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Chapter 10, End of Chapter, EXERCISES, Exercise 10-1

Here is the step-by-step explanation, verified by an educator:

Step 1 of 8

As, when the return on assets is 15%, then it is known as a good state and when the return on assets is 4%, then it is
known as a bad state.

Calculate the net operating income in good state when the debt to assets ratio is 30% (NOI1,G) by multiplying the total
assets (TA) which are $1,500,000 with the return on assets at good state (ROAG) is 15%.

Calculate the interest expenses when the debt to assets ratio is 30% (IE1) by multiplying the total assets (TA) which are
$1,500,000 with the borrowing rate (R) which is 9% and the debt to assets ratio (DA1) is 30%.

Net operating income of good state:

NOI1,G = TA × ROAG
= $1, 500, 000 × 15%
= $225, 000

Interest expenses:

IE1 = TA × R × DA1
= $1, 500, 000 × 9% × 30%
= $40, 500

Step 2 of 8

Calculate the net income at good state (NI1,G) by subtracting the the interest expenses when the debt to assets ratio is
30% (IE1) which is $40,500 from net operating income (NOI1,G) at good state when the debt to assets ratio is 30%
(NOI1,G) which is $2,25,000.

Calculate the return on equity of good state (ROE1,G) by using the formula for the same. Here, the total assets (TA) is
$1,500,000 and the debt to assets (DA1) is 30%.

Net income of good state:

NI1,G = NOI1,G − IE1

= $225, 000 − $40, 500
= $184, 500

Return on equity of good state:

NI
 NI1,G
ROE1,G =
(1 − DA1 ) × TA
$184, 500
=
(1 − 0.30) × $1, 500, 000
= 17.57%

Step 3 of 8

Calculate the net operating income at a bad state when the debt to assets is 30% (NOI1,B) by multiplying the total assets
(TA) which is $1,500,000 with the return on assets at a bad state (ROAB) is 4%.

Calculate the net income at a bad state when the debt to assets is 30% (NI1,B) by subtracting the interest expenses (IE1)
which is $40,500 from the net operating income at a bad state (NOI1,B).

Net operating income of bad state:

NOI1,B = TA × ROAB
= $1, 500, 000 × 4%
= $60, 000

Net income at a bad state:

NI1,B = NOI1,B − IE1

= $60, 000 − $40, 500
= $19, 500

Step 4 of 8

Calculate the return on equity at a bad state when the debt to asset ratio is 30% (ROE1,B) by using the formula for the
same. Here, the net income at a bad state (NI1,B) is $19,500, the total assets (TA) is $1,500,000 and the debt to assets
(DA1) is 30%.

NI1,B
ROE1,B =
(1 − DA1 ) × TA
$19, 500
=
(1 − 0.30) × $1, 500, 000
= 1.86%

Step 5 of 8

Calculate the interest expenses when the debt to assets ratio is 50% (IE2) by multiplying the total assets (TA) which is
$1,500,000 with the borrowing rate (R) which is 9% and the debt to assets (DA2) is 50%.

IE2 = TA × R × DA2
= $1, 500, 000 × 9% × 50%
= $67, 500
Step 6 of 8

Calculate the net income at a good state when the debt to assets ratio is 50% (NI2,G) by subtracting the interest
expenses (IE2) which is $67,500 from the net operating income of good state (NOI2,G) which is $2,25,000.

Calculate the return on equity of good state (ROE2,G) by using the formula for the same. Here, the net income at a good
state is denoted by (NI2,G), the total assets (TA) is $1,500,000 and the debt to assets (DA2) is 50%.

Net income of good state:

NI2,G = NOI2,G − IE2

= $225, 000 − $67, 500
= $157, 500

Return on equity of good state:

NI2,G
ROE2,G =
(1 − DA2 ) × TA
$157, 500
=
(1 − 0.50) × $1, 500, 000
= 21%

Step 7 of 8

Calculate the net income at a bad state (NI2,B) by subtracting the interest expenses (IE2) which is $67,500 from the net
operating income at a bad state (NOI2,B) which is $60,000.

NI2,B = NOI2,B − IE2

= $60, 000 − $67, 500
= −$7, 500

Step 8 of 8

Calculate the return on equity at a bad state (ROE2,B) by using the formula for the same. Here, the net income at a bad
state (NI2,B) is -$7,500, the total assets (TA) is $1,500,000 and the debt to assets (DA2) is 50%.

NI2,B
ROE2,B =
(1 − DA2 ) × TA
−$7, 500
=
(1 − 0.50) × $1, 500, 000
= −1%
 Final answer

Attachment URL

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Ch 10, End of Chapter, Ex 10-1

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Chapter 10, End of Chapter, EXERCISES, Exercise 10-2

Part a Part b

Explanation

Calculate the post-money valuation of company S by dividing the financing amount which is $4,000,000 with the desired
equity which is 40%.

Financing Amount
Post-money Valuation =
Desired Equity
$4, 000, 000
=
40%
= $10, 000, 000

Verified Answer

$10,000,000

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Chapter 10, End of Chapter, EXERCISES, Exercise 10-2

Part a Part b

Explanation

Calculate the pre-money valuation of company S by subtracting the financing amount which is $4,000,000 from the post-
money value which is $10,000,000.

Pre-money Valuation = Post-money Value − Financing Amount

= $10, 000, 000 − $4, 000, 000
= $6, 000, 000

Verified Answer

$6,000,000

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Ch 10, End of Chapter, Ex 10-2

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Chapter 10, End of Chapter, EXERCISES, Exercise 10-3

Here is the step-by-step explanation, verified by an educator:

Step 1 of 2

Calculate the earnings before interest, taxes, depreciation and amortization at the end of five years (EBITDA5) by using
the formula of compounding.

Here, initial earnings (EBITDA) is $750,000, growth rate (G) is 30% and time period (T) is 5 years.

EBITDA5 = EBITDA × (1 + G)T

= $750, 000 × (1 + 0.30)5
= $2, 784, 697.50

Step 2 of 2

Calculate the enterprise value of a company after 5 years (EV5) by multiplying the earnings before interest, taxes,
depreciation and amortization of five years (EBITDA5) which is $2,784,697.50 with the EBITDA multiple which is 5.

EV5 = EBITDA5 × EBITDA Multiple

= $2, 784, 697.50 × 5
= $13, 923, 487.50

Final answer

$13,923,487.50

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Chapter 10, End of Chapter, Problems, Exercise 10-4

Part a Part b Part c Part d

Here is the step-by-step explanation, verified by an educator:

Step 1 of 4

Calculate the required dollar return to the firm by using the formula of compounding.

Here, the capital needed is $500,000, the time period (T) is 5 years and required rate of return (R) is 45%.

Required Dollar Return = Capital Needed × (1 + R)T

= $500, 000 × (1 + 0.45)5
= $3, 204, 867.03

Step 2 of 4

Determine the enterprise value after five years (EV5) by multiplying the EBITDA at Year 5 (EBITDA5) which is $1,050,000
with the EBITDA sales multiple which is 6 times.

EV5 = EBITDA5 × EBITDA Sales Multiple

= $1, 050, 000 × 6
= $6, 300, 000

Step 3 of 4

Compute the equity value in year 5 (Equity Value5) by subtracting the interest bearing debt which is $1,000,000 from the
enterprise value after five years (EV5) which is $6,300,000. Then add the resultant value with the cash balance in fifth
year (Cash5) which is $200,000.

Equity Value5 = (EV5 − Interest Bearing Debt) + Cash5

= ($6, 300, 000 − $1, 000, 000) + $200, 000
= $5, 500, 000

Step 4 of 4

Calculate the required ownership share by dividing the required dollar return which is $3,204,867.03 with the equity value
in year 5 (Equity Value5) which is $5,500,000.
 Required Dollar Return
Required Ownership Share =
Equity Value5
$3, 204, 867.03
=
$5, 500, 000
= 58.27%

Final answer

58.27%

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Chapter 10, End of Chapter, Problems, Exercise 10-4

Part a Part b Part c Part d

Here is the step-by-step explanation, verified by an educator:

Step 1 of 5

Calculate the interest expense on debt by multiplying the interest rate of 10% with the required funds of $500,000.

Interest Expense = Required Funds × Interest Rate

= $500, 000 × 10%
= $50, 000

Step 2 of 5

In order to calculate the Year 5 return to the VC firm, it is required to calculate the terminal value of the subordinate debt
(sub-debt).

Firstly, draft the calculation of the IRR of the debt holders on a spreadsheet using Excel IRR function with cash flows as
inputs. For the Year 0 the cash outflows will be the initial funding of $500,000. For the Years 2, 3, 4 the cash flows will be
$50,000 each. These are the interest payments. For the final Year 5 the cash flow will be the summation of the interest
payment and the terminal value. Keep the cell that represents the terminal value blank as of now.

Calculate the terminal value of the subordinate debt by using Excel Goal-seek function.

For the option 'Select cell' the input will be the cell 'C'. This is the cell that has the value of IRR. The input for the option
'To value' will be '0.35' as the desired return is 35%. For the option 'By changing cell' the input will be 'D9', this is the cell
that has the value of the terminal value. Click 'Solve' to get the desired results.

Goal-seek inputs:

Terminal value:
 Attachment URL

Step 3 of 5

Determine the enterprise value after five years (EV5) by multiplying the EBITDA of Year 5 (EBITDA5) which is $1,050,000
with the EBITDA sales multiple which is 6 times.

EV5 = EBITDA5 × EBITDA Sales Multiple

= $1, 050, 000 × 6
= $6, 300, 000

Step 4 of 5

Compute the equity value in year 5 (Equity Value5) by subtracting the interest bearing debt which is $1,000,000 from the
enterprise value after five years (EV5) which is $6,300,000. Then add the resultant value with the cash in fifth year
(Cash5) which is $200,000.

Equity Value5 = (EV5 − Interest Bearing Debt) + Cash5

= ($6, 300, 000 − $1, 000, 000) + $200, 000
= $5, 500, 000

Step 5 of 5

Calculate the required ownership share by dividing the required dollar return which is $1,743,827 with the equity value in
year 5 (Equity Value5) which is $5,500,000.

Required Dollar Return

Required Ownership Share =
Equity Value5
$1, 743, 827
=
$5, 500, 000
= 31.71%

Final answer

31.71%
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Chapter 10, End of Chapter, Problems, Exercise 10-4

Part a Part b Part c Part d

Here is the step-by-step explanation, verified by an educator:

Step 1 of 5

Calculate the estimated equity value in fifth year (Estimated Equity5) by subtracting the required capital which is
$500,000 from the equity value in fifth year (Equity Value5) which is $5,500,000.

Estimated Equity5 = Equity Value5 − Required Capital

= $5, 500, 000 − $500, 000
= $5, 000, 000

Step 2 of 5

Determine the amount of dividends by multiplying the required capital which is $500,000 with the dividend rate which is
8%. The same will be the dividend cash flow for years 2, 3 , 4 and 5.

Dividend = Required Capital × Dividend Rate

= $500, 000 × 8%
= $40, 000

Step 3 of 5

Calculate the equity value adjusted for warrant price (Equity ValueAdjusted) by multiplying the estimated equity value in fifth
year (Estimated Equity5) which is $5,000,000 with the required ownership which is 40%. Then subtract the warrant price
which is $100,000 from the resultant value.

Equity ValueAdjusted = (Estimated Equity5 × Required Ownership) − Warrant Price

= ($5, 000, 000 × 40%) − $100, 000
= $1, 900, 000

Step 4 of 5

Determine the cash flow of year 5 (CF5) by adding the dividend which is $40,000 with the equity value adjusted for
warrant price (Equity ValueAdjusted) which is $1,900,000 and the required capital which is $500,000.

CF5 = Equity ValueAdjusted + Dividend + Required Capital

= $1, 900, 000 + $40, 000 + $500, 000
= $2, 440, 000
Step 5 of 5

Compute the rate of return of preferred alternatives by using the Excel IRR function with cash flows as inputs. Cash flows
for year 1 to year 4 are $40,000 each and for year 5 it is $2,440,000. The initial investment is $500,000.

Attachment URL

Final answer

41.65%

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Chapter 10, End of Chapter, Problems, Exercise 10-4

Part a Part b Part c Part d

Explanation

After analysing the alternatives of investment structures, it can be inferred that the lowest return is expected when the
financing is through convertible debentures. Moreover, at exit year, the percentage of ownership required to be given up is
also not very high in comparison to the other alternatives.

Verified Answer

The convertible debt alternative should be preferred by the management of the company.

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Ch 10, End of Chapter, Ex 10-4

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Chapter 10, End of Chapter, Problems, Exercise 10-5

Part a Part c

Here is the step-by-step explanation, verified by an educator:

Step 1 of 3

Calculate the EBITDA for the year 2015 (EBITDA2015) by adding the EBITDA of Company C (EBITDAC) which is
$4,000,000 with that of Company O&M (EBITDAO&M) which is $1,000,000.

EBITDA2015 = EBITDAC + EBITDAO&M

= $4, 000, 000 + $1, 000, 000
= $5, 000, 000

Step 2 of 3

Calculate the estimated earnings after five years (EBITDA2020) by using the formula of compounding.

Here, the total earnings for the year 2015 (EBITDA2015) is $5,000,000, growth rate (G) is 20% and time period (T) is 5
years.

EBITDA2020 = EBITDA2015 × (1 + G)T

= $5, 000, 000 × (1 + 0.20)5
= $12, 441, 600

Step 3 of 3

Calculate the enterprise value after five years (EV5) by multiplying the estimated earnings after five years (EBITDA2020)
which is $12,441,600 with the EBITDA multiple which is 5.

EV5 = EBITDA2020 × EBITDA Multiple

= $12, 441, 600 × 5
= $62, 208, 000

Final answer

$62,208,000

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Chapter 10, End of Chapter, Problems, Exercise 10-5

Part a Part c

Here is the step-by-step explanation, verified by an educator:

Step 1 of 3

Calculate the estimated earnings after five years (EBITDA2020) by using the formula of compounding.

Here, the total earnings for the year 2015 (EBITDA2015) is $5,000,000, new growth rate (G') is 30% and time period (T) is
5 years.

EBITDA2020 = EBITDA2015 × (1 + G’)T

= $5, 000, 000 × (1 + 0.30)5
= $18, 564, 650

Step 2 of 3

Calculate the new enterprise value after five years (EV') by multiplying the estimated earnings after five years
(EBITDA2020) which is $18,564,650 with the EBITDA multiple which is 5.

EV’ = EBITDA2020 × EBITDA Multiple

= $18, 564, 650 × 5
= $92, 823, 250

Step 3 of 3

Calculate the share of the firm that is required by the venture capital by dividing the conversion value of five years which
is $13,890,266 with the new enterprise value after five years (EV') which is $92,823,250.

Conversion Value
Required Share =
EV’
$13, 890, 266
=
$92, 823, 250
= 14.96%

Final answer

14.96%
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Chapter 10, End of Chapter, Problems, Exercise 10-6

Here is the step-by-step explanation, verified by an educator:

Step 1 of 8

Determine the enterprise value after five years (EV5) by multiplying the EBITDA at Year 5 (EBITDA5) which is $1,500,000
with the EBITDA sales multiple which is 6 times.

Compute the equity value in year 5 (Equity Value5) by subtracting the interest bearing debt which is $1,000,000 from the
enterprise value after five years (EV5). Then add the resultant value to the cash balance in fifth year (Cash5) which is
$200,000.

Calculate the required dollar return when financing is done through common stock common (Required Dollar ReturnCS)
by multiplying the VC ownership share in common stock (OwnershipCS) which is 49% with the equity value in year 5
(Equity Value5).

Enterprise value after five years:

EV5 = EBITDA5 × EBITDA Sales Multiple

= $1, 500, 000 × 6
= $9, 000, 000

Equity value in year 5:

Equity Value5 = (EV5 − Interest Bearing Debt) + Cash5

= ($9, 000, 000 − $1, 000, 000) + $200, 000
= $8, 200, 000

Required dollar return on common stock:

Required Dollar ReturnCS = OwnershipCS × Equity Value5

= 49% × $8, 200, 000
= $4, 018, 000

Step 2 of 8

Determine the investors return when financing is done through common stock by using the Excel Rate function with the
following inputs:

NPER = 5 (This is the exit year).

PMT = 0
PV = 500000 (Take this value as negative for the purpose of calculation.)
FV = 4018000 (This is required dollar return).
Type = 0 (Specifies that the payment is made at the end of the period)
Guess = 0
 = RATE(NPER, PMT, PV, [FV], [TYPE], [GUESS])
= RATE(5, 0, −500000, 4018000, 0, 0)
= 51.71%

Step 3 of 8

Calculate the required dollar return on convertible debt (Required Dollar ReturnCD) by multiplying the VC ownership share
in convertible debt (OwnershipCD) which is 30% with the equity value in year 5 (Equity Value5) which is $8,200,000.

Compute the periodic interest payment by multiplying the required capital which is $500,000 with the coupon rate on
debt which is 10%.

Required dollar return on convertible debt:

Required Dollar ReturnCD = OwnershipCD × Equity Value5

= 30% × $8, 200, 000
= $2, 460, 000

Interest payment:

Interest Payment = Required Capital × Coupon Rate

= $500, 000 × 10%
= $50, 000

Step 4 of 8

Determine the investors return when the financing is done through convertible debt by using the Excel Rate function with
the following inputs:

NPER = 5 (This is exit year)

PMT = 50000 (This is the interest payment)
PV = 500000 (Take this value as negative for the purpose of calculation.)
FV = 2460000
Type = 0 (Specifies that the payment is done at the end of the period)
Guess = 0

= RATE(NPER, PMT, PV, [FV], [TYPE], [GUESS])

= RATE(5, 50000, −500000, 2460000, 0, 0)
= 43.52%

Step 5 of 8

Calculate the required dollar return on preferred debt (Required Dollar ReturnPD) by subtracting the required capital
which is $500,000 from the equity value in year 5 (Equity Value5) which is $8,200,000 and then multiply the resultant
value with the equity share which is 40%.
 Required Dollar ReturnPD = (Equity Value5 − Required Capital) × Equity Share
= ($8, 200, 000 − $500, 000) × 40%
= $3, 080, 000

Step 6 of 8

Compute the annual dividend by multiplying the required capital which is $500,000 with the dividend rate which is 8%.

Annual Dividend = Required Capital × Dividend Rate

= $500, 000 × 8%
= $40, 000

Step 7 of 8

Determine the future value (FV) by subtracting the warrant price which is $100,000 from the required dollar return on
preferred debt (Required Dollar ReturnPD) which is $3,080,000. Then add the resultant value with the required capital
which is $500,000.

FV = (Required Dollar ReturnPD − Warrant Price) + Required Capital

= ($3, 080, 000 − $100, 000) + $500, 000
= $3, 480, 000

Step 8 of 8

Determine the investors return by using the excel Rate function with the following inputs:

NPER = 5
PMT = 40000
PV = 500000 (Take this value as negative for the purpose of calculation.)
FV = 3480000
Type = 0 (Specifies that the payment is made at the end of the period)
Guess = 0

= RATE(NPER, PMT, PV, [FV], [TYPE], [GUESS])

= RATE(5, 40000, −500000, 3480000, 0, 0)
= 51.76%

Final answer

The return expected by the investors when financing is done through common stock, convertible debt and redeemable
preference stock is 51.71%, 43.52%, 51.76% respectively.

After analysing the alternatives of investment structures, it can be inferred that the lowest return is expected when the
financing is through convertible debentures. Moreover, at exit year, the percentage of ownership required to be given
up is also not very high in comparison to the other alternatives.

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Chapter 10, End of Chapter, Problems, Exercise 10-7

Part a Part b Part c Part d Part e

Here is the step-by-step explanation, verified by an educator:

Step 1 of 5

Calculate the enterprise value at 6 times multiple (EV1) by multiplying the earning of fifth year (EBITDA Year 5) which is
$1,200,000 with the EBITDA multiple which is 6.

EV1 = EBITDAYear 5 × EBITDA Multiple

= $1, 200, 000 × 6
= $7, 200, 000

Step 2 of 5

Calculate the enterprise value at 7 times multiple (EV2) by multiplying the earning of the fifth year (EBITDAYear 5) which is
$1,200,000 with the EBITDA multiple which is 7.

EV2 = EBITDAYear 5 × EBITDA Multiple

= $1, 200, 000 × 7
= $8, 400, 000

Step 3 of 5

Determine the net debt by subtracting the cash balance at Year 5 (CashYear 5) which is $300,000 from the interest
bearing debt which is $2,000,000.

Net Debt = Interest Bearing Debt − CashYear 5

= $2, 000, 000 − $300, 000
= $1, 700, 000

Step 4 of 5

Compute the equity value at 6 times multiple (Equity Value1) by subtracting the net debt which is $1,700,000 from the
enterprise value of 6 times multiple (EV1) which is $7,200,000.
 Equity Value1 = EV1 − Net Debt
= $7, 200, 000 − $1, 700, 000
= $5, 500, 000

Step 5 of 5

Determine the equity value of 7 times multiple (Equity Value2) by subtracting the net debt which is $1,700,000 from the
enterprise value of 7 times multiple (EV2) which is $8,400,000.

Equity Value2 = EV2 − Net Debt

= $8, 400, 000 − $1, 700, 000
= $6, 700, 000

Final answer

Enterprise value:

For 6 times multiple = $7,200,000

For 7 times multiple = $8,400,000

Equity value:

For 6 times multiple = $5,500,000

For 7 times multiple = $6,700,000

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Chapter 10, End of Chapter, Problems, Exercise 10-7

Part a Part b Part c Part d Part e

Here is the step-by-step explanation, verified by an educator:

Step 1 of 8

Calculate the terminal cash flow of common stock at 6 times multiple (CFCS,1) by multiplying the equity value at 6 times
multiple (Equity Value1) which is $5,500,000 with the percentage ownership of common stock (OwnershipCS) which is
60%.

Determine the terminal cash flow of common stock at 7 times multiple (CFCS,2) by multiplying the equity value at 7 times
multiple (Equity Value2) which is $6,700,000 with the percentage ownership of common stock (OwnershipCS) which is
60%.

Terminal cash flow at 6 times multiple :

CFCS,1 = Equity Value1 × OwnershipCS

= $5, 500, 000 × 60%
= $3, 300, 000

Terminal cash flow at 7 times multiple:

CFCS,2 = Equity Value2 × OwnershipCS

= $6, 700, 000 × 60%
= $4, 020, 000

Step 2 of 8

Compute the required rate of return of common stock at 6 times multiple by using the excel Rate function with following
inputs.

NPER = 5
PMT = 0
PV = 500000 (Take this value as negative for the calculation purpose)
FV = 3300000
Type = 0 (Specifies that the payment is at the end of the period)
Rate guess = 0

Calculate the required rate of return of common stock at 7 times multiple by using the excel Rate function.

NPER = 5
PMT = 0
PV = 500000 (Take this value as negative for the calculation purpose)
FV = 4020000
Type = 0 (Specifies that the payment is at the end of the period)
 Rate guess = 0

Required rate of return at 6 times multiple:

= RATE(NPER, PMT, PV, [FV], TYPE, [RATE GUESS])

= RATE(5, 0, −500000, 3300000, [0], [0])
= 45.85%

Required rate of return at 7 times multiple:

= RATE(NPER, PMT, PV, [FV], [TYPE], [RATE GUESS])

= RATE(5, 0, −500000, 4020000, [0], [0])
= 51.72%

Step 3 of 8

Calculate the annual interest of convertible bonds (Annual InterestCB) by multiplying the stated rate of return of
convertible bonds (RCB) which is 10% with the required funds which is $500,000.

Annual InterestCB = Required Funds × RCB

= $500, 000 × 10%
= $50, 000

Step 4 of 8

Calculate the terminal cash flow of convertible bonds at 6 times multiple (CFCB,1) by multiplying the equity value at 6
times multiple (Equity Value1) which is $5,500,000 with the percentage ownership of convertible bonds (OwnershipCB)
which is 40%.

Determine the terminal cash flow of convertible bonds at 7 times multiple (CFCB,2) by multiplying the equity value at 7
times multiple (Equity Value2) which is $6,700,000 with the percentage ownership of convertible bond (OwnershipCB)
which is 40%.

Terminal cash flow at 6 times multiple :

CFCB,1 = Equity Value1 × OwnershipCB

= $5, 500, 000 × 40%
= $2, 200, 000

Terminal cash flow at 7 times multiple:

CFCB,2 = Equity Value2 × OwnershipCB

= $6, 700, 000 × 40%
= $2, 680, 000

Step 5 of 8

Compute the required rate of return of convertible bonds at 6 times multiple by using the excel Rate function.
 NPER = 5
PMT = 50000
PV = 500000 (Take this value as negative for the purpose of calculations.)
FV = 2200000
Type = 0 (Specifies that the payment is at the end of the period)
Rate guess = 0

Calculate the required rate of return of convertible bonds at 7 times multiple by using the excel Rate function.

NPER = 5
PMT = 50000
PV = 500000 (Take this value as negative for the purpose of calculations.)
FV = 2680000
Type = 0 (Specifies that the payment is at the end of the period)
Rate guess = 0

Required rate of return at 6 times multiple:

= RATE(NPER, PMT, PV, [FV], [TYPE], [RATE GUESS])

= RATE(5, 50000, −500000, 2200000, [0], [0])
= 40.67%

Required rate of return at 7 times multiple:

= RATE(NPER, PMT, PV, [FV], [TYPE], [RATE GUESS])

= RATE(5, 50000, −500000, 2680000, [0], [0])
= 45.76%

Step 6 of 8

Compute the annual interest of convertible preferred stock (Annual InterestCP) by multiplying the stated rate of return of
convertible preferred stock (RCP) which is 10% with the required funds which is $500,000.

Annual InterestCP = Required Funds × RCP

= $500, 000 × 10%
= $50, 000

Step 7 of 8

Calculate the terminal cash flow of convertible preferred stock at 6 times multiple (CFCP,1) by multiplying the equity value
at 6 times multiple (Equity Value1) which is $5,500,000 with the percentage ownership of convertible preferred stock
(OwnershipCP) which is 45%.

Determine the terminal cash flow of convertible preferred stock at 7 times multiple (CFCP,2) by multiplying the equity value
at 7 times multiple (Equity Value2) which is $6,700,000 with the percentage ownership of convertible preferred stock
(OwnershipCP) which is 45%.

Terminal cash flow at 6 times multiple :

CFCP,1 = Equity Value1 × OwnershipCP

= $5, 500, 000 × 45%
= $2, 475, 000
 Terminal cash flow at 7 times multiple:

CFCP,2 = Equity Value2 × OwnershipCP

= $6, 700, 000 × 45%
= $3, 015, 000

Step 8 of 8

Compute the required rate of return of convertible preferred stock at 6 times multiple by using the excel Rate function.

NPER = 5
PMT = 50000
PV = 500000 (Take this value as negative for the purpose of calculations.)
FV = 2475000
Type = 0 (Specifies that the payment is at the end of the period)
Rate guess = 0

Calculate the required rate of return of convertible preferred stock at 7 times multiple by using the excel Rate function.

NPER = 5
PMT = 50000
PV = 500000 (Take this value as negative for the purpose of calculations.)
FV = 3015000
Type = 0 (Specifies that the payment is at the end of the period)
Rate guess = 0

Required rate of return at 6 times multiple:

= RATE(NPER, PMT, PV, [FV], [TYPE], [RATE GUESS])

= RATE(5, 50000, −500000, 2475000, [0], [0])
= 43.68%

Required rate of return at 7 times multiple:

= RATE(NPER, PMT, PV, [FV], [TYPE], [RATE GUESS])

= RATE(5, 50000, −500000, 3015000, [0], [0])
= 48.91%

Final answer

Rate of return of common stock:

For 6 times multiple = 45.85%

For 7 times multiple = 51.72%

Rate of return of convertible bonds:

For 6 times multiple = 40.67%

For 7 times multiple = 45.76%

Rate of return of convertible preferred stock:

 For 6 times multiple = 43.68%

For 7 times multiple = 48.91%

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Ch 10, End of Chapter, Ex 10-7

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Chapter 10, End of Chapter, Problems, Exercise 10-7

Part a Part b Part c Part d Part e

Here is the step-by-step explanation, verified by an educator:

Step 1 of 6

Calculate the post-money value of common stock (Post-money ValueCS) by dividing the required funds which is
$500,000 with the percentage ownership of common stock (OwnershipCS) which is 60%.

Required Funds
Post-money ValueCS =
OwnershipCS
$500, 000
=
60%
= $833, 333.33

Step 2 of 6

Determine the pre-money value of common stock (Pre-money ValueCS) by subtracting the required funds which is
$500,000 from the post money value of common stock (Post-money ValueCS) which is $833,333.33.

Pre-money ValueCS = Post-money ValueCS − Required Funds

= $833, 333.33 − $500, 000
= $333, 333.33

Step 3 of 6

Calculate the post-money value of convertible debt (Post-money ValueCD) by dividing the required funds which is
$500,000 with the percentage ownership of convertible debt (OwnershipCD) which is 40%.

Required Funds
Post-money ValueCD =
OwnershipCD
$500, 000
=
40%
= $1, 250, 000

Step 4 of 6

Compute the pre-money value of convertible debt (Pre-money ValueCD) by subtracting the required funds which is
$500,000 from the post-money value of convertible debt (Post-money ValueCD) which is $1,250,000.
 Pre-money ValueCD = Post-money ValueCD − Required Funds
= $1, 250, 000 − $500, 000
= $750, 000

Step 5 of 6

Calculate the post-money value of convertible preferred stock (Post-money ValueCP) by dividing the required funds which
is $500,000 with the percentage ownership of convertible preferred stock (OwnershipCP) which is 45%.

Required Funds
Post-money ValueCP =
OwnershipCP
$500, 000
=
45%
= $1, 111, 111.11

Step 6 of 6

Determine the pre-money value of convertible preferred stock (Pre-money ValueCP) by subtracting the funds raised which
is $500,000 from the post-money value of convertible preferred stock (Post-money ValueCP) which is $1,111,111.11.

Pre-money ValueCP = Post-money ValueCP − Required Funds

= $1, 111, 111.11 − $500, 000
= $611, 111.11

Final answer

Post money value:

For common stock = $833,333.33

For convertible debt = $1,250,000

For convertible preferred stock = $1,111,111.11

Pre money value:

For common stock = $333,333.33

For convertible debt = $750,000

For convertible preferred stock = $611,111.11

The estimate of the pre and post money value is different for each of the three alternatives. This is because the
ownership percentage to be given up is different in each of the cases.

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Chapter 10, End of Chapter, Problems, Exercise 10-7

Part a Part b Part c Part d Part e

Verified Answer

An increase in the EBITDA multiple will increase the enterprise value and equity value. When EBITDA multiple is 6 times,
then equity value is $5,500,000 but on increasing the multiple to 7 times, the equity value increases to $6,700,000.

The increase in size of multiple will increase the required return by VC and also increase the interest of entrepreneurs in
all deal structures. When the multiple is 7 times then the percentage required return by VC in common stock is 51.72%, in
convertible bonds is 45.76% and in preferred stock is 48.91%.

The VC should consider pre-money value of convertible debt, which is $750,000. This is the highest pre-money value
among all alternatives.

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Ch 10, End of Chapter, Ex 10-7

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Chapter 10, End of Chapter, Problems, Exercise 10-7

Part a Part b Part c Part d Part e

Verified Answer

The need for expansion of the business has led to the sources of finances to emerge outside the traditional financing
systems. Following are some of the pros and cons of alternative sources of finances.

Pros:

It is a quick way to raise finance. Obtaining bank loans may invite tedious paperwork, however raising funds from
investors may take comparatively less time. Moreover, it enables us to test the reaction of investors.

Huge amount of funds can be raised. Banks often have restrictions and limitations on lending. However, a corporation
can raise a huge sum by asking investors or the general public.

The cost of borrowing is comparatively lower. Moreover, in case of equity funding, there is no obligation to repay the
investments. It also provides high returns to the investors as there are very few middle men involved.

Cons:

Though the direct cost of the funding is low, the corporations might need to incur decent expenses for marketing
about the projects. Unless the investors are provided confidence with respect to the proposed expansion they won't
invest.

As it is important to provide knowledge of the investment, this hampers the business secrecy. The peers may get an
idea of the business strategies of the corporation.

Some of the alternative sources of financing are not clearly regulated in many jurisdictions. So, these inadequate
regulatory bodies create a huge risk of fraud for lenders.

The alternative sources of finance benefit only in the long run. Thus, if the operations of the corporations are not
large enough, the investors may not be ready to invest for a significant duration.

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Ch 10, End of Chapter, Ex 10-7

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Chapter 10, End of Chapter, Problems, Exercise 10-8

Part a Part b Part c Part e

Here is the step-by-step explanation, verified by an educator:

Step 1 of 4

Calculate the EBITDA value of year 2020 by multiplying the estimated earnings (EBITDA) which is $650,000 with the
EBITDA multiple which is 6 times.

EBITDA Value = EBITDA × EBITDA Multiple

= $650, 000 × 6
= $3, 900, 000

Step 2 of 4

Determine the enterprise value (EV) by adding the EBITDA value of year 2020 which is $3,900,000 with the cash value
of year 2020 (Cash2020) which is $300,000.

EV = EBITDA Value + Cash2020

= $3, 900, 000 + $300, 000
= $4, 200, 000

Step 3 of 4

Calculate the interest bearing debt by adding the short term notes of year 2020 (SN2020) which is $250,000 with the
senior debt of year 2020 (SD2020) which is $400,000.

Interest Bearing Debt = SN2020 + SD2020

= $250, 000 + $400, 000
= $650, 000

Step 4 of 4

Compute the equity value by subtracting the interest bearing debt which is $650,000 from the enterprise value (EV)
which is $4,200,000.
 Equity Value = EV − Interest Bearing Debt
= $4, 200, 000 − $650, 000
= $3, 550, 000

Final answer

The enterprise value = $4,200,000

Equity value = $3,550,000

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Ch 10, End of Chapter, Ex 10-8

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Chapter 10, End of Chapter, Problems, Exercise 10-8

Part a Part b Part c Part e

Here is the step-by-step explanation, verified by an educator:

Step 1 of 3

Calculate the sub-debt interest income (Interest IncomeSD) by multiplying the sub-debt interest rate (Interest rateSD)
which is 12% with the subordinate debt of year 2015 (SD2015) which is $100,000.

Interest IncomeSD = SD2015 × Interest RateSD

= $100, 000 × 12%
= $12, 000

Step 2 of 3

Determine the conversion value of subordinate debt (Conversion ValueSD) by multiplying the conversion rate of equity
which is 10% with the equity value (Equity value) which is $3,550,000.

Conversion ValueSD = Equity Value × Conversion Rate

= $3, 550, 000 × 10%
= $355, 000

Step 3 of 3

Compute the estimated rate of return of subordinate debt by using the IRR function of excel.

NPER = 6
PMT = 12,000
PV = 100000 (This will be in negative form for the purpose of calculation.)
FV = 355000
Type = 0 (Specifies that the payment is at the end of the period)
Rate guess = 0

= RATE(NPER,PMT,PV,[FV],[TYPE],[RATE GUESS])
= RATE(6, 12, 000, −100000, 355000, [0], [0])
= 31.34%

Final answer

The rate of return = 31.34%

 NO, the firm will not want the subordinate debt holders to be converted to the common stock owners. This is because
the required return on investment of 31.34% is very high.

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Ch 10, End of Chapter, Ex 10-8

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Chapter 10, End of Chapter, Problems, Exercise 10-8

Part a Part b Part c Part e

Here is the step-by-step explanation, verified by an educator:

Step 1 of 6

Calculate the annual dividends of convertible preferred stock (DividendsCP) by multiplying the dividend yield which is 8%
with the investment amount which is $250,000.

DividendsCP = Investment Amount × Dividend Yield

= $250, 000 × 8%
= $20, 000

Step 2 of 6

Determine the required equity value for conversion at desired rate of return (Equity ValueConversion) by using the excel FV
function with the following inputs:

RATE = 45% (This is required return by the investor).

NPER = 5 (This is the life of the investment)
PMT = 20000 (This is amount of dividends on preferred stock)
PV = 250000 (Take this value to be negative for the purpose of calculation)
TYPE = 0 (Specifies that the payment is at the end of the period.)

= FV(RATE, NPER, PMT, [PV], [TYPE])

= FV(45%, 5, 20000, [250000], [0])
= $1, 362, 000.89

Step 3 of 6

Compute the required ownership percentage of equity (OwnershipE) by dividing the required equity value for conversion
at desired rate of return (Equity ValueConversion) which is $1,362,000.89 with the equity value (Equity Value) which is
$3,550,000.

Equity ValueConversion
OwnershipE =
Equity Value
$1, 362, 000.89
=
$3, 550, 000
= 38.37%
Step 4 of 6

Calculate the ownership percentage of equity left for individual DT after the said conversion (Equity OwnershipDT) by
subtracting the ownership percentage of sub-debt holders (OwnershipSD) which is 10% and ownership percentage of
convertible preferred stockholders (OwnershipCP) which is 38.37% from 100%.

Equity OwnershipDT = 100% − OwnershipSD OwnershipCP

= 100% − 10% − 38.37%
= 51.63%

Step 5 of 6

Calculate the future value of equity (FV) by multiplying the equity value (Equity Value) which is $3,550,000 with the
ownership percentage of equity left for individual DT after the said conversion (Equity OwnershipDT) which is $51.63%.

FV = Equity Value × Equity OwnershipDT

= $3, 550, 000 × 51.63%
= $1, 832, 865

Step 6 of 6

Determine the rate of return of DT equity by using the IRR function of excel.

NPER = 6
PMT = 0
PV = 200000 (This will be in negative form for the purpose of calculation.)
FV = 1832865
Type = 0 (Specifies that the payment is at the end of the period)
Rate guess = 0

= RATE(NPER,PMT,PV,[FV],[TYPE],[RATE GUESS])
= RATE(6, 0, −200000, 1832865, [0], [0])
= 44.66%

Final answer

Ownership percentage of equity for investor of convertible preferred stock = 38.37%

Ownership of individual DT after the said conversion = 51.63%.

Expected Rate of return for equity investor by 2020 = 44.66%

Yes, the plan is acceptable by the investors because the rate of return for individual DT is approximately equal to
preferred stockholders. MOreover, the preferred stock owners are getting a return which is approximately the same as
their required return of 45%. Similarly, the IRR of the subordinated debt holders is known to be 31.34%, which is
significantly high.

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Chapter 10, End of Chapter, Problems, Exercise 10-8

Part a Part b Part c Part e

Here is the step-by-step explanation, verified by an educator:

Step 1 of 2

Calculate the post-investment value of equity by dividing the additional fund needed in 2015 (Additional Fund2015) which is
$250,000 with the required percentage of equity for conversion (OwnershipEquity) which is 38.37%.

Additional Fund2015
Post-investment Value =
OwnershipEquity
$250, 000
=
38.37%
= $651, 614.85

Step 2 of 2

Determine the pre-investment value of equity by subtracting the preferred stockholder investment which is $250,000
from the post-investment value of equity which is $651,614.85.

Pre-investment Value = Post-investment Value − Preferred Investment

= $651, 614.85 − $250, 000
= $401, 614.85

Final answer

Post-investment value = $651,614.85

Pre-investment value = $401,614.85

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Chapter 10, End of Chapter, Problems, Exercise 10-9

Part a Part b Part c

Here is the step-by-step explanation, verified by an educator:

Step 1 of 6

Determine the projected enterprise value of year 2020 (EV2020) by multiplying the EBITDA value of year 2020
(EBITDA2020) which is $16,105,100 with the EBITDA multiple which is 5.

EV2020 = EBITDA2020 × EBITDA Multiple

= $16, 105, 100 × 5
= $80, 525, 500

Step 2 of 6

Determine the EBITDA for Year 1 (EBITDAYear 1) by multiplying the current EBITDA (EBITDAYear 0) which is $10,000,000
by (1+g), where 'g' is the growth rate of 10%.

Similarly, determine the EBITDA for remaining years.

EBITDAYear 1 = EBITDAYear 0 × (1+g)

= $10, 000, 000 × (1 + 10%)
= $11, 000, 000

Step 3 of 6

Calculate the depreciation expense for Year 1 (DepreciationYear 1) by dividing the capital expenditure of $400,000 by the
life of assets which is 10 years and adding the current depreciation expense (DepreciationYear 0) which is $3,500,500.
Similarly determine the depreciation expense or remaining years.

Capex
DepreciationYear 1 = DepreciationYear 0 +
Life of Assets
$400, 000
= $3, 500, 000 +
10
= $3, 900, 000

Step 4 of 6

Calculate the debt by multiplying the purchase price of $50,000,000 by the proportion of debt finance which is 90%
 Debt = Purchase Price × Proportion of Debt
= $50, 000, 00 × 90%
= $45, 000, 000

Step 5 of 6

Determine the interest expense for Year 1 by multiplying the debt of $45,000,000 by the interest rate of 14%. Determine
the taxes for Year 1 by subtracting the depreciation and interest expense from EBITDA and multiplying the restaurant
value by the tax rate of 30%. The EBITDA and depreciation expense for Year 1 are $11,000,000 and $3,900,000
respectively.

Determine the earnings after tax (EAT) for year 1 by subtracting depreciation, interest expense, CAPEX and taxes from
EBITDA. Compute the loan balance for Year 1 by subtracting the EAT from the debt of $45,000,000. Similarly determine
the loan balance for the remaining years.

It is to be noted that the interest expense for year 2 will be calculated by multiplying the interest rate by the loan balance
of Year 1. Similarly, the interest expense for remaining years will be calculated on the loan balance of the previous year.

Attachment URL

Step 6 of 6

Calculate the equity value of year 2020 (Equity Value2020) by subtracting the loan balance of year 2020 (Loan
Balance2020) which is $31,538,544.86 from the projected enterprise value of year 2020 (EV2020) which is $80,525,500.

Equity Value2020 = EV2020 − Loan Balance2020

= $80, 525, 500 − $31, 538, 544.86
= $48, 986, 955.14

Final answer

Enterprise value of year 2020 = $80,525,000

Equity value of year 2020 = $48,986,955.14

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Chapter 10, End of Chapter, Problems, Exercise 10-9

Part a Part b Part c

Here is the step-by-step explanation, verified by an educator:

Step 1 of 7

Calculate the rate of return on its equity with debt by using the Excel Rate function with following inputs.

NPER = 5 (This is the exit year)

PMT = 0
PV = 5000000 (Take this value as negative for the purpose of calculation.)
FV = 48986955.14 (This is the value of equity at Year 5)
Type = 0 (Specifies that the payment is made at the end of the period)
Guess = 0

= RATE(NPER, PMT, PV, [FV], [TYPE], [GUESS])

= RATE(5, 0, −5000000, [48986955.14], 0, 0)
= 57.84%

Step 2 of 7

Calculate the taxes of Year 2016 (Taxes2016) by multiplying the EBIT of Year 2016 (EBIT2016) which is $7,100,000 with the
corporate tax rate which is 30%.

Determine the taxes of Year 2017 (Taxes

2017
) by multiplying the EBIT of Year 2017 (EBIT
2017
) which is $7,800,000 with the corporate tax rate which is 30%.

Taxes of Year 2016:

Taxes2016 = EBIT2016 × Corporate Tax Rate

= $7, 100, 000 × 30%
= $2, 130, 000

Taxes of Year 2017:

Taxes2017 = EBIT2017 × Corporate Tax Rate

= $7, 800, 000 × 30%
= $2, 340, 000
Step 3 of 7

Calculate the taxes of Year 2018 (Taxes2018) by multiplying the EBIT of Year 2018 (EBIT2018) which is $8,610,000 with the
corporate tax rate which is 30%.

Determine the taxes of Year 2019 (Taxes2019) by multiplying the EBIT of Year 2019 (EBIT2019) which is $9,541,000 with
the corporate tax rate which is 30%.

Taxes of Year 2018:

Taxes2018 = EBIT2018 × Corporate Tax Rate

= $8, 610, 000 × 30%
= $2, 583, 000

Taxes of Year 2019:

Taxes2019 = EBIT2019 × Corporate Tax Rate

= $9, 541, 000 × 30%
= $2, 862, 300

Step 4 of 7

Compute the taxes of Year 2020 (Taxes2020) by multiplying the EBIT of Year 2020 (EBIT2020) which is $10,605,100 with
the corporate tax rate which is 30%.

Calculate the operating cash flows of Year 2016 (CF2016) by subtracting the taxes of Year 2016 (Taxes2016) which is
$2,130,000 from the EBIT of Year 2016 (EBIT2016) which is $7,100,000 and then add the depreciation expense of Year
2016 (Depreciation2016) which is $3,900,000. Subtract the CAPEX which is $4,000,000 from the resulting value.

Taxes of Year 2020:

Taxes2020 = EBIT2020 × Corporate Tax Rate

= $10, 605, 100 × 30%
= $3, 181, 530

Operating cash flows of Year 2016:

CF2016 = (EBIT2016 − Taxes2016 ) + Depreciation2016 − CAPEX

= ($7, 100, 000 − $2, 130, 000) + $3, 900, 000 − $4, 000, 000
= $4, 870, 000

Step 5 of 7

Calculate the operating cash flows of Year 2017 (CF2017) by subtracting the taxes of Year 2017 (Taxes2017) which is
$2,340,000 from the EBIT of Year 2017 (EBIT2017) which is $7,800,000 and then add the depreciation expense of Year
2017 (Depreciation2017) which is $4,300,000. Subtract the CAPEX which is $4,000,000 from the resulting value.
 Determine the operating cash flows of Year 2018 (CF2018) by subtracting the taxes of Year 2018 (Taxes2018) which is
$2,583,000 from the EBIT of Year 2018 (EBIT2018) which is $8,610,000 and then add the depreciation expense of Year
2018 (Depreciation2018) which is $4,700,000. Subtract the CAPEX which is $4,000,000 from the resulting value.

Operating cash flows of Year 2017:

CF2017 = (EBIT2017 − Taxes2017 ) + Depreciation2017 − CAPEX

= ($7, 800, 000 − $2, 340, 000) + $4, 300, 000 − $4, 000, 000
= $5, 760, 000

Operating cash flows of Year 2018:

CF2018 = (EBIT2018 − Taxes2018 ) + Depreciation2018 − CAPEX

= ($8, 610, 000 − $2, 583, 000) + $4, 700, 000 − $4, 000, 000
= $6, 727, 000

Step 6 of 7

Calculate the operating cash flows of Year 2019 (CF2019) by subtracting the taxes of Year 2019 (Taxes2019) which is
$2,862,300 from the EBIT of Year 2019 (EBIT2019) which is $9,541,000 and then add the depreciation expense of Year
2019 (Depreciation2019) which is $5,100,000. Subtract the CAPEX which is $4,000,000 from the resulting value.

Determine the operating cash flows of Year 2020 (CF2020) by subtracting the taxes of Year 2020 (Taxes2020) which is
$3,181,530 from the EBIT of Year 2020 (EBIT2020) which is $10,605,100 and then add the depreciation expense of Year
2020 (Depreciation2020) which is $5,500,000. Subtract the CAPEX which is $4,000,000 from the resulting value. As this
is the last year, the firm value of $80,525,500 should also be added in the cash flows.

Operating cash flows of Year 2019:

CF2019 = (EBIT2019 − Taxes2019 ) + Depreciation2019 − CAPEX

= ($9, 541, 000 − $2, 862, 300) + $5, 100, 000 − $4, 000, 000
= $7, 778, 700

Operating cash flows of Year 2020:

CF2020 = (EBIT2020 − Taxes2020 ) + Depreciation2020 − CAPEX + Firm Value

= ($10, 605, 100 − $3, 181, 530) + $5, 500, 000 − $4, 000, 000 + $80, 525, 500
= $89, 449, 070

Step 7 of 7

Calculate the rate of return on its equity without debt by using the IRR function on excel.

The cash flow in Year 0 is -$50,000,000, in Year 1 it is $4,870,000, in Year 2 it is $5,760,000, in Year 3 it is $6,727,000, in
Year 4 it is $7,778,700 and in Year 5 it is $89,449,070.

Use the Excel IRR function which is =IRR(values,[guess]).

 Attachment URL

Final answer

Rate of return on equity with debt = 57.84%

Rate of return on equity without debt = 20.93%

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Ch 10, End of Chapter, Ex 10-9

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Chapter 10, End of Chapter, Problems, Exercise 10-9

Part a Part b Part c

Here is the step-by-step explanation, verified by an educator:

Step 1 of 8

Compute the EBITDA for Year 5 (EBITDAYear 5) by multiplying the EBITDA for Year 4 (EBITDAYear 4), which is $16,105,100
by (1+g), where 'g' is the growth rate of 10%.

Determine the projected enterprise value of year 2020 (EV2020) by multiplying the EBITDA value of year 2020
(EBITDA2020) which is $17,715,610 with the EBITDA multiple which is 5.

Calculate the new current EBITDA after using the operating expense (New EBITDA
Year 0
) by adding the EBITDA (EBITDA
Year 0
), which is $10,000,000 with the operating expense, which is $1,000,000.

EBITDA for Year 5:

EBITDAYear 5 = EBITDAYear 4 × (1+g)

= $16, 105, 100 × (1 + 10%)
= $17, 715, 610

Projected enterprise value of year 2020:

EV2020 = EBITDA2020 × EBITDA Multiple

= $17, 715, 610 × 5
= $88, 578, 050

New current EBITDA:

New EBITDAYear 0 = EBITDAYear 0 + Operating Expense

= $10, 000, 000 + $1, 000, 000
= $11, 000, 000

Step 2 of 8

Determine the EBITDA for Year 1 (EBITDAYear 1) by multiplying the new current EBITDA (New EBITDAYear 0) which is
$11,000,000 by (1+g), where 'g' is the growth rate of 10%.

Similarly, determine the EBITDA for remaining years.

 Calculate the depreciation expense for Year 1 (Depreciation
Year 1
) by dividing the capital expenditure of $400,000 by the life of assets which is 10 years and adding the current
depreciation expense (Depreciation
Year 0
) which is $3,500,000. Similarly determine the depreciation expense or remaining years.

EBITDA for Year 1:

EBITDAYear 1 = New EBITDAYear 0 × (1+g)

= $11, 000, 000 × (1 + 10%)
= $12, 100, 000

Depreciation expense for Year 1:

Capex
DepreciationYear 1 = DepreciationYear 0 +
Life of Assets
$400, 000
= $3, 500, 000 +
10
= $3, 900, 000

Step 3 of 8

Determine the new purchase price by multiplying the new current EBITDA after using the operating expense (New
EBITDAYear 0), which is $11,000,000 with the EBITDA multiple, which is 5.

Calculate the debt by multiplying the new purchase price of $55,000,000 by the proportion of debt finance which is 90%

New purchase price:

New Purchase Price = New EBITDAYear 0 × EBITDA Multiple

= $11, 000, 000 × 5
= $55, 000, 000

Debt:

Debt = New Purchase Price × Proportion of Debt

= $55, 000, 000 × 90%
= $49, 500, 000

Step 4 of 8

Determine the interest expense for Year 1 by multiplying the debt of $49,500,000 by the interest rate of 14%. Determine
the taxes for Year 1 by subtracting the depreciation and interest expense from EBITDA and multiplying the restaurant
value by the tax rate of 30%. The EBITDA and depreciation expense for Year 1 are $12,100,000 and $3,900,000
respectively.
 Determine the earnings after tax (EAT) for year 1 by subtracting depreciation, interest expense, CAPEX and taxes from
EBITDA. Compute the loan balance for Year 1 by subtracting the EAT from the debt of $49,500,000. Similarly determine
the loan balance for the remaining years.

It is to be noted that the interest expense for year 2 will be calculated by multiplying the interest rate by the loan balance
of Year 1. Similarly, the interest expense for remaining years will be calculated on the loan balance of the previous year.

Attachment URL

Step 5 of 8

Calculate the equity value of year 2020 (Equity Value2020) by subtracting the loan balance of year 2020 (Loan
Balance2020) which is $33,103,869.67 from the projected enterprise value of year 2020 (EV2020) which is $88,578,050.

Equity Value2020 = EV2020 − Loan Balance2020

= $88, 578, 050 − $33, 103, 869.67
= $55, 474, 180.33

Step 6 of 8

Determine the rate of return on its equity with debt by using the Excel Rate function with following inputs.

NPER = 5 (This is the exit year)

PMT = 0
PV = 5500000 (Take this value as negative for the purpose of calculation.)
FV = 55474180.33 (This is the value of equity at Year 5)
Type = 0 (Specifies that the payment is made at the end of the period)
Guess = 0

= RATE(NPER, PMT, PV, [FV], [TYPE], [GUESS])

= RATE(5, 0, −5500000, [55474180.33], 0, 0)
= 58.76%

Step 7 of 8

Determine the EBIT of Year 1 (EBITYear 1) by subtracting the depreciation expense for Year 1 (DepreciationYear 1), which is
$3,900,000 from the EBITDA for Year 1 (EBITDAYear 1), which is $12,100,000. Similarly, determine the EBIT for remaining
years. Similarly determine the EBIT for remaining years.

Determine the taxes of Year 1 (TaxesYear 1) by multiplying the EBIT of Year 1 (EBITYear 1) with the corporate tax rate which
is 30%. Similarly, determine the taxes for the remaining years.
 Calculate the operating cash flows of Year 2 (CFYear 2) by subtracting the taxes of Year 1 (TaxesYear 1) which is
$2,460,000 from the EBIT of Year 1 (EBITYear 1) which is $8,200,000 and then add the depreciation expense of Year 1
(DepreciationYear 1) which is $3,900,000. Subtract the CAPEX which is $4,000,000 from the resulting value. Similarly
calculate the cash flows for remaining years.

It is to be noted that the operating cash flows of Year 5 will be calculated by adding the enterprise value of $80,525,500
in the cash flows. This enterprise value of year 5 includes the principal payment of $6,199,223,84.

Attachment URL

Step 8 of 8

Calculate the rate of return on its equity without debt by using the IRR function on excel.

The cash flow in Year 0 is -$55,000,000, in Year 1 it is 0, in Year 2 it is $5,640,000, in Year 3 it is $6,607,000, in Year 4 it
is $7,658,700 and in Year 5 it is $89,329,070.
 Attachment URL

Final answer

Enterprise value of year 2020 = $88,578,050

Equity value of year 2020 = $55,474,180.33
Rate of return on equity with debt = 58.76%
Rate of return on equity without debt = 16.09%

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Chapter 10, End of Chapter, Problems, Exercise 10-10

Part b Part c Part d

Explanation

Determine the unlevered cost of equity by multiplying the average unlevered beta (Unlevered BetaAvg) which is 1.18 with the
market risk premium (MRP) of 5.50% and then add the resultant value to the risk-free rate which is 5%.

Unlevered Cost of Equity = (Unlevered BetaAvg. × MRP) + Risk-free Rate

= (1.18 × 5.50%) + 5%
= 11.47%

Verified Answer

11.47%

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Ch 10, End of Chapter, Ex 10-10

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Chapter 10, End of Chapter, Problems, Exercise 10-10

Part b Part c Part d

Here is the step-by-step explanation, verified by an educator:

Step 1 of 8

Calculate the taxes of year 2016 (Taxes2016) by multiplying the EBIT of year 2016 (EBIT2016) which is $7,100,000 with the
corporate tax rate which is 30%.

Determine the taxes of year 2017 (Taxes2017) by multiplying the EBIT of year 2017 (EBIT2017) which is $7,800,000 with
the corporate tax rate which is 30%.

Taxes of year 2016:

Taxes2016 = EBIT2016 × Corporate Tax Rate

= $7, 100, 000 × 30%
= $2, 130, 000

Taxes of year 2017:

Taxes2017 = EBIT2017 × Corporate Tax Rate

= $7, 800, 000 × 30%
= $2, 340, 000

Step 2 of 8

Calculate the taxes of year 2018 (Taxes2018) by multiplying the EBIT of year 2018 (EBIT2018) which is $8,610,000 with the
corporate tax rate which is 30%.

Determine the taxes of year 2019 (Taxes2019) by multiplying the EBIT of year 2019 (EBIT2019) which is $9,541,000 with
the corporate tax rate which is 30%.

Taxes of year 2018:

Taxes2018 = EBIT2018 × Corporate Tax Rate

= $8, 610, 000 × 30%
= $2, 583, 000

Taxes of year 2019:

 Taxes2019 = EBIT2019 × Corporate Tax Rate
= $9, 541, 000 × 30%
= $2, 862, 300

Step 3 of 8

Compute the taxes of year 2020 (Taxes2020) by multiplying the EBIT of year 2020 (EBIT2020) which is $10,605,100 with
the corporate tax rate which is 30%.

Calculate the operating cash flows of year 2016 (CF2016) by subtracting the taxes of year 2016 (Taxes2016) which is
$2,130,000 from the EBIT of year 2016 (EBIT2016) which is $7,100,000 and then add the depreciation expense of year
2016 (Depreciation2016) which is $3,900,000. Subtract the CAPEX which is $4,000,000 from the resulting value.

Taxes of year 2020:

Taxes2020 = EBIT2020 × Corporate Tax Rate

= $10, 605, 100 × 30%
= $3, 181, 530

Operating cash flows of year 2016:

CF2016 = (EBIT2016 − Taxes2016 ) + Depreciation2016 − CAPEX

= ($7, 100, 000 − $2, 130, 000) + $3, 900, 000 − $4, 000, 000
= $4, 870, 000

Step 4 of 8

Calculate the operating cash flows of year 2017 (CF2017) by subtracting the taxes of year 2017 (Taxes2017) which is
$2,340,000 from the EBIT of year 2017 (EBIT2017) which is $7,800,000 and then add the depreciation expense of year
2017 (Depreciation2017) which is $4,300,000. Subtract the CAPEX which is $4,000,000 from the resulting value.

Determine the operating cash flows of year 2018 (CF2018) by subtracting the taxes of year 2018 (Taxes2018) which is
$2,583,000 from the EBIT of year 2018 (EBIT2018) which is $8,610,000 and then add the depreciation expense of year
2018 (Depreciation2018) which is $4,700,000. Subtract the CAPEX which is $4,000,000 from the resulting value.

Operating cash flows of year 2017:

CF2017 = (EBIT2017 − Taxes2017 ) + Depreciation2017 − CAPEX

= ($7, 800, 000 − $2, 340, 000) + $4, 300, 000 − $4, 000, 000
= $5, 760, 000

Operating cash flows of year 2018:

CF2018 = (EBIT2018 − Taxes2018 ) + Depreciation2018 − CAPEX

= ($8, 610, 000 − $2, 583, 000) + $4, 700, 000 − $4, 000, 000
= $6, 727, 000
Step 5 of 8

Calculate the operating cash flows of year 2019 (CF2019) by subtracting the taxes of year 2019 (Taxes2019) which is
$2,862,300 from the EBIT of year 2019 (EBIT2019) which is $9,541,000 and then add the depreciation expense of year
2019 (Depreciation2019) which is $5,100,000. Subtract the CAPEX which is $4,000,000 from the resulting value.

Determine the operating cash flows of year 2020 (CF2020) by subtracting the taxes of year 2020 (Taxes2020) which is
$3,181,530 from the EBIT of year 2020 (EBIT2020) which is $10,605,100 and then add the depreciation expense of year
2020 (Depreciation2020) which is $5,500,000. Subtract the CAPEX which is $4,000,000 from the resulting value.

Operating cash flows of year 2019:

CF2019 = (EBIT2019 − Taxes2019 ) + Depreciation2019 − CAPEX

= ($9, 541, 000 − $2, 862, 300) + $5, 100, 000 − $4, 000, 000
= $7, 778, 700

Operating cash flows of year 2020:

CF2020 = (EBIT2020 − Taxes2020 ) + Depreciation2020 − CAPEX

= ($10, 605, 100 − $3, 181, 530) + $5, 500, 000 − $4, 000, 000
= $8, 923, 570

Step 6 of 8

Calculate the present value of operating cash flows (PVOCF) by using the excel NPV function with the following inputs:

RATE = 11.47%
Cashflow1 = 4870000
Cashflow2 = 5760000
Cashflow3 = 6727000
Cashflow4 = 7778700
Cashflow5 = 8923570

= NPV(Rate,Cashflow1,Cashflow2...Cashflow5)
= NPV(11.47%, 4870000, 5760000, 6727000, 7778700, 8923570)
= $24, 083, 570.70

Step 7 of 8

Calculate the interest tax savings of 2016 (Tax Savings2016) by multiplying the interest expense of 2016 (Interest
Expense2016) which is $6,300,000 with the corporate tax rate which is 30%.

Determine the interest tax savings of 2017 (Tax Savings2017) by multiplying the interest expense of 2017 (Interest
Expense2017) which is $6,235,600 with the corporate tax rate which is 30%.

Calculate the interest tax savings of 2018 (Tax Savings2018) by multiplying the interest expense of 2018 (Interest
Expense2018) which is $6,040,288.80 with the corporate tax rate which is 30%.

Compute the interest tax savings of 2019 (Tax Savings2019) by multiplying the interest expense of 2019 (Interest
Expense2019) which is $5,690,457.10 with the corporate tax rate which is 30%.
 Determine the interest tax savings of 2020 (Tax Savings2020) by multiplying the interest expense of 2020 (Interest
Expense2020) which is $5,159,103.90 with the corporate tax rate which is 30%

Interest tax savings of 2016:

Tax Savings2016 = Interest Expense2016 × Corporate Tax Rate

= $6, 300, 000 × 30%
= $1, 890, 000

Interest tax savings of 2017:

Tax Savings2017 = Interest Expense2017 × Corporate Tax Rate

= $6, 235, 600 × 30%
= $1, 870, 680

Interest tax savings of 2018:

Tax Savings2018 = Interest Expense2018 × Corporate Tax Rate

= $6, 040, 288.80 × 30%
= $1, 812, 086.64

Interest tax savings of 2019:

Tax Savings2019 = Interest Expense2019 × Corporate Tax Rate

= $5, 690, 457.10 × 30%
= $1, 707, 137.13

Interest tax savings of 2020:

Tax Savings2020 = Interest Expense2020 × Corporate Tax Rate

= $5, 159, 103.90 × 30%
= $1, 547, 731.17

Step 8 of 8

Determine the present value of interest tax savings in the planning period (PVITS) by using the excel NPV function with
the following inputs:

RATE = 14%
Cashflow1 = 1890000
Cashflow2 = 1870680
Cashflow3 = 1812086.64
Cashflow4 = 1707137.13
Cashflow5 = 1547731.17

= NPV(Rate,Cashflow1,Cashflow2...Cashflow5)
= NPV(14%, 1890000, 1870680, 1812086.64, 1707137.13, 1547731.17)
= $6, 135, 034.42
 Final answer

Present value of operating cash flows = $24,083,570.70

Present value of interest tax savings = $6,135,034.42

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Ch 10, End of Chapter, Ex 10-10

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Valuation: The Art and Science of Corporate Investment Decisions (3rd Edition) See all exercises

Chapter 10, End of Chapter, Problems, Exercise 10-10

Part b Part c Part d

Here is the step-by-step explanation, verified by an educator:

Step 1 of 5

Calculate the present value of operating cash flows (PVOCF) by using the excel NPV function with the following inputs:

RATE = 11.47% (This is unlevered cost of equity)

Cashflow1 = 4870000
Cashflow2 = 5760000
Cashflow3 = 6727000
Cashflow4 = 7778700
Cashflow5 = 8923570

= NPV(Rate,Cashflow1,Cashflow2...Cashflow5)
= NPV(11.47%, 4870000, 5760000, 6727000, 7778700, 8923570)
= $24, 083, 570.70

Step 2 of 5

Determine the present value of interest tax savings (PVITS) by using the excel NPV function with the following inputs:

RATE = 14% (This is interest on debt)

Cashflow1 = 1890000
Cashflow2 = 1870680
Cashflow3 = 1812086.64
Cashflow4 = 1707137.13
Cashflow5 = 1547731.17

= NPV(Rate,Cashflow1,Cashflow2...Cashflow5)
= NPV(14%, 1890000, 1870680, 1812086.64, 1707137.13, 1547731.17)
= $6, 135, 034.42

Step 3 of 5

Calculate the present value of the terminal value of the firm (PV of TV) by using the formula of discounting. Terminal value
will be calculated by multiplying the EBITDA of the Year 2020 (EBITDA2020) by EBITDA multiple.

Here, the EBITDA of year 2020 (EBITDA2020) is $16,105,100, multiple of EBITDA is 5, number of years (N) is 5 years and
unlevered cost of equity is 11.47%.
 TV
PV of TV =
(1 + Unlevered Cost of Equity)N
EBITDA2020 × EBITDA Multiple
=
(1 + Unlevered Cost of Equity)N
$16, 105, 100 × 5
=
(1 + 11.47%)5
= $46, 786, 173.03

Step 4 of 5

Determine the enterprise value by adding the present value of operating cash flows (PVOCF) which is $24,083,570.70
with the present value of interest tax savings (PVITS) which is $6,135,034.42 and the present value of terminal value of the
firm (PV of TV) which is $46,786,173.03.

Enterprise Value = PVOCF + PVITS + PV of TV

= $24, 083, 570.70 + $6, 135, 034.42 + $46, 786, 173.03
= $77, 004, 778.14

Step 5 of 5

Calculate the equity value of the firm by subtracting the debt which is $45,000,000 from the enterprise value of the firm
which is $77,004,778.14.

Equity Value = Enterprise Value − Debt

= $77, 004, 778.14 − $45, 000, 000
= $32, 004, 778.14

Final answer

Terminal value of the firm as on 2015 = $46,786,173.03

Enterprise Value = $77,004,778.14
Equity value = $32,004,778.14

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P, Ex 10-9

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Ch 10, End of Chapter, Ex 10-10