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Topic 5 Risk and return

P51 Rate of return Dougas Kee, a fnanca anayst for Orange Industres, wshes
to estmate the rate of return for two smar-rsk nvestments, X and Y. Dougass
research ndcates that the mmedate past returns w serve as reasonabe
estmates of future returns.
A year earer, nvestment X had a market vaue of $20,000; nvestment Y had a
market vaue of $55,000. Durng the year, nvestment X generated cash fow of
$1,500 and nvestment Y generated cash fow of $6,800. The current market
vaues of nvestments X and Y are $21,000 and $55,000, respectvey.
a. Cacuate the expected rate of return on nvestments X and Y usng the most
recent years data.
b. Assumng that the two nvestments are equay rsky, whch one shoud Dougas
recommend? Why?
P53 Risk aversion Sharon Smth, the fnanca manager for Barnett Corporaton,
wshes to evauate three prospectve nvestments: X, Y, and Z. Currenty, the frm
earns 12% on ts nvestments, whch have a rsk ndex of 6%. The expected return
and expected rsk of the nvestments are shown beow. If Sharon Smth s risk-
averse, whch nvestment, f any, woud she seect? Why?
Expected Expected
Investment return risk index
X 14% 7%
Y 12 8
Z 10 9
P54 Risk analysis Soar Desgns s consderng an nvestment n an expanded
product ne. Two possbe types of expanson are beng consdered. After
nvestgatng
the possbe outcomes, the company made the estmates shown n the
foowng tabe:
Expanson A Expanson B
Inta nvestment $12,000 $12,000
Annua rate of return
Pessmstc 16% 10%
Most key 20% 20%
Optmstc 24% 30%
a. Determne the range of the rates of return for each of the two pro|ects.
b. Whch pro|ect s ess rsky? Why?
c. If you were makng the nvestment decson, whch one woud you choose?
Why? What does ths mpy about your feengs toward rsk?
d. Assume that expanson Bs most key outcome s 21% per year and that
a other facts reman the same. Does ths change your answer to part c
Why?
P5! "oefficient of variation Meta Manufacturng has soated four aternatves for
meetng ts need for ncreased producton capacty. The data gathered reatve to
each of these aternatves are summarzed n the foowng tabe:
Expected #tandard
$lternative return deviation of return
A 20% 7.0%
B 22 9.5
C 19 6.0
D 16 5.5
a. Cacuate the coefficient of variation for each aternatve.
b. If the frm wshes to mnmze rsk, whch aternatve do you recommend?
Why?
TOPIC 6: Interest rate and bond valuation
P%5 &ond interest payments before and after taxes
Charter Corp. has ssued 2,500 debentures wth a tota prncpa vaue of
$2,500,000. The bonds have a coupon nterest rate of 7%.
a. What doar amount of nterest per bond can an nvestor expect to receve each
year from Charter?
b. What s Charters tota nterest expense per year assocated wth ths bond
ssue?
c. Assumng that Charter s n a 35% corporate tax bracket, what s the companys
net after-tax nterest cost assocated wth ths bond ssue?
P%% &ond 'uotation Assume that the foowng quote for the Fnanca
Management
Corporatons $1,000-par-vaue bond was found n the Wednesday, November 8,
ssue of the Wall Street Journal.
(inancial )ana*ement +(), 5.!-- )ay 15. /-13 0!.!-1 %.-34 1/0 1- 4!.1-!
Gven ths nformaton, answer the foowng questons:
a. On what day dd the tradng actvty occur?
b. What was the ast prce at whch the bond traded on November 7?
c. When does the bond mature?
d. What doar vaue of these bonds was traded on the day quoted?
e. What s the bonds coupon nterest rate?
f. What s the bonds yield? Expan what ths vaue represents.
*. What was ths bonds spread over a smar-maturty U.S. Treasury ssue?
What maturty Treasury ssue s used n ths comparson?
P%! 2aluation fundamentals Imagne that you are tryng to evauate the economcs
of purchasng an automobe. You expect the car to provde annua after-tax cash
benefts of $1,200 at the end of each year, and assume that you can se the car
for after-tax proceeds of $5,000 at the end of the panned 5-year ownershp
perod. A funds for purchasng the car w be drawn from your savngs, whch are
currenty earnng 6% after taxes
a. Identfy the cash fows, ther tmng, and the requred return appcabe to
vaung the car.
b. What s the maxmum prce you woud be wng to pay to acqure the car?
Expan.
P%0 $sset valuation and risk Laura Drake wshes to estmate the vaue of an asset
expected to provde cash nfows of $3,000 per year at the end of years 1 through
4 and $15,000 at the end of year 5. Her research ndcates that she must earn
10% on ow-rsk assets, 15% on average-rsk assets, and 22% on hgh-rsk assets.
a. Determne what s the most Laura shoud pay for the asset f t s cassfed as
(1) ow-rsk, (2) average-rsk, and (3) hgh-rsk.
b. Suppose Laura s unabe to assess the rsk of the asset and wants to be certan
shes makng a good dea. On the bass of your fndngs n part a. what s the most
she shoud pay? Why?
c. A ese beng the same, what effect does ncreasng rsk have on the vaue of an
asset? Expan n ght of your fndngs n part a.
P%1/ &ond value and c3an*in* re'uired returns Mdand Uttes has outstandng a
bond ssue that w mature to ts $1,000 par vaue n 12 years. The bond has a
coupon nterest rate of 11% and pays nterest annually.
a. Fnd the vaue of the bond f the requred return s (1) 11%, (2) 15%, and (3)
8%.
b. Pot your fndngs n part a on a set of "requred return (x axs)-market
vaue of bond (y axs)" axes. c. Use your fndngs n parts a and b to dscuss the
reatonshp between the coupon nterest rate on a bond and the requred return
and the market vaue of the bond reatve to ts par vaue.
d. What two possbe reasons coud cause the requred return to dffer from the
coupon nterest rate?
TOPIC 7: #tock 2aluation
P!% "ommon stock valuation45ero *ro6t3 Scotto Manufacturng s a mature frm n
the machne too component ndustry. The frms most recent common stock
dvdend was $2.40 per share. Because of ts maturty as we as ts stabe saes
and earnngs, the frms management fees that dvdends w reman at the
current eve for the foreseeabe future.
a. If the requred return s 12%, what w be the vaue of Scottos common stock?
b. If the frms rsk as perceved by market partcpants suddeny ncreases,
causng the requred return to rse to 20%, what w be the common stock vaue?
c. |udgng on the bass of your fndngs n parts a and b. what mpact does rsk
have on vaue? Expan.
P!1 Preferred stock valuation |ones Desgn wshes to estmate the vaue of ts
outstandng preferred stock. The preferred ssue has an $80 par vaue and pays
an annua dvdend of $6.40 per share. Smar-rsk preferred stocks are currenty
earnng a 9.3% annua rate of return.
a. What s the market vaue of the outstandng preferred stock?
b. If an nvestor purchases the preferred stock at the vaue cacuated n part a.
how much does she gan or ose per share f she ses the stock when the requred
return on smar-rsk preferreds has rsen to 10.5%? Expan.
P!1- "ommon stock value4"onstant *ro6t3 McCracken Roofng, Inc., common
stock pad a dvdend of $1.20 per share ast year. The company expects earnngs
and dvdends to grow at a rate of 5% per year for the foreseeabe future.
a. What requred rate of return for ths stock woud resut n a prce per share of
$28?
b. If McCracken expects both earnngs and dvdends to grow at an annua rate of
10%, what requred rate of return woud resut n a prce per share of $28?
P!13 (ree cas3 flo6 valuation Nabor Industres s consderng gong pubc but s
unsure of a far offerng prce for the company. Before hrng an nvestment
banker to assst n makng the pubc offerng, managers at Nabor have decded to
make ther own estmate of the frms common stock vaue. The frms CFO has
gathered data for performng the vauaton usng the free cash fow vauaton
mode.
The frms weghted average cost of capta s 11%, and t has $1,500,000 of debt
at market vaue and $400,000 of preferred stock at ts assumed market vaue.
The estmated free cash fows over the next 5 years, 2007 through 2011, are
gven beow. Beyond 2011 to nfnty, the frm expects ts free cash fow to grow
by 3% annuay.
7ear +t, (ree cas3 flo6 +FCFt,
2007 $200,000
2008 250,000
2009 310,000
2010 350,000
2011 390,000
LG5
LG4
a. Estmate the vaue of Nabor Industres entre company by usng the free cash
flow aluation model.
b. Use your fndng n part a. aong wth the data provded above, to fnd Nabor
Industres common stock vaue.
c. If the frm pans to ssue 200,000 shares of common stock, what s ts estmated
vaue per share?
Topc 8 Capta Budgetng and cash fow
P11 "lassification of expenditures Gven the foowng st of outays, ndcate
whether each s normay consdered a capital or an operating expendture.
Expan your answers.
a. An nta ease payment of $5,000 for eectronc pont-of-sae cash regster
systems.
b. An outay of $20,000 to purchase patent rghts from an nventor.
c. An outay of $80,000 for a ma|or research and deveopment program.
d. An $80,000 nvestment n a portfoo of marketabe securtes.
e. A $300 outay for an offce machne.
f. An outay of $2,000 for a new machne too.
*. An outay of $240,000 for a new budng.
3. An outay of $1,000 for a marketng research report
P13 Relevant cas3 flo6 pattern fundamentals For each of the foowng pro|ects,
determne the relevant cash flows, cassfy the cash fow pattern, and depct the
cash fows on a tme ne.
a. A pro|ect that requres an nta nvestment of $120,000 and w generate
annua operatng cash nfows of $25,000 for the next 18 years. In each of the 18
years, mantenance of the pro|ect w requre a $5,000 cash outfow.
b. A new machne wth an nstaed cost of $85,000. Sae of the od machne w
yed $30,000 after taxes. Operatng cash nfows generated by the repacement
w exceed the operatng cash nfows of the od machne by $20,000 n each year
of a 6-year perod. At the end of year 6, qudaton of the new machne w yed
$20,000 after taxes, whch s $10,000 greater than the after-tax proceeds
expected from the od machne had t been retaned and qudated at the end of
year 6.
c. An asset that requres an nta nvestment of $2 mon and w yed annua
operatng cash nfows of $300,000 for each of the next 10 years. Operatng cash
outays w be $20,000 for each year except year 6, when an overhau requrng
an addtona cash outay of $500,000 w be requred. The assets qudaton
vaue at the end of year 10 s expected to be zero.
P15 #unk costs and opportunity costs Covo Industres s deveopng the reevant
cash fows assocated wth the proposed repacement of an exstng machne too
wth a new, technoogcay advanced one. Gven the foowng costs reated to the
proposed pro|ect, expan whether each woud be treated as a sunk cost or an
opportunity cost n deveopng the reevant cash fows assocated wth the
proposed repacement decson.
a. Covo woud be abe to use the same toong, whch had a book vaue of
$40,000, on the new machne too as t had used on the od one.
b. Covo woud be abe to use ts exstng computer system to deveop programs
for operatng the new machne too. The od machne too dd not requre these
programs. Athough the frms computer has excess capacty avaabe, the
capacty coud be eased to another frm for an annua fee of $17,000.
c. Covo woud have to obtan addtona foor space to accommodate the arger
new machne too. The space that woud be used s currenty beng eased to
another company for $10,000 per year.
d. Covo woud use a sma storage facty to store the ncreased output of the
new machne too. The storage facty was but by Covo 3 years earer at a cost
of $120,000. Because of ts unque confguraton and ocaton, t s currenty of no
use to ether Covo or any other frm.
e. Covo woud retan an exstng overhead crane, whch t had panned to se
for ts $180,000 market vaue. Athough the crane was not needed wth the od
machne too, t woud be used to poston raw materas on the new
machne too.
P1! &ook value and taxes on sale of assets Troy Industres purchased a new machne
3 years ago for $80,000. It s beng deprecated under MACRS wth a 5-year
recovery perod usng the percentages gven n Tabe 3.2 on page 94. Assume a
40% tax rate.
a. What s the book value of the machne?
b. Cacuate the frms tax abty f t sod the machne for each of the foowng
amounts: $100,000; $56,000; $23,200; and $15,000.
P11- "alculatin* initial investment Vastne Medca, Inc., s consderng repacng ts
exstng computer system, whch was purchased 2 years ago at a cost of
$325,000. The system can be sod today for $200,000. It s beng deprecated
usng MACRS and a 5-year recovery perod (see Tabe 3.2, page 94). A new
computer system w cost $500,000 to purchase and nsta. Repacement of the
computer system woud not nvove any change n net workng capta. Assume a
40% tax rate.
a. Cacuate the book value of the exstng computer system.
b. Cacuate the after-tax proceeds of ts sae for $200,000.
c. Cacuate the initial investment assocated wth the repacement pro|ect.
P11/ Initial investment at various sale prices Edwards Manufacturng Company
(EMC) s consderng repacng one machne wth another. The od machne was
purchased 3 years ago for an nstaed cost of $10,000. The frm s deprecatng
the machne under MACRS, usng a 5-year recovery perod. (See Tabe 3.2 on
page 94 for the appcabe deprecaton percentages.) The new machne costs
$24,000 and requres $2,000 n nstaaton costs. The frm s sub|ect to a 40% tax
rate. In each of the foowng cases, cacuate the initial investment for the
repacement.
a. EMC ses the od machne for $11,000.
b. EMC ses the od machne for $7,000.
c. EMC ses the od machne for $2,900.
d. EMC ses the od machne for $1,500.
P111 8erminal cas3 flo64Replacement decision Russe Industres s consderng
repacng a fuy deprecated machne that has a remanng usefu fe of 10 years
wth a newer, more sophstcated machne. The new machne w cost $200,000
and w requre $30,000 n nstaaton costs. It w be deprecated under MACRS
usng a 5-year recovery perod (see Tabe 3.2 on page 94 for the appcabe
deprecaton percentages). A $25,000 ncrease n net workng capta w be
requred to support the new machne. The frms managers pan to evauate the
potenta repacement over a 4-year perod. They estmate that
the od machne coud be sod at the end of 4 years to net $15,000 before taxes;
the new machne at the end of 4 years w be worth $75,000 before taxes.
Cacuate the terminal cash flow at the end of year 4 that s reevant to the
proposed purchase of the new machne. The frm s sub|ect to a 40% tax rate
TOPIC 9 Capital budgeting techniques
P0/ Payback comparisons Daas Too has a 5-year maxmum acceptabe payback
perod. The frm s consderng the purchase of a new machne and must choose
between two aternatve ones. The frst machne requres an nta nvestment of
$14,000 and generates annua after-tax cash nfows of $3,000 for each of the
next 7 years. The second machne requres an nta nvestment of $21,000 and
provdes an annua cash nfow after taxes of $4,000 for 20 years.
a. Determne the payback period for each machne.
b. Comment on the acceptabty of the machnes, assumng that they are
ndependent pro|ects.
c. Whch machne shoud the frm accept? Why?
d. Do the machnes n ths probem ustrate any of the weaknesses of usng
payback? Dscuss
P04 9P2 for varyin* costs of capital Cherys Beauty Ads s evauatng a new
fragrance-
mxng machne. The machne requres an nta nvestment of $24,000 and w
generate after-tax cash nfows of $5,000 per year for 8 years. For each of the
costs of capta sted, (1) cacuate the net present value !"#$, (2) ndcate
whether to accept or re|ect the machne, and (3) expan your decson.
a. The cost of capta s 10%.
b. The cost of capta s 12%.
c. The cost of capta s 14%.
P0% 9P2 and maximum return A frm can purchase a fxed asset for a $13,000
nta nvestment. The asset generates an annua after-tax cash nfow of $4,000
for 4 years.
a. Determne the net present value !"#$ of the asset, assumng that the frm has
a 10% cost of capta. Is the pro|ect acceptabe?
b. Determne the maxmum requred rate of return (cosest whoe-percentage
rate) that the frm can have and st accept the asset. Dscuss ths fndng n ght
of your response n part a.
P011 IRR. investment life. and cas3 inflo6s Cncnnat Machne Too (CMT) accepts
pro|ects earnng more than the frms 15% cost of capta. CMT s currenty
consderng a 10-year pro|ect that provdes annua cash nfows of $10,000 and
requres an nta nvestment of $61,450. (!ote% A amounts are after taxes.)
a. Determne the IRR of ths pro|ect. Is t acceptabe?
b. Assumng that the cash nfows contnue to be $10,000 per year, how many
additional years woud the fows have to contnue to make the pro|ect acceptabe
(that s, to make t have an IRR of 15%)?
c. Wth the gven fe, nta nvestment, and cost of capta, what s the mnmum
annua cash nfow that the frm shoud accept?
P01/ 9P2 and IRR Lo Manufacturng has prepared the foowng estmates for a
ong-term pro|ect t s consderng. The nta nvestment s $18,250, and the
pro|ect s expected to yed after-tax cash nfows of $4,000 per year for 7 years.
The frm has a 10% cost of capta.
a. Determne the net present value !"#$ for the pro|ect.
b. Determne the internal rate of return &''$ for the pro|ect.
c. Woud you recommend that the frm accept or re|ect the pro|ect? Expan your
answer.
P01! Inte*rative4"omplete investment decision Hot Sprngs Press s consderng the
purchase of a new prntng press. The tota nstaed cost of the press s $2.2
mon. Ths outay woud be partay offset by the sae of an exstng press. The
od press has zero book vaue, cost $1 mon 10 years ago, and can be sod
currenty for $1.2 mon before taxes. As a resut of acquston of the new press,
saes n each of the next 5 years are expected to be $1.6 mon hgher than wth
the exstng press, but product costs (excudng deprecaton) w represent 50%
of saes. The new press w not affect the frms net workng capta
requrements. The new press w be deprecated under MACRS usng a 5-year
recovery perod (see Tabe 3.2 on page 94). The frm s sub|ect to a 40% tax rate.
Hot Sprngs cost of capta s 11%. (!ote% Assume that both the od and the new
press w have termna vaues of $0 at the end of year 6.)
a. Determne the initial investment requred by the new press.
b. Determne the operating cash inflows attrbutabe to the new press.
(!ote% Be sure to consder the deprecaton n year 6.)
c. Determne the payback period.
d. Determne the net present value !"#$ and the internal rate of return &''$
reated to the proposed new press.
e. Make a recommendaton to accept or re|ect the new press, and |ustfy your
answer.
TOPIC 10 Cost of Capital
P1-/ "ost of debt usin* bot3 met3ods Currenty, Warren Industres can se 15-year,
$1,000-par-vaue bonds payng annual interest at a 12% coupon rate. As a resut
of current nterest rates, the bonds can be sod for $1,010 each; fotaton costs of
$30 per bond w be ncurred n ths process. The frm s n the 40% tax bracket.
a. Fnd the net proceeds from sae of the bond, !d.
b. Show the cash fows from the frms pont of vew over the maturty
of the bond.
c. Use the &'' approach to cacuate the before-tax and after-tax costs of debt.
d. Use the approximation formula to estmate the before-tax and after-tax
costs of debt.
e. Compare and contrast the costs of debt cacuated n parts c and d.
Whch approach do you prefer? Why?
P1-4 "ost of preferred stock Tayor Systems has |ust ssued preferred stock. The
stock has a 12% annua dvdend and a $100 par vaue and was sod at $97.50
per share. In addton, fotaton costs of $2.50 per share must be pad.
a. Cacuate the cost of the preferred stock.
b. If the frm ses the preferred stock wth a 10% annua dvdend and nets
$90.00 after fotaton costs, what s ts cost
P1-1/ "alculation of specific costs. :$"". and :)"" Don Labs has asked ts
fnanca manager to measure the cost of each specfc type of capta as we as
the weghted average cost of capta. The weghted average cost s to be
measured
by usng the foowng weghts: 40% ong-term debt, 10% preferred stock,
and 50% common stock equty (retaned earnngs, new common stock, or both).
The frms tax rate s 40%.
;ebt The frm can se for $980 a 10-year, $1,000-par-vaue bond payng
annual interest at a 10% coupon rate. A fotaton cost of 3% of the par vaue
s requred n addton to the dscount of $20 per bond.
Preferred stock Eght percent (annua dvdend) preferred stock havng a par vaue
of $100 can be sod for $65. An addtona fee of $2 per share must be pad to the
underwrters.
"ommon stock The frms common stock s currenty seng for $50 per share. The
dvdend expected to be pad at the end of the comng year (2007) s $4. Its
dvdend payments, whch have been approxmatey 60% of earnngs per share n
each of the past 5 years, were as shown n the foowng tabe.
7ear ;ividend
2006 $3.75
2005 3.50
2004 3.30
2003 3.15
2002 2.85
It s expected that to attract buyers, new common stock must be underprced $5
per share, and the frm must aso pay $3 per share n fotaton costs. Dvdend
payments are expected to contnue at 60% of earnngs.
a. Cacuate the specfc cost of each source of fnancng. (Assume that kr_ks.)
b. If earnngs avaabe to common sharehoders are expected to be $7 mon,
what s the break point assocated wth the exhauston of retaned earnngs?
c. Determne the weghted average cost of capta between zero and the break
pont cacuated n part b.
d. Determne the weghted average cost of capta |ust beyond the break pont
cacuated n part b.
P1-13 "alculation of specific costs. :$"". and :)"" Lang Enterprses s nterested
n measurng ts overa cost of capta. Current nvestgaton has gathered the
foowng data. The frm s n the 40% tax bracket.
;ebt The frm can rase an unmted amount of debt by seng $1,000-parvaue,
8% coupon nterest rate, 20-year bonds on whch annual interest payments w be
made. To se the ssue, an average dscount of $30 per bond woud have to be
gven. The frm aso must pay fotaton costs of $30 per bond.
Preferred stock The frm can se 8% preferred stock at ts $95-per-share par vaue.
The cost of ssung and seng the preferred stock s expected to be $5 per share.
An unmted amount of preferred stock can be sod under these terms.
"ommon stock The frms common stock s currenty seng for $90 per share.
The frm expects to pay cash dvdends of $7 per share next year. The frms
dvdends
have been growng at an annua rate of 6%, and ths growth s expected to
contnue nto the future. The stock must be underprced by $7 per share, and
fotaton costs are expected to amount to $5 per share. The frm can se an
unmted amount of new common stock under these terms.
Retained earnin*s When measurng ths cost, the frm does not concern tsef wth
the tax bracket or brokerage fees of owners. It expects to have avaabe
$100,000 of retaned earnngs n the comng year; once these retaned earnngs
are exhausted, the frm w use new common stock as the form of common stock
equty fnancng.