FIN 380 Chapter Notes - Chapter 13: Risk Measure, Iput, Stok
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The following Balance Sheet extract relates to the Snapple Company:
Bonds payable $1,000,000
Common Stock $3,000,000
Preferred Stock $2,000,000
Additional Information:
The bonds are 8%, annual coupon bonds, with 9 years to maturity and are currently selling for 95% of par.
The companyâs common shares which have a book value of $25 per share are currently selling at $20 per share.
The company has an equity beta of 1.5 and the current Treasury bill rate is 3.5%. The market risk premium is 1.5%
The preferred dividends are 5% preferred shares with a book value of $100 per share. These shares are currently selling at $80 per share.
The Companyâs tax rate is 35%.
Required:
a) Calculate Snappleâs cost of debt. [5 marks]
b) Calculate Snappleâs cost of equity. [5 marks]
c) Calculate Snappleâs cost of preferred shares. [3 marks]
d) Calculate Snappleâs Weighted Average Cost of Capital [8 marks]
e) Explain why the cost of debt is cheaper than the cost of equity. [3 marks]
f) Explain why the cost of retained earnings is equivalent to the cost of an existing issue of common stock. [4 marks]
g) Outline two (2) reasons why a firmâs cost of capital is critically important. [2 marks]
2.
The Beacon Inc. is considering two mutually exclusive projects, each with an initial investment of $150,000. The companyâs board of directors has set up a 4-year payback requirement and has set its cost of capital at 9%. The cash inflows associated with the two projects are as follows:
| Year | Cash Inflows (CFt) | ||
| Project A | Project B | ||
| 1 | $45,000 | $75,000 | |
| 2 | $45,000 | $60,000 | |
| 3 | $45,000 | $30,000 | |
| 4 | $45,000 | $30,000 | |
| 5 | $45,000 | $30,000 | |
| 6 | $45,000 | $30,000 | |
a) Calculate the payback period for each project. [2 marks]
b) Calculate the NPV for each project at 7% and 9%. [6 marks]
c) Based on b) above which project would you choose and why.[ 2 marks]
d) Briefly explain why firms engage in âcapital rationingâ [2 marks]
e) What are Real Options? What are some major types of real options? [3 marks]
3.
The Lifeâs Good Corporation 2012 income statement shows the following:
|
Income Statement 2012 | |
| Sales | $ 5,250,000 |
| Costs | 2,173,000 |
| Other expenses | 67,400 |
| Depreciation expense | 179,000 |
| EBIT | $ 2,830,600 |
| Interest expense | 85,555 |
| EBT | $ 2,745,045 |
| Taxes | 89,000 |
| Net income | $ 2,656,045 |
| Dividends | $ 169,000 |
| Addition to retained earnings | $ 2,487,045 |
Lifeâs Good Corp. also issued $106,700 in new equity during the year and redeemed $65,300 in outstanding long-term debt.
i. Calculate the operating cash flow for the firm. (2 marks) $2,920,600
ii. Calculate the cash flow to creditors. (2 marks) $150,855
iii. Calculate the cash flow to stockholders. (2 marks) 62,300
iv. Define free cash flow (FCF) and state one of the equations for computing FCF. (3 marks)
4.
Clarkâs Drug Store, a medium-size drugstore located in Bridgetown Barbados, is owned and operated by Robert Clark. Clarkâs sells pharmaceuticals, cosmetics, toiletries, magazines, and various novelties. Clarkâs most recent annual net income statement is as follows:
| Sales Revenue | $2,600,000 |
| COGS | 1,460,000 |
| Wages and Salaries | 250,000 |
| Rent | 190,000 |
| Depreciation | 70,000 |
| Utilities | 95,000 |
| Miscellaneous | 30,000 |
| Total Expenses | 2,095,000 |
| Net Profit before Tax | 505,000 |
Clarkâs sales and expenses have remained relatively constant over the past few years and are expected to continue unchanged in the near future. To increase sales, Clarkâs is considering using some floor space for a small soda fountain. Clarkâs would operate the soda fountain for an initial three-year period and then would reevaluate its profitability. The soda fountain would require an incremental investment of $85,000 to lease furniture, equipment, utensils, and so on. This is the only capital investment required during the three-year period. At the end of that time, additional capital would be required to continue operating the soda fountain, and no capital would be recovered if it were shut down.
The soda fountain is expected to have annual sales of $670,000 and food and materials expenses of $380,000 per year.
The soda fountain is also expected to increase wage and salary expenses by 6% and utility expenses by 5%. Because the soda fountain will reduce the floor space available for display of other merchandise, sales of non-soda fountain items are expected to decline by 10%.
Calculate net incremental cash flows for the soda fountain. (6 marks)
ii. Assume that Clarkâs has the capital necessary to install the soda fountain and that he places a 12% opportunity cost on those funds. Should the soda fountain be installed? Why or why not? (4 marks)
5. âIn order for a project to be acceptable, its required rate of return must exceed the cost of debtâ. Do you agree? In light of the statement, define what is cost of capital and what role does it play in long-term investment decisions? (5 marks)
6. What do you understand by the term net proceeds in context with a bond sale? How do floatation costs affect the net proceeds? (3 marks)
7. Go-geta Corp. issued 10-year bonds 2 years ago at a coupon rate of 6 percent. The bonds make semiannual payments. If these bonds currently sell for 98 percent of par value, what is the YTM? (2 marks)
| FV | $1000 |
| PV | $ (980.00) |
| Coupon | $ 30.00 |
8. ABC Company has an unusual dividend policy. The company has just paid a dividend of $5 per share and has announced that it will increase the dividend by $2 per share for each of the next four years, and then never pay another dividend. If you required a 9 percent return on the companyâs stock, how much will you pay for a share today? (5 marks)
| Dividend D0 | 5.00 | ||
| Div increase yrly | 2.00 | ||
| Required return | 9.00% | ||
| Stock Price | |||
| Factor | Price | ||
| D (1) | 1.09 | 5.00 | 4.59 |
| D (2) | 1.1881 | 7.00 | 5.89 |
| D (3) | 1.295029 | 9.00 | 6.95 |
| D (4) | 1.411582 | 11.00 | 7.79 |
9 âWhile contemplating to create a portfolio, it is imperative to study the correlation amongst the assets that constitute the portfolioâ. Discuss the statement and explain how diversification helps in reducing the risk of the portfolio as compared to the individual risks of constituting assets. (5 marks)
You are proposing a new venture, to branch out into animals and cartoon characters but this will require some new equipment and a capital outlay. Pertinent financial information is given below.
BALANCE SHEET
| Cash | 2,000,000 | Accounts Payable and Accruals | 18,000,000 |
| Accounts Receivable | 28,000,000 | Notes Payable | 40,000,000 |
| Inventories | 42,000,000 | Long-Term Debt | 60,000,000 |
| Preferred Stock | 10,000,000 | ||
| Net Fixed Assets | 133,000,000 | Common Equity | 77,000,000 |
| Total Assets | 205,000,000 | Total Claims | 205,000,000 |
� Last year�s sales were $225,000,000.
� The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10 percent annual coupon, and are currently selling for $874.78.
� You also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00. Any new issues of preferred stock would incur a $3.00 per share flotation cost.
� The company has 10 million shares of common stock outstanding with a currently price of $14.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D0) was $.80. New stock could be sold with 15% flotation costs.
� The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 14 percent. Your stock�s beta is 1.22.
� Stockholders require a risk premium of 5 percent above the return on the firms bonds.
� The firm expects to have additional retained earnings of $10 million in the coming year, and expects depreciation expenses of $35 million.
� Your firm does not use notes payable for long-term financing.
� The firm considers its current market value capital structure to be optimal, and wishes to maintain that structure. (Hint: Examine the market value of the firm�s capital structure, rather than its book value.)
� The firm is currently using its assets at capacity.
� The firm�s management requires a 2 percent adjustment to the cost of capital for risky projects.
� Your firm�s federal + state marginal tax rate is 40%.
� Your firm�s dividend payout ratio is 50 percent, and net profit margin was 8.89 percent.
� The firm has the following investment opportunities currently available in addition to the expansion you are proposing:
| Project | Cost | IRR |
| A | 10,000,000 | 20% |
| B | 20,000,000 | 18% |
| C | 15,000,000 | 14% |
| D | 30,000,000 | 12% |
| E | 25,000,000 | 10% |
Your expansion would consist of a new product introduction (You should label your venture as Project I, for �introduction�). You estimate that your product will have a six-year life span (after all how many people will really buy this stuff), and the equipment used to manufacture the project falls into the MACRS 5-year class. Your venture would require a capital investment of $15,000,000 in equipment, plus $2,000,000 in installation costs. The venture would also result in an increase in accounts receivable and inventories of $4,000,000. At the end of the six-year life span of the venture, you estimate that the equipment could be sold at a $4,000,000 salvage value.
Your venture, which management considers fairly risky, would increase fixed costs by a constant $1,000,000 per year, while the variable costs of the venture would equal 30 percent of revenues. You are projecting that revenues generated by the project would equal $5,000,000 in year 1, $10,000,000 in year 2, $14,000,000 in year 3, $16,000,000 in year 4, $12,000,000 in year 5, and $8,000,000 in year 6.
The following list of steps provides a structure that you should use in analyzing your new venture.
Note: Carry all final calculations to two decimal places.
Find the WACC:
1. Find the costs (rate of return under current market conditions) of the individual capital components:
a. long-term debt (Hint: PV=-$874.78, FV = $1000, PMT=$100, n=15 solve for i)
b. preferred stock
c. retained earnings (avg. of CAPM and bond yield + risk premium approaches)
d. new common stock
2. Compute the value of the long-term elements of the capital structure, and determine the target percentages for the optimal capital structure. (Carry weights to four decimal places. For example: 0.2973 or 29.73%)
Find the Cash Flow from the project:
3. Compute the Year 0 investment for Project I.
4. Compute the annual operating cash flows for years 1-6 of the project.
5. Compute the additional non-operating cash flow at the end of year 6.
Find alternative capital budgeting measures:
6. Compute the IRR and payback period for Project I.
7. Determine your firm�s cost of capital. (Hint this is the WACC plus an adjustment from the write up)
Make Some Decisions:
8. Compute the NPV for Project I. Should management adopt this project based on your analysis? Explain. Would your answer be different if the project were determined to be of average risk? Explain.
9. Indicate which of the other projects (A through E) should be accepted and why.
