Financial Management

Fall 2022
Assignment 4
40 points

1. Consider an investment portfolio that consists of five different stocks, with the amount invested
in each asset shown below. Assume the risk-free rate is 4% and the market risk premium is 6%.
Use this information to answer the following questions.

Portfolio Stocks / Weights____ Beta

2nd National Bank 15% 0.6
Chesapeake Energy 20% 0.7
Pentair 30% 0.9
Pegasus 20% 0.6
Sodastream 15% 1.5
100%
a. Compute the expected return for each stock using the CAPM and assuming that the stocks
are all fairly priced. (3 points)
b. Compute the portfolio beta and the expected return on the portfolio. (2 points)

2. Linked on the Assignment 4 page in Canvas is the climactic scene from the movie, Executive
Suite. The scene depicts a boardroom battle over who will succeed the longstanding President &
CEO of the Tredway Corporation, Mr. Avery Bullard, who has just died unexpectedly. Although
an old movie, the issues raised, in this scene, about dividend policy and how corporate value is
created are perhaps even more relevant today. Watch the clip and explain in 150-200 words
which of the two rivals, Mr. Shaw or Mr. Walling, better reflects your textbook's view of how
shareholder value is created, and why? What assumptions do you make about Tredway. (5 points)

3. Hoosier Manufacturing (HM) has 20,000 bonds outstanding with a 6.30 percent coupon rate
(semi-annual coupon payments) and 12 years left to maturity. The bonds sell for $1028.50.
HM’s common stock has a beta of 0.8. The 10-year Treasury-Bond rate is currently 2.1 percent,
and historically, the market has earned 7% more per year than the 10-year Treasury rate. The
firm has 1,000,000 shares of common stock outstanding at a market price of $36.48 a share
(book value of $12 per share). The company’s marginal tax rate is 35 percent.
a. What is the before-tax cost of debt and what is the after-tax cost of debt? (2 points)
b. What is the cost of common stock? (2 points)
c. What is the weighted average cost of capital for Hoosier Manufacturing? (2 points)

4. Lee Corporation, an all equity-financed company, has traditionally employed a firm wide
discount rate for capital budgeting purposes. However, its two divisions – publishing and
entertainment, have different degrees of risk given by ß P = 1.0, ßE = 1.8, and the beta for the
overall firm is 1.2. Use 6% as the risk-free rate and 12% as the expected return on the market.
The firm is considering the following capital expenditures:
 4., cont.
a. Which projects would the firm accept if it uses the opportunity cost of capital for the entire
company? (3 points)
b. Which projects would it accept if it estimates cost of capital separately for each division?
(3 points)
c. If Lee Corporation only uses the cost of capital for the entire firm, what will happen to the
riskiness of the firm, compared to using the appropriate divisional cost of capital? (2 points)

Proposed Project Initial Investment IRR

P1 $1M .130
Publishing Project P2 $3M .121
P3 $2M .090

E1 $4M .160
Entertainment Project E2 $6M .170
E3 $5M .140

5. You purchased six Ford (F) call options contracts (note that a contract is for 100 options) with a
strike price of $11 at a cost of $1.75 per option. The option expires today when the value of F
stock is $13.55. Ignoring transaction costs, what is your payoff and profit on this trade?
(3 points)

6. Given what we've just learned about payout policy (from Chapter 16 of your text) reevaluate
Lazonick's argument, in Profits Without Propserity, about the effects of share repurchases.
Might a high rate of share repurchases, or dividend payments, be optimal (in terms of
increasing shareholder value) for such firms? What is the key characteristic of such firms?
Also explain how such firms contribute to general economic growth through repurchaes and
dividends (5 points)

7. Compare and Contrast the alternative methods for determining the Optimal Capital Structure
described here. The Best Circuit Company currently has no profitable growth opportunities or
debt. An in-house research group has just been assigned the job of determining whether the
firm should change its capital structure. Because of the importance of the decision,
management has also hired the investment banking firm of Stanley Morgan & Company to
conduct a parallel analysis of the situation. Mr. Harris, the in-house analyst, who is well versed in
modern finance theory, has decided to carry out the analysis using the MM
framework. Ms. Broske, the Stanley Morgan consultant, who has a good knowledge of capital
market conditions and is confident of her ability to predict the firm’s debt and equity costs at
various levels of debt, has decided to estimate the optimal capital structure as that structure
which minimizes the firm’s weighted average cost of capital. The following data are relevant to
both analyses:
EBIT = $4 million per year, in perpetuity.
Federal-plus-state tax rate = 40%.
Dividend payout ratio = 100%.
Current required rate of return on equity = 12%.

The cost of capital schedule predicted by Ms. Broske follows:

At a Debt Level of (Millions of Dollars)

$0 $2 $4 $6 $8 $10 $12 $14
Interest rate (%) - 8.0 8.3 9.0 10.0 11.0 13.0 16.0
Cost of equity (%) 12.0 12.5 13.25 13.75 14.5 15.75 17.25 19.0

Mr. Harris estimated the present value of financial distress costs at $20 million. Additionally,
he estimated the following probabilities of financial distress:

At a Debt Level of (Millions of Dollars)

$0 $2 $4 $6 $8 $10 $12 $14
Probability of financial distress (Note:
0 0 0.05 0.07 0.10 0.17 0.47 0.90
doesn't add to 1.00)

a. What level(s) of debt would Mr. Harris and Ms. Broske each recommend as optimal? (5
points)

b. Explain the similarities and differences in their approaches – not in their solutions. Is one
approach right and the other therefore wrong? Explain in one paragraph of 75 words or less. (3
points)