FINS1613 Lecture 5: FINS Week 5 Lect

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22 Jul 2018

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Key characteristics: profits and costs cash flows determined by (i) expected amount and (ii) expected timing (cid:2, uncertainty risk described by possible outcomes from the project (cid:2) Our requirements: a measure of value that must account for We also want the decision rule to help us make decisions consistent with the owner"s expectations. We will assume that the owner"s communicate a discount rate to the firm"s managers and that any decisions made with this discount rate meet the owner"s expectations. Determination of this discount rate is covered later in the course. The difference between the present value of a project"s or investment"s benefits and the present value of its costs. An investment should be accepted if the net present value is positive and rejected if it is negative. Doing so is equivalent to receiving the npv in cash today. *for typical projects, the npv decreases as the discount rate increases. Investment risk is captured by the discount rate.

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7. Within-firm risk and beta risk Aa Aa Understanding risks that affect projects and the impact of risk consideration wSp Inc. is involved in a wide range of unrelated projects. The company will pursue any project that it thinks will create value for its stockholders. Consequently, the risk level of the company's projects tends to vary a great deal from project to project. Ir WSP Inc. does not risk-adjust its discount rate for specific projects properly, which of the following is likely to occur over time? Check all that apply The firm will become less risky. The firm will make poor capital budgeting decisions that could jeopardize the long-run viability of the company The firm will reject too many relatively safe projects. Generally, a positive correlation exists between a project's returns and the returns on the firm's other assets. If this correlation is, stand-alone risk will be a good proxy for within-firm risk. high low Consider the case of another company. Davis Printing is evaluating two mutually exclusive projects. They both require a $5 million investment today and have expected NPVs of $1,000,000. Management conducted a full risk analysis of these two projects, and the results are shown below. Risk Measure Standard deviation of project's expected Npvs Project beta Project A Project B $400,000 $600,000 1.2 Correlation coefficient of project cash flows (relative to the firm's existing projects) 0.7 1.0 0.9 Which of the following statements about these projects risk is correct? Check all that apply

olivedinosaur853

1) Due to a number of lawsuits related to toxic wastes, a major chemical company has recently experienced a market revaluation. The firm has bonds outstanding that were issued 10 years ago at their par value of $1,000. These bonds have 15 years to maturity and a coupon rate of 8 percent, with interest paid semiannually. The required return on these bonds has increased to 16 percent. What is the current value of one of these bonds?

2)A bond with a $1,000 face value and a 9 percent annual coupon pays interest annually. The bond matures in 12 years.

a)Determine the value of the bond to a friend of yours with a required rate of return of 11%.

b)A zero coupon bond with similar risk is selling for $300. The bond has a face value of $1,000 and matures in 12 years. Your friend asks you which bond she should invest in, the zero coupon bond or the bond in part (a). Which bond do you recommend, and why? Assume the market price of the bond in part (a) is $720.

3)If you are willing to pay $1,077 for a 15-year $1,000 par value bond that pays 9 percent interest semi-annually, what is your expected rate of return?

4)If the expected growth rate for dividends is zero, then the value of common stock will be equal to the current dividend.

a) true

b)false

5)Diana Ltd. paid a $4.50 per share dividend yesterday. The dividend is expected to grow at 9 percent per year for the foreseeable future. Diana Ltd. has a beta of 1.4, a standard deviation of returns of 28 percent, and a required return of 16%. What is the value of a share of Diana Ltd. common stock?

6)You purchased one share of Googling Enterprises common stock for $40 today. If the stock pays a dividend of $6.50 in one year, and sells for $50 at that time, what will the dividend yield, growth rate, and total rate of return be for the year?

7)Two projects are mutually exclusive if the accept/reject decision for one project has no impact on the accept/reject decision for the other project.

a)true

b)false

8)Rent-to-Own Equipment Co. is considering a new inventory system that will cost $450,000. The system is expected to generate positive cash flows over the next four years in the amounts of $250,000 in year one, $125,000 in year two, $110,000 in year three, and $80,000 in year four. Rent-to-Own's required rate of return is 10%. What is the internal rate of return of this project?

A)10.07%

b)11.89%

c)12.26%

d)12.69%

Consider two mutually exclusive projects X and Y with identical initial outlays of $500,000 and useful lives of 5 years. Project X is expected to produce an after-tax cash flow of $150,000 each year. Project Y is expected to generate a single after-tax net cash flow of $1,015,000 in year 5. The discount rate is 15 percent.

a)Calculate the net present value for each project.

b)Calculate the IRR for each project.

c)What decision should you make regarding these projects?

10)

If a firmâs tax rate increases then its weighted average cost of capital increases also.

a)True

b)False

Question 1 Diana Dennison is a financial analyst working for a large chain of discount retail stores. Her company is looking at the possibility of replacing the existing fluorescent lights in all of its stores with LED lights. The main advantage of making this switch is that the LED lights are much more efficient and will cost less to operate. In addition, the LED lights last much longer and will have to be replaced after ten years, whereas the existing lights have to be replaced after five years. Of course, making this change will require a large investment to purchase new LED lights and to pay for the labor of switching out tens of thousands of bulbs. Dian plans to use a 10-year horizon to analyze this proposal, figuring that changes to lighting technology will eventually make this investment obsolete. Diana’s friend and coworker, David, has analyzed another energy-saving investment opportunity that involves replacing outdoor lighting with solar-powered fixtures in a few of company’s stores. David also used a 10-year horizon to conduct his analysis cash flow forecasts for each project appear below. The company uses a 10% discount rate to analyze capital budgeting proposals.

Year	LED project	Solar project
0	-RM4,200,000	-RM500,000
1	700,000	60,000
2	700,000	60,000
3	700,000	60,000
4	700,000	60,000
5	1,000,000	60,000
6	700,000	60,000
7	700,000	60,000
8	700,000	60,000
9	700,000	60,000
10	700,000	60,000

a) What is the Net Present Value (NPV) of each investment? Which investment (if either) should the company undertake? (5 marks)

b) David approaches Diana for a favor. David says that the solar lighting project is a ‘pet’ project of his boss, and David really wants to get the project approved to curry favor with his boss. He suggests to Diana that they roll their two projects into single proposal. The cash flows for this combined project would simply equal the sum of the two individual projects. Calculate the NPV of the combined projects. Does it appear to be worth doing? Would you recommend investing in the combined project? (4 marks)

c) Do the net present value (NPV) and internal rate of return (IRR) always agree with respect to accept-reject decisions; with respect to ranking decision? Explain. (3 marks)

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FINS1613 Lecture 5: FINS Week 5 Lect

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