17.  What is MM’s cost of equity?

re = rf + Beta * MRP

MRP = E(Rm) – Rf = 11% - 4% = 7%

re = 4% + 1.1*7% = 11.7%

18.  What is the value of equity?

E = Div1 / (r – g)

g = ROE * plowback = 14% * 50% = 7%

E = 32,000 / (11.7% - 7%) = 32,000 / 4.7% = $680,851.06

19.  What is MM’s WACC?

WACC = D/V * rd * (1-Tc) + E/V * re

V = 80,000 + 680,851 = 760,851

D/V = 80,000/760,851 = 10.5%

E/V = 680,851/760,851 = 89.5%

WACC = 10.5%*6%*(1-0.28) + 89.5%*11.7% = 10.9%

20. Tangshan Antiques has an equity beta of 1.40, the annual risk-free rate of interest is currently 10 percent, and the required return on the market portfolio is 16 percent. The firm estimates  that its future dividends will continue to increase at an annual compound rate of 8%. Assume that today is the last day in 2014 and the firm has just paid the $3.40 dividend Estimate the value of a Tangshan Antiques share.

rs = 0.10 + 1.4(0.16 - 0.10) = 0.184            = 18.4%

growth rate of dividends = ($3.40/$2.70)1/3 - 1 =  8%

Po = $3.40(1.08)/(0.184 - 0.08) = $35.31

21.  The firm has increased its debt level dramatically and as a result its equity beta has increased to 1.6. What is the estimated price of a share following this change?

rs = 0.10 + 1.6(0.16 - 0.10) = 0.196            =        19.6%

Po = $3.40(1.08)/(0.196 - 0.08) = $31.66

22. Discuss the statement, "Only market risk matters to a diversified investor."

It is relatively easy for an investor to diversify a portfolio sufficiently to the point where nearly all of the remaining risk is market risk. This can be achieved by combining somewhere between 15 and 20 different securities. At that point, then, the investor does not care about a strike at The Warehouse because that element of unique risk has been offset by a boom in say the telecommunications industry. Any investor who chooses not to diversify and thus retain the unique risk should be prepared to suffer   the consequences; basically, risk level will increase without a corresponding increase in expected yield.   These statements should show that diversified investors are concerned only with the market risk in their portfolios, rather than any elements of unique risk.

Galaxy Satellite Co. is attempting to select the best group of independent projects competing for the firm's fixed capital budget of $10,000,000. Any unused portion of this budget will earn less than its 20 percent cost of capital. A summary of key data about the proposed projects follows.

23. Use the NPV approach to select the best group of projects.

Choose Projects C and D, since this combination maximizes NPV at $410,000

and only requires $8,000,000 initial investment.

24. Use the IRR approach to select the best group of projects.

Choose Projects B and C, resulting in a NPV of $380,000.

25. Which projects should the firm implement? Explain why and discuss any qualifications.

Projects C and D

because NPV is better than IRR

26. Plasti-Tech Ltd. is financed 60% with equity and 40% with debt. Currently, its debt has a

before-tax interest rate of 12%. Plasti-Tech's ordinary shares trade at $15.00 per share and its   most recent dividend was $1.00. Future dividends are expected to grow at 4%. If the tax rate is 34%, what is Plasti-Tech's WACC?

re         = (1(1 + 0.04))/$15) + 0.04                        = 10.93%

WACC = 0.4[0.12(1 -0.34)] + 0.6(0.1093)  = .0317 + .0656  = 9.73%

27. The Chief Financial Officer at Plasti-Tech notes that its cost of debt is below that of equity. He   reasons that the firm should ensure that it is able to increase its borrowings, because otherwise the firm will be forced to use more expensive equity to finance its new projects. Then, the firm  may have to reject some projects that it would have accepted when evaluated at the lower cost of debt. Comment on this reasoning.

This reasoning is faulty in that it implicitly treats the discount rate for the project as the cost of debt if the project is debt financed, and as the cost of equity if the project is equity financed. In fact, if the project poses risk comparable to the risk of the firm's other projects, the proper discount rate is the firm's cost of capital, which is a weighted-average of the costs of both debt and equity.

28. In addition to the tax shield offered by tax regulations, debt has a lower required rate of return than equity. Why is it not common to see firms that have much larger debt components in their capital structure?

At least three factors need to be mentioned when answering this question.

First, when normal proportions of debt are included in capital structure, the required return on debt is commonly below that of equity

However, as the proportion of debt rises to levels that investors consider risky, that required return will increase rapidly to reflect the increased uncertainty of repayment. That is the explicit cost of debt.

Second, as more debt is included in the capital structure the equity investors will also require a   higher rate of return to reflect the fact that more of the firm's cash flows have been promised to other stakeholders. This is the implicit cost of adding more debt.

Finally, a tax shield is of questionable value if the firm is not profitable (ignoring the possibility of loss carry-back) or, at worst, bankrupt.

29. What is the present value of a company with a WACC of 12%, and the following cash flows for years 1 to 5, respectively: $1 million, $1.25 million, $1.5 million, $1.75 million, and $2 million?

Assume the firm will then grow at 5% per year, indefinitely.

30. Explain why bond issuers might voluntarily choose to put restrictive covenants into a new bond issue. In your answer be sure to explain what restrictive covenants are and why they might be  used.

Restrictive covenants in bond agreements place requirements/restrictions on the bond issuer.   Common restrictions include no senior debt will be issued without agreement, regular financial

statements will be provided, no significant asset sales or purchases without approval, minimum working capital to be maintained, keep insurance in place, dividend paying restrictions.

Bond covenants reduce the risk to the lenders and therefore should reduce the interest rate that they require.

The willingness of the issuer to provide covenants can reduce information asymmetry and also is a positive signal to lenders.

31.  How much would an investor expect to pay for a $1,000 par value bond with a 9% annual coupon that matures in 5 years if the interest rate is 7%?                     (4 marks)

32. How does competition among investors lead to efficient markets?

The search for information and insightful analysis makes investor assessments of stock values as

reliable as possible. Since the rewards accrue to the investors who uncover relevant information before it is reflected in stock prices, competition among these investors means that there is always an active search for mispriced stocks. This competition between investors will tend to produce an efficient market—that is, a market in which prices rapidly reflect new information, and investors have difficulty making consistently superior returns. Of course, we all hope to beat the market, but if the market is efficient, all we can rationally expect is a return that is sufficient on average to compensate for the time value of money and for the risks we bear.

33. Describe how adding depreciation expense to net income can approximate cash flow from operations. Does depreciation expense really reflect a cash flow?

Depreciation is a noncash expense that is intended to approximate the decline in economic value over the life of an asset. Since it can be counted as an expense, it reduces net income and, accordingly, tax  liability. Therefore, by the time you reach the bottom line on an income statement— net income—you  have already experienced the impact of depreciation through lower taxes. Depreciation creates a tax shield, which is a valuable factor. Since no cash was currently expended for the depreciation expense, it is added back to net income to approximate cash flows from operations.

34. Why is it important to use market values rather than book values when determining the weighted-average cost of capital?

Book values represent the amount and terms of funding for a firm or a project as it was originally placed into existence. Because firms and projects are often long-lived, circumstances can change current values substantially from their original book values. These current, or market, values represent the consensus of the investment community as to the value of the firm or project at this point in time. Recalling that past values may represent sunk costs, it is imperative that values be determined with an eye toward their future benefits.

35. What is the relationship between the market risk of a security and the rate of return that investors demand of that security?

The extra return that investors require for taking risk is known as the risk premium. The capital asset

pricing model states that the expected risk premium of an investment should be proportional to both  its beta and the market risk premium. The expected rate of return from any investment is equal to the  risk-free interest rate plus the risk premium, so the CAPM boils down to r = rf + β(rm - rf). The security market line is the graphical representation of the CAPM equation. The security market line relates the  expected return investors demand of a security to the beta.

36. A firm sells a product that it realizes is short-lived and thus the firm plans to close after 2 more years. The firm expects to have free cash flows of $398,000 next year and $211,000 in Year 2 after incurring the costs of closing. The firm's cost of equity is 14% and its cost of debt is 5.5%. What is the present value of the firm if its debt to value ratio is 40%?

WACC = 0.4(5.5%) + (1 - 0.4)(14%) = 10.6%

PV = $398,000/1.106 + $211,000/1.1062 = $532,349

37. It is easy to imagine that a financial manager would be reluctant to abandon a project in which large sums of money have been invested with no cash return. Discuss the important concept    here that should be the manager's guiding policy.

Financial managers should recall that previously expended sums are "sunk" and, as such, have no relevance in future decisions. While it may be difficult to scrap a project that has received considerable investment and attention, only the expected future cash flows have any relevance. Thus, managers should ignore sunk investments unless it can be justified that future expenditures will be appropriately rewarded.

38. Calculate the expected rate of return for the following portfolio, based on a Government bond yield of 4% and an expected market return of 13%: (Show your workings)

βPortfolio = (0.2 × 1.6) + (0.25 × 1.2) + (0.1 × 1) + (0.3 × 0.9) + (0.15 × 0.8) = 1.11

E(R) = 4% + 1.11(13% - 4) = 13.99%

39. Discuss the statement, "Changes in working capital necessitated by a project represent only an opportunity cost to the firm."

Most capital budgeting projects require an increase in working capital, typically from the excess of increased inventories and accounts receivable over that of increased accounts payable. However, capital budgeting practices allow for this "increase" in investment to be automatically reversed at the  end of the project's life. While immediate reversal at a discretionary point in time may be questioned, it should be true that if the working capital was actually required for an investment that is no longer   in use, then the levels should return to their previous level. Since changes in working capital are reversed, the only "cost" to the firm is the opportunity cost of funds while the working capital is increased.