The Severn Company plans to raise a net amount of $270 million to finance new equipment in early 2017. Two alternatives are being considered: Common stock may be sold to net$60 per share, or bonds yielding 12% may be issued. The balance sheet and income statement of the Severn Company prior to financing are as follows: $$ \begin{matrix} \text{The Severn Company: Balance Sheet as of December 31, 2016 (Millions of Dollars)}\\ \text{Current assets} & \text{\$ 900.00} & \text{Notes payable} & \text{\$ 255.00}\\ \text{Net fixed assets} & \text{450.000} & \text{Long-term deb(10\\%)} & \text{697.50}\\ \text{ } & \text{ } & \text{Common stock, \$ par} & \text{60.00}\\ \text{ } & \text{ } & \text{Retained earnings} & \text{337.50}\\ \text{Total assets} & \text{\$ 1.350.00} & \text{Total liabilities and equity} & \text{\$ 1.350.00}\\ \end{matrix} $$ $$ \begin{matrix} \text{The Severn Company: Income Statement for Year Ended December 31, 2016 (Millions of Dollars)}\\ \text{Sales} & \text{\$ 2.475.00}\\ \text{Operating costs} & \text{2.227.50}\\ \text{Earnings before interest and taxes (10\\%)} & \text{\$ 247.50}\\ \text{Interest on short-term debt} & \text{15.00}\\ \text{Interest on long-term debt} & \text{69.75}\\ \text{Earnings before taxes} & \text{\$ 162.75}\\ \text{Federal-plus-state taxes (40\\%)} & \text{65.10}\\ \text{Net income} & \text{\$ 97.65}\\ \end{matrix} $$ The probability distribution for annual sales is as follows: $$ \begin{matrix} \text{Probability} & \text{Annual Sales (Millions of Dollars)}\\ \text{0.30} & \text{\$ 2.250}\\ \text{0.40} & \text{2.700}\\ \text{0.30} & \text{3.150}\\ \end{matrix} $$ Assuming that EBIT equals 10% of sales, calculate earnings per share (EPS) under the debt financing and the stock financing alternatives at each possible sales level. Then calculate expected EPS and $\sigma_{\mathrm{EPS}}$ under both debt and stock financing alternatives. Also calculate the debt-to-capital ratio and the times-interest-earned (TIE) ratio at the expected sales level under each alternative. The old debt will remain outstanding. Which financing method do you recommend?

How would you describe Sunset Boards’s cash flows for $2018$? Write a brief discussion.

Find functions $f:R^2\to R^2$ and $g:R^2\to R^2$ such that $f(e_1)=g(e_1)$ and $f(e_2)=g(e_2)$ but $f(v)\neq g(v)$ for some v in $R^2$.

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.

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?

Sunset Boards is a small company that manufactures and sells surfboards in Malibu. Tad Marks, the founder of the company, is in charge of the design and sale of the surfboards, but his background is in surfing, not business. Hence, the company’s financial records are not well maintained.

 The initial investment in Sunset Boards was provided by Tad and his friends and family. Because the initial investment was relatively small, and the company has made surf-boards only for its own store, the investors haven’t required detailed financial statements from Tad. But thanks to word of mouth among professional surfers, sales have picked up recently, and Tad is considering a major expansion. His plans include opening another surfboard store in Hawaii, as well as supplying his “sticks” (surfer lingo for boards) to other sellers.

Tad’s expansion plans require a significant investment, which he plans to finance with a combination of additional funds from outsiders along with some money borrowed from banks. Naturally, the new investors and creditors require more organized and detailed financial statements than Tad has previously prepared. At the urging of his investors, Tad has hired financial analyst Christina Wolfe to evaluate the performance of the company over the past year.

 After rooting through old bank statements, sales receipts, tax returns, and other records, Christina has assembled the following information:

	2014	2015
Cost of goods sold	$196,619	$248,263
Cash	28,372	42,865
Depreciation	55,506	62,738
Interest expense	12,067	13,831
Selling and administrative	36,668	50,469
Accounts payable	20,143	34,091
Net fixed assets	244,881	298,350
Sales	385,724	470,172
Accounts receivable	20,104	26,078
Notes payable	22,855	24,955
Long-term debt	123,607	140,000
Inventory	38,706	52,057
New equity	0	15,000

Sunset Boards currently pays out 40% of net income as dividends to Tad and the other original investors, and it has a 30% tax rate. You are Christina’s assistant, and she has asked you to prepare the following:

1. An income statement for 2014 and 2015.

2 A balance sheet for 2014 and 2015.

3. Operating cash flow for each year.

4. Cash flow from assets for 2015.

5. Cash flow to creditors for 2015.

6. Cash flow to stockholders for 2015.

QUESTION

How would you describe Sunset Boards’ cash flows for 2015? Write a brief discussion.

Lakeside, Inc., is considering replacing old production equipment with state-of-the-art technology that will allow production cost savings of $10,000 per month. The new equipment will have a five-year life and cost$450,000, with an estimated salvage value of $30,000. Lakeside’s cost of capital is 10%.

Required: Calculate the net present value of the new production equipment.

All American Telephones Inc. is considering the production of a new cell phone. The project will require an investment of 13 million dollars. If the phone is well received, the project will produce cash flows of 8 million dollars a year for 3 years, but if the market does not like the product, the cash flows will be only 2 million dollars per year. There is a 50 percent probability of both good and bad market conditions. All American 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. All American's WACC is 8 percent. What action do you recommend?

Currently, Forever Flowers Inc. has a capital structure consisting of 25% debt and 75% equity. Forever’s debt currently has a 7% yield to maturity. The risk-free rate $\left(\mathrm{r}_{\mathrm{RF}}\right)$ is 6%, and the market risk premium $\left(\mathrm{r}_{\mathrm{M}}-\mathrm{r}_{\mathrm{RF}}\right)$ is 7%. Using the CAPM, Forever estimates that its cost of equity is currently 14.5%. The company has a 40% tax rate. a. What is Forever’s current WACC? b. What is the current beta on Forever’s common stock? c. What would Forever’s beta be if the company had no debt in its capital structure? (That is, what is Forever’s unlevered beta, $\left.\mathrm{b}_{\mathrm{U}} ?\right)$ Forever’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 10.5%. 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 Forever to adopt the proposed change in capital structure? Explain.

Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $\$ 28.80$ per set, and this year's sales are expected to be $450,000$ units. Variable production costs for the expected sales under present production methods are estimated at $\$ 10,200,000$, and fixed production (operating) costs at present are $\$ 1,560,000$. WCC has $\$ 4,800,000$ of debt outstanding at an interest rate of $8 \%$. There are $240,000$ shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is $70 \%$, and WCC is in the $40 \%$ federal-plus-state tax bracket.

The company is considering investing $\$ 7,200,000$ in new equipment. Sales would not increase, but variable costs per unit would decline by $20 \%$. Also, fixed operating costs would increase from $\$ 1,560,000$ to $\$ 1,800,000$. WCC could raise the required capital by borrowing $\$ 7,200,000$ at $10 \%$ or by selling $240,000$ additional shares of common stock at $\$ 30$ per share.

On the basis of the analysis in previous parts, and given that operating leverage is lower under the new setup, which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume that there is a fairly high probability of sales falling as low as $250,000$ units. Determine $\mathrm{EPS}_{\text {Debt }}$ and $\text{EPS}_\text{Stock}$ at that sales level to help assess the riskiness of the two financing plans.

Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $\$ 28.80$ per set, and this year's sales are expected to be $450,000$ units. Variable production costs for the expected sales under present production methods are estimated at $\$ 10,200,000$, and fixed production (operating) costs at present are $\$ 1,560,000$. WCC has $\$ 4,800,000$ of debt outstanding at an interest rate of $8 \%$. There are $240,000$ shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is $70 \%$, and WCC is in the $40 \%$ federal-plus-state tax bracket.

The company is considering investing $\$ 7,200,000$ in new equipment. Sales would not increase, but variable costs per unit would decline by $20 \%$. Also, fixed operating costs would increase from $\$ 1,560,000$ to $\$ 1,800,000$. WCC could raise the required capital by borrowing $\$ 7,200,000$ at $10 \%$ or by selling $240,000$ additional shares of common stock at $\$ 30$ per share.

At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it with debt or with stock? {Hint: $\mathrm{V}=$ variable cost per unit = $\$ 8,160,000 / 450,000$, and $\mathrm{EPS}=[(\mathrm{PQ}-\mathrm{VQ}-\mathrm{F}-\mathrm{I})(1-\mathrm{T})] / \mathrm{N}$. Set $\text{EPS}_\text{Stock}$ $=\mathrm{EPS}_{\text {Debt }}$ and solve for Q.}

A company’s fixed operating costs are $430,000, its variable costs are$2.95 per unit, and the product’s sales price is $4.50. What is the company’s break-even point; that is, at what unit sales volume will its income equal its costs?

Tapley Inc, currently has total capital equal to $\$ 5$ million, has zero debt, is in the $40 \%$ federal-plus-state tax bracket, has a net income of $\$ 1$ million, and distributes $40 \%$ of its earnings as dividends. Net income is expected to grow at a constant rate of $5 \%$ per year, $200,000$ shares of stock are outstanding, and the current WACC is $13.40 \%$.

The company is considering a recapitalization where it will issue $\$ 1$ million in debt and use the proceeds to repurchase stock. Investment bankers have estimated that if the company goes through with the recapitalization, its before-tax cost of debt will be $11 \%$ and its cost of equity will rise to $14.5 \%$.

a. What is the stock's current price per share (before the recapitalization)?

b. Assuming that the company maintains the same payout ratio, what will be its stock price following the recapitalization? Assume that shares are repurchased at the price calculated in part above.

Did you know that you can get lots of financial information free of charge? Go to finance.yahoo.com. Use the quote lookup located on the left side to get financial information about any publicly traded company. 1. For your company of choice, obtain the most recent income statement and balance sheet information by clicking on the financials in the bottom left hand corner. 2. Click on competitors to obtain a direct competitor comparison with your company of choice. Select a competing company and obtain their most recent income statement and balance sheet information. 3. Calculate the following risk ratios for both companies for the most recent year. Based on these calculations, which company appears to be more risky? a. Receivables turnover ratio. b. Inventory turnover ratio. c. Current ratio. d. Acid-test ratio. e. Debt to equity ratio. 4. Calculate the following profitability ratios for both companies for the most recent year. Based on these calculations, which company appears to be more profitable? a. Gross profit ratio. b. Return on assets. c. Profit margin. d. Asset turnover. e. Return on equity.