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1 d) JBC could adopt a constant dividend payout percentage. Annual earnings would be multiplied by this percentage to identify total cash dividends for the year. Per-share dividends would be this total amount divided by the number of shares outstanding. Under this policy, per-share dividends fluctuate from year to year, with earnings. Shareholders do not have the stable cash flows they receive under the current constant-dollar dividend policy. JBC could also adopt a residual dividend payout policy. Dividends would then be paid only after all positive NPV projects had been undertaken. That is, only residual funds are paid out and the rest is retained in the firm for reinvestment. Under this policy, annual dividends fluctuate with annual investment opportunities, with given levels of earnings. Again, shareholders are unlikely to have the stability of dividends that they enjoy under the current policy. CHAPTER SIX Qualitative Questions Question 1 Sponsors guarantee that the project will be completed on time and will meet certain specifications or quality tests. Sponsors guarantee the supply of raw materials to the project during or after completion. Sponsors guarantee purchasing part or all of the output from or services of a project. Sponsors effectively guarantee the project against default. Question 2 Calculate the cash flows obtained from the project assuming the project will be financed with all equity (unlevered project). Determine the cost of capital assuming an all-equity firm. Discount the unlevered cash flows by the unlevered cost of equity. Question 3 Calculate the base-case NPV (all equity). Calculate the incremental cash flows obtained if the firm uses a source other than equity to finance the project. Determine the after-tax cost of debt for the firm. Determine the interest tax shield. Discount the present value of incremental cash flows at the after-tax cost of debt. Add the present value of the finance-related benefits and costs to present value from the base-case NPV. Question 4 Leasing uses up the firm s debt capacity in the same manner as debt. Lease payments magnify the variability of the net cash flows to shareholders. Leasing allows the lessee to avoid the investment outlays that would be required to purchase. Leasing requires periodic cash outflows similar to those required to service debt. Question 5 The entire periodic lease payment can be claimed as a tax-deductible expense. Lessees cannot claim capital cost allowances on the leased equipment. The lessee loses the advantages derived from the asset s residual value. Solutions to Self-Test Questions 55

2 Question 6 Identify the costs and benefits of leasing as opposed to those of borrowing to buy. Discount the incremental costs and benefits of leasing at the after-tax cost of debt or a higher rate, depending on risk. Identify an equivalent loan that exactly commits the firm to the same cash outflows that the lease would. Leasing is preferable to borrowing if the amount of the equivalent loan is less than the initial investment outlay saved under the lease. A positive net present value of leasing means the firm should lease rather than borrow to buy. Question 7 In the case of an operating lease, the lessor is entitled to claim capital cost allowance for the equipment. The leased equipment provides more security than a mortgage, enabling risky customers to qualify for leasing. Costs of leasing may be lower than borrowing. Leasing may allow a company to finance the acquisition of equipment in spite of restrictive covenants included in the firm s loan agreements or bond indentures. Question 8 The production cost per unit decreases, allowing the firm to decrease its price. A firm may acquire component manufacturers that cannot afford to invest in technological improvements. Creditors are more willing to lend to bigger companies than to medium or small ones. The cost per dollar of new funds decreases with the size of the issue, as some costs are fixed. Question 9 Identify cases in which acquired companies or assets are similar to the target firm or assets. Calculate ratios based on the offer price. Determine for each ratio the lowest and highest value it took during past mergers. Identify an offer price that falls within the common range. Question 10 Buyers commit very little capital and borrow the balance. The target company s assets serve as security for the loans taken out by the acquiring firm. Buyers hope to achieve quick improvement in operations and higher residual cash flows. High leverage enables the owners, if successful, to gain substantial wealth from improving the operating performance of their firms. If the owners are unsuccessful in improving operating performance, the LBO will have difficulty servicing its debt and may go bankrupt. Question 11 LBOs require very little capital and large amounts of debt by pledging the acquired company s assets as collateral. Senior debt is provided by financial institutions. Subordinated debt is provided by life insurance companies or by special funds, such as pension plans. Preferred shares are used when a firm exhausts its ability to use interest tax shields. 56 Solutions to Self-Test Questions

3 Qualitative Multiple Choice Questions Question 1 i) A firm that uses well-known, mature production technology Question 2 i) The main disadvantage of the APV method is that it discounts the cash flows that will be used to pay debtholders at the rate required on the unlevered firm s equity. Question 3 i) Vertical mergers are attractive if the activity is complex and difficult to define under conventional legal contracts. Question 4 iii) The WACC method assumes that the debt-to-equity ratio will be constant over time. Question 5 i) A horizontal merger Question 6 iv) Diversification Question 7 iii) Some leases require the lessor to handle all maintenance and servicing. Question 8 i) Operating leases enable the lessor to claim the investment tax credits and tax deductions associated with ownership. Question 9 i) Creating a class of shares with superior voting powers, such as 10 votes per share Quantitative Multiple Choice Questions Question 1 i) The appropriate discount rate is the after-tax cost of debt = 6%(1-0.35) = 3.9%. Question 2 iv) $70,000 [1 + PVIFA (15%, 4 years) ] - $70,000(0.35) PVIFA (15%, 5 years) This includes the annuity due of payments, which start immediately at the beginning of each period, less the tax shields on these payments, which do not occur until the end of each period. Question 3 iii) b L = b U + (1 - T )a D E b b U 1.35 = b U + (1-0.4)a b b U = 1.6b U b U = = b Lnew = (0.6)a 0.33 b( ) = Required return on the new project, using CAPM = ( ) = 11.7% Solutions to Self-Test Questions 57

4 Quantitative Problems Problem 1 a) Analysis of investment proposal: APV Initial investment $ (10,000,000) If the project is financed with all equity, the PV of the operating cash flows is: (revenues - variable costs) (1 - tax rate) PVIFA (15%, 15 years) = (4,000,000-2,500,000)(1-0.4)(5.847) = $900,000(5.847) 5,262,300 PV of CCA tax shields: {8,500,000(0.2) (0.4) / [2( )]} (2.15/1.15) = 971,429(1.87) 1,816,572 PV of operating cost subsidies after tax: 250,000(1-0.4) PVIFA (6% (1-0.4), 15 years) = 150,000 PVIFA (3.6%, 15 years) = 150,000(11.436) 1,715,400 PV of flotation costs, after tax: 350, ,000 (0.4) * PVIFA 5 (3.6%,5 years) = 350,000-28,000 * = 350, ,056 PV of interest tax shields: (223,944) 5,000,000(0.06)(0.4) PVIFA (3.6%, 15 years) 120,000(11.436) 1,372,320 PV of expected salvage value for land and building: 1,500,000 PVIF (3.6%, 15 years) = 1,500,000(0.588) 882,000 APV $ 824,648 As the APV is positive, the investment proposal should be accepted. b) The tax deductibility of interest is accounted for differently in the APV and WACC capital budgeting methods. In the APV method, the present value of the interest tax shield is added to the base-case NPV. When calculating NPV under the WACC method, the tax deductibility of interest expense is accounted for by averaging the cost of equity and the after-tax cost of debt to obtain the WACC. That is, the cost of debt is calculated on an after-tax basis. Problem 2 This question involves an adjusted present value (APV) analysis of an investment proposal that has financing side effects. a) The cost of equity for SIGMA without the plant expansion is calculated using the unlevered beta and the capital asset pricing model: Cost of equity = 6% + 1.1(10% - 6%) = 10.4% 58 Solutions to Self-Test Questions

5 The plant expansion proposal involves a change in capital structure, including debt financing. The levered beta will be: (1-0.35) a 25 (1.1) = = b So the cost of equity, if the plant expansion proposal is accepted, will be: 6% (10% - 6%) = 11.4% b) Without the plant expansion, SIGMA is 100% equity financed, so the weighted average cost of capital equals the unlevered cost of equity for SIGMA, or 10.4%. With the plant expansion, SIGMA is financed 25% with debt and 75% with equity. The weighted average cost of capital is: WACC = 0.25(7.5%)(1-0.35) (11.4%) = 9.8% The rate with the plant expansion is lower than the unlevered cost of equity. This is a result of the after-tax cost of debt financing. Note that the market rate of interest and the levered cost of equity are used in this calculation. c) Reasons that APV is more appropriate than NPV in this case are: The project qualifies for a subsidized loan. The project has a different capital structure than the firm as a whole. The project has partial debt financing, which provides SIGMA with interest tax shields. d) Base-case NPV is calculated using the unlevered cost of equity as the discount rate: Investment outlay = $600,000 PV of incremental operating revenues = 120,000(1-0.35) PVIFA (10.4%, 7 years) = 78,000( ) = $374,787 $600,000(0.2)(0.35) PV of CCA tax shields = * ( ) = 69,079( ) = $131,650 Base-case NPV = $(600,000) + 374, ,650 = $(93,563) e) For APV, add the PV of the two side effects, using the after-tax cost of debt at the market rate for SIGMA as the discount rate 7.5%(1-0.35) = 4.875%. PV subsidy = 2.5%(600,000)(1-0.35) PVIFA (4.875%, 7 years) = $56,673 PV interest tax shield = 5%(600,000)(0.35) PVIFA (4.875%, 7 years) = $61,033 PV side effects = 56, ,033 = $117,706 APV = base-case NPV + PV side effects = $(93,549) + 117,706 = $24,157 The APV is positive so the project is acceptable. Problem 3 The equity residual method is to be used to assess the investment project proposal. Under this method, the cash flows from operations are those that can be distributed to shareholders after paying interest, taxes, and principal payments on the debt. Solutions to Self-Test Questions 59

6 Background Calculations: Debt financing at start of project = (0.75) ($15,000,000) = $11,250,000 Debt principal repaid at end of each year = $11,250,000 4 Schedule of debt payments annual interest and principal repayments: = $2,812,500 Interest + principal Remaining Year Interest repaid principal (11,250,000) = $675,000 $3,487,500 $8,437, (8,437,500) = 506,250 3,318,750 5,625, (5,625,000) = 337,500 3,150,000 2,812, (2,812,500) = 168,750 2,981,250 0 NPV Calculations: Present value of operating earnings, discounted at levered cost of equity of 16%: (7,000,000-1,220,000) (0.5) PVIFA (16%, 4 years) = $2,890,000(2.7982) = $8,086,798 Present value of principal payments to debt holders: 2,812,500 PVIFA (16%, 4 years) = 2,812,500(2.7982) = $7,869,938 Present value of interest payments, after tax: Year Interest Interest, after tax PV factor PV 1 $675,000 $337, $290, , , , , , , ,750 84, ,600 Total PV = $633,800 Present value of CCA tax shields: (0.3)(0.5) $15,000,000e [2( ) fc d = $2,445,652( ) = $4,553,975 Present value of CCA tax shields lost on salvage: (0.3)(0.5) [$2,500,000 PVIF (16%, 4 years) ] c ( ) d = $2,500,000(0.5523)( ) = $450,249 Present value of salvage value: $2,500,000 PVIF (16%, 4 years) = $2,500,000(0.5523) = $1,380,750 NPV = -15,000, ,250, ,086,798-7,869, , ,553, , ,380,750 = 1,317,536 The NPV is positive. This project should be undertaken. 60 Solutions to Self-Test Questions

7 Problem 4 a) NVL = initial investment outlay - equivalent loan Equivalent loan = PV(after-tax lease payments) - PV(operating costs) + PV(CCA tax shields) + PV(salvage value) Discount rate = 10%(1-40%) = 6% Because the series of lease payments occur at the beginning of the year, the present value of the annuity due is calculated as follows: $28,000 PVIFA (6%, 10 years) 1.06 = $218,447 The tax shield due to the lease payment each year: $28, = $11,200 The present value of the tax shield due to lease payments at the after-tax cost of debt: $11,200 PVIFA (6%, 10 years) = $82,433 The present value of the lease payments on an after-tax basis: $218,447 - $82,433 $136,014 The present value of after-tax operating costs for the owning alternative: $1,000(1-40%) PVIFA (6%, 10 years) (4,416) The present value of CCA tax shield available on purchase of the asset: 200,000(30%)(40%)[ (6%)] (30% + 6%)(1 + 6%) - 20,000(30%)(40%) (1 + 12%) 10 (30% + 6%) 62,634 The present value of the salvage value lost by leasing would be: $20,000 (1 + 12%) 10 6,439 Equivalent loan $200,671 NVL = $200,000 - $200,671 = $(671) < 0 Since the net value to leasing is negative, LaSalle should not lease the asset. b) The firm will be indifferent between leasing and buying if NVL = 0. Initial investment outlay = equivalent loan = PV(after-tax lease payments) - PV(after-tax operating costs) + PV(CCA tax shields) + PV(salvage value) PV(after-tax lease payments) = initial investment outlay + PV(after-tax operating costs) - PV(CCA tax shields) - PV(salvage value) = $200,000 + $4,416 - $62,634 - $6,439 = $135,343 Solutions to Self-Test Questions 61

8 Problem 5 Let X = pre-tax annual lease payment: X * PVIFA (6%,10) (1.06) - X (0.4) * PVIFA (6%, 10) = $135,343 X = $27,862 Sudbury Corporation Analysis of Project Proposals Evaluating the Project as a Single Project Unlevered beta for the comparable company: D b L = b U + (1 - T) b E U = b U + (1-0.4) b 0.5 U 1.2 b U = = The levered beta for the new project is: b L = (1-30%) a 30% (0.75) = % b Using the CAPM, the required rate of return on the new project is: r = r f + b L (r m - r f ) = 5% + (0.975)(10% - 5%) = 9.875% The expected return on the new project is 11%, which exceeds the risk-adjusted required rate of return. Therefore, the new project should be accepted on its own merits. Evaluating the Project in Relation to Our Portfolio We also need to consider whether adding the new project would increase the risk of our whole portfolio. The total risk of the portfolio after adding the new project is: s P = ca 7 9 b 2 (2%) 2 + a 2 9 b 2 (3%) a 7 9 ba2 9 b(0.9)(2%)(3%) d 1/2 = 2.175% The expected rate of return on the portfolio after adding the new project is: a 700, ,000 b(10%) + a b(11%) = 10.22% 900, ,000 The coefficient of variation of the portfolio after adding the new project is: CV = 2.175% 10.22% = After adding the new project, the degree of risk of the whole portfolio increases marginally from 0.2 to Summary In general, if a firm has a well-diversified portfolio of projects, any new project should be evaluated on its own merits. In other words, only the market risk of a new project 62 Solutions to Self-Test Questions

9 represented by beta should be taken into account. However, if a firm is not welldiversified and/or there is a high correlation between the returns from the firm s existing portfolio of projects and the new project, as exhibited in this case, the financial manager should consider the total risk of the portfolio. Cases Case 1: Victoria Corp. This minicase involves integrating material learned in Chapters 1, 2, and 6. This capital budgeting problem involves more than one asset class, CCA effects of salvage value, various capital budgeting techniques, and also the option of leasing one of the two assets under consideration. a) PV of costs of purchasing and operating Brand X equipment: Initial outlay = $700,000 Annual operating and maintenance costs = $35,000 per year for 4 years Salvage value = $100,000 PV = PVIFA (12%, 4) PVIF (12%, 4) - PV(CCA tax shields) = (0.55)(3.0373) - 100(0.6355) - PV(CCA tax shields) = PV(CCA tax shields) = PV of CCA tax shields The pool continues to have assets and a positive balance after salvage, so salvage value is deducted from costs and remaining CCA tax shields forgone are added to costs, as follows: = (0.2)(0.45) [2( )] a b * PVIF (0.45) (4,12%)(0.2) ( ) = * (0.6355)( ) = = $526,520 PV of costs of purchasing and operating Brand Y equipment: PV = (0.55) PVIFA (12%, 4) - 80 PVIF (12%, 4) - PV(CCA tax shields) = (0.55)(3.0373) - 80(0.6355) - PV(CCA tax shields) = PV(CCA tax shields) = PV(CCA tax shields) Since the pool has no other assets in this class, depreciation must be calculated for this individual asset each year, and then salvage value must be compared with UCC at time of salvage to determine residual tax effects. The detailed calculations shown here were not required for marks. CCA for Brand Y equipment: In year 1, = 0.25 (550,000) = $68,750 2 In year 2, = 0.25(550,000-68,750) = 0.25(481,250) = $120,313 In year 3, = 0.25(481, ,313) = 0.25(360,938) = $90,234 In year 4, would be 0.25(360,938-90,234) = 0.25(270,704) = $67,676 UCC at time of salvage would be $203,028 but the actual salvage value is only $80,000. There is a terminal loss of $203,028 - $80,000 = $123,028. PV(costs) = (0.45) PVIF (12%, 1) Solutions to Self-Test Questions 63

10 (0.45) PVIF (12%, 2) (0.45) PVIF (12%, 3) (0.45) PVIF (12%, 4) (0.45) PVIF (12%, 4) PV(costs) = (0.8929) (0.7972) (0.7118) (0.6355) (0.6355) PV(costs) = = The present value of costs for Brand X is higher than for Brand Y. Brand Y should be selected. The present value of CCA tax shields would have to exceed = $59.55 for Y to have lower costs than X. b) If there is a leasing alternative for Brand Y, its costs must be calculated and compared with the purchase cost for Brand Y. PV of costs of leasing include lease payments, after-tax, plus annual operating costs, aftertax. There are no maintenance costs as these are included in the lease payment. There are no salvage value or CCA effects as these are captured by the owner of the asset. PV(leasing costs) = $347 [1 + PVIFA (12%, 3) ] (347) PVIFA (12%, 4) + 40(1-0.45) PVIFA (12%, 4) = 347( ) - 156(3.0373) + 22(3.0373) = 1, = or $773,400 The Brand Y equipment is the most expensive under the leasing alternative. Leasing Y costs more than buying either X or Y. Brand Y should be selected and the equipment should be purchased. The leasing alternative did not change the decision. Case 2: Saskatoon Industries A firm has decided to acquire a major piece of equipment and must now decide whether to purchase or lease it. The problem involves an investment tax credit, an uncertain salvage value, and differences in who bears the costs of maintenance and insurance under the two financing alternatives. a) WACC = 0.5(7%)(1-0.4) + 0.5(14%) = = 9.1% The after-tax cost of debt is 7%(1-0.4) = 4.2%. The required return on equity is 14%. The firm is financed 50/50 with debt and equity and is assumed to stay this way. b) There will be two discount rates used in the analysis. Certain items, like contractual debt or lease payments and their tax shields, will be discounted at the after-tax cost of debt of 4.2%. Uncertain items, in this case the salvage value, will be discounted at the weighted-average cost of capital of 9.1%. This rate will be used both to take the present value of the salvage value, and to calculate the impact on the CCA tax shields of salvaging the asset for this amount. c) The net value to leasing has several components, as follows: Initial investment outlay = purchase price - investment tax credit = 0.95(purchase price) = 0.95($690,000) = $655,500 Equivalent loan = PV(lease payments) - PV(tax shields on lease payments) - PV(maintenance and insurance costs saved, after tax) + PV(CCA tax shields if buying the asset and keeping it indefinitely) 64 Solutions to Self-Test Questions

11 + PV(lease payments) - PV(CCA tax shields lost on salvage) + PV(expected salvage value) + PV(investment tax credits lost under the lease option) = $200,000[1 + PVIFA (4.2%, 4 years) ] = $200,000( ) $922,600 - PV(tax shields on lease payments) = 0.4($200,000) PVIFA (4.2%, 5 years) = $80,000(4.427) (354,160) - PV(maintenance and insurance costs saved, after tax) = $40,000(1-0.4) PVIFA (4.2%, 5 years) = $24,000(4.427) (106,248) + PV(CCA tax shields if buying the asset and keeping it indefinitely) = c $655,500(0.2)(0.4) da ,327 2( ) b - PV(CCA tax shields lost due to salvage) = (0.2)(0.4) $200,000 * PVIF (9.1%, 5 years) * c ( ) d = $200,000(0.647)(0.331) (42,831) + PV(expected salvage value) = $200,000(0.647) 129,400 + PV(lost investment tax credits) = 0.05($690,000) 34,500 Equivalent loan $795,588 Net value to leasing = initial outlay - equivalent loan = $690, ,588 = $(105,588) d) A summary should include: description of project under consideration explanation of type of analysis that was conducted (NVL) summary of numerical results explanation of results and implication for the decision The conclusion is that the lease alternative displaces $795,588 of conventional debt, so it is too costly. The borrowing to purchase alternative is less expensive. It is recommended that the firm finance its equipment acquisition by borrowing. Case 3: East Travel Ltd. a) Jane should buy ET shares on January 16, 2007, the dividend-on date. b) ET should take the following factors into account when it determines how much cash to pay out as dividends: Investment requirement: ET should put aside sufficient cash to invest in new projects. Signalling effect: ET should set the cash dividend at a level that can be supported by its expected future earnings so that it won t send a negative message by cutting cash dividend in the future. Clientele effect: ET should review the composition of its shareholders and whether its different shareholders would prefer cash dividend or capital gain due to their tax profile. Legal restrictions may be imposed by legislative authorities. Investors may impose restrictive constraints in the form of protective covenants included in debt and preferred share contracts. c) Share repurchase from the market may be the most appropriate substitute for cash dividends in this particular situation. Solutions to Self-Test Questions 65

12 From the perspective of the company, ET s share price must have been depressed as its industry was in a downturn. Now is a good time to repurchase the shares to provide support for the share price. From the perspective of the shareholders, a share repurchase gives them greater tax efficiency: with cash dividends, they have to pay tax, now at a higher tax rate than that for capital gains; with a share repurchase, they are taxed only if they sell their shares and realize a capital gain. d) This is an example of horizontal merger. e) Any two of the following: Operating economies of scale and/or scope to lower operating costs Strategic motives to eliminate a competitor Market power and control over pricing policies Faster growth to be a dominant player in the industry f) Solution Case Exhibit 6-1 Ranges of Possible Offer Prices for WT Shares Minimum Maximum Level of Prior Offer Prior Offer item considered WT item ratio price ratio Price Share price $ % $ % $50.75 Earnings per share Cash flow per share Book value per share Replacement cost per share A reasonable range of share price should be $48.75 to $ Case 4: Asian Auto Co. a) The adjusted present value (APV) method separates the cash flows of a project into two sets. The first set contains the cash flows that would be obtained from the project if it were unlevered; that is, financed with all equity. The second set contains the incremental cash flows that would be obtained if the firm were to use a source of funds other than equity to finance the project. Each cash flow is discounted at a rate that reflects its inherent risk. The traditional weighted average cost of capital method is used to incorporate the finance-related effects into investment analysis. The equity residual method is a valuation method that first determines the cash flows that can be distributed to shareholders after paying operating costs, financing costs, and debt repayments, and then calculates the present value of these cash flows by discounting at the cost of equity. In this particular case, at the beginning, AA will finance the project with equity, and this excludes the weighted average cost of capital method. Then the government financial incentives play an important role in AA s decision to locate the assembly in Ontario. Only the adjusted present value method can determine the value of the government financial incentives. b) The discount rate should be the rate of return required by shareholders; that is, the cost of equity, as AA will use equity capital to finance this project. We apply the CAPM model to estimate the cost of equity based on the information in the problem. In the following equation: E(R) = R f + b[e(r M ) - R f ] = 4% + b(5%) 66 Solutions to Self-Test Questions

13 b is unknown and calculated as follows: From the industry leveraged b L = , we get the industry unleveraged b U : b L b U = 1 + (1 - T)a D = E b 1 + (1-50%)a 50% = % b Applying AA s debt ratio and tax rate to the industry unleveraged b U, we get AA s leveraged b L : b L = b U + (1 - T)a D E b b U = (1-40%)a 40% 60% b = 1.2 The discount rate = 4% + (1.2)(5%) = 10%. The initial investment for the U.S. location is just the cost of equipment; that is, $800 million. For the Ontario location, there is additional investment in a building; thus, the total initial investment will be $800 million + $200 million = $1,000 million. The annual after-tax operating income (cash flow) = 100,000($30,000)(6%) = $180 million for the U.S. location. The present value of the 10-year after-tax operating cash flow = $180 million PVIFA (10%, 10) = $1,106 million. For the Ontario location, the annual after-tax operating cash flow = 100,000($30,000)(6.6%) = $198 million. The present value of the 10-year after-tax operating cash flows = $198 million PVIFA (10%, 10) = $1,216.6 million. The present value of the CCA tax shields from the equipment over the 10 years equals: a $800 million * 40% * 20% 2(10% + 20%) This is also the present value of the total CCA tax shields for the U.S. location. For the Ontario location, there is also the present value of the CCA tax shields from the building: a $200 million * 40% * 4% 2(10% + 4%) The total present value of the CCA tax shields for the Ontario location is: $ million + $21.82 million = $ million The net present value of the plant in the U.S. location is: $1,106 million + $ million - $800 million = $ million For the plant in the Ontario location: ba % b = $ million % ba % b = $21.82 million % NPV = $1,216.6 million + $ million - $1,000 million = $ million As $ million > $ million, AA should choose the U.S. location. c) The after-tax market interest rate 6%(1-40%) = 3.6% is used to calculate the present value of the governments financial incentives. The present value of the federal government s low-interest loan subsidy is: $100 million - $100 million (4%)(1-40%)PVIFA (3.6%, 10) - $100 million PVIF (3.6%, 10) = $100 million - $19.86 million - $70.21 million = $9.93 million The present value of the provincial government s operating subsidies is: $25 million(1-40%) PVIFA (3.6%, 5) = $67.53 million Solutions to Self-Test Questions 67

14 Taking the financial incentives from the governments into account, the NPV of the plant in the Ontario location will be: $ million + $9.93 million + $67.53 million = $ million As $ million > $ million, AA should choose the Ontario location. CHAPTER SEVEN Qualitative Questions 1. What types of interest rate risk may a treasury risk manager face? The risk that interest on a planned investment or loan deviates from the expected rate The risk that realized net income deviates from expected income because of changes in interest rates The risk that the value of an asset or liability changes adversely because of changes in interest rates 2. What other types of risk can a treasury risk manager face? The risk that net income deviates from expected income because of changes in the prices of key commodities The risk that net income deviates from expected income because of changes in foreign exchange rates 3. How is duration used to measure risk? The volatility of a security s value depends upon the security s duration. The longer the duration of a security, the more volatile its value will be in response to changes in interest rates. The duration of a portfolio is a weighted average of the durations of the assets and liabilities that make up the portfolio. The duration of a portfolio measures the sensitivity of the portfolio s value to changes in interest rates. 4. How is gap analysis used to measure interest-rate risk in financial institutions? Gap analysis attempts to identify gaps between assets and liabilities that expose the institution to interest-rate risk. An asset is interest rate sensitive if the asset is repriced when rates change. The gap is equal to rate-sensitive assets less rate-sensitive liabilities. If the gap is negative, net income decreases if rates rise and increases if rates drop. The magnitude of the potential decrease or increase in net income is proportional to the size of the gap. 5. How are gap analysis and duration calculations used to create basic hedges? Determining the gap between rate-sensitive assets and rate-sensitive liabilities allows management to create a basic hedge by narrowing the gap. Gap analysis will not eliminate risk because a true matching of asset rates and terms with liability rates and terms is unlikely. The duration calculation allows management to match asset duration to liability duration. Matching durations is a form of hedging known as portfolio immunization. 6. What are the general approaches to risk management? The opportunistic approach relies on management to have a superior ability to forecast financial or commodity prices, which will enable the firm to benefit from the changes. The passive approach ignores risk and relies on the company riding out changes, assuming that gains or losses will balance out. 68 Solutions to Self-Test Questions