EXAM 1 REVIEW QUESTIONS

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1 EXAM 1 REVIEW QUESTIONS 1) Free cash flow. Consider the following financial statements for United Technologies Corp. What is UT's free cash flow (total cash flow from assets) for 2001? UNITED TECHNOLOGIES: BALANCE SHEET Fiscal Year Ending Assets: Cash $ 3,853 $ 3,700 Marketable Securities $ 698 $ 1,261 Receivables $20,988 $18,866 Inventories $10,108 $ 9,463 Other Current Assets $ 3,273 $ 2,585 Total Current Assets $38,920 $35,875 Prop., Plant & Equip. $63,631 $56,527 Accumulated Deprec. $32,291 $28,291 Net Property. & Equipment $31,340 $28,236 Investment & Adv- to Subs. $17,308 $13,623 Total Assets $87,568 $77,734 Liabilities & Owners Equity: Notes Payable $ 7,602 $ 5,892 Accounts Payable $ 3,367 $ 3,167 Accrued Expenses $11,801 $11,276 Other Current Liab. $ 2,506 $ 1,365 Total Current liabilities $25,276 $21,700 Deferred Charges $ 3,861 $ 3,280 Long-Term Debt $11,943 $10,825 Other Long-Term Liabilities $ 3,656 $ 3,420 Total Liabilities $44,736 $39,225 Common Stock -Net $ 6,357 $ 6,341 Retained Earnings $36,475 $32,168 Total Shareholder Equity $42,832 $38,509 Total Liabilities & Net Worth $87,568 $77,734 INCOME STATEMENT Sales $69,513 $63,438 Cost of Goods Sold $30,723 $27,701 Gross Profit $38,790 $35,737 R&D Expenses $ 6,554 $ 6,827 SGA Expenses $20,709 $21,289 Income before Deprec. & Amort. $11,527 $ 7,621 Interest Expense $ 1,324 $ 976 Deprec. & Amort. $ 4,000 $ 4,500 Income before Tax $ 6,203 $ 2,145 Net Income $ 3,660 $ 1,266 Outstanding Shares 571,391, ,699,837

2 1, ) Your company is considering a potential project that needs $1 million of initial investment. The initial outlay would be depreciated to zero over the 10-year period by the straight-line method. The project is estimated to generate $300,000 of additional EBIT to the company per year. The marginal tax rate would be 34%. What is the payback period of this project? If the maximum acceptable payback period for this kind of projects is four years, would this project be accepted? payback period for the project = 3.36 years The project should be accepted. 3) Family Roadside Equipment is considering a new batting machine. The machine Costs $90,000 and can be depreciated to zero on a straight-line basis over its life of 3 years. The machine is expected to have no salvage value. Revenues are expected to be $45,000 per year, and cost are estimated at $10,000 per year. Operating cash flows are expected to rise with inflation, forecasted at 5% per year. The real interest rate is 4.0%, and given the expected inflation rate, the nominal rate is 9.2%. The firm is in the 34% tax bracket. Calculate the NPV, IRR and payback period for this investment. Should the investment be undertaken? NPV = IRR = 7.97% Payback = 2.59 yrs 4) You are graduating in June and would like to start your own business manufacturing wine bottles. You collect the following information on the initial costs: Cost of Plant and Equipment = $500,000 Licensing and Legal Costs $50,000 You can claim an investment tax credit of 10% on plant and equipment. You also have been left a tidy inheritance that will cover the initial cost, and your estimated opportunity cost is 10%. You estimate that you can sell 1 million bottles a year at $1 a bottle. You estimate your costs as follows: Variable costs/bottle = 50 cents Fixed Costs/ year = $200,000 Adding up state, local, and federal taxes, you note that you will he in the 50% tax bracket. To he conservative, you assume that you will terminate the business in five years and that you will get nothing from the plant and equipment as salvage. (You also use straight-line depreciation.) As a final consideration, you note that starting this business will mean that you will not he able to take the investment banking job you have been offered (which offered $75,000 a year for the next five years). a. Should you take on the project? b. How many bottles do you have to sell to break even on an accounting basis? c. How many bottles do you have to break even on a financial (PV) basis? d. Now assume at the end of 5 years, the equipment has a market value of $58,000. What is the new financial breakeven point?

3 a. NPV of this project = $258,157 NPV of investment banking job = $142,155 Take the investment! b. Q =600,000 c. Q = d. Q = ) You are the manager of a pharmaceutical company and are considering what type of laptops to buy for your sales representatives to take with them on their calls. You can buy fairly inexpensive (and less powerful) older machines for about $2,000 each. These machines will be obsolete in three years and are expected to have an annual maintenance cost of $150. You can buy newer and more powerful laptops for about $4,000 each. These machines will last five years and are expected to have an annual maintenance cost of $50. Assume straight line depreciation to zero salvage value, and tax rate of 34%. If your discount rate is 12%, which option would you pick and why? EAC = EAC = Pick less expensive computers 6) You are the owner of a small hardware store, and you are considering opening a gardening shop in a vacant area in the back of the store. You estimate that it will cost you $50,000 to set up the store and that you will generate $10,000 in after-tax cash flows for the life of the store (which is expected to be 10 years). The one concern you have is that you have limited parking; by opening the gardening shop you run the risk of not having enough parking for customers who shop at your hardware store. You estimate that the lost sales would amount to $3,000 a year and that your after tax operating margin on sales at the hardware store is 40%. If your discount rate is 14%, would you open the gardening shop? NPV = $(4,098) I would not open the store. 7) You are considering test marketing a new breakfast bar that you have just developed. It is estimated that the test marketing will cost approximately $10 million. Based on your prior experiences with similar products, there is a 60% chance that the test market will be successful; if it is, a plant will be built at a cost of $50 million and the product can expect to generate after-tax cash flows of $10 million a year for 10 years; if it is not, the product will be abandoned. The cost of capital is 10%. a. Draw the decision tree for this project. b. Would you do the test market for the project? Why? Build ($50,000,000) : $ 10 million each year for 10 years Plant ($10,000,000).6.4 Abandon Plant

4 NPV of Project = [-50+10A r=.10 t=10 ]/ *0 = $ (3.756) 8) Cash flow analysis: Decision trees. The Quick-Start Company has the following pattern of potential cash flows with their planned investment in a new cold weather starting system for fuel injected cars: If the company has a discount rate of 17%, should the company go ahead with the initial test? NPV 0 = ) Idaho Slopes (IS) and Dakota Steppes (DS) are both seasonal businesses. IS is a downhill skiing facility, while DS is a tour company that specializes in walking tours and camping. The returns on each company over the next year is expected to be: Economy Idaho Slopes Dakota Steppes Strong Downturn -10% 2% Mild Downturn -4% 7% Slow Growth 4% 6% Moderate Growth 12% 4% Strong Growth 20% 4% a) Find the mean and variance of returns for each company. b) Find the covariance and correlation of returns for the two companies.

5 c) If IS and DS are combined in a portfolio with 50% invested in each, find the portfolio expected return and standard deviation. IS = 4.4 DS = 4.6 s 2 IS = s 2 DS = s DS = r IS,DS = r p = 4.5 s P = = ) (Question #10 is for Tuesday class only!) Kindercare Inc. has a beta of The risk free rate is 6% and the expected return on the market portfolio is 14.5%. The company presently pays an annual dividend of $5 per share, and investors expect it to experience a growth in dividends of 1% per annum for many years to come. a. What is the stock s present market price per share, assuming the required rate of return is determined by the CAPM? b. Consider an alternative investment in the stock of Maxicare Inc. Maxicare has an expected return of 15% and a beta of 1.5. Should you purchase this stock? (why or why not?) a. P = b.compare risk reward ratios: expected return is too low relative to systematic risk, dont buy Maxicare. Or, from CAPM: Since return is lower than that predicted by CAPM (below security market line), don t buy it. 11) (Question #11 is for Tuesday class only!) The risk-free rate is 5.5%, and the market portfolio has an expected return of 14%. The market portfolio has a standard deviation of 10%. Stock Z has a correlation coefficient with the market of 0.2 and a standard deviation of 12%. According to the CAPM, what is the expected rate of return on stock Z? r z =7.54%

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