BA 2802 – PRINCIPLES OF FINANCE

Graded Homework 2 – Due on May 24, 2022 by 17:00

Rules: Students are allowed to work in groups on this homework assignment

however a single submission for the whole group is not allowed. Each and every
student in the group should turn in his or her own work. If you work in groups,
you need to list the names of people that you worked together on the upper right-
hand corner of the first page of your assignment. Your answers to the
questions should be hand written on PROFESSIONAL LOOKING A4
paper.

You graduated from the university five years ago and since then you have been working at the
Affordable Cars Company (ACC) Inc. The ACC Inc. is an American multinational automobile
manufacturer. The company was founded almost 100 years ago. It is the second-largest US-
based automaker and the fifth-largest in the world. You attend the meeting with the chief
financial officer, Ben, and the chief operating officer, Jane. Jane’s group is planning to launch
a new car.
1. The ACC Inc. already has two luxury sports brands and three affordable family cars on the
market. This new car will be a more affordable sports car. Jane called this meeting to go
over the long-awaited market research report for this affordable sports car model
commissioned from the Markets-R-Us company and delivered yesterday. According to this
report, there is a niche for an affordable sports car. However, this niche will be filled by the
company’s competitors in five years. Therefore, Jane thinks that the company can produce
and sell these affordable sports cars for the next five years without any competition and
then terminate the project when the competitors move into the market. The ACC has to pay
$5,000,000 for this market research report at the end of the month.
The ACC will hire an external design team for this new model and pay $6,000,000 for their
services if the company decides to produce the new model. Ben recommends using the
building owned by the company as the production facility for this new model. The company
has been renting this building for $10,000,000 per year to its neighbor firm for the past
several years. Ben talked to the tenant before the meeting and learned that the tenant would
like to continue renting this building for the following 5 years.
The report shows that this new sports car model can be sold for $60,000 per car this year.
The price of this car will increase by 2% inflation every year. The company can sell 50,000
cars per year during the next 5 years. The variable production costs are expected to be 75%
of the sales revenue. In addition to these variable production costs, there will be
$100,000,000 fixed costs every year.
The ACC Inc. has to buy a new machine to produce the new model which costs
$1,000,000,000. Shipping, insurance and installation costs will be 5% of the acquisition
cost. This machine will be depreciated to a value of 0 by straight-line depreciation method
over a 6 year period. The company can sell this machine for $100,000,000 at the end of 5
years.
One important point is that this new model will affect the sales of Model X20, another
affordable car produced by the company. Sales of Model X20 will decrease by 10,000 units
per year for the next 5 years. The existing model is selling for $50,000 now and its price is
also expected to increase with inflation every year. The variable production costs for Model

1
 X20 are also 75% of its sales revenue. The fixed production costs of this model are
$50,000,000 per year.
To produce this new sports car model, the company has to carry an inventory of parts equal
to 10% of the sales revenue of the new model in the following year. Similarly, ACC will
have an increase in its accounts payables equal to 5% of the sales revenue of the new model
in the following year.
The ACC, Inc. is in the 34% tax bracket, and the company’s investors expect a return of
12% on a project like this.
a. Calculate the total cash flows from assets (CFFA) throughout the life of this project.
b. Decide if this is an acceptable project or not.
2. To finance the growth in its operations, ACC Inc. needs to raise additional capital. Ben and
his group decided to issue two bonds for this purpose.
Bond N – ACC Inc. wants to issue $500,000,000 worth of bonds. These bonds have $1,000
par value, a time to maturity of 20 years, and a 10% coupon rate. Bond N makes semi-
annual coupon payments. These bonds are issued at par value today.
Bond P – ACC Inc. wants to issue $100,000,000 worth of pure discount bonds with 7-years
to maturity. These bonds also have $1,000 par value. Bond P is issued at a yield to maturity
of 8% today.
a. The ACC Inc. is an old and very large company thus its credit rating is very high. Its
existing bonds have a credit rating of AAA. However, this new project is riskier
compared to its ongoing productions. As a result, Bond N is issued with a credit rating
of A. Given this information, briefly discuss the relationship between the yields on
company’s existing 20-year bonds and Bond N at the time of its issue.
b. State the yield to maturity on Bond N.
c. Calculate the price of Bond P today.
d. Suppose a year has passed and the yield to maturity on Bond N changed to 12%.
Calculate the price of Bond N in the market at that time.
e. Calculate Bond N's current and capital gains yields in the last year.
f. Suppose two more years have passed and the rating agencies has changed the credit
rating of Bond N to AA today. These bonds are trading in the market at a price of
$1,086.23.
i. Briefly discuss a reason for the change in the price of Bond N.
ii. Calculate the yield to maturity for Bond N.
iii. Briefly discuss if it is possible for Bond P to trade at a price above par as well.
3. The ACC Inc. has both common stock and preferred stock outstanding.
Common Stock - 1 million shares of common stock are outstanding. Since it is an old and
established firm, the company has paid dividends every year including today. However, to
finance the investment in this new project, the ACC decides not to pay any dividends for
the next 3 years. At the end of year 4, the company will pay a dividend of $2.2 per share.
From there on, the company's dividends are expected to grow at 25% per year for the
following 3 years, and at 6% per year forever thereafter. Analysts argue that investors
would require a return of 18% for the following 5 years and 13% thereafter forever.

2
Preferred Stock – 250,000 shares of cumulative preferred stock are outstanding. The
company pays dividends of $3.1 per share every year including today. However, to finance
the investment in this new project, the ACC decides not to pay any dividends for the
following 3 years to its preferred stockholders as well. At the end of year 4, the company
will continue to pay annual dividends of $3.1 per share every year. Analysts estimate that
investors require a return of 12% from this investment.
a. Given all this information,
i. Calculate the price at which ACC Inc.’s common stock can trade in the market
today.
ii. Calculate the price at which ACC Inc.’s cumulative preferred stock can trade in
the market today.
b. Suppose 4 years have passed. Holding everything else constant,
i. Calculate the value of ACC Inc.’s common stock now.
ii. Calculate the value of ACC Inc.’s preferred stock now.