You expect your firm to be worth $100, $160, or $190 with probabilities 15%, 50% and 35% respectively. You can raise debt today if you promise to repay $175 one year from now. The expected return on this debt is 7%. If this is how you finance your firm, then your expected cost of equity is 25%. Assume perfect markets. Fill out the following table, assuming you utilize this capital structure. You can show work below the chart if you need additional room. Make sure your final answers are clear.
Scenario Probability Firm (100% Equity)
Debt Equity Bad 0.15 100 Middle 0.5 160 Good 0.35 190 Expected Value
Value Today
Expected Return
You expect your firm to be worth $100, $160, or $190 with probabilities 15%, 50% and 35% respectively. You can raise debt today if you promise to repay $175 one year from now. The expected return on this debt is 7%. If this is how you finance your firm, then your expected cost of equity is 25%. Assume perfect markets. Fill out the following table, assuming you utilize this capital structure. You can show work below the chart if you need additional room. Make sure your final answers are clear.
Scenario | Probability | Firm (100% Equity) | Debt | Equity |
Bad | 0.15 | 100 | ||
Middle | 0.5 | 160 | ||
Good | 0.35 | 190 | ||
Expected Value | ||||
Value Today | ||||
Expected Return |
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Related questions
In March 2015 the management team of Londonderry Air (LA) met to discuss a proposal to purchase five short haul aircraft at a total cost of $25 million. There was general enthusiasm for the investment, and the new aircraft were expected to generate an annual cash flow of $4 million for 20 years.
The focus of the meeting was on how to finance the purchase. LA had $20 million in cash and marketable securities (see table), but Ed Johnson, the chief financial officer, pointed out that the company needed at least $10 million in cash to meet normal outflow and as a contingency reserve. This meant that there would be a cash deficiency of $15 million, which the firm would need to cover either by the sale of common stock or by additional borrowing. While admitting that the arguments were finely balanced, Mr. Johnson recommended an issue of stock. He pointed out that the airline industry was subject to wide swings in profits and the firm should be careful to avoid the risk of excessive borrowing. He estimated that in market value terms the long-term debt ratio was about 59% and that a further debt issue would raise the ratio to 62%.
Mr. Johnson's only doubt about making a stock issue was that investors might jump to the conclusion that management believed the stock was overpriced, in which case the announcement might prompt an unjustified selloff by investors. He stressed therefore that the company needed to explain carefully the reasons for the issue. Also, he suggested that demand for the issue would be enhanced if at the same time LA increased its dividend payment. This would provide a tangible indication of management's confidence in the future.
These arguments cut little ice with LA's chief executive. "Ed," she said, "I know that you're the expert on all this, but everything you say flies in the face of common sense. Why should we want to sell more equity when our stock has fallen over the past year by nearly a fifth? Our stock is currently offering a dividend yield of 6.5%, which makes equity an expensive source of capital. Increasing the dividend would simply make it more expensive. What's more, I don't see the point of paying out more money to the stockholders at the same time that we are asking them for cash. If we hike the dividend, we will need to increase the amount of the stock issue; so we will just be paying the higher dividend out of the shareholders' own pockets. You're also ignoring the question of dilution. Our equity currently has a book value of $12 a share; it's not playing fair by our existing shareholders if we now issue stock for around $10 a share.
"Look at the alternative. We can borrow today at 6%. We get a tax break on the interest, so the after-tax cost of borrowing is .65*6 = 3.9%. That's about half the cost of equity. We expect to earn a return of 15% on these new aircraft. If we can raise money at 3.9% and invest it at 15%, that's a good deal in my book.
"You finance guys are always talking about risk, but as long as we don't go bankrupt, borrowing doesn't add any risk at all. In any case my calculations show that the debt ratio is only 45%, which doesn't sound excessive to me.
"Ed, I don't want to push my views on this after all, you're the expert. We don't need to make a firm recommendation to the board until next month. In the meantime, why don't you get one of your new business graduates to look at the whole issue of how we should finance the deal and what return we need to earn on these planes?"
Evaluate Mr. Johnson's arguments about the stock issue and dividend payment as well as the reply of LA's chief executive. Who is correct? What is the required rate of return on the new planes?
Balance sheet | |||
bank Debt | 50 | cash | 20 |
other current liabilities | 20 | other current assets | 20 |
10% bond, due 2032* | 100 | Fixed assets | 250 |
Stockholders' equity** | 120 | ||
Total liabilities | 290 | Total Assets | 290 |
Income statement | |||
Gross Profit | $57.5 | ||
Depreciation | 20.0 | ||
Interest | 7.5 | ||
Pretax profit | 30.0 | ||
Tax | 10.5 | ||
Net profit | 19.5 | ||
Dividend | 6.5 | ||
*the yield to maturity on LA debt is currently 6%
**LA has 10 million shares outstanding, with a market price of $10 a share. LA's equity beta s estimated at 1.25, the market risk premium is 8%, and the Treasury bill rate is 3%
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 10â15 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.
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 10â15 pages in length and include an executive summary.