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ECON 261 Lecture Notes - Lecture 12: Surbhi

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School
ACU
Department
MGTS - Economics
Course
ECON 261
Professor
Sir Du

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Document Summary

All investments offer a balance between risk and potential return. The balance between risk and return varies depending on the attitude of investors to risk bearing. As sifma (2013) indicated, to earn the higher returns, an investor has to take greater risk. On the other hand, the least risky investments also have the lowest returns. However, the average returns from bond investments have also been historically lower than average stock market returns. Therefore, those who are investing in bonds are considered not irrational. Investors with long horizons holding entirely bonds are rational. Such investors are highly risk averse and do not want to risk any of their investments in stocks. Several reasons make bonds in general less risky than stock. The first reason would be that bonds pay investors a fixed rate of interest income. However, their issuer has no obligation to make these payments to shareholders (sifma, 2013).

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Related Questions

Why do CDs have lower rates of return than stocks?

CDs are much riskier investments than stocks.

CDs are less risky than stocks.

CDs are not taxed while stock s returns are taxable.

CDs are not as liquid as stocks.

Given that most investors tend to be risk averse,

no one buys risky assets.

there's a trade-off between risk and return.

low risk assets provide the best return.

it must be a superior strategy compared to one that is risk loving.

Which of the following financial assets has both the highest risk and highest return for the period of 1926-2009?

small company stocks

large company stocks

corporate bonds

Treasury bills

Since all assets typically do not move together, how can investors typically reduce risk?

purchase only the best performing assets

diversify one's portfolio across different asset classes

avoid poor performing assets

actively manage one's portfolio

Risk that is common to all assets (e.g., common stocks) of a certain type is referred to as

systematic risk.

unsystematic risk.

idiosyncratic risk.

structural risk.

Which is the best example of idiosyncratic risk?

a financial crisis

a lawsuit because the corporation produced a faulty product

a recession

rising interest rates

If market participants rely only past stock prices to forecast future stock prices,

they will be better able to forecast future price increases than future price decreases.

they will be better able to forecast future price decreases than future price increases.

they have adaptive expectations.

they have rational expectations.

Final Project Scenario

You are an economist for the Vanda-Laye Corporation, which produces and distributes outdoor cooking supplies. The company has come under new ownership and management and will be undergoing changes in its product lines and operating structure. As an economist, your responsibilities include examining the market factors that affect success or failure of a product, including the supply and demand for the product, market conditions, and the behavior of competitors with similar products.

The new management has identified several possible investments for the coming year. It has asked you and your team to evaluate the possibilities and make a recommendation to the board of directors. Jorge has identified two mutually exclusive opportunities (Investment A) and two independent opportunities (Investment B) and assigned you the task of making a recommendation on the investments.

Investment A

Your company would like to increase its product lines. Two alternatives are available, a new line of outdoor smokers and a new line of outdoor grills. The two lines are mutually exclusive, meaning that only one of these investment alternatives can be selected. The projected cash flows and their respective probabilities for each alternative are given in the table. There are three possible levels of demand and their corresponding probabilities, which depend on the state of the economy.

Click here to download the table for Investment A. (Table Below)

Investment A

Demand

Probability

Year 1

Year 2

Year 3

Year 4

Year 5

Outdoor Smoker

High

0.2

$800,000

$900,000

$1,000,000

$1,100,000

$1,500,000

Moderate

0.6

$500,000

$700,000

$800,000

$960,000

$1,240,000

Low

0.2

$200,000

$350,000

$500,000

$600,000

$750,000

Outdoor Grill

High

0.2

$600,000

$750,000

$850,000

$975,000

$5,160,000

Moderate

0.6

$450,000

$500,000

$700,000

$825,000

$4,980,000

Low

0.2

$150,000

$220,000

$370,000

$500,000

$4,750,000

The two alternatives carry equal risk and should be evaluated at the company's cost of capital. The cost for the new smoker line will be $7,000,000. Also, the company has been guaranteed a buyer for the new line at the end of the fifth year. The buyer has agreed to purchase the new line for $7,900,000. The outdoor grill alternative will cost $3,987,000 and also has a guaranteed buyer, who has agreed to pay $4,000,000 at the end of the fifth year.

Investment B

Investment B involves two independent investment opportunities. The decisions on these two investment alternatives are also independent of Investment A. Investment B-1 involves a new packaging machine, which will eliminate the need for a local firm for packaging Vanda-Laye's products. The cost of this machine will be $24,000, and the expected revenues from this opportunity are given in the table and are considered to be of average risk. Investment B-2 is the purchase of a new computer system that will allow the company to sell its products on the Internet worldwide. The cost of this new system will be $29,000, with the expected cash flows after taxes given in the table.

Click here to download the table for Investment B. (Table Below)

Investment B

Year

Cash Flows

Packaging Machine

Computer System

1

$8,400

$9,100

2

$4,800

$8,800

3

$7,800

$8,300

4

$6,200

$8,000

5

$5,500

$5,100

6

$4,600

$4,000

7

$3,000

$3,500

Jorge has asked you to provide detailed responses to the following:

Management of Vanda-Laye has determined that the capital structure of the company will involve 30% debt and 70% common equity. This structure will be used to finance all investments by the company. Currently, the company can sell new bonds at par, with a coupon rate of 7%. Any new common stock can be sold for $45, with a required return (or cost) of 15.57%. Using Microsoft Excel, calculate the company's cost of capital to be used in the evaluation of possible investment projects.

For Investment A:

Using Microsoft Excel, create a decision tree. Indicate the various levels of demand and their respective probabilities. Also, include the calculations for the expected cash flows.

Calculate the expected NPV for each alternative. Explain the decision rules for making a selection between the two alternatives on the basis of the expected NPV.

Assuming the two alternatives are mutually exclusive, specify which alternative you would recommend to the company. Explain why.

If the two alternatives were independent of each other, specify which project you would select. Would you accept both projects if funding were available for both? Explain your answer.

For Investment B:

Using Microsoft Excel, calculate the NPV for each alternative.

Using the decision-making criteria for the NPV, specify which alternative you would select if the two alternatives were mutually exclusive. Explain your answer.

Given that the two alternatives are independent of each other, specify which investment you would select, if not both. Explain your answer.

Using Microsoft Excel, calculate the IRR for each investment.

Using the decision-making criteria for the IRR, specify which alternative you would prefer. Explain your answer.

If funding were available, specify whether you would select both investments. Why or why not?

Calculate the profitability index (PI) for the two investments. Which project is preferred?

Determine whether there is a ranking conflict present in terms of the IRR and the NPV. Explain your answer. If a conflict does exist, explain how you would resolve the situation.

Submission Details:

Compile a report including all your responses from Weeks 1, 3, and 5. Make sure your report reads as one report rather than three reports pasted together. Complete all revisions suggested by your instructor in previous weeks. Make sure all responses are complete and accurate, supported by references and documented examples. The report should be 10–15 pages in length and include an executive summary.

You are an economist for the Vanda-Laye Corporation, which produces and distributes outdoor cooking supplies. The company has come under new ownership and management and will be undergoing changes in its product lines and operating structure. As an economist, your responsibilities include examining the market factors that affect success or failure of a product, including the supply and demand for the product, market conditions, and the behavior of competitors with similar products.

The new management has identified several possible investments for the coming year. It has asked you and your team to evaluate the possibilities and make a recommendation to the board of directors. Jorge has identified two mutually exclusive opportunities (Investment A) and two independent opportunities (Investment B) and assigned you the task of making a recommendation on the investments.

Investment A

Your company would like to increase its product lines. Two alternatives are available, a new line of outdoor smokers and a new line of outdoor grills. The two lines are mutually exclusive, meaning that only one of these investment alternatives can be selected. The projected cash flows and their respective probabilities for each alternative are given in the table. There are three possible levels of demand and their corresponding probabilities, which depend on the state of the economy.

Click here to download the table for Investment A.

The two alternatives carry equal risk and should be evaluated at the company's cost of capital. The cost for the new smoker line will be $7,000,000. Also, the company has been guaranteed a buyer for the new line at the end of the fifth year. The buyer has agreed to purchase the new line for $7,900,000. The outdoor grill alternative will cost $3,987,000 and also has a guaranteed buyer, who has agreed to pay $4,000,000 at the end of the fifth year.

Investment B

Investment B involves two independent investment opportunities. The decisions on these two investment alternatives are also independent of Investment A. Investment B-1 involves a new packaging machine, which will eliminate the need for a local firm for packaging Vanda-Laye's products. The cost of this machine will be $24,000, and the expected revenues from this opportunity are given in the table and are considered to be of average risk. Investment B-2 is the purchase of a new computer system that will allow the company to sell its products on the Internet worldwide. The cost of this new system will be $29,000, with the expected cash flows after taxes given in the table.

Click here to download the table for Investment B.

Jorge has asked you to provide detailed responses to the following:

Management of Vanda-Laye has determined that the capital structure of the company will involve 30% debt and 70% common equity. This structure will be used to finance all investments by the company. Currently, the company can sell new bonds at par, with a coupon rate of 7%. Any new common stock can be sold for $45, with a required return (or cost) of 15.57%. Using Microsoft Excel, calculate the company's cost of capital to be used in the evaluation of possible investment projects.

For Investment A:

Using Microsoft Excel, create a decision tree. Indicate the various levels of demand and their respective probabilities. Also, include the calculations for the expected cash flows.

Calculate the expected NPV for each alternative. Explain the decision rules for making a selection between the two alternatives on the basis of the expected NPV.

Assuming the two alternatives are mutually exclusive, specify which alternative you would recommend to the company. Explain why.

If the two alternatives were independent of each other, specify which project you would select. Would you accept both projects if funding were available for both? Explain your answer.

For Investment B:

Using Microsoft Excel, calculate the NPV for each alternative.

Using the decision-making criteria for the NPV, specify which alternative you would select if the two alternatives were mutually exclusive. Explain your answer.

Given that the two alternatives are independent of each other, specify which investment you would select, if not both. Explain your answer.

Using Microsoft Excel, calculate the IRR for each investment.

Using the decision-making criteria for the IRR, specify which alternative you would prefer. Explain your answer.

If funding were available, specify whether you would select both investments. Why or why not?

Calculate the profitability index (PI) for the two investments. Which project is preferred?

Determine whether there is a ranking conflict present in terms of the IRR and the NPV. Explain your answer. If a conflict does exist, explain how you would resolve the situation.

 
After reading the article, post substantive comments on the economic impact of the Tax Cuts and Jobs Act of 2017.
 
THE ECONOMIC IMPACT OF THE TRUMP TAX CUTS
April 25, 2018
The Economic Impact of the Trump Tax Cuts
By Hilary Schmidt, International Banker
 
On December 22, US President Donald Trump signed into law the Tax Cuts and Jobs Act of 2017. The legislation is one of the most radical changes to fiscal policy the United States has undertaken in decades, with sweeping amendments implemented across the entire breadth of the tax code. Indeed, in his State of the Union Address, Trump called it the biggest tax cuts and reforms in American history. As such, its impact is likely to be felt throughout the economy for quite some time to come.
 
It is arguably the cut in a corporate tax that forms the centrepiece of this new legislation, with the rate being cut from 35 to 21 per cent. That puts the new rate broadly in line with the worldwide average, which as measured by the Tax Foundation across 202 jurisdictions currently stands at 22.96 per cent or 29.41 per cent when weighted by gross domestic product (GDP). Corporations will also stop having to pay corporate tax on any income earned from foreign operations, while such money that is brought back home will be taxed between 8 and 15.5 per cent, significantly lower than the 35-per cent tax they are currently paying.
 
Republicans believe such substantial cuts will spur a massive influx of business investment that will eventually lead to higher average wages for Americans. For example, Texas Congressman Mike Conaway stated, It's in all of our best interest to have these tax cuts for corporations so that they will have more money to invest in their business and pay their workers. But much of the research conducted thus far suggests otherwise; the Center on Budget and Policy Priorities, for instance, recently concluded that workers would receive a maximum of only a quarter of the benefits from tax cuts; and even then, it is most likely to be the higher earners that would be the biggest beneficiaries.
 
Another piece of evidence to which analysts are pointing is data from S&P Dow Jones Indices, which shows that non-financial companies in the S&P 500 are already flush with cash at the moment, having between them an estimated $1.63 trillion. And despite this vast sum of cash, an investment boom has not transpired. Indeed, some top companies have made it explicitly clear that any tax relief they receive from the reforms will be primarily used to increase dividends and buy back stock to boost share prices. Amgen CEO Robert Bradway, for example, said We've been actively returning capital in the form of growing dividend and buyback, and expect us to continue that. And in terms of what businesses planned to do with any profit returned from abroad, a Bank of America Merrill Lynch survey of more than 300 CEOs found that paying down debt and stock buybacks were by far and away from the biggest priorities for businesses.
 
The other major pillar of the reform is the cuts that have been enacted for individual income earners, with middle-class taxpayers earning between $19,050 and $77,400 per year receiving a cut in tax from 15 to 12 per cent. Higher-bracket earners, meanwhile, will see their tax rates go from 25 to 22 percent (for incomes between $77,400 and $165,000); 33 to 24 percent ($165,000 to $315,000); and 39.6 to 35 percent ($400,000 to $600,000). And as far as analysis from the Tax Center is concerned, after-tax income will increase by an average of 2.2 per cent across all groups. However, all of this changes after a few years, due to official budget rules that limit the cost of the bill to $1.5 trillion in total which therefore means that to make the corporate tax cuts permanent, the individual tax relief will expire by 2025. As such, a tax increase will likely result by 2027, which, according to projections by the Tax Policy Center, will impact 53 per cent of Americans.
 
Whether the overall impact will be a net positive or negative for the US economy remains to be seen at this stage, therefore. While most analysis produced to date agrees that economic growth will receive a boost in the short-term, the predictions that have so far come in have been decidedly more mixed and less sure for longer time horizons. The non-partisan Joint Committee on Taxation of the US Congress expects the gross domestic product to be 0.8 per cent higher on average each year during the next 10 years than baseline forecasts, thanks mainly to an expected increase in labour supply and business investment. According to the independent non-profit research organisation the Tax Foundation, meanwhile, the plan will primarily reduce marginal tax rates and the cost of capital. In turn, this will lead to a 1.7-per cent rise in GDP over the long-term, a 1.5-per cent increase in wages and a further 339,000 full-time equivalent jobs. This year, moreover, will see GDP growth being posted at 2.45 per cent, compared to baseline growth of 2.01 per cent.
 
But most analysts see the economic benefits tapering off much sooner than the 10 years asserted by the Joint Committee on Taxation. Goldman Sachs, for example, believes the tax cuts will only slightly boost growth in the short-term before fading quickly. Alec Phillips and Blake Taylor, analysts on Goldman's US economic-analysis team, stated in December that the bank's estimate of the growth effects of the legislation in 2018 and 2019 would be 0.3 per cent per year, before dropping off. Indeed, Phillips and Taylor warn that the legislation may end up damaging the economy in the long run: We note that the effect in 2020 and beyond looks minimal and could be slightly negative.
 
Some also point to the fact that the cuts will drastically deepen the national debt, with Maya MacGuineas of the Committee for a Responsible Federal Budget estimating an additional $1.5 trillion will be added to the $10 trillion already forecast for the next decade. As she explained, Instead of trickling down economic growth, the House plan will unleash a tidal wave of debt that will ultimately slow wage growth and hurt the economy. She seems to have a point the debt today is 77 per cent of GDP, much higher than the 31 per cent in place when the 2001 Bush tax cuts were passed, and the highest it has ever been save for the period just after World War II. What's more, given that interest rates could well rise faster than expected as a result of the likely ballooning of the debt, it may well dampen the expected boost to business-capital expenditure, consumer spending and wage growth.
 
Indeed, the arbiter of monetary policy itself, the Federal Reserve, has indicated that it remains somewhat unsure of the overall impact of the tax cuts. According to the released minutes of the central bank's December meeting, growth will only modestly be boosted, with members of the Fed's board and presidents of its member regional banks saying they expect real GDP growth of just 2.2-2.6 per cent and a median expectation of 2.5 per cent growth for this year. The comparatively tempered projections are reflective of the debate within the Fed over just how much of a boost business investment and consumer spending will receive from the tax cuts.
 
According to the minutes, Many participants judged that the proposed changes in business taxes, if enacted, would likely provide a modest boost to capital spending, although the magnitude of the effects was uncertain. While they are highly likely to have a positive effect on economic growth, the Fed also warned that much of the extra cash that is generated is more likely to be utilised for mergers and acquisitions or debt reduction and stock buybacks. Moreover, the boost to consumer spending may have already occurred in part on the back of realised future tax-cut expectations.
 
Ultimately, it may be too soon to make any firm conclusions about how impactful the tax cuts will eventually be; but given that the US economy is already experiencing strong economic growth, and given that virtually all the signs point to an economy operating at full employment and therefore, at full capacity such sweeping reforms that have been at least partly designed as an economic stimulus could well be dangerous. The impact on inflation and debt may well force the Fed to hike rates more than the three times that back in December it had projected for 2018. Time will tell.