Short Answer and Short Problems

1.      Briefly discuss the most important factors limiting the significant growth of a sole proprietorship or partnership?

2.      Briefly describe the relationship between IRR and NPV.  Highlight the situations where using IRR may lead a firm to select a less than optimal project.

3.       Briefly explain why the YTM of a bond subject to default risk overstates the Expected Return of the bond. 

Use the table for question 4 below.

4.      Calculate the no-arbitrage price for security C that is consistent with the "law of one price."

5.      You invest $25,000 today and are guaranteed to receive $36,000 in five years.  If you need to earn a real return of at least 3% annually what is the maximum inflation rate over the next five years that will allow you to meet your real return objective?

6.      Briefly describe why we focus on NOPAT instead of Net Income when evaluating the performance of a firm.

7.      Your niece's 16^th birthday is today.  As trustee of your grandmother's estate you are required to establish a trust fund for her that will provide annual payments of $50,000 to her and her heirs in perpetuity starting on her 21^st birthday (5 years from today).  The fair rate of interest is 7%.  Calculate the amount you must contribute to the trust fund today to fund the required payments.  Provide a time line and detail your calculation below.

8.       Explain why comparing the ROIC (NOPAT/INVESTED CAPITAL) across different industries can be misleading.

9.       You plan to retire in 30 years.  You plan on saving $20,000 in real dollars annually, starting at the end of this year, for the next 30 years.  You expect to live 35 years during retirement (the first retirement payment will be 31 years from today).  You expect to need to spend $30,000 a year (in real dollars) for four years starting 10 years from today to pay for college tuition for your son and these payments must be paid out of your retirement savings.  If the fair nominal rate of interest is 6.6%, and you expect that inflation will average 2.5% for the next 65 years, how much will you be able to spend annually during retirement in real dollars?

Diagram the cash flows on a timeline below and calculate the values requested in the boxes provided. 

_______Value Today of the Four College Tuition Payments

______Estimated Total Savings at Retirement in 30 years (in Real Dollars)]

_______Estimated Available Annual Retirement Spending (in Real Dollars)

________Estimated First Annual Retirement Withdrawal in Nominal Dollars   

10.  You are refinancing your existing mortgage with a new 30 year mortgage.  The existing mortgage has a $400,000 outstanding balance so the new loan will be for $400,000.  6.5% APR is the current fair market rate on 30 year monthly pay mortgages.  The mortgage company has agreed to give you a $400,000 loan at an APR of 6.25% if you make a lump sum payment at closing of $4,000 to "buy down" the interest rate.  If you plan on staying in the house for five years should you take the offer?  Ignore the impact of taxes.  Use the book's definition of APR.  The APR for each loans is based on an initial principal balance of $400,000.

Support you answer with any relevant calculated values below:

11.  You purchase a six year 5% annual coupon bond at a Market YTM of 6% and a ten year 7% annual coupon bond at a Market YTM of 6%.  Assume you sell both of the bonds at the end of five years. Calculate the effective annual return on each of the bonds assuming you were able to reinvest all the coupons at 7%, and the fair market YTM for both bonds is also 7% at the end of year five.  Assume a par value of $1,000.

Calculate the values requested in the boxes below

________Market Price of the Six Year Bond Today

______Market Price of the Ten Year Bond Today 

____Market Price of the Six Year Bond in Five Years

______Market Price of the Ten Year Bond in Five Years

_____Realized Effective Annual Return on the Six Year Bond

_____Realized Effective Annual Return on the Ten Year Bond

Use and modify the Excel Template posted on Moodle to calculate the NPV.  Use the information below to answer questions 12 & 13.   (Attach a print out of your model for #13.)

After spending $500,000 on research last year to study the potential market for a new specialty chemical, Nelson Industries is considering a new plant requiring an initial investment in new construction and equipment of $8,000,000.  The IRS will require Nelson to depreciate the plant and equipment (land is not depreciable) using the MACRS seven year schedule. The first year of depreciation will be in year one. 

The firm purchased the land to build this plant at a cost of $500,000 ten years ago.  The land could now be sold for $1,000,000.  The project will last eight years and, at the end of eight years they expect to be able to sell the land, plant and equipment for $4,000,000.

The firm estimates that annual gross sales will be 20,000,000 in year one and grow at a rate of 4% per year for the first six years of the project. Then it is estimated that sales will decrease at a rate of 20% per year over the last two years of the project.  The Cost of Goods Sold is estimated to be 75% of sales over the entire period.  General and Administrative expenses are estimated to remain constant at $1,500,000 annually.  This estimate includes an allocation of $250,000 annually in overhead costs that are not actual incremental costs due to the project.  Sales and Marketing expenses are estimated to be 5% of each year's gross sales.

Ongoing net operating working capital requirements for the project are expected to be 45 days of Accounts Receivable to next year's sales, 50 days of Inventory to next year's COGS and 30 days of Accounts Payable to next year's COGS.  20 days of Other Accruals to next year's combined General & Administrative Expenses and Sales & Marketing Expenses.  Assume 365 days for al NOWC calculations.  At the end of the project the working capital will no longer be required so it will be used up during year eight.

12.  Calculate the estimated NOWC by year for each of the four NOWC accounts.  Provide the information in the table below (In thousands):

13.  The Opportunity Cost of Capital for Nelson is 14% and their marginal tax rate is 35%.  Attach your NPV analysis spreadsheet to this document.

Attachment:- Finance Spring 2013 NPV Template.xls