Essay Instructions: Week 3 Actual Questions
Corporate Finance: Core Principles and Applications 3th edition Ross, Westerfield, Jaffe, Jordan
Discussion Question 1 Chapter 10 Closing Case Page 319-320 (answer question 6 only. (Your answer should be in no more than 200 words.)
A JOB AT EAST COAST YACHTS, PART 1
You recently graduated from college, and your job search led you to East Coast Yachts. Since you felt the company?s business was seaworthy, you accepted a job offer. The first day on the job, while you are finishing your employment paperwork, Dan Ervin, who works in Finance, stops by to inform you about the company?s 401(k) plan.
A 401(k) plan is a retirement plan offered by many companies. Such plans are tax-deferred savings vehicles, meaning that any deposits you make into the plan are deducted from your current pretax in- come, so no current taxes are paid on the money. For example, assume your salary will be $50,000 per year. If you contribute $3,000 to the 401(k) plan, you will only pay taxes on $47,000 in income. There are also no taxes paid on any capital gains or income while you are invested in the plan, but you do pay taxes when you withdraw money at retirement. As is fairly common, the company also has a 5 percent match. This means that the company will match your contribution up to 5 percent of your salary, but you must contribute to get the match.
The 401(k) plan has several options for investments, most of which are mutual funds. A mutual fund is a portfolio of assets. When you purchase shares in a mutual fund, you are actually purchasing partial ownership of the fund?s assets. The return of the fund is the weighted average of the return of the assets owned by the fund, minus any expenses. The largest expense is typically the management fee, paid to the fund manager. The management fee is compensation for the manager, who makes all of the investment decisions for the fund.
East Coast Yachts uses Bledsoe Financial Services as its 401(k) plan administrator. The investment options offered for employees are discussed below.
Company Stock One option in the 401(k) plan is stock in East Coast Yachts. The company is currently privately held. However, when you interviewed with the owner, Larissa Warren, she informed you the company stock was expected to go public in the next three to four years. Until then, a company stock price is simply set each year by the board of directors.
Bledsoe S&P 500 Index Fund This mutual fund tracks the S&P 500. Stocks in the fund are weighted exactly the same as the S&P 500. This means the fund return is approximately the return on the S&P 500, minus expenses. Since an index fund purchases assets based on the composition of the index it is following, the fund manager is not required to research stocks and make investment decisions. The result is that the fund expenses are usually low. The Bledsoe S&P 500 Index Fund charges expenses of .15 percent of assets per year.
Bledsoe Small Cap Fund This fund primarily invests in small capitalization stocks. As such, the returns of the fund are more volatile. The fund can also invest 10 percent of its assets in companies based outside the United States. This fund charges 1.70 percent in expenses.
Bledsoe Large Company Stock Fund This fund invests primarily in large capitalization stocks of companies based in the United States. The fund is managed by Evan Bledsoe and has outperformed the market in six of the last eight years. The fund charges 1.50 percent in expenses.
Bledsoe Bond Fund This fund invests in long-term corporate bonds issued by U.S. domiciled companies. The fund is restricted to investments in bonds with an investment grade credit rating. This fund charges 1.40 percent in expenses.
Bledsoe Money Market Fund This fund invests in short-term, high credit quality debt instruments, which include Treasury bills. As such, the return on the money market fund is only slightly higher than the return on Treasury bills. Because of the credit quality and short-term nature of the investments, there is only a very slight risk of negative return. The fund charges .60 percent in expenses.
1. What advantages do the mutual funds offer compared to the company stock?
2. Assume that you invest 5 percent of your salary and receive the full 5 percent match from East Coast Yachts. What EAR do you earn from the match? What conclusions do you draw about matching plans?
3. Assume you decide you should invest at least part of your money in large capitalization stocks of companies based in the United States. What are the advantages and disadvantages of choosing the Bledsoe Large Company Stock Fund compared to the Bledsoe S&P 500 Index Fund?
4. The returns on the Bledsoe Small Cap Fund are the most volatile of all the mutual funds offered in the 401(k) plan. Why would you ever want to invest in this fund? When you examine the expenses of the mutual funds, you will notice that this fund also has the highest expenses. Does this affect your decision to invest in this fund?
5. A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The standard deviation and return of the funds over the past 10 years are listed below. Calculate the Sharpe ratio for each of these funds. Assume that the expected return and standard deviation of the company stock will be 15 percent and 65 percent, respectively. Calculate the Sharpe ratio for the company stock. How appropriate is the Sharpe ratio for these assets? When would you use the Sharpe ratio?
Bledsoe S&P 500 Index Fund 10.15% 23.85%
Bledsoe Small Cap Fund 14.83 29.62
Bledsoe Large Company Stock Fund 11.08 26.73
Bledsoe Bond Fund 8.15 10.34
6. What portfolio allocation would you choose? Why? Explain your thinking carefully.
(Answer question 6 only in no more than 200 words.)
Discussion Question 2 Chapter 11 Closing Case Page 361 (answer question 1 only. Your answer should be in no more than 200 words.)
A JOB AT EAST COAST YACHTS, PART 2
You are discussing your 401(k) with Dan Ervin, when he mentions that Sarah Brown, a representative from Bledsoe Financial Services, is visiting East Coast Yachts today. You decide that you should meet with Sarah, so Dan sets up an appointment for you later in the day.
When you sit down with Sarah, she discusses the various investment options available in the company?s 401(k) account. You mention to Sarah that you researched East Coast Yachts before you accepted your new job. You are confident in management?s ability to lead the company. Analysis of the company has led to your belief that the company is growing and will achieve a greater market share in the future. You also feel you should support your employer. Given these considerations, along with the fact that you are a conservative investor, you are leaning toward investing 100 percent of your 401(k) account in East Coast Yachts.
Assume the risk-free rate is the historical average risk-free rate (in Chapter 10). The correlation between the bond fund and the large cap stock fund is .16. (Note: The spreadsheet graphing and ?Solver? functions may assist you in answering the following questions.)
1. Considering the effects of diversification, how should Sarah respond to the suggestion that you invest 100 percent of your 401(k) account in East Coast Yachts stock?
2. After hearing Sarah?s response to investing your 401(k) account entirely in East Coast Yachts stock, she has convinced you that this may not be the best alternative. Since you are a conservative investor, you tell Sarah that a 100 percent investment in the bond fund may be the best alternative. Is it?
3. Using the returns for the Bledsoe Large-Cap Stock Fund and the Bledsoe Bond Fund, graph the opportunity set of feasible portfolios.
4. After examining the opportunity set, you notice that you can invest in a portfolio consisting of the bond fund and the large-cap stock fund that will have exactly the same standard deviation as the bond fund. This portfolio will also have a greater expected return. What are the portfolio weights and expected return of this portfolio?
5. Examining the opportunity set, notice there is a portfolio that has the lowest standard deviation. This is the minimum variance portfolio. What are the portfolio weights, expected return, and standard deviation of this portfolio? Why is the minimum variance portfolio important?
6. A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The portfolio with the highest possible Sharpe ratio on the opportunity set is called the Sharpe optimal portfolio. What are the portfolio weights, expected return, and standard deviation of the Sharpe optimal portfolio? How does the Sharpe ratio of this portfolio compare to the Sharpe ratio of the bond fund and the large-cap stock fund? Do you see a connection between the Sharpe optimal portfolio and the CAPM? What is the connection?
(Answer question 1 only in about 200 words.)
Assignment Chapter 12 Closing Case Page
You have recently been hired by Goff Computer, Inc. (GCI), in the finance area. GCI was founded eight years ago by Chris Goff and currently operates 74 stores in the Southeast. GCI is privately owned by Chris and his family and had sales of $97 million last year.
GCI sells primarily to in-store customers. Customers come to the store and talk with a sales representative. The sales representative assists the customer in determining the type of computer and peripherals that are necessary for the individual customer?s computing needs. After the order is taken, the customer pays for the order immediately, and the computer is assembled to fill the order. Delivery of the computer averages 15 days but is guaranteed in 30 days.
GCI?s growth to date has been financed from its profits. Whenever the company had sufficient capital, it would open a new store. Relatively little formal analysis has been used in the capital budgeting process. Chris has just read about capital budgeting techniques and has come to you for help. The company has never attempted to determine its cost of capital, and Chris would like you to perform the analysis. Because the company is privately owned, it is difficult to determine the cost of equity for the company. You have determined that to estimate the cost of capital for GCI, you will use Dell as a representative company. The following steps will allow you to calculate this estimate:
1. Most publicly traded corporations are required to submit 10Q (quarterly) and 10K (annual) reports to the SEC detailing their financial operations over the previous quarter or year, respectively. These corporate filings are available on the SEC Web site at www.sec.gov. Go to the SEC Web site, follow the ?Search for Company Filings? link and the ?Companies & Other Filers? link, enter ?Dell Computer,? and search for SEC filings made by Dell. Find the most recent 10Q and 10K (USE DECEMBER 3, 2009) and download the forms. Look on the balance sheet to find what is the book value of debt and the book value of equity. If you look further down the report, you should find a section titled either ?Long-Term Debt? or ?Long-Term Debt and Interest Rate Risk Management? that will list a breakdown of Dell?s long-term debt.
(NOTE: The book value of the company?s liabilities and equity can be found from a number of sources. We went to http://www.sec.gov and found Dell?s Form 10Q, dated December 3, 2009. Dell?s Form 10Q).
2. To estimate the cost of equity for Dell, go to finance.yahoo.com and enter the ticker symbol ?DELL.? Follow the various links to find answers to the following questions: What is the most recent stock price listed for Dell? What is the market value of equity, or market capitalization? How many shares of stock does Dell have outstanding? What is the beta for Dell? Now go back to finance.yahoo.com and follow the ?Bonds? link. What is the yield on 3-month Treasury bills? Using a 7 percent market risk premium, what is the cost of equity for Dell using the CAPM?
(NOTE: We need various pieces of information to estimate the cost of equity. The following information is necessary for our calculations. We gathered all the information from finance.yahoo.com.)
3. Go to www.reuters.com and find the list of competitors in the industry. Find the beta for each of these competitors, and then calculate the industry average beta. Using the industry average beta, what is the cost of equity? Does it matter if you use the beta for Dell or the beta for the industry in this case?
(NOTE: Below are five top competitors in the computer hardware industry by market capitalization in March 2010 were: )
Company Beta
Hitachi, Ltd. 1.06
Helwett-Packard 1.00
EMC Corporation 1.02
Corning Incorporated 1.31
Western Digital 1.50
Industry Average 1.18
4. You now need to calculate the cost of debt for Dell. Go to cxa.marketwatch.com/finra/ BondCenter/Default.aspx, enter Dell as the company, and find the yield to maturity for each of Dell?s bonds. What is the weighted average cost of debt for Dell using the book value weights and the market value weights? Does it make a difference in this case if you use book value weights or market value weights?
(NOTE: To get the yield to maturity on Dell?s bonds, we went to http://cxa.marketwatch.com/finra/MarketData/Default.aspx. We gathered the following information: )
5. You now have all the necessary information to calculate the weighted average cost of capital for Dell. Calculate the weighted average cost of capital for Dell using book value weights and market value weights assuming Dell has a 35 percent marginal tax rate. Which cost of capital number is more relevant?
6. You used Dell as a representative company to estimate the cost of capital for GCI. What are some of the potential problems with this approach in this situation? What improvements might you suggest?
(NOTE: For this case you are to describe the process you can use to answer the questions. I have given you hints above. You do not have to do the calculations (no points deducted), but if you wish to do so it will be entirely up to you.
