SECTION 1: SHORT ANSWER PROBLEMS

1. Vindaloo Corporation reported retained earnings of $400 on its year-end 2002 balance sheet. During 2003, the company reported a loss of $40 in net income, and it paid out a dividend of $60. We will calculate retained earnings for Vindaloo's 2003 year-end balance sheet.

2. A firm has an ROA of 8%, sales of $100, and total assets of $75. What is its profit margin?.

3. Given the following information: profit margin = 10%; sales = $100; retention ratio = 40%; assets = $200; equity multiplier = 2.0. If the firm maintains a constant debt-equity ratio and no new equity is used, what is the maximum sustainable growth rate (SGR)? (Assume a constant profit margin.)

4. Your brother-in-law invests in the stock market and doubles his money in a single year while the market, on average, earned a return of only about 15%, here a discussion is done whether  your brother-in-law's performance a violation of market efficiency or not.

5. Iggie's Used Cars will sell you a 2002 Suzuki Aerio for $3,000 with no money down. You agree to make weekly payments of $40 for two years, beginning one week after you buy the car. What is the EAR of this loan?

6. The Rebus Co. is trying to decide between the following two mutually exclusive projects:

The only requirement the company has is that any project that is accepted must produce a minimum rate of return of 11%.

Calculate payback period, discounted payback period, IRR and NPV, as well as any other measures which would be helpful.

Fill in the following table with your results:

What should the company do and why?

Section 2 - PROBLEMS

Problem 1 -

a. Suppose that current assets, costs, and accounts payable maintain a constant ratio to sales. The firm retains 40% of earnings.

i. If the firm is producing at full capacity, what is the total external financing needed if sales increase 25%, assuming fixed assets increase proportionately with sales?

ii. If the firm is producing at only 90% capacity, describe how this would impact your answer. You don't need to do a calculation, but it may help you to explain your reasoning.

b. Suppose the firm wishes to maintain a constant debt-equity ratio, retains 60% of net income, and raises no new equity. Assets and costs maintain a constant ratio to sales. What is the maximum increase in sales the firm can achieve?

Problem 2 - The managers of Magma International, Inc. plan to manufacture engine blocks for classic cars from the 1960s era. They expect to sell 250 blocks annually for the next five years. The necessary foundry and machining equipment will cost a total of $800,000 and belongs in a 30% CCA class for tax purposes. The firm expects to be able to dispose of the manufacturing equipment for $150,000 at the end of the project. Labour and materials costs total $500 per engine block, fixed costs are $125,000 per year. Assume a 35% tax rate and a 12% discount rate.

a. What is the depreciation tax shield in the third year for this project?

b. What is the present value of the CCA tax shield?

c. What is the minimum bid price the firm should set as a sale price for the blocks if the firm were in a bidding situation?

d. Assume that management believes that auto restorers will pay $3,000 retail per engine block. What is the NPV of this project?

Problem 3 - King's Mfg. Inc. has 12,000 bonds outstanding that have a 6% coupon rate. The bonds are selling at 98% of face value, pay interest semi-annually, and mature in 28 years. There are 400,000 shares of 9% $100 preferred stock outstanding with a current market price of $83 a share. In addition, there are 1.40 million shares of common stock outstanding with a market price of $54 a share and a beta of 1.2. The common stock paid a total of $1.80 in dividends last year and expects to increase those dividends by 4% annually. The firm's marginal tax rate is 34%. The overall stock market is yielding 12% and the Treasury bill rate is 4.0%.

a. What is the cost of equity based on the dividend growth model?

b. What is the cost of equity based on the security market line?

c. What is the cost of financing using preferred stock?

d. What is the pre-tax cost of debt financing?

e. What weight should be given to equity in the weighted average cost of capital computation?

f. What would be the cost of new financing (including the impact of each of 28-year bonds, preferred shares and common shares), assuming that flotation costs would be 5% of the proceeds of the issue?

g. If net income in the next year is expected to be $8,000,000, what would be the common equity breakpoint for new financing, assuming the current capital structure is considered optimal?