BA4811 Corporate Finance

Fall 2020-2021

Exam 2

Name:

 Exam duration is 75 minutes.

 Exam is 55 points in total.
 There are 6 questions in the exam including the bonus question.
 You should show steps of your calculations!

Good luck.
Question 1. (10 pts) A proposed single lockbox system will reduce collection time 3 days on
average. Daily interest rate is 0.1%. Average number of daily payments to the lockbox is
1,000. Average size of payment is $500. The processing fee is $0.5 per check each day. Is this
lockbox system acceptable? Show each step of your calculation.

Answer 1.
First of all, we need to find the daily collections, and we can find it by multiplying the
average number of daily payments with average size of payments.
 Daily collection is 1000 x 500 = 500000 dollar
Secondly, we need to find the increased bank balance, which is the result of the shortened
collection time. It can be found by multiplying the reduction in the process time with daily
collections.
 Increased bank balance is 3 x 500000 = 1500000 dollar
Now we need to find the daily cost of the lockbox service to the company. It is found by
multiplying the average number of daily payments with processing fee per check.
 1000 x 0.5 = 500 dollar
To decide whether the lockbox system is acceptable or not, we need to find the Net Present
Value (NPV) of it. For calculating the NPV we need to know the present value of the cost of
the system.
The firm is going to increase that daily cost forever, so we can treat it like a perpetuity.
Present value of a perpetuity is found by dividing it with daily interest rate.
 PV of the cost of the lockbox system is 500 / 0.001 = 500000 dollar
NPV is found by deducting the present value of cost of the lockbox system from the increased
bank balance that comes with the lockbox system.
 NPV = 1500000 – 500000 = 1000000 dollar
Since NPV > 0 the lockbox system is acceptable.

Question 2. (10 pts) National Event Coordinators is contemplating the acquisition of a new
tent that will be used for major outdoor events. The purchase price is $147,000. The firm uses
depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent
depreciation over years 1 to 4, respectively. The tent will be worthless after four years. The
tent can be leased for four years at $42,500 a year. The firm can borrow money at 7.5 percent
and has a 34 percent tax rate. What is the net advantage to leasing? Show each step of your
calculation.

Answer 2.
In a purchase vs lease comparison, there are three relevant cash flows from the lessee’s point:
1- After-tax lease payments (cash outflow, since it is paid to the lessor)
2- Lost depreciation tax shield (cash outflow, since you are not the owner, you cannot
benefit from the tax deductibility of depreciation expense)
3- Initial cost of tent (cash inflow, since you are not the owner, you cannot pay the
buying price of the tent)
These three cash flows is used to calculate Net Advantage to Leasing (NAL) which is
calculated as the same way with Net Present Value (NPV). You need to discount all future
cash flows to the present, in order to calculate NPV or in this case NAL.
After-tax lease payments is calculated by this formula:
Lease payment x (1- tax rate)
 42500 x (1- 0.34) = 28050 dollar
We use after tax lease payments because the lease compromise if the whole life of the tent,
which classifies it as a capital lease, and lease payments in capital leases are tax deductible.
We find the depreciation expense of each year by the rates for that year.
 Year 1 depreciation = 147000 x 0.3333 = 48995.1 dollar
 Year 2 depreciation = 147000 x 0.4444 = 65326.8 dollar
 Year 3 depreciation = 147000 x 0.1482 = 21785.4 dollar
 Year 4 depreciation = 147000 x 0.0741 = 10892.7 dollar
We can find the lost depreciation tax shild by this formula:
Depreciation expense x tax rate
 Year 1 lost depreciation tax shield = 48995.1 x 0.34 = 16658.33 dollar
 Year 2 lost depreciation tax shield = 65326.8 x 0.34 = 22211.11 dollar
 Year 3 lost depreciation tax shield = 21785.4 x 0.34 = 7407.04 dollar
 Year 4 lost depreciation tax shield = 10892.7 x 0.34 = 3703. 52 dollar
So we can write all cash flows from year 0 to year 4 in a table:
Year 0 Year 1 Year 2 Year 3 Year 4
ATLP - 28050 - 28050 - 28050 - 28050
LDTS -16658.33 -22211.11 -7407.04 -3703.52
COST + 147000
TOTAL CF +147000 -44708.33 -50261.11 -35457.04 -31753.52

A lease is like a debt to the company. So relevant discount rate for discount future cash flows
of the lease is the after-tax cost of debt. After tax cost of debt is calculated by this formula:
Cost of debt x (1- tax rate)
 After tax cost of debt = 0.075 x (1-0.34) = 0.0495 4.95%
The NAL can be calculated by discounting future cash flows with 4.95% interest rate and
deducting them from the year 0 cash flow. ( Year 1 cash flow will discounted using PVIF
4.95%,1 , Year 2 cash flow will discounted using PVIF 4.95%,2 , Year 3 cash flow will
discounted using PVIF 4.95%,3 , Year 4 cash flow will discounted using PVIF4.95%,4)

Question 3. (10 pts) George's Equipment is planning on merging with Nelson Machinery.
George's will pay Nelson's shareholders the current value of their stock in shares of George's
Equipment. George's currently has 4,600 shares of stock outstanding at a market price of $31
a share. Nelson's has 1,600 shares outstanding at a price of $38 a share. What is the value per
share of the merged firm? Show each step of your calculation.

Answer 3.
First of all we need to find the merged value of the firm. The value of the merged firm is the
total of the George’s Equipment value and Nelson Machinery’s value.
We can find George’s Equipment’s value by multiplying its share price with its number of
outstanding shares.
 31 x 4600 = 142600 dollar
We can find Nelson Machinery’s value by multiplying its share price with its number of
outstanding shares.
 38 x 1600 = 60800 dollar
The total value of the merged firm is 142600 + 60800 = 203400 dollar
George’s Equipment is deal with Nelson Machinery to give it x number of George’s
Equipment shares that worth as its value. We can find how many shares (x) that George’s
Equipment gives to Nelson Machinery is dividing the worth of Nelson Machinery by the price
per share of George’s Equipment shares.
 60800 / 31 = 1961 shares
Before finding the price per share of the merged firm, we need to calculate the number of
outstanding shares in the merged firm. We can calculate it by adding number of shares given
to Nelson Machinery with number of outstanding shares of George’s Equipment.
 1961 + 4600 = 6561 shares
To find the price per share of the firm, we need to divide the merged value of the firm with
the number of outstanding shares in the merged firm.
 203400 / 6561 = 31 dollar
Question 4. (10 pts) Saucier & Co. currently sells 2,100 units a month for total monthly sales
of $86,500. The company is considering replacing its current cash only credit policy with a
net 30 policy. The variable cost per unit is $18 and the monthly interest rate is 1.2 percent.
What is the switch break-even level of sales? (Assume the selling price per unit and the
variable costs per unit remain constant.) Show each step of your calculation.

Answer 4.
A net 30 policy means that the total amount will due in 30 days.
The break-even level of sales is found by setting NPV of the switch equal to zero. In order to
find the NPV we need to find the incremental cash flows that come with the credit policy.
Incremental cash flows of a credit policy is the revenue that come from the increased sales
and the cost which also increased due to increased sales.
NPV if a switch is found by this formula
-(PQ + v(Q’-Q)) + ((P-v)(Q’-Q))/R
Where Q’ reflects the new amount of sales
Where Q reflects the current amount of sales, in this question 2100
Where v reflects the variable cost, in this question 18 dollar
Where P reflects the price per unite in this question is found by dividing the total monthly
sales with number of units sold
 86500 / 2100 = 41. 19 dollar
Where R is the appropriate discount rate, in this question it is 1.2% 0.012
Since we need to find the break-even level of sales we need to solve this equation for Q’-Q
Q’-Q = PQ / ((P-v)/R – v)
 Q’ – 2100 = 41.19 x 2100 / ((41.19- 18)/ 0.012 – 18) = 45.18 unit
The company need to increase its sales 45.18 unit per month, so break-even sales amount is
2145.52 units.
Question 5. (10 pts)Consider the following premerger information about Firm A and Firm B:

   

Assume that Firm A acquires Firm B via an exchange of stock at a price of $25 for each share
of B's stock. Both A and B have no debt outstanding. What will the earnings per share of Firm
A be after the merger? Show each step of your calculation.

Answer 5.
The firm A spend 25 dollar per share of Firm B, so the total cost of merger is found by
multiplying 25 with number of outstanding shares of firm B
 25 x 210 = 5250
We can find the increase in Firm A shares by dividing total cost of merger with price per
share of Firm A stock.
 5250 / 40 = 131 shares
Now we need to find the total number of shares outstanding of Firm A. We can found it by
adding increase in Firm A shares with number of outstanding shares of Firm A.
 131 + 620 = 751 shares.
Earnings per share is calculated by dividing total earnings of firm with price per share. In this
question total earnings of the firm A is equal to the earnings of firm A plus earnings of Firm
B.
 (930 + 650) / 751 = 2.10 dollar per share.

Bonus Question (5pts)

You are considering implementing a lockbox system for your firm. The system is expected to
reduce the average collection time by 2.8 days. On an average day, your firm receives 2,419
checks with an average value of $1,287 each. The daily interest rate on Treasury bills is 0.016
percent. The bank charge per check is $0.30. What is the net present value of this lockbox
arrangement? Show each step of your calculation.
Answer: