Chapter 18 International Capital Budgeting

8/11/2019 Chapter 18 International Capital Budgeting

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Chapter 18 International Capital Budgeting1.Before you pose these next seven questions to your students, give consideration to theirfinance backgrounds. At my school (University of Missouri at olumbia! capital budgetingquestions in this level of detail "ould be #fair game# because the students have had plenty of

capital budgeting before in a prior finance course. $ust glancing at equations %&'% through %&'f

is not preparation for these seven questions. )here are plenty of easier questions in this testbank.

Tiger Towers, Inc. is considering an expansion of their existing business, student apartments. Thenew project will be built on some vacant land that the firm has just contracted to bu. The landcost !1,""",""" and the pament is due toda. Construction of a #"$unit office building will costpretax !% million& this expense will be depreciated straight$line over %" ears to 'ero salvagevalue& the value of the land and building in ear %" will be !18,""",""". The !%,""","""construction cost is to be paid toda. The project will not change the ris( level of the firm. Thefirm will lease #" offices suites at !#",""" per suite per ear& pament is due at the start of theear& occupanc will begin in one ear. )ariable cost is !%,*"" per suite. +ixed costs, excluding

depreciation, are !*,""" per ear. The project will re-uire a !1",""" investment in net wor(ingcapital.

#. hat is the unlevered after$tax incremental cash flow for ear "/0.$!%,","""B.$!*,1"","""C.$!2,""","""

D.$!2,"1","""3.4one of the above

$!2,"1",""" 5 $ 6!1,""",""" 7 !%,""",""" 7 1","""

%. hat is the unlevered after$tax incremental cash flow for ear #/0.$!2,1"B.!1"#,%""C.!#"#,%""9.!#**,"""3.4one of the above


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2. hat is the unlevered after$tax incremental cash flow for ear %"/0.!1#,2%#,%""B.!1#,##*,%:"C.!1#,%%#,%""9.!1#,28*,"""

3.4one of the above

!1#,2%#,%"" 5 !#"#,%"" 7 return of 4C 7 building;land

#"#,%"" 7 !1",""" 7 !18,""",""" $ ".%2

4otice that the answer to -uestion * is a function of the student>s answer to -uestion 2?Correct response to @*

5 response to @2 7 !1",""" 7 !18,""",""" $ ".%2

Aou ma wish to award partial credit based on the following rubric?1#,2%#,%"" if @2 5 c=1#,##*,%:" if @2 5 a=1#,%%#,%"" if @2 5 b=

!1#,28*,""" if @2 5 d=

0warding partial credit on a multiple choice test isn>t hard. Import their responses into 3xcel. seif statements. The advantage of path$dependent grading is that ou can get the same level ofdiscrimination in grading on a multiple choice test as on an essa test.

*. +or the next % -uestions, assume that the firm will partiall finance the project with a!%,""",""" interest$onl %"$ear loan at 1"." percent 0DE with annual paments.hat is the levered after$tax incremental cash flow for ear "/A.$!1,"1","""

B.$!1,""","""C.$!","""9.$!#,1"","""3.4one of the above

*+"5 !%,""",""" $ response to @%=$!1,"1","""Aou ma wish to award partial credit on this -uestion according to the following rubric$!1,"1",""" is correct if @%5 2=$!1,""",""" is correct if @% 5 %=$!",""" is correct if @% 5 1=$!#,1"",""" is correct if @% 5 #=


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. +or the next % -uestions, assume that the firm will partiall finance the project with a!%,""",""" interest$onl %"$ear loan at 1"." percent 0DE with annual paments.hat is the levered after$tax incremental cash flow for ear 1/A.!2,%""B.$!#"#,1"

C.$!:*,""9.!*,"""3.4one of the above

Aour response to @2 $ !%"",""" ".

4ote? ou ma wish to award partial credit according to?!2,%"" is correct if @2 5 %=$!#"#,1" is correct if @2 5 1=$!:*,"" is correct if @2 5 #=!*,""" is correct if @2 5 2=

. +or the next % -uestions, assume that the firm will partiall finance the project with a!%,""",""" interest$onl %"$ear loan at 1"." percent 0DE with annual paments.hat is the levered after$tax incremental cash flow for ear %"/

0.!:,"#,%:"B.!:,#%2,%""C.!:,1%2,%""9.!:,#8,"""3.4one of the above


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the right answer is our response to @* $ !%"",""" ". $ !%,""","""

Aou should consider awarding partial credit on this according to this rubric?!:,"#,%:" is correct if @* 5 #=!:,#%2,%"" is correct if @* 5 1=!:,1%2,%"" is correct if @* 5 %=!:,#8,""" is correct if @* 5 2=

8. 0ssume that the firm will partiall finance the project with a subsidi'ed !%,""",""" interestonl %"$ear loan at 8." percent 0DE with annual paments. 4ote that eight percent is less thanthe 1" percent that the normall borrow at. hat is the 4D) of the loan/0.!1:8,2:B.!*%,::.8%C.!1"#,#.**D.!1,%%2,8*1.":3.4one of the above

sing the cash flow menu on a financial calculator?C+" 5 !%,""","""

C+1 5 $!1*8,2"" 5 $!%,""",""" "."8 .

+"1 5 #:C+# 5 $!%,1*8,2""I 5 1"F4D) 5 !1,%%2,8*1.":


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:. The firm>s tax rate is %2F. The firm>s pre$tax cost of debt is 8F& the firm>s debt$to$e-uit ratiois %& the ris($free rate is %F& the beta of the firm>s common stoc( is 1.*& the mar(et ris( premiumis :F. hat is the firm>s cost of e-uit capital/0.%%.%%FB.1".8*F

C.1%.1#FD.1.*F3.4one of the above

re-uit5 %F 7 1.* :F 5 1.*F

1". The firm>s tax rate is %2F. The firm>s pre$tax cost of debt is 8F& the firm>s debt$to$e-uitratio is %& the ris($free rate is %F& the beta of the firm>s common stoc( is 1.*& the mar(et ris(premium is :F. hat is the re-uired return on assets/0.%%.%%FB.1".8*F

C.1%.1#F9.1.*F3.4one of the above

1.*F 5 rasset7 % 6 rasset$ rdebt


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sing the cash flow menu of a financial calculator? C+" 5 $!1"","""& C"1 5 !%:,8""& +"1 5 2&C"# 5 !2%,1""& I 5 r0CC5 8.2& 4D) 5 !*8,"#8.8


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1%. hat is the 4D) of the project using the 0D) methodolog/0.!2:,1%."%B.!1:8,2:C.!1"#,#.**

D.!12:,*8".1#3.4one of the above

0D) 5 $Cost 7 Base$case 4D) 7 4D) depreciation tax shield 7 4D) interest tax shield 5The project does not cost !1"",""" but rather !:8,:%.2: 5 $!1"",""" 7 !1,"#.*1


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12. hat is the 4D) of the project using the 0CC methodolog/0.!*8,"#8.8B.!2:,1%."%C.!28,%"".2

9.!1"#,#.**3.4one of the above

sing the cash flow menu of a financial calculator? C+" 5 $!1"","""& C"1 5 !%:,8""& +"1 5 2&C"# 5 !2%,1""& I 5 r0CC5 11.#"& 4D) 5 !28,%"".2

1*. hen using the 0D) methodolog, what is the 4D) of the depreciation tax shield/0.!%#,"*1.*#B.!#*,.%*

C.!##,:2.*9.!:,1*#.:83.4one of the above

sing a financial calculator>s cash flow menu? 4 5 *& DGT 5 !,8"" 5 !#",""" .%2 I;AE 5 rdebt

5 1"F&-depreciationtax shield5 !#*,.%*

1. hen using the 0D) methodolog, what is the 4D) of the interest tax shield/A.!:,.*1

B.!1#,"1:.%#C.!:,%.%19.!,""".%3.4one of the above

using a financial calculator, 4 5 *& DGT 5 !#,**" 5 .1" !*,""" .%2& I;AE 5 rdebt5 1"F&

D)interesttax shield5 !:,.*1


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1. Toda is Hanuar 1, #"":. The state of Iowa has offered our firm a subsidi'ed loan. It will bein the amount of !1",""",""" at an interest rate of *F and have 0440


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+irst, get our financial calculator into begin mode and 1 pament per ear?D) 5 1",""","""45 %I5 *FDGT 5 $!%,2:,##2.2%

0morti'e the loan

The si'e and timing of the cash flows of the loan are?

C+" 5 !,*"#,*.*C+1 5 $!%,%8,.#2C+# 5 $!%,22","#."I5 8F& 4D) 5 !21,#"1."*If ou are covering 0D) in detail, this (ind of -uestion is appropriate. 0lternative versions ofthis are nearb.


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18. Toda is Hanuar 1, #"":. The state of Iowa has offered our firm a subsidi'ed loan. It will bein the amount of !1",""",""" at an interest rate of *F and have 0440


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1:. The re-uired return on assets is 18F. The firm can borrow at 1#.*F& firm>s target debt tovalue ratio is %;*. The corporate tax rate is %2F, and the ris($free rate is 2F and the mar(et ris(premium is :.# percent. hat is the weighted average cost of capital/0.1#.1*F

B.1%."#FC.12.%%F9.#%.2*F3.4one of the above

l5 #%.2*F 5 18F 7 1.*


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#1. The firm>s tax rate is %2F. The firm>s pre$tax cost of debt is 8F& the firm>s debt$to$e-uitratio is %& the ris($free rate is %F& the beta of the firm>s common stoc( is 1.*& the mar(et ris(premium is :F.Calculate the weighted average cost of capital.0.%%.%%F

B.8.":FC.:."#F9.1.*F3.4one of the above

NOTE TO FACULTY:the next six -uestions are similar to the six that follow them, but havedifferent answers as the debt$e-uit ratio changes from # to %. This can discourage cheating,especiall if ou onl give credit to students who have the right answers on the right testOConsider a project of the Cornell Naul Goving Compan, the timing and si'e of the incrementalafter$tax cash flows s tax rate is %2F& the firm>s bonds trade with a ield to maturit of 8F& the current andtarget debt$e-uit ratio is #& if the firm were financed entirel with e-uit, the re-uired returnwould be 1"F

##. sing the 0D) method, what is the value of the debt side effects/0.!#%:,"#,*#."B.!,8:1,1%.C.!*:,2*:,%"1."%9.!",""","""

3.4one of the above

C+" 5 ",""","""& C+1 5 $%2,828,""" 5 ."8 !",""","""


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4LT3 TL +0CTA? the next six -uestions are similar to the last six, but have differentanswers as the debt$e-uit ratio changed from # to %. This can discourage cheating, especiall ifou onl give credit to students who have the right answers on the right testOConsider a project of the Cornell Naul Goving Compan, the timing and si'e of the incrementalafter$tax cash flows s tax rate is %2F& the firm>s bonds trade with a ield to maturit of 8F& the current andtarget debt$e-uit ratio is %& if the firm were financed entirel with e-uit, the re-uired returnwould be 1"F

#%. sing the weighted average cost of capital methodolog, what is the 4D)/ I didn>t round mintermediate steps. If ou do, ou>re not going to get the right answer.A.$!1,2",%"1.#*

B.!1#,2:2,2%.*C.!%,*8",.**9.!1"8,::2.18.#"3.!*:,2*:,%"1."%

)he "eighted average cost of capital is

re-uit5 1"F 7 %


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#2. hat is the levered after$tax incremental cash flow for ear #/A.!18*,:,"""B.!#1*,1*#,"""C.!#,:*#,"""9.!#82,828,"""

3.4one of the above

*+#5 !1:",1*#,"""

5 !##*,""",""" $ ."8 !2#,*"","""


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#8. sing the 0D) method, what is the value of the debt side effects/0.!#%:,"#,*#."B.!,8:1,1%.C.!*:,2*:,%"1."%

9.!",""","""3.4one of the above

C+" 5 2#,*"","""& C+1 5 $%:,#"2,""" 5 ."8 !2#,*"",""" s existing bonds trade with a ield to maturit of eight percent. The state ofGissouri has offered to loan our firm !1",""",""" at 'ero percent for five ears. Eepamentwill be of the form of !#,""",""" per ear for five ears the first pament is due in one ear.hat is the value of this offer/0.!2,#:,##.*B.!#,"12,*:.:%C.!"9.!1:,:#:.883.4one of the above

sing a financial calculator? 4 5 *& I;A 5 8F DGT 5 $!#,""",""" solve for D) 5 !,:8*,2#"."The state is giving ou !1",""",""" for a promise that>s worth onl !,:8*,2#".". The value ofthat is !#,"12,*:.:%

%". hat proportion of the firm is financed b debt for a firm that expects a 1*F return one-uit, a 1#F return on assets, and a 1"F return on debt/ The tax rate is #*F.0.#"FB.1;%C."FD.#;%3.8"F


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+rom Godigliani$Giller Droposition II s eas to find debt to value?

%1. The re-uired return on e-uit for a levered firm is 1"."F. The debt to e-uit ratio is P thetax rate is 2"F, the pre$tax cost of debt is 8F. +ind the cost of capital if this firm were financed

entirel with e-uit.A.1"FB.1#FC.8.F9.4one of the above

+rom Godigliani and Giller proposition # the re-uired return on e-uit for a levered firm isl5

u7


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%#. The re-uired return on e-uit for an all$e-uit firm is 1"."F. The are considering a changein capital structure to a debt$to$e-uit ratio of P the tax rate is 2"F, the pre$tax cost of debt is8F. +ind the new cost of capital if this firm changes capital structure.0.12.:%F

B.8.FC..2"F9.4one of the above

+rom Godigliani and Giller proposition # that the re-uired return on e-uit for a levered firm is

l5u7


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%2. hat is the expected return on e-uit for a tax$free firm with a 1*F expected return onassets that pas 1#F on its debt, which totals #*F of assets/0.#2FB.1*."FC.1F

9.#"F3.1*.*F

Jtart with debt$to$value ratio of #*F, find debt$to$e-uit ratio, then use

l5u7


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%. 0ssume that SAM Corporation is a leveraged compan with the following information?l5 cost of e-uit capital for SAM 5 1%Fi5 before$tax borrowing cost 5 8Ft5 marginal corporate income tax rate 5 %"FCalculate the debt$to$total$mar(et$value ratio that would result in SAM having a weighted

average cost of capital of :.%F.0.%*FB.2"FC.2*FD.*"F

3-uation 1.1et/5 debt$to$total$mar(et$value ratio

".":% 5


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%. Toda is Hanuar 1, #"":. The state of Iowa has offered our firm a subsidi'ed loan. It will bein the amount of !1",""",""" at an interest rate of *F and have 0440


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%8. 0n Italian firm is considering selling its line of coin$operated cappuccino machines in the.. The business ris( will be identical to the firm>s existing line of business in the euro 'one,the cost of capital in the euro 'one is iU5 1"F. The expected inflation rate over the next twoears in the .. is %F per ear and #F per ear in the euro 'one. The spot exchange rates are

!1.8" 5 1."" and !1.1* 5 U1.""The pound sterling denominated cash flows are as follows?

hat is the U$denominated 4D) of this project/ I did not round m intermediate steps, if oudid, select the answer closest to ours.

A.U*,*%.#%B.U#,#".:C.U,##%.129.U%,**2.#:3.There is not enough information


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the appropriate cost of capital for the firm to use on these $denominated cash flows is

se that discount rate in the cash flow menu of a financial calculator with C+" 5 $1"","""& C+15 #*,"""& C+# 5 1"","""& 4D) 5 %,**2.#8

+inall translate to pounds at the spot cross rate? Gost students will ta(e this approach?

here the ear$1 cash flow is given b

, and the ear$two cash flow is

given bThese euro$denominated cash flows have an 4D) of exactl U*,*%.#%. Jtudents who ta(e thisapproach have lots of room for grievous rounding errors.


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%:. The spot exchange rate is 1#* 5 !1. The .J. discount rate is 1"F& inflation over the next

three ears is %F per ear in the .J. and #F per ear in Hapan. Calculate the dollar 4D) of thisproject.

I did not round m intermediate steps, if ou did, select the answer closest to ours.0.!#,181.8B.!12,1.C.!#,*%.2:D.!#,1%.23.4one of the above

the eas wa to do this is to estimate the en$denominated re-uired return

The en$denominate cash flows given above ield an 4D) 5 #,181.8, which converts to

!#,1%.2 at the spot exchange rate.In the alternative, ou could convert the cash flows at the exchange rates expected to prevail overthe next three ears

hen discounted at 1"F this series of dollar$denominated cash flows has 4D) 5 !#,1%.2Jtudents prefer ta(ing this approach, but the do tend to ma(e a great deal of rounding errors.

2". 0s of toda, the spot exchange rate is U1."" 5 !1.#* and the rates of inflation expected toprevail for the next ear in the .J. is #F and %F in the euro 'one. hat is the one$ear forwardrate that should prevail/A.U1."" 5 !1.#%:

B.U1."" 5 !1.#1%:C.U1."" 5 !".::"%9.!1."" 5 U1.##%


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Ta(e the spot rate and gross up each side b the respective inflation rates

21. 0s of toda, the spot exchange rate is U1."" 5 !1.*" and the rates of inflation expected toprevail for the next ear in the .J. is #F and %F in the euro 'one. hat is the one$ear forwardrate that should prevail/0.U1."" 5 !1.*12B.U1."" 5 !1.28*2C.U1."" 5 !"."#9.!1."" 5 U"."#


0s of toda, the spot exchange rate is U1."" 5 !1.#* and the rates of inflation expected to prevailfor the next three ears in the .J. is #F and %F in the euro 'one. hat spot exchange rateshould prevail three ears from now/0.U1."" 5 !1.#%:B.U1."" 5 !1.#1%:C.U1."" 5 !".::"%9.!1."" 5 U1.##%


Chapter 18 International Capital Budgeting

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Transcript of Chapter 18 International Capital Budgeting