61FIN2FIM - FINANCIAL MANAGEMENT

TUTORIAL 9– CAPITAL BUDGETING

Short Answer Questions

Use the following information to answer question 1 - 10

Projects A and B have the same expected lives and initial cash outflows. However, one project's cash flows
are larger in the early years, while the other project has larger cash flows in the later years. The following
NPV profiles of two mutually exclusive project A and B are provided as below

1. At the discount rate of 10%, which project should be undertaken under NPV criterion?

2. At the discount rate of 13%, which project should be undertaken under NPV criterion?

3. At the discount rate of 10%, which project should be undertaken under IRR criterion?

4. At the discount rate of 13%, which project should be undertaken under IRR criterion?

5. From what discount rate, the NPV and IRR methods yield the same decision?

6. From what discount rate, the NPV and IRR methods provides conflict decisions?

7. As a financial manager, you expect that the discount rate of 10% should be used to evaluate the two
projects. Which project should you pick?
8. As a financial manager, you expect that the discount rate of 13% should be used to evaluate the two
projects. Which project should you pick?

9. Which project has larger cash flows in the later years?

10. At what discount rate, the NPV of the two projects are the same?

11. What are independent projects? Mutually exclusive projects?

12. What is reinvestment rate used in IRR calculation? NPV calculation?

13. Why NPV is superior to IRR?

14. What are some problems of using IRRs in capital budgeting?

15. What criteria are used to measure project’s liquidity and what criteria are used to measure project’s
profitability?

Part 2 - Problems

1. Project K costs $52,125, its expected cash inflows are $12,000 per year for 8 years, and its WACC is 12%.

A. Calculate the project’s NPV.

B. Calculate the project’s IRR.

C. Calculate the project’s payback.

D. Calculate the project’s discounted payback.

E. Should the project be undertaken?

2. Your division is considering two projects with the following cash flows (in millions):

A. What are the projects’ NPVs assuming the WACC is 5%? 10%? 15%?

B. What are the projects’ IRRs at each of these WACCs?

C. Draw NPV profiles for the two projects.

D. Calculate the cross-over rate.

E. Based on the examination of NPV profile and given that the WACC was 5% and A and B were mutually
exclusive, which project would you choose? What if the WACC was 10% or 15%?

3. A firm with a 14% WACC is evaluating two projects for this year’s capital budget. After-tax cash flows,
including depreciation, are as follows:

A. Calculate NPV, IRR, payback, and discounted payback for each project.

B. Assuming the projects are independent, which one(s) would you recommend?

C. If the projects are mutually exclusive, which would you recommend?

4. Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the
units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC and LCC
(for high and low capital costs, respectively). HCC has a high capital cost but relatively low operating costs,
while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the
units are shown here. Kim’s WACC is 7%.

A. Which unit would you recommend? Explain.

B. If Kim’s controller wanted to know the IRRs of the two projects, what would you tell him?
 FIN5FMA - FINANCIAL MANAGEMENT
TUTORIAL 10– DIVIDEND POLICY
Part 1: Indicate whether each of the following statement is TRUE or FALSE.

1. The dividend irrelevance theory, proposed by Miller and Modigliani, says that as long as a firm pays a
dividend, how much it pays does not affect either its cost of capital or its stock price.

2. Managers, on average, do not raise dividends unless they believe future earnings will be able to sustain the
higher level dividends.

3. Firms with a large number of acceptable capital budgeting projects generally have a high dividend payout
ratio.

4. A stock split is always associated with an increase in the value of the equity outstanding.

5. If the information content, or signaling, hypothesis is correct, then changes in dividend policy can be
important with respect to firm value and capital costs.

6. If a firm repurchases its stock in the open market, the shareholders who tender the stock are subject to
capital gains taxes.

7. If you own 100 shares in a company’s stock and the company’s stock splits 2-for-1, you will own 200 shares in
the company following the split.

8. Some dividend reinvestment plans increase the amount of equity capital available to the firm.

9. If your company has established a clientele of investors who prefer large dividends, the company is unlikely to
adopt a residual dividend policy.

10. If a firm follows a residual dividend policy, holding all else constant, its dividend payout will tend to rise
whenever the firm’s investment opportunities improve.

Part 2 – Questions & problems

1. How would each of the following changes tend to affect aggregate (that is, the average for all corporations)
payout ratios, other things held constant? Explain your answers.

a. An increase in the personal income tax rate

b. A rise in interest rates

c. An increase in corporate profits

d. A decline in investment opportunities

2. Axel Telecommunications has a target capital structure that consists of 70% debt and 30% equity. The
company anticipates that its capital budget for the upcoming year will be $3,000,000. If Axel reports net income
of $2,000,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio?

3. Gamma Medical’s stock trades at $90 a share. The company is contemplating a 3-for-2 stock split. Assuming
that the stock split will have no effect on the market value of its equity, what will be the company’s stock price
following the stock split?

4. Beta Industries has net income of $2,000,000, and it has 1,000,000 shares of common stock outstanding. The
company’s stock currently trades at $32 a share. Beta is considering a plan in which it will use available cash to
repurchase 20% of its shares in the open market. The repurchase is expected to have no effect on net income or
the company’s P/E ratio. What will be Beta’s stock price following the stock repurchase?

5. Northern Pacific Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating
system. To meet this demand, management plans to expand production capacity by 40% with a $10 million
investment in plant and machinery. The firm wants to maintain a 40% debt-to-total-assets ratio in its capital
structure. It also wants to maintain its past dividend policy of distributing 45% of last year’s net income. In 2011,
net income was $5 million. How much external equity must Northern Pacific seek at the beginning of 2012 to
expand capacity as desired? Assume that the firm uses only debt and common equity in its capital structure.
6. Welch Company is considering three independent projects, each of which requires a $5 million investment.
The estimated internal rate of return (IRR) and cost of capital for these projects are presented here:

Note that the projects’ costs of capital vary because the projects have different levels of risk. The company’s
optimal capital structure calls for 50% debt and 50% common equity, and it expects to have net income of
$7,287,500. If Welch establishes its dividends from the residual dividend model, what will be its payout ratio?

7. Rubenstein Bros. Clothing is expecting to pay an annual dividend per share of $0.75 out of annual earnings
per share of $2.25. Currently, Rubenstein Bros.’stock is selling for $12.50 per share. Adhering to the company’s
target capital structure, the firm has $10 million in assets, of which 40% is funded by debt. Assume that the
firm’s book value of equity equals its market value. In past years, the firm has earned a return on equity (ROE) of
18%, which is expected to continue this year and into the foreseeable future.

a. Based on that information, what long-run growth rate can the firm be expected to maintain? (Hint: g =
Retention rate ×ROE.)

b. What is the stock’s required return?

c. If the firm changed its dividend policy and paid an annual dividend of $1.50 per share, financial analysts would
predict that the change in policy will have no effect on the firm’s stock price or ROE. Therefore, what must be
the firm’s new expected long-run growth rate and required return?

d. Suppose instead that the firm has decided to proceed with its original plan of disbursing $0.75 per share to
shareholders, but the firm intends to do so in the form of a stock dividend rather than a cash dividend. The firm
will allot new shares based on the current stock price of $12.50. In other words, for every $12.50 in dividends
due to shareholders, a share of stock will be issued. How large will the stock dividend be relative to the firm’s
current market capitalization? (Hint: Remember that market capitalization = P0 × number of shares
outstanding.)

e. If the plan in Part d is implemented, how many new shares of stock will be issued, and by how much will the
company’s earnings per share be diluted?