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.