Apr 01 2017 |

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Introduction
Corporate Finance - Chu
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Question
1 of 6
Based on Exhibit 1, the after-tax operating cash flow (in thousands) for Year 1 is closest to:
$33,200.
$46,600.
$31,600.

Question not answered

Hi Chu manages a manufacturing subdivision of Restar Corporation. Restar is a conglomerate with

divisions in the container industry. Chus task is to forecast the profitability of a four-year project for the
manufacturing of specialty labeled aluminum cans. Restar has never manufactured such an item before
and will require new equipment for the project. Exhibit 1 displays Chus abridged forecasted financial
projections for the project.

Exhibit 1
 Specialty Labeled Aluminum Cans Project Financial Projections, Year End Totals

($ thousands) Year 0 Year 1 Year 2 Year 3 Year 4

Fixed capital 100,000

Working capital 0
Total investment 100,000

Sales 60,000 72,000 86,400 103,680

Operating costs 24,000 28,800 34,560 41,472

Depreciation 25,000 25,000 25,000 25,000

Earnings before
interest and taxes 11,000 18,200 26,840 37,208
(EBIT)

Interest 4,000 3,112 2,154 1,118

Earnings before taxes

7,000 15,088 24,686 36,090
(EBT)

Tax (40%) 2,800 6,035 9,874 14,436

Net income 4,200 9,053 14,812 21,654

Dividends 1,680 3,621 5,925 8,662

Addition to retained
2,520 5,432 8,887 12,992
earnings

Capital used 100,000 75,000 50,000 25,000 0

Restars Cost of Capital and Capital Structure

Cost of debt (pretax) 8.00%
Cost of equity 15.00%
Debt ratio (Total debt/Total assets) 50.00%

In a meeting with Restars CFO, Trey Papier, Chu discusses the merits of the project. Chu makes the
following points:
All assumptions in the projections are based on Restars overall debt and equity mix and on
Restars corporate policy regarding dividend payout.
Instead of using the weighted average cost of capital (WACC), however, the project should be
evaluated with a project-specific market-determined discount rate of 16% because the project is
unlike any of the firms current manufacturing processes.

Papier asks Chu if he has considered other evaluation methods. Chu replies that he has computed the
economic profit using the WACC.

Chu states that he is uncertain about the appropriate cost of equity to use, however, because two weeks
earlier, Restars management announced that the financing mix would change by increasing the target
debt ratio to 60%. As a result, he says, the choices seem to be the
 firms current cost of equity, or
cost of equity based on the ModiglianiMiller tax model and the new target debt ratio, assuming
that the pretax cost of debt rises to 8.75%.

Papier interjects that the current cost of equity would be better because the implementation of the new
financing mix is likely to be delayed. Papier states that the delay is because the structure of the board of
directors is about to change in the following manner:
The CEO will no longer be the chairman of the board.
The retired original founder of Restar will become the chairman of the board.
The board will now have a majority of members that are independent.

Despite these changes, Papier believes it is still important to explore the potential value of this new
project.

Three weeks later, Chu and Papier meet again to review Chus work. After some discussion, they think an
alternative project will perform the same task as the original project. The alternative project will cover a
six-year period. Chu has calculated its net present value (NPV) based on after-tax operating cash flows
with the same discount rate of 16% used for the original project. Chu and Papier agree that because the
two projects are mutually exclusive, they can decide between the projects using the equivalent annual
annuity approach. Exhibit 2 summarizes the two projects NPVs.

Exhibit 2

Comparison of Project NPVs

Project
Project NPV
Life

Original 4 years $6,406,450

Alternative 6 years $8,141,220

Question not answered.

Cash Flow = (Sales Operating costs Depreciation) (1 Tax rate) + Depreciation

= ($60,000 $24,000 $25,000) (1 0.40) + $25,000
= $31,600

CFA Level II
Capital Budgeting, John D. Stowe and Jacques R. Gagne
Section 5.3

Question
2 of 6
Based on Exhibit 1, the economic profit (in thousands) for Year 1 is closest to:
 $1,100.
$3,300.
$8,400.

Question not answered

Note that capital used is based on beginning-of-year values, and the debt ratio is 50%.

Economic profit (EP) = Net operating profit after taxes WACC

CFA Level II
Capital Budgeting, John D. Stowe and Jacques R. Gagne
Section 8.3.1

Question
3 of 6
The dividend payment policy assumed by Chu in Exhibit 1 is most accurately described as a:
stable dividend policy.
constant dividend payout ratio policy.
residual dividend payout policy.

Question not answered

In Exhibit 1, the dividend payout ratio for each year is 40% of net income. This payout is consistent with a
constant dividend payout policy.
($ thousands) Year 1 Year 2 Year 3 Year 4
Dividend 1,680 3,621 5,925 8,662
Net income 4,200 9,053 14,812 21,654
Payout ratio 0.40 0.40 0.40 0.40
(Dividend/Net income)

CFA Level II
Dividends and Share Repurchases: Analysis, Gregory Noronha and George H. Troughton
Sections 4.1.14.1.3

Question
4 of 6
The cost of equity under the newly announced financing mix using Chu's assumption on the change
in the cost of debt and the ModiglianiMiller tax model is closest to:
 15.6%.
16.3%.
15.1%.

Question not answered

Determine the unleveraged cost of equity from the current cost of capital and capital structure:

r0 = cost of equity of an all-equity

company = ?
re = cost of equity for the firm = 0.15
(Exhibit 1)
rd = cost of debt for the firm = 0.08
(Exhibit 1)
Solve for r0 based on current debt and equity mix given the following original inputs:
Current D/E = debt-to-equity ratio =
0.50/(1 0.50) = 1.0 (implied from
Exhibit 1)
t = tax rate = 0.40 (Exhibit 1)

Then solve for re based on the new debt and equity mix (0.60) and the new cost of debt (0.0875):
Revised D/E = debt-to-equity ratio =
0.60/(1 0.60) = 1.5 (based on debt
ratio of 0.60)

CFA Level II
Capital Structure, Raj Aggarwal, Pamela Peterson Drake, Adam Kobor, and Gregory Noronha
Section 2.3

Question
5 of 6
Which changes to the board of directors is least consistent with best practices in the composition of a board?
 Which changes to the board of directors is least consistent with best practices in the composition of a board?

Specific choice of the new chairman of the board

Change in the composition of the board membership
Change regarding the CEO

Question not answered

Based on best practices, the chairman of a board should not be a senior executive from the firm.

CFA Level II
Corporate Governance, Rebecca Todd McEnally and Kenneth Kim
Section 5.1.2

Question
6 of 6
Based on the equivalent annual annuity method for the original and alternative projects, the most appropriate
conclusion is to:

be indifferent between the two projects.

accept the original project.
accept the alternative project.

Question not answered

Find the annuitized value of the NPV based on 16% for each project:
Project Life Calculation Equivalent Annual Cash Flow

Four years

PV = 6,406,450; N = 4; I = 16; CPT PMT

(original project) = $2,289,506

Six years

PV = 8,141,220; N = 6; I = 16; CPT PMT

(alternative project) = $2,209,445

Choose the original four-year project, because it produces the highest equivalent
Conclusion:
annual cash flow

CFA Level II
Capital Budgeting, John D. Stowe and Jacques R. Gagne
Section 7.1.2