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Under which scenario(s) of base-case, best-case or worst-case would you recommend Samupgrade the railroad company?s station equipment on the basis of NPV?Find the IRR for the base-case. Use 27% (NPVBase =$ ?7,760) or 7% (NPVBase =$ 181,137) asthe second rate depending if you need to increase or decrease the rate. Show all working stepsclearly.
(1) This assignment is to be done individually. You must sign and submit the standard
cover page supplied as the last page of this assignment; otherwise you will be deducted 5
(2) Before you start, please note the necessary working steps to be shown as explained in
the first lecture.
(3) This assignment is due in the ADMS office (Atk 282) or at the final exam review class on
April 4, 2016.
(4) This assignment must be handwritten. Any work that is not original handwritten (e.g.,
printed or photocopied) will receive zero credit. Work that is too difficult to read due to
messiness and poor handwriting will also receive zero credit. You must show all the
necessary working steps to receive full credit.
(5) This assignment carries a total of 100 marks.
(6) Under no circumstances would a late assignment be accepted after the answer key to
the assignment has been posted on the course website.
(7) Decimal places: please keep at least 4 in your calculations and round to the nearest
penny or basis point in your final answers.
MM Arbitrage Exercise
Leasing (20 marks)
Your firm needs to either buy or lease $230,000 worth of vehicles. These vehicles have a life of
4 years after which time they are worthless. The vehicles belong in CCA class 10 (a 30% class)
and can be leased at a cost of $68,000 a year for the 4 years. The corporate tax rate is 34% and
the cost of debt is 10%. There are many more assets in this asset class. The lease payments are
made at the beginning of the period. The half year rule is applicable.
What is the after-tax cost of debt? (1 mark)
What is the amount of the after-tax lease payment? (1 mark)
What is the present value of the depreciation tax shield? (1 mark)
What is the net advantage to leasing? (2 marks)
The lessor in this case has a tax rate of 35%. What is the net advantage of leasing to the lessor?
What is the amount of the break-even lease payment to the lessee? How would you solve for it
on Excel? (4 marks)
What is the amount of the breakeven to the lessor? (3 marks)
Is a lease feasible? (2 marks)
What should be the tax rate of the lessor so that a lease is feasible? (2 marks)
Financial Ratios (20 marks)
What is the current ratio for 2009? (2 marks)
What is the equity multiplier for 2009? (2 marks)
What is the days' sales in receivables for 2009? (2 marks)
What is the change in net working capital? (3 marks)
What is the net working capital turnover rate for 2009? (2 marks)
What is the cash coverage ratio for 2009? (2 marks)
What is the market-to-book ratio if the Smith Co. has 2,603 shares of common stock outstanding
with a current market price of $22 per share? (2 marks)
h) On a common size statement of comprehensive income for 2009, earnings before interest and
taxes would be assigned a common value of? (2 marks)
i) Suppose interest expense is $2,000, times interest earned is 5, and cash coverage ratio is
5.5. Calculate the depreciation expense. (3 marks)
Mergers and Acquisitions (20 marks)
Blenheim PLC is considering making an offer to purchase Howard Department Store. The vice
president of finance has collected the following information:
Number of shares
Earnings per share
Dividends per share ($)
Blenheim also knows that securities analysts expect the earnings and dividends of Howard to
grow at a constant rate of 5 percent each year. Blenheim management believes that the
acquisition of Trafford will provide the firm with some economies of scale that will increase this
growth rate to 6 percent per year.
a) What is the value of Howard to Blenheim?
b) What would Blenheim's gain be from this acquisition?
c) If Blenheim were to offer $38 in cash for each share of Howard, what would the NPV of
the acquisition be?
d) What's the most Blenheim should be willing to pay in cash per share for the stock of
e) If Blenheim were to offer one of its shares in exchange for 1.75 shares of Howard, what
would the NPV be?
f) If shares are exchanged in proportion to the current market price, what would be the NPV
of the acquisition?
g) Why NPV or gain of acquirer from all cash offer is greater than NPV or gain from a
proportional stock offer?
MM Arbitrage Exercise (20 marks)
Unique Corporation and Levon Corporation are identical in every way except for capital
structures. Unique Corporation, an all-equity firm, has 250,000 shares of common stock
outstanding, currently trading at $40 per share. Unique Corporation has an equity capitalization
rate of 20%. Levon Corporation uses leverage in its capital structure and has $2,500,000 of debt,
on which it pays 12 percent annually. Each firm is expected to have annual earnings before
interest of $2,000,000 in perpetuity. Assume that every investor can borrow at 12 percent
annually and that there are no corporate or personal taxes and no transactions costs.
(a)What is the value of Unique Corporation? (1 mark)
(b)What is the value of Levon Corporation? (1 mark)
(c) How much will it cost to purchase 5 percent of each firm?s equity? (3 marks)
(d)Assuming each firm meets its earnings estimates, what will be the dollar return to each
position in part (c) over the next year? (2 marks)
(e)Develop an investment strategy in which an investor purchases 5 percent of Unique?s equity
and replicates both the cost and dollar return of purchasing 5 percent of Levon?s equity. Show all
supporting calculations. (4 marks)
(f)Assume that the value of Unique is $10,000,000 and the value of Levon is $12,500,000.
According to M&M, do these values represent equilibrium? If not, explain the process by which
equilibrium will be achieved. Show all supporting calculations, assuming that you own 5 percent
of Levon?s shares. (9 marks)
Scenario Analysis (20 marks)
George and The Man then visit Bloom Lake Railway. Their junior corporate analyst, Sam, is
considering upgrading their station equipment to meet increased demand and lower operating
costs as the new station equipment is more energy efficient. The old station equipment was
purchased four years ago at a capital cost of $240,000. When purchased, the old equipment was
expected to last ten years with a salvage value of $28,000. New station equipment will cost
$365,000, including installation costs. The new equipment is expected to last six years along
with a salvage value of $107,000. The old station equipment could be sold for $110,000 at
present. Both the old and new equipment fall into CCA asset class 8 and they follow the CRA
requirement of using the declining balance method at a CCA rate of 20 percent. For simplicity,
changes in net working capital will be ignored. The railroad?s weighted average cost of capital is
14 percent taking into account all opportunity costs. The corporate tax rate is 37 percent. The
projections for annual pre-tax revenues and annual pre-tax costs with the new station equipment
Annual Pre-tax Revenues
Annual Pre-tax Cost
Under which scenario(s) of base-case, best-case or worst-case would you recommend Sam
upgrade the railroad company?s station equipment on the basis of NPV?
Find the IRR for the base-case. Use 27% (NPVBase =$ ?7,760) or 7% (NPVBase =$ 181,137) as
the second rate depending if you need to increase or decrease the rate. Show all working steps
Faculty of Liberal Arts and Professional Studies
School of Administrative Studies
Toronto, Ontario, Canada
ADMS 4540 Winter 2016
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