Assignment -
Show all arithmetic, present value keystrokes or Excel entries where relevant. Answer question one and five (5) of the following six (6) questions; do NOT answer all problems
1. (Required and Double-counted) Evaluate the following capital budgeting project by a profitable firm. The firm is considering investment in specialized equipment for a cost of $900 million including installation and modification expenses. The equipment is categorized as a seven-year asset to be depreciated to a zero salvage value. The firm can depreciate 14% of the investment in year one and 25% in year two when the equipment will be sold to another firm for $600 million. The investment is projected to generate $200 million in pre-tax net operating income each year for the two years the equipment is retained. The firm pays income taxes and capital gains taxes at the 35% marginal rate. The firm is profitable and would recapture prior taxes paid or offset taxes to be paid in any year the proposed project is unprofitable. The firm's weighted, average after-tax cost of capital is 5.00% and cost of equity is 7.00%. First, develop the annual after-tax, pre-leverage operating and non-operating cash flow for the investment for year zero, year one and year two. Clearly label all cash flows. Second, derive either the NPV or the IRR for the project and indicate whether and why the project is acceptable or unacceptable.
2. Kohl's Corporation is a retailer. Recently, long-term US Treasury notes yield 2.30%, high-grade corporate bonds yield 3.50%, medium-term debt yields 4.40% and low-grade debt yields 5.40%. The firm's beta is 1.1 based on the average of various financial sites. The median market risk premium (Rm Rf) for the CAPM is 5.70% as of 2017. The firm is rated "Baa2 or BBB" by the major credit rating agencies and the median equity market premium (Rm - Kd) for the bond premium model is 5.00%. The firm is taxed @ 35.0% and relies on long-term debt @ 45% and equity @ 55% of capital. Management project the firm will earn $750 million in 2018 and pay cash dividends of about $400 million. First, estimate the weighted, average, after-tax cost of capital for the firm when relying on retained earnings for equity; estimate the cost of equity by the bond premium model. Second, identify the dollar breakeven point for the firm's cost of capital in 2018 when Kohl's may not rely on retained earnings but must issue common stock given projections of net income and dividends. Third, hów and why should the cost of capital change when Kohl's must rely on common stock v retained earnings when obtaining the pro-rata share of equity?
3. Kohl's pays an annual dividend of $2.20 per share ($.55 per quarter) and generates earnings per share of $3.86 in 2017. Their stock is trading at $40 per share.
- First, what is the dividend yield on Kohl's stock in 2017 based on the current dividend?
- Second, what is the dividend payout by the Company?
- Third, the Company paid a dividend of $1.00 per share in 2012. What is the average, annual growth in dividends between 2012 and 2017 (5 years of growth)?
Finally, if the Company is generating a return on equity of 13.1% this year, estimate the sustainable growth rate for firm given recent dividend payments and compare to the rate earlier derived and note potential financial problems, if any, of dividend policy.
4. Another firm is evaluating investment in specialized equipment that cost $400 million and is projected to generate after-tax and post-leverage cash flow of $80 million per year for seven years. The firm's cost of equity is 7.00% and weighted, average after-tax cost of capital is approximately 4.00%. Determine each of the following capital budgeting metrics and indicate whether and why the equipment should be purchased (or not) by each metric. Reinvest cash flow for the MIRR model at the appropriate benchmark given leverage specification of cash flow.
5. Kohl 's Corporation would like to borrow USD funds on a fixed-rate basis for five years. They can issue a note with a fixed coupon of 3.40% (semi-annual coupon) or a floatingrate note with a coupon of three-month Libor + 1.35% (quarterly coupon). Both notes would be issued at par. Five-year USD interest rate swaps are priced with a bid rate of 2.10% (receive 2.10% and pay three-month Libor quarterly) and an ask rate of 2.13% (pay 2.13% and receive three-month Libor quarterly). Determine the effective annual yield of the fixed-rate note and the floating-rate note when swapped from a floating-rate basis to a fixed-rate. What is the preferable method of borrowing fixed-rate funds?
6. Many US companies (e.g., Apple, ExxonMobil and Verizon) have elected to increase reliance on debt and leveraged their balance sheet over the past five years. First, why would an investment-grade firm want to rely more fully on debt? Second, how and why should the credit rating, bond credit spread or CDS pricing change as firms increase their respective debt ratios? Third, graphically illustrate by application of a loanable funds graph how higher debt ratios engineered by these companies will impact the yield on their bonds. Label the vertical axis with yield and the horizontal axis with dollars, and show the supply curve and demand curve. Note the shift in the applicable supply and/or demand curve consistent with borrowers or companies leveraging their balance sheet and investors reacting to the additional debt. Distinguish the shift for borrowers v. investors.
7. Assume that Kohl's needs additional funding for one-year to finance inventory. The Corporation can borrow from a consortium of Bank's at a fixed rate of 3.0% with the interest discounted or pay supplier bills late on day 90 when terms indicate 1/10/net 60. First, estimate the effective cost of the bank loan and the trade credit given terms and late payment projected. Second, briefly identify the benefits and risks of using either source of short-term credit. Finally, indicate how and why the retailer's working capital conversion cycle would differ, if at all, between relying on the bank loan v. paying suppliers late.