- The document provides information about two franchise opportunities for a $300,000 investment: Franchise L (Lisa's Soups, Salads, and Stuff) and Franchise S (Sam's Fried Chicken). - Net cash flows over 3 years are provided, showing Franchise L's cash flows increasing as health consciousness grows, while Franchise S's decrease as other competitors enter. - The investor must calculate various metrics like NPV, IRR, MIRR to determine which franchise(s) to invest in, considering a required 10% return.

1. COVERFINANCIAL POLICY AND STRATEGY.PROFESSOR
MANUCHEHR SHAHROKHIDIAGNOSTIC TESTNote: Please
use EXCEL FORMULAS to do your calculations and show your
work for partial credit. This test is open book, open notes and
you may access the Internet.However, communication of any
kind is NOT allowed. Once you are done, please save it and
submit it via Bb. Time allowed: 6 HOURSGOOD LUCK!By
entering name and student ID, you are attesting that you
individually did work on the test, and the entire test was
completed by you individually and WITH NO HELP OR
ADVICE OR HINT, FROM ANYONE ELSE.NAME:
____________________________STUDENT ID:
___________________________
1
2
3
4
5
6
7
Some Relevant and Useful Formulas:
VU =EBIT/Ku; VL = VU;D + SL = VL; KsL = KsU
+ (KsU - Kd) (D/S)
WACC = Wd Kd + WceKs = (D/V)Kd + (S/V)Ks
M&M Proposition I: VL=VU + TD
M&M Proposition II: KsL = KsU + (KsU – Kd) (1 - T) (D/S).
VU = EBIT(1-T)/KsU
KsL= KsU + (KsU - Kd) (1-T)(D/S)
WACCL= (D/V) Kd (1-T) + (S/V)Ks and VL = VU + TCD
VL = VU +D
8
9

2. 10
11SOLUTION A. FCFE2015 =NI+ DEPR -CAP EXP -
(WORKING CAPITAL 2015- WORKING CAP 2013) + (DEBT
2015-DEBT 2014)FCFE2015 = $117.9 + $573.5 - $800 - ($92 -
$34.8) + (2000-1750) = $84.20 million FCFE2016 = $130 +
$580 - $850 - (-370 - 92) + (2200 - 2000) = $522 million
Today is Jack’s 30th birthday. Five years ago, Jack opened a
brokerage account when his grandmother gave him $25,000 for
his 25th birthday. Jack added $2,000 to this account on his 26th
birthday, $3,000 on his 27th birthday, $4,000 on his 28th
birthday, and $5,000 on his 29th birthday. Jack’s goal is to
have $400,000 in the account by his 40th birthday. Starting
today, he plans to contribute a fixed amount to the account each
year on his birthday. He will make 11 contributions, the first
one will occur today, and the final contribution will occur on
his 40th birthday. Complicating things somewhat is the fact
that Jack plans to withdraw $20,000 from the account on his
40th birthday to finance the down payment on a home. How
large does each of these 11 contributions have to be for Jack to
reach his goal? Assume the account has earned (and will
continue to earn) an effective return of 12% a year.
Today is Jack’s 30
th
birthday. Five years ago, Jack opened a brokerage account
when his grandmother gave him $25,000 for his 25
th
birthday. Jack added $2,000 to
this account on his 26
th
birthday, $3,000 on his 27
th
birthday, $4,000 on his 28
th
birthday, and $5,000 on his 29
th

3. birthday. Jack’s goal is to have $400,000 in the
account by his 40
th
birthday. Starting today, he plans to contribute a fixed amount
to the account each year on his birthday. He will make 11
contributions, the first
one will occur today, and the final contribution will occur on
his 40
th
birthday. Complicating things somewhat is the fact that Jack
plans to withdraw $20,000 from the
account on his 40
th
birthday to finance the down payment on a home. How large
does each of these 11 contributions have to be for Jack to reach
his goal? Assume the
account has earned (and will continue to earn) an effective
return of 12% a year.
A financial analyst has been following Fast Start Inc., a new
high-growth company. She estimates that the current risk-free
rate is 6.25%, the market risk premium is 5%, and that Fast
Start's beta is 1.75. The current earnings per share (EPS0) is
$2.50. The company has a 40% payout ratio. The analyst
estimates that the company's dividend will grow at a rate of
25% this year, 20% next year, and 15% the following year.
After three years the dividend is expected to grow at a constant
rate of 7% a year. The company is expected to maintain its
current payout ratio. The analyst believes that the stock is
fairly priced. What is the current price of the stock?
A financial analyst has been following Fast Start Inc., a new
high -growth company. She estimates that the current risk -free
rate is 6.25%, the market risk premium is 5 %, and that Fast
Start's beta is 1.75. The current earnings per share (EPS
0

4. ) is $2.50. The company has a 40% payout ratio. The analyst
estimates that the company's dividend will grow at a rate of 25
%
this year, 20% next year, and 15% the following year. After
three years the dividend is expected to grow at a constant rate
of 7 % a year. The company is expected to maintain its current
payout ratio. The analyst believes that the stock is fairly
priced. What is the current price of the stock?
You own 100 bonds issued by Euler, Ltd. These bonds have 8
years remaining to maturity, an annual coupon payment of $80,
and a par value of $1,000. Unfortunately, Euler is on the brink
of bankruptcy. The creditors, including yourself, have agreed to
a postponement of the next 4 interest payments (otherwise, the
next interest payment would have been due in 1 year). The
remaining interest payments, for Years 5 through 8, will be
made as scheduled. The postponed payments will accrue
interest at an annual rate of 6%, and they will then be paid as a
lump sum at maturity 8 years hence. The required rate of return
on these bonds, considering their substantial risk, is now 28%.
What is the present value of each bond?
You own 100 bonds issued by Euler, Ltd. These bonds have 8
years remaining to maturity, an annual coupon payment of $80,
and a par v alue of $1,000.
Unfortunately, Euler is on the brink of bankruptcy. The
creditors, including yourself, have a greed to a postponement of
the next 4 interest payments (otherwise, the
next interest payment would have been due in 1 year). The
remaining interest payments, for Years 5 through 8, will be
made a s scheduled. The postponed
payments will accrue interest a t an annual rate of 6%, and they
will then be paid as a lump sum at maturity 8 years hence. The
required rate of return on these
bonds, considering their substantial risk, is now 28 %. What is
the present value of each bond?
A money manager is holding the following portfolio:

5. StockAmount InvestedBeta
1
$300,000
0.6
2
300,000
1.0
3
500,000
1.4
4
500,000
1.8
The risk-free rate is 6% and the portfolio’s required rate of
return is 12.5%. The manager would like to sell all of her
holdings of Stock 1 and use the proceeds to purchase more
shares of Stock 4. What would be the portfolio’s required rate
of return following this change?
A money manager is holding the following portfolio:
Stock Amount Invested Beta
1 $300,000 0.6
2 300,000 1.0
3 500,000 1.4
4 500,000 1.8

6. The risk-free rate is 6% and the portfolio’s required rate of
return is 1 2.5%. The manager would like to sell all of her
holdings of Stock 1 and use the proceeds to purchase more
shares
of Stock 4. What would be the portfolio’s required rate of
return following this change?
Watkins Inc. has never paid a dividend, and when it might
begin paying dividends is unknown. Its current free cash flow
(FCF) is $100,000 which is expected to grow at a constant 7%
rate. The weighted average cost of capital (WACC=K) is 11%.
Watkins currently holds $325,000 of non-operating marketable
securities. Its long-term debt is $1,000,000, but it has never
issued preferred stock.
a. Calculate Watkin’s value operations
b. Calculate the company’s total value
c. Calculate the value of common equity
Watkins Inc. has never paid a dividend, and when it might
begin paying dividends is unknown. Its current free cash flow
(FCF) is $100,000 which is expected to grow at a constant 7%
rate.
The weighted average cost of capital (WACC=K) is 11%.
Watkins currently holds $325,000 of non -operating marketable
securities. Its long -term debt is $1,000,000, but it has never
issued
preferred stock.
a. Calculate Watkin’s value operations
b. Calculate the company’s total value
c. Calculate the value of common equity
Six Sigma Software Co. is trying to estimate its optimal capital
structure. Right now, Six Sigma has a capital structure that
consists of 20% debt and 80% equity. (Its D/E ratio is 0.25.) %.

7. Currently the company’s cost of equity is 12% and its tax rate is
40%. The risk The risk-free rate is 6% and the market risk
premium is 5%.
What would be Six Sigma’s estimated cost of equity if it were
to change its capital structure to 50% debt and 50% equity?
Six Sigma Software Co. is trying to estimate its optimal capital
structure. Right now, Six Sigma has a capital structure that con
sists of 20% debt and 80% equity. (Its D/E ratio is
0.25.) %. Currently the company’s cost of equity is 12% and its
tax rate is 40 %. The risk The risk-free rate is 6% and the
market risk premium is 5%.
What would be Six Sigma’s estimated cost of equity if it were
to change its capital structure to 50% debt and 50% equity?
Firms U and L are in the same risk class and that both have
EBIT = $1,000,000. Firm U uses no debt financing and its cost
of equity is KsU=15%. Firm L has $2 million of debt
outstanding at a cost of Kd = 5%. There are no taxes and MM
assumptions hold.
1. Find V, S, Ks, and WACC for firms U and L.
2. Using the data given above, but now assuming that firms L
and U are both subject to a 40% corporate tax rate, repeat the
analysis under the MM with-tax model.
3. Now suppose investors are subject to the following tax rates:
TD=20% and TS=10%. What is the gain from leverage
according to the Miller’s Model?
4. How does this gain compare to the gain in the MM model
with corporate taxes?
Firms U and L are in the same risk class and that both have

8. EBIT = $1,000,000. Firm U uses no debt financing and its cost
of equity is K
sU
=15%. Firm L has $2 million of debt
outstanding at a cost of K
d
= 5%. There are no taxes and MM assumptions hold.
1. Find V, S, K
s
, and WACC for firms U and L.
2. Using the data given above, but now assuming that firms L
and U are both subject to a 40% corporate tax rate, repeat the
anal ysis under the MM with-tax model.
3. Now suppose investors are subject to the following tax rates:
T
D
=20% and T
S
=10%. What is the gain from leverage according to the Miller’s
Model?
4. How does this gain compare to the gain in the MM model
with corporate taxes?

9. You have just inherited $300,000 and have decided to purchase
at least one established franchise in the fast food industry or
possibly two if profitable. Your investment horizon is 3 years.
You have narrowed down your choices to two choices:
(1) Franchise L: Lisa’s Soups, Salads, and Stuff and
(2) Franchise S: Sam’s Fried Chicken. The net cash flows
shown below include the price you would receive for selling the
franchise in 3 years and the forecast of how each franchise will
do over the 3-year period.
Franchise L’s cash flows will start off slowly but will increase
rather quickly as people become more health conscious, while
Franchise S’s cash flows will start off high but will trail off as
other chicken competitors enter the marketplace and as people
become more health conscious and avoid fried foods.
Franchise L serves breakfast and lunch, while franchise S serves
only dinner, so it is possible to invest in both franchises. You
see these franchises as perfect complements to on another: you
could attract both the lunch and dinner crowds and the health
conscious and not so health conscious crowds with the
franchises directly competing against one another.
Below are the projects’ net cash flows (in thousands of dollars):
Expected Net Cash Flows
YearFranchise LFranchise S
0
($100)
($100)

10. 1
10
70
2
60
50
3
80
20
Depreciation, salvage values, net working capital requirements,
and tax effects are all included in these cash flows. You have
made subjective risk assessment of each franchise, and
concluded that both franchise have risk characteristics that
require a return 10%. You must now determine whether one or
both of the projects should be accepted.
1.
The NPV of franchise L is ____________
2.
The NPV of franchise S is ____________
3.
The IRR of franchise L is _____________
4.
The IRR of franchise S is _____________

11. 5.
The MIRR of L is ________
6.
The MIRR is S is ________
7.
Draw NPV profiles for both franchises. Show at what discount
rate do the profiles cross?
You have just inherited $300,000 and have decided to purchase
at least one established franchise in the fast food industry or
possibly two if profitable. Your investment horizon is 3 years.
You
have narrowed down your choices to two choices:
(1) Franchise L: Lisa’s Soups, Salads, and Stuff and
(2) Franchise S: Sam’s Fried Chicken. The net cash flows
shown below include the price you would receive for selling the
fra nchise in 3 years and the forecast of how each franchise will
do over
the 3-year period.
Franchise L’s cash flows will start off slowly but will increase
rather quickly as people become more health conscious, while
Franchise S’s cash flows will start off high but will trail off as
other
chicken competitors enter the marketplace and as people b
ecome more health conscious and avoid fried foods.
Franchise L serves breakfast and lunch, while franchise S serves
only dinner, so it is possible to invest in both franchises. You
see these franchises as perfect complements to on another: you
could attract both the lunch and dinner crowds and the health
conscious and not so health conscious crowds with the

12. franchises directl y competing against one another.
Below are the projects’ net cash flows (in thousands of dollars):
Expected Net Cash Flows
Year Franchise L Franchise S
0 ($100) ($100)
1 10 70
2 60 50
3 80 20
Depreciation, salvage values, net working capital requirements,
and tax effects are all included in these cash flows. You ha ve
made subjective risk assessment of each franchise, and
concluded
that both franchise have risk characteristics that require a return
10%. You must now determine whether one or both of the p
rojects should be accepted.
1. The NPV of franchise L is ____________
2. The NPV of franchise S is ____________
3. The IRR of franchise L is _____________
4. The IRR of franchise S is _____________
5. The MIRR of L is ________
6. The MIRR is S is ________
7. Draw NPV profiles for both franchises. Show at what
discount rate do the profiles cro ss?
During the past few years, Harry Davis Industries (HDI) has
been constrained by high cost of capital to make many capital
investments. Recently, though, capital costs have been declining
and the company has decided to look seriously at a major
expansion program that had been proposed by the marketing
department. Assume that you are an assistant to the CFO. Your
first task is estimate HDI’s cost of capital. The CFO has
provided you with the following data, which is considered to
your task:
1. The current price of HDI’s 12% coupon , seminal annual,

13. non-callable bonds with 15 years to maturity is $1153.72. HDI
does not use short-term interest bearing debt on a permanent
basis. New bonds would be privately placed with no flotation
costs.
2. The current price of HDI’s 10%, $100 par value, quarterly
dividend, perpetual preferred stock is $113.10. HDI would
incur flotation cost of $2.00 per share.
3. HDI’s common stock is currently selling for $50 per share.
Its last dividend (d0) was $4.19, and dividends are expected to
grow at a constant rate of 5% in the foreseeable future. HDI’s
beta is 1.2; the yield on T-Bonds is 7%; and the market risk
premium is estimated to be 6%. For the bond-yield-plus-risk-
premium approach, the firm uses a 4% point risk premium.
4. HDI’s target capital structure:30% long-term, 10% pref.
stock, and 60% common equity.
5. The firm’s tax rate is 40%
To structure the task somewhat, CFO has asked you to answer
the following questions:
1. The after-tax cost of HDI’s debt, Kd is ___________
2. The firm’s cost of preferred stock, Kp, is __________
3. Using CAPM the firm’s cost of equity, Ke is _______
4. The estimated cost of equity using Discounted Cash Flow
(DCF) model is ______
5. The cost of equity, Ke, based on the bond-yield-plus-risk-
premium method is ____

14. 6. The overall cost of equity, Ke is __________
7. The weighted average cost of capital (WACC) is _________
8. HDI estimates that if it issues new common stock, the
flotation cost will be 15%. HDI incorporates the flotation costs
into the DCF approach. The estimated cost of newly issued
common stock, taking into account the flotation cost is
_________
9. Suppose HDI has historically earned 15% on equity (ROE)
and retained 35% of earnings, and investors expect this
situation to continue in the future. How could you use this
information to estimate the future dividend growth rate, and
what growth rate would you get? Is this consistent with the 5%
growth rate given?
HDI is interested in establishing a new division, which will
focus primarily on developing new internet-based projects. In
trying to determine the cost of capital for this new division,
you discover that stand-alone firms involved in similar projects
have on average the following characteristics:
- Capital structure of 10% debt and 90% equity.
- Cost of debt of 12% and beta of 1.7.
10. Given this information, your estimate of the division’s cost
capital is _______
During the past few years, Harry Davis Industries (HDI) has
been constrained by high cost of capital to make many capital
inv estments. Recently, though, capital costs have been
declining
and the company has decided to look seriously at a major
expansion pr ogram that had been proposed by the marketing

15. department. Assume that you are an assistant to the CFO. Your
first
task is estimate HDI’s cost of capital. The CFO has provided
you with the following data, which is considered to your task:
1. The current price of HDI’s 12% coupon , seminal annual,
non-callable bonds with 15 years to maturity is $1153.72. HDI
does not use short -term interest bearing debt on a permanent
basis. New bonds would be privately placed with no flotation
costs.
2. The current price of HDI’s 10%, $100 par value, quarterly
dividend, perpetual preferred stock is $113.10. HDI would
incur flotation cost of $2.00 per share.
3. HDI’s common stock is currently selling for $50 per share.
Its last dividend (d
0
) was $4.19, and dividends are expected to grow at a constant
rate of 5% in the foreseeable future.
HDI’s beta is 1.2; the yield on T-Bonds is 7%; and the market
risk premium is estimated to be 6%. For the bond -yield-plus-
risk-premium approach, the firm uses a 4% point risk
premium.
4. HDI’s target capital structure:30% long-term, 10% pref.
stock, and 60% common equity.
5. The firm’s tax rate is 40%
To structure the task somewhat, CFO has asked you to answer
the following questions:
1. The after-tax cost of HDI’s debt, K
d
is ___________
2. The firm’s cost of preferred stock, K
p
, is __________
3. Using CAPM the firm’s cost of equity, K

16. e
is _______
4. The estimated cost of equity using Discounted Cash Flow
(DCF) model is ______
5. The cost of equity, K
e,
based on the bond-yield-plus-risk-premium method is ____
6. The overall cost of equity, K
e
is __________
7. The weighted average cost of capital (WACC) is _________
8. HDI estimates that if it issues new common stock, the
flotation cost will be 15%. HDI incorporates the flota tion
costs into the DCF approach. The estimated cost of newly
issued
common stock, taking into account the flotation cost is
_________
9. Suppose HDI has historically earned 15% on equity (ROE)
and retained 35% of earnings, and investors expect this situa
tion to continue in the future. How could you use this
information to estimate the future dividend growth rate, and
what growth rate would you get? Is this consistent with the 5%
g rowth rate given?
HDI is interested in establishing a new division, which wil l
focus primarily on developing new internet-based projects. In
trying to determine the cost of capital for this new division,
you discover that stand-alone firms involved in similar projects
have on average the following characteristics:
- Capital structure of 10% debt and 90% equity.
- Cost of debt of 12% and beta of 1.7.
10. Given this information, your estimate of the division’s cost
capital is _______

17. Miller Technologies recently reported the following balance
sheet in its annual report (all numbers are in millions of
dollars):
Cash
$ 100
Accounts payable
$ 300
Accounts receivable
300
Notes payable
500
Inventory
500
Total current liabilities
$ 800
Total current assets
$ 900
Long-term debt
1,500
Total debt
$2,300
Common stock
500
Retained earnings
400
Net fixed assets
2,300
Total common equity
$ 900

18. Total assets
$3,200
Total liabilities & equity
$3,200
Miller also reported sales revenues of $4.5 billion and a 20%
ROE for this same year.
A. What is Miller’s ROA?
B. Miller Technologies is considering issuing $300 million in
notes payable to purchase new fixed assets (for this problem,
ignore depreciation). If this plan were carried out,
what would Miller’s current ratio be immediately following the
transaction?
Miller Technologies recently reported the following balance
sheet in its annual report (all numbers are in millions of dollar
s):
Cash $ 100 Accounts payable $ 300
Accounts receivable 300 Notes payable 500
Inventory 500 Total current liabilities $ 800
Total current assets $ 900 Long-term debt 1,500
Total debt $2,300
Common stock 500
Retained earnings 400
Net fixed assets 2,300 Total common equity $ 900
Total assets $3,200 Total liabilities & equity $3,200
Miller also reported sales revenues of $4.5 billion and a 20%
ROE for this same year.
A. What is Miller’s ROA?
B. Miller Technologies is considering issuing $300 million in
notes payable to purchase new fixed assets (for th is problem,
ignore depreciation). If this plan were carried out,

19. what would Miller’s current ratio be immediately following the
transaction?
ABC Corp is a full-service truck leasing, maintenance, and
rental firm with operations in North America and Europe. The
following are selected numbers from the financial statements
for 2014 and 2015(in millions).
2014
2015
Revenues
$5,192.0
$5,400.0
(Less) Operating Expenses
($3,678.5)
($3848.0)
(Less) Depreciation
($573.5)
($580.0)
= EBIT
$940.0
$972.0
(Less) Interest Expenses
($170.0)
($172.0)
(Less) Taxes
($652.1)
($670.0)
= Net Income
$117.9
$130.0
Working Capital
$92.0
<$370.0>
Total Debt
$2,000 mil

20. $2,200 mil
The firm had capital expenditures of $800 million in 2014 and
$850 million in 2015. The working capital in 2014 was $34.8
million, and the total debt outstanding in 2014 was $1.75
billion. There were 77 million shares outstanding, trading at $29
per share.
A. Estimate the cash flows to equity in 2014 and 2015.
B. Estimate the cash flows to the firm in 2014 and 2015.
C. Assuming that revenues and all expenses (including
depreciation and capital expenditures) increase 6%, and that
working capital remains unchanged in 2016 estimate the
projected cash flows to equity and the firm in 2016. (The firm is
assumed to be at its optimal financial leverage.)
D. How would your answer in (c) change if the firm planned to
increase its debt ratio in 2016 by financing 75% of its capital
expenditures (net of depreciation) with new debt issues?
ABC Corp is a full-service truck leasing, maintenance, and
rental firm with operations in North America and Europe. The
following are selected numbers
from the financial statements for 2014 and 2015(in millions).
2014 2015
Revenues $5,192.0 $5,400.0
(Less) Operating Expenses ($3,678.5) ($3848.0)
(Less) Depreciation ($573.5) ($580.0)
= EBIT $940.0 $972.0
(Less) Interest Expenses ($170.0) ($172.0)
(Less) Taxes ($652.1) ($670.0)
= Net Income $117.9 $130.0
Working Capital $92.0 <$370.0>
Total Debt $2,000 mil $2,200 mil
The firm had capital expenditures of $800 million in 2014 and

21. $850 million in 2015. The working capital in 2014 was $34.8
million, and the total debt
outstanding in 2014 was $1.75 billion. There were 77 million
shares outstanding, trading at $29 per share.
A. Estimate the cash flows to equity in 2014 and 2015.
B. Estimate the cash flows to the firm in 2014 and 2015.
C. Assuming that revenues and all expenses (including
depreciation and capital expenditures) increase 6%, and that
working capital remains unchanged
in 2016 estimate the projected cash flows to equity and the firm
in 2016. (The firm is assumed to be at its optimal financial
leverage.)
D. How would your answer in (c) change if the firm planned to
increase its debt ratio in 2016 by financing 75% of its capital
expenditures (net of
depreciation) with new debt issues?