Currently, Bloom Flowers Inc. has a capital structure consisting of $20 \%$ debt and $80 \%$ equity. Bloom's debt currently has an $8 \%$ yield to maturity. The risk-free rate $\left(\mathrm{r}_{\mathrm{RF}}\right)$ is $5 \%$, and the market risk premium $\left(\mathrm{r}_{\mathrm{M}}-\mathrm{r}_{\mathrm{RF}}\right)$ is $6 \%$. Using the CAPM, Bloom estimates that its cost of equity is currently $12.5 \%$. The company has a $40 \%$ tax rate.

a. What is Bloom's current WACC?

b. What is the current beta on Bloom's common stock?

c. What would Bloom's beta be if the company had no debt in its capital structure? (That is, what is Bloom's unlevered beta, $b_U$?)

Bloom's financial staff is considering changing its capital structure to $40 \%$ debt and $60 \%$ equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to $9.5 \%$. The proposed change will have no effect on the company's tax rate.

d. What would be the company's new cost of equity if it adopted the proposed change in capital structure?

e. What would be the company's new WACC if it adopted the proposed change in capital structure?

f. Based on your answer to part e, would you advise Bloom to adopt the proposed change in capital structure? Explain.

The firms HL and LL are identical except for their debt-to-total-assets ratios and interest rates on debt. Each has $20 million in assets, earned $4 million before interest and taxes, and has a 40 percent marginal tax rate. Firm HL, however, has a debt-to-total-assets ratio (D/TA) of 50 percent and pays 12 percent interest on its debt, whereas LL has a 30 percent debt-to-total-assets ratio and pays only 10 percent interest on debt.

Observing that HL has a higher return on equity, LL's treasurer decides to raise the debt-to-total-assets ratio from 30 to 60 percent, which will increase LL's interest rate on all debt to 15 percent. Calculate the new ROE for LL.$RO $=$ (Net income)/(Common equity).

Olinde Electronics Inc. produces stereo components that sell at P = 100 dollars per unit. Olinde's fixed costs are 200,000 dollars, variable costs are 50 dollars per unit, 5,000 components are produced and sold each year, EBIT is currently 50,000 dollars, and Olinde's assets (all equity-financed) are 500,000 dollars. Olinde can change its production process by adding 400,000 dollars to assets and 50,000 dollars to fixed operating costs. This change would (1) reduce variable costs per unit by 10 dollars and (2) increase output by 2,000 units, but (3) the sales price on all units would have to be lowered to 95 dollars to permit sales of the additional output. Olinde has tax loss carry-forwards that cause its tax rate to be zero, it uses no debt, and its average cost of capital is 10 percent.

a. Should Olinde make the change? Why or why not?

b. Would Olinde's break-even point increase or decrease if it made the change?

c. Suppose Olinde was unable to raise additional equity financing and had to borrow the 400,000 dollars at an interest rate of 10 percent to make the investment. Use the DuPont equation to find the expected ROA of the investment. Should Olinde make the change if debt financing must be used? Explain.

The firms HL and LL are identical except for their debt-to-total-assets ratios and interest rates on debt. Each has $20 million in assets, earned $4 million before interest and taxes, and has a 40 percent marginal tax rate. Firm HL, however, has a debt-to-total-assets ratio (D/TA) of 50 percent and pays 12 percent interest on its debt, whereas LL has a 30 percent debt-to-total-assets ratio and pays only 10 percent interest on debt.

Calculate the rate of return on equity (net income/equity) for each firm.

Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total$1 million, and the firm plans to maintain a 60% debt-to-assets ratio. Rentz’s interest rate is currently 8% on both short- and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level are under consideration: (1) a restricted policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 12% of total sales, and the federal-plus-state tax rate is 40%. a. What is the expected return on equity under each current assets level? b. In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption? Why or why not? c. How would the firm’s risk be affected by the different policies?

The Neal Company wants to estimate next year’s return on equity (ROE) under different financial leverage ratios. Neal’s total capital is $14 million, it currently uses only common equity, it has no future plans to use preferred stock in its capital structure, and its federal-plus-state tax rate is 40%. The CFO has estimated next year’s EBIT for three possible states of the world:$4.2 million with a 0.2 probability, $2.8 million with a 0.5 probability, and$700,000 with a 0.3 probability. Calculate Neal’s expected ROE, standard deviation, and coefficient of variation for each of the following debt-to-capital ratios; then evaluate the results: $$ \begin{matrix} \text{Debt/Capital Ratio} & \text{Interest Rate}\\ \text{0\\%} & \text{--}\\ \text{10} & \text{9\\%}\\ \text{50} & \text{11}\\ \text{60} & \text{14}\\ \end{matrix} $$

Harley Motors has $\$ 10$ million in assets, which were financed with $\$ 2$ million of debt and $\$ 8$ million in equity. Harley's beta is currently $1.2$, and its tax rate is $40 \%$. Use the Hamada equation to find Harley's unlevered beta, $b_U$.

Terrell Trucking Company is in the process of setting its target capital structure. The CFO believes that the optimal debt-to-capital ratio is somewhere between 20% and 50%, and her staff has compiled the following projections for EPS and the stock price at various debt levels: $$ \begin{matrix} \text{Debt/Capital Ratio} & \text{Projected EPS} & \text{Projected Stock Price}\\ \text{20\\%} & \text{\$ 3.10} & \text{\$ 34.25}\\ \text{30} & \text{3.55} & \text{36.00}\\ \text{40} & \text{3.70} & \text{35.50}\\ \text{50} & \text{3.55} & \text{34.00}\\ \end{matrix} $$ Assuming that the firm uses only debt and common equity, what is Terrell’s optimal capital structure? At what debt-to-capital ratio is the company’s WACC minimized?

Given the following information, calculate the expected value for Firm C’s EPS. Data for Firms A and B are as follows: $\mathrm{E}\left(\mathrm{EPS}_{\mathrm{A}}\right)=\$ 5.10, \sigma_{\mathrm{A}}=\$ 3.61, \mathrm{E}\left(\mathrm{EPS}_{\mathrm{B}}\right)=\$ 4.20$, and $\sigma_{\mathrm{B}}=\$ 2.96$.

$$\begin{matrix} \text{ } & \text{Probability}\\ \text{ } & \text{0.1} & \text{0.2} & \text{0.4} & \text{0.2} & \text{0.1}\\ \text{Firm A: }{\mathrm{EPS}_{\mathrm{A}}} & \text{(\$ 1.50)} & \text{\$ 1.80} & \text{\$ 5.10} & \text{\$ 8.40} & \text{\$ 11.70}\\ \text{Firm B: }{\mathrm{EPS}_{\mathrm{B}}} & \text{(1.20)} & \text{1.50} & \text{4.20} & \text{6.90} & \text{9.60}\\ \text{Firm C: }{\mathrm{EPS}_{\mathrm{C}}} & \text{(2.40)} & \text{1.35} & \text{5.10} & \text{8.85} & \text{12.60}\\ \end{matrix}$$

b. You are given that $\sigma_{\mathrm{C}}=\$ 4.11$. Discuss the relative riskiness of the three firms’ earnings.

McDowell Industries sells on terms of $3 / 10$, net $30$ . Total sales for the year are $\$ 912,500 ; 40 \%$ of the customers pay on the $10^{\text {th }}$ day and take discounts, while the other $60 \%$ pay, on average, $40$ days after their purchases.

a. What is the days sales outstanding?

b. What is the average amount of receivables?

c. What is the percentage cost of trade credit to customers who take the discount?

d. What is the percentage cost of trade credit to customers who do not take the discount and pay in $40$ days?

e. What would happen to McDowell's accounts receivable if it toughened up on its collection policy with the result that all nondiscount customers paid on the $30^{\text {th }}$ day?

Nevada Enterprises is considering buying a vacant lot that sells for $\$ 1.2$ million. If the property is purchased, the company's plan is to spend another $\$ 5$ million today ( $t=0$ ) to build a hotel on the property. The cash flows from the hotel will depend critically on whether the state imposes a tourism tax in this year's legislative session. If the tax is imposed, the hotel is expected to produce cash flows of $\$ 600,000$ at the end of each of the next $15$ years. If the tax is not imposed, the hotel is expected to produce cash flows of $\$ 1,200,000$ at the end of each of the next $15$ years. The project has a $12 \%$ WACC. Assume at the outset that the company does not have the option to delay the project.

a. What is the project's expected NPV if the tax is imposed?

b. What is the project's expected NPV if the tax is not imposed?

c. Given that there is a $50 \%$ chance that the tax will be imposed/ what is theproject's expected NPV if management proceeds with it today?

d. Although the company does not have an option to delay construction, it does have the option to abandon the project $1$ year from now if the tax is imposed. If it abandons the project, it will sell the complete property 1 year from now at an expected price of $\$ 6$ million after taxes. Once the project is abandoned, the company will no longer receive any cash flows. Assuming that all cash flows are discounted at $12 \%$, will the existence of this abandonment option affect the company's decision to proceed with the project today? Explain.

e. Finally, assume that there is no option to abandon or delay the project, but that the company has an option to purchase an adjacent property in $1$ year at a price of $\$ 1.5$ million (outflow at $t=1$ ). If the tourism tax is imposed, the expected net present value of developing this property (as of $t=1$ ) will be only $\$ 300,000$ (so it doesn't make sense to purchase the property for $\$ 1.5$ million). However, if the tax is not imposed, the expected net present value of the future opportunities from developing the property will be $\$ 4$ million (as of $t=1$ ). Thus, under this scenario, it makes sense to purchase the property for $\$ 1.5$ million (at $t=1$ ). Assume that these cash flows are discounted at $12 \%$, and the probability that the tax will be imposed is still $50 \%$. What is the most the company would pay today $(\mathrm{t}=0)$ for the $\$ 1.5$ million purchase option (at $t=1$ ) for the adjacent property?

The Bush Oil Company is deciding whether to drill for oil on a tract of land that the company owns. The company estimates that the project will cost $\$ 8$ million today. Bush estimates that once drilled, the oil will generate positive cash flows of $\$ 4$ million a year at the end of each of the next $4$ years. Although the company is fairly confident about its cash flow forecast, it recognizes that if it waits $2$ years, it will have more information about the local geology as well as the price of oil. Bush estimates that if it waits $2$ years, the project will cost $\$ 9$ million, and cash flows will continue for $4$ years after the initial investment is made. Moreover, if it waits $2$ years, there is a $90 \%$ chance that the cash flows will be $\$ 4.2$ million a year for $4$ years, and there is a $10 \%$ chance that the cash flows will be $\$ 2.2$ million a year for $4$ years. Assume that all cash flows are discounted at $10 \%$.

a. If the company chooses to drill today, what is the project's expected net present value?

b. Would it make sense to wait $2$ years before deciding whether to drill? Explain.

c. What is the value of the investment timing option?

d. What disadvantages might arise from delaying a project such as this drilling project?

The Sorensen Supplies Company recently purchased a new delivery truck. The new truck costs $22,500; and it is expected to generate after-tax cash flows, including depreciation, of$5,875 per year. The truck has a 5-year expected life. The expected year-end abandonment values (salvage values after tax adjustments) for the truck are given here. The company’s WACC is 9%.

$$\begin{matrix} \text{Year} & \text{Annual After-Tax Cash Flow} & \text{Abandonment Value}\\ \text{0} & \text{(\$ 22.500)} & \text{--}\\ \text{1} & \text{5875} & \text{\$ 17.000}\\ \text{2} & \text{5875} & \text{15.000}\\ \text{3} & \text{5875} & \text{9000}\\ \text{4} & \text{5875} & \text{4750}\\ \text{5} & \text{5875} & \text{0}\\ \end{matrix}$$

a. Should the firm operate the truck until the end of its 5-year physical life; if not, what is the truck’s optimal economic life? b. Would the introduction of abandonment values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project? Explain.

Digital Inc is considering the production of a new cell phone. The project will require an investment of $\$ 15$ million. If the phone is well received, the project will produce cash flows of $\$ 10$ million a year for $3$ years; but if the market does not like the product, the cash flows will be only $\$ 2$ million per year. There is a $50 \%$ probability of both good and bad market conditions. Digital can delay the project a year while it conducts a test to determine whether demand will be strong or weak. The delay will not affect the dollar amounts involved for the project's investment or its cash flows-only their timing. Because of the anticipated shifts in technology, the $1$-year delay means that cash flows will continue only $2$ years after the initial investment is made. Digital's WACC is $10 \%$. What action do you recommend??