INSTRUCTION

There are two parts to this exam.The first part is problem solving and the second part is a capital-budgeting analysis.You must show all work to receive full credit.On the problem solving section, make sure to clearly identify your final answer.Make sure to format your work as necessary so that it is ready for immediate printing when downloaded from the drop box for grading purposes.For the capital budgeting analysis, make sure to clearly identify all cash flows and compute the NPV, IRR, and clearly state your recommendation.

Q 1.

You have finally saved up \$5,000 for a down payment for a new jet ski.After weeks of intensive research, you decide to purchase a 2014 Kawasaki Ultra 310LX.You will have the ultimate combination of class-leading horsepower (310), precise handling, and superior luxury.Sea Doo riders won’t dare mess with you.You believe you have cut a sweet deal, negotiating the purchase price down to \$14,999 plus 7% taxes.After making your \$5,000 down payment, you will be financing the remainder.The salesperson mentions to you that you qualify for a great interest rate and informs you that your monthly payment on your 48 month loan will be based on an APR of 6%.He also tells you that the jet ski comes with a 4 year warranty, so any problems that may arise will be completely covered until you get it paid off.What is the monthly payment on this loan?(10 points)

Q 2.

Alex has not budgeted wisely.As a result, he needs a quick loan from Maddie.Alex needs \$6,000 and Maddie has agreed to lend him the \$6,000 if he makes 15 monthly payments to Maddie in the amount of \$480, to be paid at the end of each month.Because the total amount to be repaid is \$7,200, Maddie points out that she believes the interest rate is 20% (\$1,200 in interest on a \$6,000 principal loan).When pressed, Maddie acknowledges that the effective annual rate is the true measure of the annualized interest and that it will probably be higher because of compounding.However, neither Maddie nor Alex knows how to calculate the effective annual rate for this loan, so they have turned to you for help.What is the effective annual rate (E.A.R.) on this loan?(10 points)

Q 3.

Microsoft’s most recent yearly dividend was \$1.12.Over the past five years, Microsoft’s dividends have experienced an average rate of growth of 15%.Use the following information to value Microsoft’s stock using the dividend growth model.Dividends are expected to grow at a rate of 15% per year for the next 3 years.For the following three years (i.e., years 4 – 6), dividends will grow by 10% per year.After that, the dividends are projected to grow at a constant rate of 4%, forever.The firm has a debt-to-equity ratio (in market value terms) of 0.2.The YTM on the company’s bonds averages 4% and the company’s tax rate is 31%.If the risk-free rate is 3.34%, the market risk premium is 7%, and the company’s beta is 0.7, what should the stock sell for based on a discounted valuation of its projected dividends?(10 points)

Q 4.

You have hit it rich.Oil has been discovered on the land that you inherited from your Grandma in Southern Indiana.After tense negotiations with Evansville Oil Extraction Inc.’s lawyer (Dewey, Cheatem & Howe), you have agreed to receive 15 years of monthly royalty payments of \$3,000 per month from the Oil Company.Because it will take a little time to get the oil rig in place, the first of the monthly royalty payments will be paid exactly 18 months from now.If the interest rate implicit in the agreement is 3.36% APR, compounded monthly, what is the present value of the royalty agreement that you have made?(10 points)

Q 5.

Greenfield Manufacturing has hired you to estimate its cost of capital for new investment decisions.The firm has 1,600,000 shares of common stock outstanding that are trading for \$38.75 per share.The company’s beta is 0.87.The rate on 30-year t-bonds (risk free rate) is currently 3.34%.The market risk premium is 7%.Greenfield has an average tax rate of 32.5% and a marginal tax rate of 35%.Greenfield’s bonds have a 7.25% coupon rate, a \$1,000 face value, pay semi-annual coupons, and mature in 9 years.There are 32,000 of these bonds that are outstanding and they are currently selling in the open market for \$1,023.35.What is Greenfield’s Weighted Average Cost of Capital (WACC)?(12 points).

Q 6.

Suppose two all equity-financed firms, Firm X and Firm Y, are considering the same new project that has a beta of 0.6.The project has an IRR of 9.5%.Firm X has a beta of 1.2 and Firm Y has a beta of 0.8.The risk-free rate is 4% and the expected market risk premium 8%.Which firm(s) should take the project?Clearly explain. (8 points).

Part 2

Q7

It is May of 2014, and Krushenski Industries is examining a capital investment proposal that involves the replacement of a wheel-a-brator that was purchased only 4 years ago, but is nonetheless relatively inefficient compared to newer models.

Company Background

Krushenski Industries was established in the early 1970s for the purpose of manufacturing and forging high quality steel products with a specialized niche in the production of custom forgings for the agricultural, construction, earth- moving equipment, and heavy brake industries.Krushenski also developed a standard proprietary forged product line comprised of yokes and clevises manufactured to the Society of Automotive Engineer’s Specifications.Krushenski has the advantage of in-house forging and heat-treating departments, which allowed Krushenski to develop a variety of innovative forged products.Within a few years, the company was distributing forged products across the country.

In the 1970s and 1980s, major suppliers of the trucking industry such as Bendix, Rockwell International, and Bristol began to out-source many components to independent forging companies such as Krushenski Industries.The company entered into this new area by forging slack-adjusters, S-cams, and compressor crankshafts for the above- mentioned companies.In addition, Krushenski Industries forged components for large construction equipment producers such as Caterpillar and John Deere.With this new influx of business, Krushenski shifted its strategy away from its proprietary product line and focused attention on forging products for companies considered “heavy industry”.Thus, Krushenski today is a supplier of forged components to numerous heavy industry manufacturers who prefer to sublet the forging and tooling parts of their production process.

Replacement Decision

Should the wheel-a-brator be replaced?

The wheel-a-brator in place was purchased 4 years ago for \$127,000.When purchased, it had an estimated useful life of 13 years.The depreciation charges for the old wheel-a-brator are based on the 7-yr MACRS schedule.Ian Smith, the company’s industrial engineer, recently confirmed that the old wheel-a-brator has approximately 9 years of remaining service left if it is not replaced.If it is to be replaced, the existing wheel-a-brator can now be sold for approximately \$18,000.If the existing wheel-a-brator is kept for the remaining 9 years of its useful life, it will be worthless at the end of nine years.

If a new wheel-a-brator is purchased now, it would cost the company \$246,000.Expectations are that the new larger and more efficient wheel-a-brator would produce an annual pre-tax cost savings (relative to the wheel-a-brator in place) of \$50,000 per year for the duration of its expected useful life of 9 years.Though it has an expected useful life of 9 years, the new wheel-a-brator would also be depreciated according to the 7-year MACRs schedule.Assume that the new machine will be sold for a scrap value of \$15,000 at the end of 9 years.This replacement proposal will have no effect on net working capital investments.

Aubrey Williams, the firm’s accountant, points out that the portion of the factory that would house the new wheel-a- brator underwent a major ‘renovation’ last year with a total cost of \$45,000.Because the installation of the new wheel-a-brator would not have been feasible without the renovation, Aubrey contends that the costs of the renovation should be allocated as one of the replacement project’s initial ‘expenses’.Aubrey also estimates that interest charges associated with the purchase of the new wheel-a-brator would average \$6,000 per year over the equipment’s 9-year expected life.

The CFO of Krushenski Industries (Cesar Dominguez) requests your assistance in preparing an analysis of the net cash flow projections for the immediate replacement of the wheel-a-brator.In particular, Cesar is interested in the net present value and IRR of the replacement decision, along with your recommendation based on these figures.Cesar has informed you to use the company’s 12% cost of capital as the discount rate for this project and a tax rate of 35%. (40 POINTS)

Use the following MACRs Schedule for the purpose of determining the depreciation charges.

7-year MACRS Schedule

YearDepreciation

114.29%

224.49%

317.49%

412.49%

58.93%

68.92%

78.93%

84.46%