/-S;r >.34J> L .438 G >.JIK
7. If we in%est in the <.S. for the ne#t three months, we will ha%e0
234$.>.44D9/
3
G 234,D4H,869.63
If we in%est in Rreat Aritain, we must e#change the dollars toda! for pounds, and e#change the
pounds for dollars in three months. )fter ma,ing these transactions, the dollar amount we would
ha%e in three months would "e0
.234$/.=4.9H-2>/.>.44H4/
3
-.=4.9J-2>/ G 268,JJ4,644.49
We should in%est in <.S.
8. <sing the relati%e purchasing power parit! e&uation0
;t G S4 Q N> L .h;C @ h<S/O
t

We find0
b3.J6 G b3.8DN> L .h;C @ h<S/O
3

h;C @ h<S G .b3.J6-b3.8D/
>-3
@ >
h;C @ h<S G .44HJ
Inflation in +oland is e#pected to e#ceed that in the <.S. "! 4.HJK o%er this period.
9. The profit will "e the &uantit! sold, times the sales price minus the cost of production. The
production cost is in Singapore dollars, so we must con%ert this to <.S. dollars. Eoing so, we find
that if the e#change rates sta! the same, the profit will "e0
+rofit G 34,444N2>D9 @ Z.S2>H8.94/-.S2>.H964-2>/[O
+rofit G 2>,6J4,4I6.HD
If the e#change rate rises, we must ad:ust the cost "! the increased e#change rate, so0
+rofit G 34,444N2>D9 @ Z.S2>H8.94/->.>.S2>.H964-2>/[O
+rofit G 2>,9H8,6DI.89
B-552
CHAPTER 31 B-
If the e#change rate falls, we must ad:ust the cost "! the decreased e#change rate, so0
+rofit G 34,444N2>D9 @ Z.S2>H8.94/-4.J.S2>.H964-2>/[O
+rofit G 2J94,484.I>
To calculate the "rea,e%en change in the e#change rate, we need to find the e#change rate that ma,e
the cost in Singapore dollars e&ual to the selling price in <.S. dollars, so0
2>D9 G S2>H8.94-ST
ST G S2>.>H6>-2>
ST G @.6JHH or @6J.HHK decline
10. a. If IR+ holds, then0
;>84 G .Mr H.D3/N> L ..48 @ .49/O
>-6

;>84 G Mr H.969I
Since gi%en ;>84 is MrH.9H, an ar"itrage opportunit! e#ists( the forward premium is too high.
Aorrow Mr> toda! at 8K interest. )gree to a >84*da! forward contract at Mr H.9H. Con%ert the
loan proceeds into dollars0
Mr > .2>-Mr H.D3/ G 24.>9996
In%est these dollars at 9K, ending up with 24.>9J3>. Con%ert the dollars "ac, into ,rone as
24.>9J3>.Mr H.9H-2>/ G Mr >.4D94H
Repa! the Mr > loan, ending with a profit of0
Mr>.4D94H @ Mr>.438H8 G Mr 4.44H38
b. To find the forward rate that eliminates ar"itrage, we use the interest rate parit! condition, so0
;>84 G .Mr H.D3/N> L ..48 @ .49/O
>-6

;>84 G Mr H.969I
11. The international ;isher effect states that the real interest rate across countries is e&ual. We can
rearrange the international ;isher effect as follows to answer this &uestion0
R<S @ h<S G R;C @ h;C
h;C G R;C L h<S @ R<S
a. h)<S G .49 L .439 @ .43J
h)<S G .4DH or D.HK
b. hC)? G .4I L .439 @ .43J
hC)? G .4HH or H.HK
c. hT)I G .>4 L .439 @ .43J
hT)I G .4JH or J.HK
553
SOLUTIONS
12. a. The !en is e#pected to get stronger, since it will ta,e fewer !en to "u! one dollar in the future
than it does toda!.
b. h<S @ hJ)+ .V>6J.IH @ V>3>.34/-V>3>.34
h<S @ hJ)+ G @ .4>>I or @>.>IK
.> @ .4>>I/
D
@ > G @.4DH> or @D.H>K
The appro#imate inflation differential "etween the <.S. and Japan is @ D.H>K annuall!.
13. We need to find the change in the e#change rate o%er time, so we need to use the relati%e purchasing
power parit! relationship0
;t G S4 Q N> L .h;C @ h<S/O
T

<sing this relationship, we find the e#change rate in one !ear should "e0
;> G 6>9N> L ..48H @ .439/O
>

;> G 5<; 669.JI
The e#change rate in two !ears should "e0
;6 G 6>9N> L ..48H @ .439/O
6

;6 G 5<; 63I.DJ
)nd the e#change rate in fi%e !ears should "e0
;9 G 6>9N> L ..48H @ .439/O
9

;9 G 5<; 6I9.I>
14. <sing the interest*rate parit! theorem0
.> L R<S/ - .> L R;C/ G F.4,>/ - S4
We can find the forward rate as0
F.4,>/ G N.> L R<S/ - .> L R;C/O S4
F.4,>/ G .>.>3 - >.4J/2>.94-=
F.4,>/ G 2>.9H-=
B-554
CHAPTER 31 B-
&ntermediate
15. ;irst, we need to forecast the future spot rate for each of the ne#t three !ears. ;rom interest rate and
purchasing power parit!, the e#pected e#change rate is0
E.ST/ G N.> L R<S/ - .> L R;C/O
T
S4
So0
E.S>/ G .>.4D84 - >.4D>4/
>
2>.66-B G 2>.6686-B
E.S6/ G .>.4D84 - >.4D>4/
6
2>.66-B G 2>.63H9-B
E.S3/ G .>.4D84 - >.4D>4/
3
2>.66-B G 2>.6DD8-B
?ow we can use these future spot rates to find the dollar cash flows. The dollar cash flow each !ear
will "e0
\ear 4 cash flow G @B2>6,444,444.2>.66-B/ G @2>D,HD4,444.44
\ear > cash flow G B26,I44,444.2>.6686-B/ G 23,3>H,>DJ.8H
\ear 6 cash flow G B23,944,444.2>.63H9-B/ G 2D,36I,H>8.H3
\ear 3 cash flow G .B3,344,444 L I,D44,444/.2>.6DD8-B/ G 2>3,3>J,>>>.J4
)nd the ?+X of the pro:ect will "e0
?+X G @2>D,HD4,444 L 23,3>H,>DJ.8H->.>3 L 2D,36I,H>8.H3->.>3
6
L 2>3,3>J,>>>.J4->.>3
3
?+X G 2J>D,H>8.I3
16. a. Implicitl!, it is assumed that interest rates wont change o%er the life of the pro:ect, "ut the
e#change rate is pro:ected to decline "ecause the Euroswiss rate is lower than the Eurodollar
rate.
b. We can use relati%e purchasing power parit! to calculate the dollar cash flows at each time. The
e&uation is0
ENSTO G .S;r >.I6/N> L ..4I @ .48/O
T

ENSTO G >.I6..JJ/
T

So, the cash flows each !ear in <.S. dollar terms will "e0
t S;r ENS
T
O <S2
4 @6I.4$ >.I644 @2>9,HJI,HID.D6
> LI.9$ >.I468 2D,D4D,9>4.66
6 LI.9$ >.H898 2D,DDJ,444.66
3 LI.9$ >.HH8J 2D,DJ3,J3J.H6
D LI.9$ >.H966 2D,93J,336.J9
9 LI.9$ >.H39I 2D,989,>8D.IJ
555
SOLUTIONS
)nd the ?+X is0
?+X G @2>9,HJI,HID.D6 L 2D,D4D,9>4.66->.>3 L 2D,DDJ,444.66->.>3
6
L 2D,DJ3,J3J.H6->.>3
3
L
2D,93J,336.J9->.>3
D
L 2D,989,>8D.IJ->.>3
9
?+X G 2I>,984.>4
c. Rearranging the relati%e purchasing power parit! e&uation to find the re&uired return in Swiss
francs, we get0
RS;r G >.>3N> L ..4I @ .48/O @ >
RS;r G >>.8IK
So, the ?+X in Swiss francs is0
?+X G @S;r 6I.4$ L S;r I.9$.+XI;)>>.8IK,9/
?+X G S;r >63,>>I.IH
Con%erting the ?+X to dollars at the spot rate, we get the ?+X in <.S. dollars as0
?+X G .S;r >63,>>I.IH/.2>-S;r >.I6/
?+X G 2I>,984.>4
'hallenge
17. a. The domestic ;isher effect is0
> L <9, G .> L r9,/.> L h9,/
> L r9, G .> L <9,/-.> L h9,/
This relationship must hold for an! countr!, that is0
> L rF' G .> L <F'/-.> L hF'/
The international ;isher effect states that real rates are e&ual across countries, so0
> L r9, G .> L <9,/-.> L h9,/ G .> L <F'/-.> L hF'/ G > L rF'
b. The e#act form of un"iased interest rate parit! is0
EN,tO G Ft G S4 N.> L <F'/-.> L <9,6O
t
c. The e#act form for relati%e +++ is0
EN,tO G ,4 N.> L hF'/-.> L h9,/O
t
B-556
CHAPTER 31 B-
d. ;or the home currenc! approach, we calculate the e#pected currenc! spot rate at time t as0
EN,tO G .B4.9/N>.4I->.49O
t
G .B4.9/.>.4>J/
t
We then con%ert the euro cash flows using this e&uation at e%er! time, and find the present
%alue. Eoing so, we find0
?+X G @ NB6$-.B4.9/O L ZB4.J$-N>.4>J.B4.9/O[->.> L ZB4.J$-N>.4>J
6
.B4.9/O[->.>
6
L
ZB4.J$-N>.4>J
3
.B4.9-2>/O[->.>
3

?+X G 23>H,634.I6
;or the foreign currenc! approach, we first find the return in the euros as0
<
F'
G >.>4.>.4I->.49/ @ > G 4.>6>
?e#t, we find the ?+X in euros as0
?+X G @ B6$ L .B4.J$/->.>6> L .B4.J$/->.>6>
6
L .B4.J$/->.>6>
3
G B>98,>>9.3H
)nd finall!, we con%ert the euros to dollars at the current e#change rate, which is0
?+X .2/ G B>98,>>9.3H -.B4.9-2>/ G 23>H,634.I6
557

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