PART I: WARM-UP QUESTIONS (30 POINTS)
1. Mr. B earns $96,000 this year and expects a 17% raise next year. He wants to consume exactly the same amount in each period. The interest rate is 8%. (a) Is Mr. B a borrower or a lender in this year? How much does he borrow/lend? (b) Suppose Mr. B has the opportunity to make an investment of $200,000 in the first period that will pay $215,000 risk-free in the second year. Should he take the investment? Justify your answer.
2. One year ago you purchased a $1000 face value, 8% coupon rate bond with annual payments and five years to maturity. The yield to maturity at the time was 8%. Today you sell the bond at a yield to maturity of 8.5%. (a) Suggest two possible reasons why the YTM may have changed in this direction. (b) Calculate your holding period rate of return on this investment and briefly discuss whether it was a good investment.
3. Company D earned $8 per share for the fiscal year ending yesterday. The firm pays out 25% of its earnings as annual, end-of-year dividends. The current stock price is $40 and the historical return on equity (ROE) is 11%. (a) Use the above information to estimate the required return on the stock, and discuss the underlying assumptions used in obtaining your estimate. (b) Calculate the NPVGO and briefly discuss what this measure tells you.
4. Company C is considering two independent investments. The first costs $200,000 to purchase, results in a cash flow of $45,000 per year (after-tax), and lasts for 10 years. The second costs $400,000 to purchase, results in a cash flow of $50,000 per year (after-tax), and lasts for 20 years. The company’s cost of capital is 10%. What recommendation would you make about these projects? Justify your response.
5. An auto plant that costs $100 million to build can produce a new line of cars that will generate cash flows with a present value of $140 million if the line is successful, but only $50 million if it is unsuccessful. You believe that the probability of success is 50 percent. Suppose the plant can be sold for $90 million if the line is not successful. The appropriate discount rate is 8%. (a) Should you build the plant? (b) What is the value of the option to abandon?
6. Some information on the measured risk of stocks C and D is provided in the table below. Which of the two stocks would you expect to expose you to more risk if it was the only investment you made? Which would you expect to offer a greater risk premium? Explain your answers.
Stock Standard Deviation (%) Beta
Company C 47.4 0.57 Company D 20.8 0.66
7. You have $50,000 to invest in a portfolio containing Stock G and Stock H. Stock G has an expected return of 13.8% and a beta of 1.8. Stock H has an expected return of 6%. The return on T-Bills is 3%. If your goal is to create a portfolio that is one-and-a-half times as risky as the overall market, how should you allocate your money?
PART II: COMPREHENSIVE PROBLEM (50 POINTS)
You have been hired as a financial consultant to General Dramatics (GD), a large publicly traded firm that is the market share leader in military vehicles. The company is looking at setting up a manufacturing plant overseas to produce a new line of vehicles. This will be a five-year project. The company bought some land three years ago for $4 million in anticipation of using it as a dump for waste materials, but it has since found a safe and inexpensive way of discarding these materials. The land was very recently appraised for $5.25 million. In five years, the after-tax value of the land is expected to be $6 million, but the company expects to keep the land for alternate uses. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $35 million to build. The plant has an eight-year tax life and GD uses straight-line depreciation. At the end of the project (that is, at the end of year five), the plant and equipment can be scrapped for $6 million.
The company will incur $7 million in annual fixed costs. The plan is to manufacture 18,000 vehicles per year and sell them for $10,900 per machine; the variable production costs are $9,400 per vehicle.
The following market data on GD’s securities are current:
Debt: 240,000 7.5 percent coupon bonds outstanding, 20 years to maturity, selling for 94% of par; the bonds have a $1,000 par value each and make semi-annual payments.
Common Stock: 9,000,000 shares outstanding, selling for $71 per share; the beta is 1.2.
Preferred Stock: 400,000 shares of 5.0 percent preferred stock outstanding, selling for $81 per share. Market: 8 percent expected market risk premium; 5 percent risk-free rate.
GM’s underwriter charges spreads of 8 percent on new common stock issues, 6 percent on new preferred stock issues, and 4 percent on new debt issues. All direct and indirect issuance costs are reflected in these spreads. The underwriter has recommended that GM raise the funds needed to build the plant by issuing new shares of common stock. GM’s tax rate is 35 percent. The project requires $1.5 million in initial net working capital investment to get operational; this amount will be fully recovered at the end of the project.
The new project is somewhat riskier than a typical project for GD, primarily because the plant is being located overseas. As a result, management has asked you to add 2 percent to the company’s discount rate.
What is your recommendation for GD regarding this project? Show your work and derivations. If you use a spreadsheet program, please email me a version, in addition to your submitted hard copy.
Subject | Business |
Due By (Pacific Time) | 10/22/2014 10:00 am |
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