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Ch. 12 and 13

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Chapter 12

7. A peak is the transition from the end of an expansion to the start of a contraction. A trough occurs at the bottom of a recession just as the economy enters a recovery. Contraction is the period from peak to trough. Expansion is the period from trough to peak.

8. a. Monetary policy is expansive and fiscal policy is expansive. This is consistent with a steeply upward-sloping yield curve because, while the expansionary policies stimulate the economy and decrease the short-term rate, high inflation in the future is expected which forces up the yield in longer maturity.

14. Expansionary (i.e., looser) monetary policy to lower interest rates would help to stimulate investment and expenditures on consumer durables. Expansionary fiscal policy (i.e., lower taxes, higher government spending, increased welfare transfers) would directly stimulate aggregate demand.

a. Oil well equipment Decline (environmental pressures, decline in easily-developed oil fields)
b. Computer hardware Consolidation stage
c. Computer software Consolidation stage
d. Genetic engineering Start-up stage
e. Railroads Relative decline


If the economy enters a recession, the firm will have $21 million after-tax profit.
Chapter 13
15. k = rf + β [E(rM) – rf ] = 0.05 + 1.5 × (0.10 – 0.05) = 0.125 or 12.5%
P0 = "D1" /"k - g" = "$2.5" /"0.125 - 0.04" = $29.41
18. ROE = 20%, b = 0.3, EPS = $2, k = 12% P/E Ratio
We can calculate the P/E ratio by dividing the current price by the projected earnings:
P0 = "D1" /"k - g" = "EPS × (1-b)" /"k - (ROE × b)" = "$2 × (1 - 0.3)" /"0.12 - 0.20 × 0.3" = "$1.4" /"0.12 - 0.06" = $23.33
P/E = $23.33/$2 = 11.67 Or we can use Equation 13.8 in the chapter:
"P0" /" E1" = "1 - b" /"k - (ROE × b)" = "1 - 0.3" /"0.12 - 0.20 × 0.3" = 11.67

Present Value of Growth Opportunities (PVGO) g = ROE × b = 0.20 × 0.3 = 0.6
PVGO = P0 – "E1" /" k" = "D1" /"k - g" – "E1" /" k" = "$1.4" /"0.12 - 0.06" – "$2 " /"0.12" = $6.67

Impacts of Reducing Plowback Ratio g = ROE × b = 0.20 × 0.2 = 0.04 = 4%
D1 = EPS × (1 – b) = $2 × (1 – 0.2) = $1.6
P0 = "D1" /"k - g" = "$1.6" /"0.12 - 0.04" = $20
P/E = $20/$2 = 10.0
PVGO = P0 – "E1" /" k" = $20.00 – "$2 " /"0.12" = $3.33

19. ROE = 16%, b = 0.5, EPS = $2, k = 12% P0 = "D1" /"k - g" ="EPS × (1-b)" /"k - (ROE × b)" = "$2 × (1 - 0.5)" /"0.12 - 0.16 × 0.5" = "$1" /"0.12 - 0.08" = $25

P3 = "EPS × (1-b) × (1 + g)3" /"k - g" = P0 × (1 + g)3 = $25 × (1.08)3 = $31.49

20. a. k = rf + β [E(rM) – rf ] = 0.06 + 1.25 × (0.14 – 0.06) = 0.16 or 16% g = ROE × b = 0.09 × (2/3)= 0.06 or 6% D1 = E0 × (1 + g) × (1 – b) = $3 × 1.06 × (1/3) = $1.06 P0 = "D1" /"k - g" = "$1.06" /"0.16 - 0.06" = $10.60

Leading P0/E1 = $10.60/$3.18 = 3.33
Trailing P0/E0 = $10.60/$3.00 = 3.53

PVGO = P0 – "E1" /" k" = $10.60 – "$3.18" /"0.16" = $9.28
The low P/E ratios and negative PVGO are due to a poor ROE (9%) that is less than the market capitalization rate (16%).

Now, you revise the plowback ratio in the calculation so that b = 1/3: g = ROE × b = 0.09 × 1/3 = 0.03 or 3%
D1 = E0 × (1 + g) × (1 – b) = 3 × 1.03 × (2/3) = $2.06
Intrinsic value = V0 = "D1" /"k - g" = "$2.06" /"0.16 - 0.03" = $15.85
V0 increases because the firm pays out more earnings instead of reinvesting earnings at a poor ROE. This information is not yet known to the rest of the market.

24. Before-tax cash flow from operations $2,100,000
Depreciation 210,000
Taxable income 1,890,000
Taxes (@ 35%) 661,500
After-tax unleveraged income 1,228,500
After-tax cash flow from operations
(After-tax unleveraged income + depreciation) 1,438,500
New investment (20% of cash flow from operations) 420,000
Free cash flow
(After-tax cash flow from operations – new investment) $1,018,500

The value of the firm (i.e., debt plus equity) is:
V0 = "FCFF1" /"k - g" = "$1,018,500" /"0.12 - 0.05" = $14,550,000
Since the value of the debt is $4 million, the value of the equity is $10,550,000.…...

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