Restructuring effects on EPS, leverage and WACC — MCQs

Norvale Manufacturing is considering replacing a labor-intensive production line with automated equipment. The investment committee asks corporate finance analyst Elena Ruiz to estimate the project's incremental cash flows and a risk-appropriate discount rate. The project will operate for three years, and all cash flows occur at year-end except the initial investment. Norvale already owns the land required for the project. The land is not currently used in operations and could be sold immediately for the after-tax amount reported in Exhibit 1. Management commissioned a feasibility study last year and has already paid the consultant. The expenditure cannot be recovered regardless of whether the project proceeds. Net working capital must be committed when the equipment is installed and is expected to be recovered fully when the project terminates. Ruiz assumes the annual operating cash flows shown in Exhibit 1 are incremental, after tax, and exclude both depreciation tax benefits and financing costs. The stated salvage value is also after tax. For an initial screening calculation, the investment committee instructs Ruiz to use a 10.0% annual project discount rate. Ruiz separately estimates Norvale's company-wide weighted average cost of capital using the information in Exhibit 2. Norvale's debt is publicly traded, and the quoted debt and equity values are current market values. The cost of equity was estimated with a standard market model, while the debt cost is a pre-tax yield. Norvale can use the full interest tax deduction. Because the automated process differs materially from Norvale's existing operations, Ruiz identifies a publicly traded pure-play comparable. She assumes the comparable's debt beta is zero and that both companies face the same 25.0% corporate tax rate. She plans to remove the effect of the comparable's leverage from its equity beta and then incorporate the project's target leverage. The project is expected to maintain its target debt-to-equity ratio throughout its life.

A company has 52 inventory days, 38 receivable days, and 31 payable days. If inventory days fall by 6 and receivable days rise by 2, the new cash-conversion cycle is closest to:

Northbridge Holdings operates industrial and consumer-products divisions. The company has accumulated excess cash and is considering alternative ways to distribute it. Management believes the shares are fairly valued at the current market price and has no material nonpublic information concerning future operating performance. Unless otherwise stated, the analyst assumes frictionless capital markets, no personal taxes, and no signaling effect from the payout method. One alternative is an open-market share repurchase at the current market price. If cash is distributed, Northbridge will no longer earn the investment return generated by that cash. The analyst is therefore instructed to incorporate the after-tax reduction in interest income when estimating post-repurchase earnings per share. The repurchase will not otherwise affect operating earnings, financing costs, or the tax rate. A second alternative is a special cash dividend using all available excess cash. The board asks whether the dividend itself creates shareholder wealth or whether the share price simply adjusts for assets leaving the company. The analyst is instructed to assess the immediate mechanical effect under the stated frictionless-market assumptions rather than infer a signaling effect. Northbridge is also evaluating a spin-off of its consumer-products division. The two divisions currently share only centralized reporting and treasury services. The board believes investors may value the businesses more accurately if they are separately listed, but it wants the analyst to identify an operating or governance benefit supported by the facts rather than assume that every spin-off creates value. Finally, a director proposes replacing the open-market repurchase with a tender offer at a premium to both the market price and estimated intrinsic value. The offer would use existing cash, and participation would be voluntary. The analyst is asked to assess which shareholder group would bear the economic cost of paying more than intrinsic value. The analysis does not assume any future performance improvement that would justify the tender premium.

A company with net income of USD 12 million and 1 million shares uses USD 6 million of cash to repurchase 200,000 shares. The cash earned 4% before tax, and the tax rate is 25%. The calculated value of post-repurchase EPS is closest to:

An analyst reviews a limited liability company (LLC) in which several members actively participate in day-to-day management decisions. Which conclusion is most accurate?

An analyst evaluates a limited partnership in which investors do not participate in management. Which feature most likely distinguishes the general partner?

A company has market values of USD 600 million common equity, USD 100 million preferred stock, and USD 300 million debt. Their costs are 11%, 8%, and 6%, respectively, and the tax rate is 25%. The calculated value of WACC is closest to: