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GREAT LAKES INSTITUTE OF MANAGEMENT

FINANCIAL MANAGEMENT I TERM I 2014 - 2015

GROUP ASSIGNMENT III DATE OF SUBMISSION SUNDAY JULY 27
TH
2014

1.At the beginning of the year, Corns Bradley owned four securities in the following amounts and with the following
current and expected end of year prices:

Security Share Amount Current Price Expected Year End
Price
A 100 \$50 \$60
B 200 \$35 \$40
C 50 \$25 \$50
D 100 \$100 \$110

What is the expected return on Corns Portfolio for the year ?

2. Assume you have all your wealth invested ( \$1 million ) in the Vanguard 500 Index Fund ( of risky assets ) and that
you expect to earn a return of 12 percent annually with a standard deviation in returns of 25 percent. You have
become more risk averse and so you decide to shift \$200000 from the Vanguard Index Fund to Treasury Bills. The
Treasury bills rate is 5 percent. Estimate the standard deviation and expected return of your new portfolio.
3. You are interested in creating a portfolio of two stocks Coca Cola and Texas Utilities. Over the last decade
, an investment in Coca Cola stock would have earned an average return of 25 percent with a standard
deviation of returns of 36 percent. An investment in Texas Utilities stock would have earned an average
return of 12 percent annually, with a standard deviation of 22 percent. The correlation in returns across
these two stocks is 0.28.

a. Assuming that the average and standard deviation, using past returns, will continue to hold in the
future , estimate the average returns and standard deviation of a portfolio composed of 60 % in
Coca Cola and 40% in Texas Utilities.
b. Estimate the minimum variance portfolio.
Now assume that Coca Colas international diversification will reduce the correlation to 0.20, while increasing Coca
Colas standard deviation in returns to 45 percent. How will your answers to a and b change ?
4.You are helping a bookstore decide whether it should open a coffee shop on the premises. The details of the
investment are as follows:
The coffee shop will cost \$50,000 to open; it will have a five-year life and be depreciated straight line over
the period to a salvage value of\$10,000.
The sales at the shop are expected to be \$15,000 in the first year and to grow 5% a year for the following
five years.
The operating expenses will be 50% of revenues.
The tax rate is 40%
The coffee shop is expected to generate additional sales of \$20,000 next year for the bookshop, and the pre
tax-operating margin is 40%. These sales will grow for the following years at 10%.
Assume the discount rate to be 10 percent.

a. Estimate the net present value of the coffee shop without the additional book sales.
b. Estimate the net present value of the cash flows accruing from the additional book sales.
c. Would you open the coffee shop?

5.The Wingler Equipment Company purchased a new machine 5 years ago at a cost of \$ 1,00,000. It had an
expected life of 10 years at the time of purchase and an expected salvage value of \$10,000 at the end of the 10
years. It is being depreciated by straight-line method towards a salvage value of \$10,000 or by \$ 9,000 per year.
A new machine can be purchased for \$150,000, including installation costs. Over its 5 years life, it will reduce cash
operating expenses by \$50,000 per year. Sales are not expected to change. At the end of its useful life, the
machine is estimated to be worthless. Reducing balance depreciation at 20% will be used, and it will be depreciated
over its 5 years economic life.
The old machine can be sold today for \$65,000. The firms tax rate is 34% .The appropriate discount rate is 15%
a. If the new machine is purchased, what is the amount of initial cash flow at year 0?
b. What incremental operating cash flow will occur at the end of year 1 through 5 as a result of replacing old
machine?
c. What incremental non- operating cash flows will occur at the end of 5 years if new machine is purchased?
d. What is the NPV of this project? Should the firm replace the old machine?

6.Pilot Plus Pens is deciding when to replace its old machine. The old machines current salvage value is \$2 million.
Its current book value is \$1 million. If not sold, the old machine will require maintenance costs of \$400,000 at the end
of the year for the next five years. Depreciation on the old machine is \$200,000 per year. At the end of five years, the
old machine will have a salvage value of \$200,000 and a book value of \$0. A replacement machine costs \$3 million
now and requires maintenance costs of \$500,000 at the end of each year during its economic life of 5 years. At the
end of five years, the new machine will have a salvage value of \$500,000. It will be fully depreciated by the straight
line method. In five years, a replacement machine will cost \$3,500,000. Pilot will need to purchase this machine
regardless of what choice it makes today. The corporate tax rate is 34 percent and the appropriate discount rate is 12
percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation. Should Pilot
Plus Pens replace the old machine now or at the end of five years ?

7.Filkins Fabric Company is considering replacement of its old, fully depreciated knitting machine .Two new models
are available: Machine 190-3, which costs of \$190,000, has a 3- year expected life, and after tax cash flows (labor
savings and depreciation) of \$87,000 per year ; and Machine 360-6, which has costs of \$360,000, a 6- year expected
life, and after tax cash flow of \$98,000 per year. Knitting machine prices are not expected to rise, because inflation
will be offset by cheaper components (microprocessor) used in the machines. Assume that Filkins discount rate is
14%
a. Should the firm replace its old knitting machine, and if so, which machine should it use?
b. Suppose the firms basic patent will expire in 9 years, and the company expects to go out of business at that time.
Assume further that the firms depreciates its assets using straight-line method, that its marginal federal- plus- state
tax rate is 40%, and that the used machine can be sold at their book values. Under these circumstances, should the
company replace the old machine and, if, so which new model should the company purchase?

8.Carbide Chemical Company is considering the replacement of two old machines with a new, more efficient
machine. The old machines could be sold for \$70,000 in the secondary market. Their depreciated book values is
\$120,000 with a remaining useful and depreciable life of 8 years. Straight line depreciation is used on these
machines. The new machine can be purchased and installed for \$480,000. It has a useful life of 8 years, at the end of
which a salvage value of \$40,000 is expected. The machine falls into the 25% annual depreciation on a reducing
balance method category. Due to its greater efficiency, the new machine is expected to result in incremental annual
savings of \$120,000. The companys annual corporate tax rate is 34% , and if a loss occurs in any year on the project
it is assumed that the company will receive a tax credit of 34% of such loss. Will you replace the machine ?

9.Listed are the estimates of the standard deviations and correlation coefficients for three stocks:

Stock Standard
Deviation
Correlation With Stock
A B C
A 12% 1.00 -1.00 0.20
B 15% -1.00 1.00 -0.20
C 10% 0.20 -0.20 1.00

(a) If a portfolio is composed of 20% in stock A and 80% in Stock C, what is the portfolios standard deviation ?

(b) If you were asked to design a portfolio using stocks A and B, what percentage investment in each stock would
produce a zero standard deviation ?

10.Consider the returns forecast in two scenarios for the market portfolio, an aggressive stock A and a defensive
stock B.

Scenario Market Rate of Return for A Rate of Return for B
Bust -8% -10% -6%
Boom 32% 38% 24%

(a) Find the beta of each stock.
(b) If each scenario is equally likely, what is the expected rate of return on the market portfolio and on each stock ?

[HINT: For this one the Beta is the slope of a line which can be derived by rise over run
If you draw a two dimensional graph with market returns on the X-axis and the stock returns on the Y-Axis, then Beta
would be the slope of the regression line. ]

(c) If the Treasury Bill rate is 4%, what rate of return is commensurate with its risk?
(d) Which stock seems to be a better buy based on your answers to (a) through (c) ?

11. Percival Hygiene has \$10 million invested in long term corporate bonds. This bond portfolios expected annual
rate of return is 9 percent, and the annual standard deviation is 10 percent.

Amanda Reckonwith, Percys financial advisor, recommends that he consider investing in an index fund which
closely tracks the Standard and Poors 500 index. The index has an expected return of 14%, and its standard
deviation is 16%.
(a) Suppose Percival puts all his money in a combination of the index fund and Treasury bills. Can he thereby
improve his expected rate of return without changing the risk of his portfolio ? The Treasury Bill yield is 6
percent.
(b) Could Percival do even better by investing equal amounts in the corporate bonds portfolio and the index fund ?
The correlation between the index fund and the bond portfolio is +0.10.

12. A company has the following long term capital outstanding as of 31
st
March 2003.
(a) 10 percent debentures with a face value of Rs 500,000 issued in 1999 and due on 31
st
March 2008. The
current market price of the debentures is Rs 950.
(b) Preference shares with a face value of Rs 400,000 and annual dividend of Rs 6 per share and current
market price of Rs 60 per share.
(c) 60,000 ordinary shares of Rs 10 par value currently selling at Rs 50 per share . The dividends per share for
the past five years are as follows :
Year Rs Year Rs
1996 2 2000 2.80
1997 2.16 2001 .3.08
1998 2.37 2002 3.38
1999 2.60 2003 3.70

Assuming a tax rate of 35 percent compute firms weighted average cost of capital .

13. A company is considering the possibility of raising Rs.10,000,000 by issuing debt, preference capital, equity and
retained earnings. The book values and the market values of the issues are as follows:

Book Value Market Value
Ordinary shares 300,000 600,000
Reserves 100,000 -
Preference Shares 200,000 240,000
Debt 400,000 360,000
10,00,000 12,00,000

The following costs are expected to be associated with the above mentioned issues of capital ( Assume a 35 percent
tax rate ).

(i) The firm can sell a 20 year Rs 1000 face value debenture with a 16 per cent rate of interest. An
underwriting fee of 2 percent of the market price would be incurred to issue the debentures.
(ii) The 11 percent Rs 100 face value preference shares would fetch a price of Rs 120 per share.
However, the firm will have to pay Rs 7.25 per preference share as underwriting commission.
(iii) The firms ordinary shares are currently selling at Rs 150 per share. It is expected that the firm will
pay a dividend of Rs 12 per share a the end of next year which is expected to grow at a rate of 7
percent. The new ordinary shares can be sold at a price of Rs 145. The firm should also incur Rs 5
per share floatation cost.
Compute its Weighted Average Cost of Capital .