1. The common shares of Trenton Ltd., which are currently trading at $12.

50, paid a
dividend of $1.50 per share during the past year. Investment analysts have informed you
that the historical growth rate for its common share dividends of 2% is expected to
continue for the foreseeable future, that the firm’s beta is 1.7, and that reasonable
estimates for the risk-free rate of return and the expected market return are 3% and 9%,
respectively.

Alternatively, the common shares of Bellville Inc. have a current market price of $10 per
share and investment analysts have informed you that the share price is expected to be $10.50
in 1 year, that the shares are expected to pay a dividend of $1 per share over the next year,
and that their beta is 0.75.

Should you invest in the common shares of Trenton or the common shares of Bellville?
Explain and support your answer with calculations. (7 marks)

Trenton; Required return = Rf + beta(Rm-Rf) = .03+1.7(.09-.03) = .132

Market value of stock = dividend/required return = 1.5(1.02)/(.132-.02) = 13.66

Since current price is 12.50 this is a buy scenario.

Belleville: Required return = .03*.75(.09-.03) = .075

Expected return = (1.00+(10.50-10.00))/10 = 15%

Expected return exceeds required return thus buy as well.

Invest in both.
 2. You have been asked to help a manufacturing company decide whether it should invest in a new
3 year project. To help with your analysis, the firm has provided you with the following
projected income statements for the project.

Year 1 Year 2 Year 3

Revenues $10,000 $11,000 $12,500

Cost of Goods Sold 4,000 4,500 5,000

Amortization 4,000 3,000 2,000

EBIT $2,000 $3,500 $5,500

In addition, the following information has been provided. The project will require an initial investment
of $15,000 in new equipment and one-time maintenance costs for the equipment of $2,000 at the end
of year two (2). The equipment is expected to have a salvage value of $6,000 at the end of the project.
Working capital requirements are expected to be 10% of the first year revenue. The company’s tax rate
is 40%, its cost of capital is 18% and the CCA rate on the equipment is 25%.

Required:

a) Using the NPV method should the project be undertaken? Explain and show all calculations.

a) After tax cash flows:

Year 1 Year 2 Year 3

Revenues $10,000 $11,000 $12,500

Cost of Goods Sold 4,000 4,500 5,000

Amortization 4,000 3,000 2,000

EBIT $2,000 $3,500 $5,500

Less: Tax (800) (1,400) (2,200)
Plus : Amort. 4,000 3,000 2,000

Net cash flow $5,,200 $5,100 $5,300

Present value of cash flow 4,406.78 3662.74 3225.74

I = 18%
Present values

Cost: P.V.
Investment in equip. $15,000 ($15,000)
Working capital: 10% of 1st yr Rev. (1,000)
W.C. recovery 608.6
Salvage of $6,000 3,651.78
Maintenance costs at end of 2nd year (861)
P.V. of cash flows 11,295.26

PCCCATS 2,373

NPV $1,068

PV ( CCA )
=[ $ 15 , 000 ] (00 .25×0 . 40 1+. 5×. 18
)(
.18+0. 25 1+. 18 )−$ 3 , 652 (
0 .25×0 . 40
0 .18+0. 25 )
=[ $ 15 , 000 ] ( 0 . 2326 ) ( 0.9237 ) - $3,652(0 . 2326) =2 ,373

Since NPV is positive project should be accepted as it will add value to the company