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Instructions for Rate Of Return College Essay Examples

Essay Instructions: Assignment:

Part 1. Capital Budgeting Practice Problems

a. Consider the project with the following expected cash flows:
Year Cash flow
0 -$400,000
1 $100,000
2 $120,000
3 $850,000

?If the discount rate is 0%, what is the project's net present value?
?If the discount rate is 2%, what is the project's net present value?
?If the discount rate is 6%, what is the project's net present value?
?If the discount rate is 11%, what is the project's net present value?
?With a cost of capital of 5%, what is this project's modified internal rate of return?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

[You can't upload the graph unto Coursenet. Look at the graph you draw and write a short paragraph stating what the graph 'shows"]..

b. Consider a project with the expected cash flows:
Year Cash flow
0 -$815,000
1 $141,000
2 $320,000
3 $440,000

?What is this project's internal rate of return?
?If the discount rate is 1%, what is this project's net present value?
?
If the discount rate is 4%, what is this project's net present value?

?
If the discount rate is 10%, what is this project's net present value?

?
If the discount rate is 18%, what is this project's net present value?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

[You can't upload the graph unto Coursenet. Observe the graph and write a short paragraph stating what the graph 'shows


c. A project requiring a $4.2 million investment has a profitability index of 0.94. What is its net present value? (Remember: Profitability Index is defined as Present Value of the proceeds divided by the initial investment)



Part 2.

Read the article below. Then write a one-to-two page paper answering the following question:

Which method do you think is the better one for making capital budgeting decisions - IRR or NPV?

Defend your answer with references to the background materials.



Please read the following article which is available in Proquest:

Internal rate of return
Computerworld. Framingham, Feb 17, 2003, Gary H Anthes, from library portal via coursenet.

Abstract:
Internal rate of return (IRR) is the flip side of net present value (NPV) and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often a company's cost of capital. IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV and above which an investment results in a negative NPV. It is the breakeven discount rate, the rate at which the value of cash outflows equals the value of cash inflows.



Assignment Expectations:

This assignment consists of a quantitative section (Part 1) and a an essay section (Part 2) below. Upload both sections as one Word document to Coursenet by the end of the Module

Excerpt From Essay:

Title: Capital Budgeting

Total Pages: 2 Words: 558 References: 3 Citation Style: APA Document Type: Essay

Essay Instructions: This assignment consists of a quantitative section (Part 1) and a an essay section (Part 2) below. Upload both sections as one Word document to Coursenet by the end of the Module.

Part 1. Capital Budgeting Practice Problems
a. Consider the project with the following expected cash flows:

Year Cash flow
0 - $500,000
1 $100,000
2 $110,000
3 $550,000

If the discount rate is 0%, what is the project's net present value?
If the discount rate is 4%, what is the project's net present value?
If the discount rate is 8%, what is the project's net present value?
If the discount rate is 10%, what is the project's net present value?
What is this project's internal rate of return?
Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

[You can't upload the graph unto Coursenet. Look at the graph you draw and write a short paragraph stating what the graph 'shows"]..

b. Consider a project with the expected cash flows:

Year Cash flow
0 - $615,000
1 + 141,000
2 + 300,000
3 + $300,000

What is this project's internal rate of return?
If the discount rate is 0%, what is this project's net present value?
If the discount rate is 4%, what is this project's net present value?

If the discount rate is 8%, what is this project's net present value?

If the discount rate is 12%, what is this project's net present value?

Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?

[You can't upload the graph unto Coursenet. Observe the graph and write a short paragraph stating what the graph 'shows

c. A project requiring a $3.2 million investment has a profitability index of 0.97. What is its net present value? (Remember: Profitability Index is defined as Present Value of the proceeds divided by the initial investment)

Part 2.

Read the article linked below. Then write a one page paper answering the following question:

Which method do you think is the better one for making capital budgeting decisions - IRR or NPV?

Defend your answer with references to the background materials.

Please read the following article which is available in Proquest:

Internal rate of return
Computerworld; Framingham; Feb 17, 2003; Gary H Anthes;

Abstract:
Internal rate of return (IRR) is the flip side of net present value (NPV) and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often a company's cost of capital. IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV and above which an investment results in a negative NPV. It is the breakeven discount rate, the rate at which the value of cash outflows equals the value of cash inflows.
(Porquest Article):

INTERNAL RATE OF RETURN:
What It Looks Like


IRR is the flip side of net present value (NPV) and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often your company's cost of capital.

IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV (and should be made) and above which an investment results in a negative NPV (and should be avoided). It's the breakeven discount rate, the rate at which the value of cash outflows equals the value of cash inflows.

Consider the three scenarios shown here (see table), each involving an initial investment of $1 million. The investment returns $300,000 (undiscounted) per year in each of the five years after the initial investment, for a net return of $500,000.

A company evaluating this investment using cash flow discounted at 10% would compute an NPV of $137,000, a decent but not spectacular result. But if the company evaluates the same investment at 15%, the project has a present value of only $6,000, essentially just breaking even, and at 20% the project's present value is negative. The IRR is a fraction of a percentage point above 15%; at that discount percentage, the investment's NPV is zero.

IRR is often used as a hurdle rate, a sort of go/no-go investment threshold. Gaylord Entertainment Co. in Nashville, for example, has computed its weighted average cost of capital -- a percentage that it won't disclose -- and a "hurdle" percentage rate a few points higher. An investment's IRR must generally equal or exceed the hurdle rate to be approved by management, says CIO Kent Fourman.

"We calculate the IRR and then compare that to our hurdle rate," Fourman says. "And we compare that IRR against every other [project's] IRR, because you always have limited cash."

But the IRR cutoff isn't an absolute test, he says. For example, management's subjective assessment of risk may influence an investment decision, he says. "But if you can't show that IRR exceeds our hurdle rate, then you'll have to have a lot of the soft justifications to get it approved," Fourman says.

Not everyone is as enthusiastic about IRR. Like NPV, it doesn't measure the absolute size of the investment or its return. And because of the way the math works, the timing of periods of negative cash flow can affect the value of IRR without accurately reflecting the underlying performance of the investment.

IRR can also produce misleading results because, as classically defined, it assumes that the cash returned from an investment is reinvested at the same percentage rate, which may not be realistic. That error is magnified when comparing two investments of different durations. Some software, such as Microsoft Excel, will compute an optional "modified IRR" that allows the user to specify a different reinvestment rate.

IRR becomes increasingly misleading the more it diverges from the cost of capital, says Ian Campbell, chief research officer at Nucleus Research Inc. in Wellesley, Mass. "IRR is a terrible metric, and it should never be used," he asserts.

The key metric for IT projects, Campbell says, is payback period, because it favors short-term, and hence less risky. projects that IT should be doing.

Excerpt From Essay:

Title: General Financial Questions

Total Pages: 5 Words: 1373 Works Cited: 0 Citation Style: MLA Document Type: Research Paper

Essay Instructions: Answer the following questions:
Chapter 4, #10 (7th ed.)
#10. You have the opportunity to make an investment of $900,000. If you make this investment now, you will receive $120,000, $250,000 and $800,000 one, two, and three years from today, respectively. The appropriate discount rate for this investment is 12.00 percent.
a. Should you make the investment?
b. What is the net present value (NPV) of this opportunity?
c. If the discount rate is 11.00 percent, should you invest? Compute the NPV to support your answer.


Chapter 5, # 7, 18, 31 (7th ed.)
#7. Consider two bonds, A and B. The coupon rates are 10.00 percent and the face values are $1,000.00 for both bonds. Both bonds have annual coupons. Bond A has 20 years to maturity while bond B has only 10 years to maturity.
a. What are the prices of the two bonds if the relevant market interest rate for both bonds is 10.00 percent?
b. If the market interest rate increases to 12.00 percent, what will be the prices of the two bonds?
c. If the market interest rate decreases to 8.00 percent, what will be the prices of the two bonds?

#18. Scubaland, Inc. is experiencing a period of rapid growth. Earnings and dividends per share are expected to grow at a rate of 18.00 percent during the next two years, 15.00 percent in the third year, and 6.00 percent thereafter. Yesterday, Scubaland paid a dividend of $1.15. If the required rate of return on the stock is 12.00 percent, what is the price of a share of the stock today?

#31. (7th ed.; 27 in 8th ed.) Consider Pacific Energy Company and U.S. Bluechips, Inc., both of which reported cash flows of $800,000.00 and have 500,000 shares of common stock outstanding. Without new projects, both firms will continue to generate cash flows of $800,000.00 in perpetuity. Assume that the cash flows are equal to earnings ( no dividends are paid). Assume both firms require a 15.00 percent rate of return.
a. Pacific Energy Company has a new project that will generate additional cash flows of $100,000.00 in perpetuity. Calculate the P/E ratio of the company.
b. U.S. Bluechips has a new project that will increase cash flows by $200,000 in perpetuity. Calculate the P/E ratio of the firm.






These problems also are to be turned in on September 12

Chapter 6 #1 (in both editions)
#1. Fuji Software, Inc has the following mutually exclusive projects.
Year Project A
Project B
0 -$7,500.00 -$5,000.00
1 4,000.00 2,500.00
2 3,500.00 1,200.00
3 1,500.00 3,000.00

a. Suppose Fuji’s payback period cutoff is two years. Which of these two projects should be chosen?
b. Suppose Fuji uses the NPV rule to rank these two projects. Which project should be chosen if the appropriate discount rate is 15.00 percent?


Chapter 7, #7 (7th ed.), #21 (8th ed.) + an extra part (b) on MACRS
#7. Scott Investors, Inc., is considering the purchase of a $500,000.00 computer with an economic life of five years. The computer will be fully depreciated over five years using the straight-line method. The market value of the computer will be $100,000.00 in five years. The computer will replace five office employees whose combined annual salaries are $120,000.00. The machine will also immediately lower the firm’s required net working capital by $100,000.00. This amount of net working capital will need to be replaced once the machine is sold. The corporate tax rate is 34.00 percent.
a. Is it worthwhile to buy the computer if the appropriate discount rate is 12.00% and the firm uses the straight-line deprecation method? What is the NPV of the computer?
b. Is it worthwhile to buy the computer if the appropriate discount rate is 12.00% and the firm uses MACRS deprecation method (table 7.3 which is replicated in my PowerPoint notes)? What is the NPV of the computer?



Chapter 10, #27 (7th ed.)
27. Consider the following two stocks:
Stock Beta Expected Return
Murck Pharmaceutical 1.4 25.00%
Pizer Drug Corp 0.7 14.00%

Assume the Capital-Asset-Pricing Model (CAPM) holds. Based on the CAPM,
a. What is the risk-free rate?
b. What is the expected return on the market portfolio?

Problems to turn in on September 24 (chapter 12)

Chapter 12

10. (8th ed.) WACC Kose, Inc. has a target debt-equity ratio of 0.80. Its WACC is 10.50 percent and the tax rate is 35.00%.
a. If Kose’s cost of equity is 15.00 percent, what is its pre-tax cost of debt?
b. If, instead, you know that the after-tax cost of debt is 6.40 percent, what is the cost of equity?


12. (8th ed.) Finding the WACC Titan Mining Corporation has 9 million shares of common stock outstanding and 120,000 bonds. Each of these bonds has a $1,000 par value and an 8.50 percent coupon (interest of 4.25% is paid semiannually, i.e., $42.50 is paid semiannually on a $1000 bond). The common stock sells for $34.00 per share and has a beta of 1.20. The bonds have 15 years to maturity and sell for 93.00 percent of par. The market risk premium is 10.00 percent. The risk-free rate is 5.00 percent, and Titan Mining’s tax rate is 35.00 percent.
a. What is the firm’s market value capital structure?
b. If Titan Mining is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should the firm use to discount the project’s cash flows?

14. (8th ed.) WACC and NPV Och, Inc., is considering a project that will result in initial after-tax cash savings of $3.5 million at the end of the first year, and these savings will grow at a rate of 5.00 percent per year indefinitely. The firm has a target debt-equity ratio of 0.65, a cost of equity of 15.00 percent, and an after-tax cost of debt of 5.50 percent. The cost-saving proposal is somewhat riskier than the usual project that the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2.00 percent to the cost of capital for such risky projects.
Under what circumstances should Och take on the project?




Problems to turn in on October 3, 2007 (Chapter 3)

Chapter 3
13. (8th ed.) External Funds Needed The Optical Scam Company has forecast a 20.00 percent sales growth for the next year. The current financial statements are shown here:

Income Statement
Sales $38,000,000
Costs 33,400,000
Taxable Income $ 4,600,000
Taxes 1,610,000
Net Income $ 2,990,000

Dividends $1,196,000
Additions to retained earnings 1,794,000

Balance Sheet
Assets Liabilities and Equity
Current assets $9,000,000 Accounts Payable 8,000,000
Long-term debt 6,000,000
Fixed assets 22,000,000
Common stock $4,000,000
Accumulated retained earnings 13,000,000
Total equity $17,000,000
Total assets $31,000,000 Total liab. & equity 31,000,000

a. Construct the firm’s pro forma Income Statement for next year.
Determine: Net Income, Dividends, Additions to retained earnings
b. Construct the firm’s pro forma Balance Sheet for next year.
c. Calculate the external funds needed for next year.
d. Calculate the sustainable growth rate for the company.
e. Can Optimal Scam eliminate the need for external funds by changing its dividend policy? What other options are available to the company to meet its growth objectives?




Problems to turn in on October 10, 2007 Chapter 29 and Chapter 19

Chapter 29
10. (7th ed.), 14. (8th ed.) Merger NPV Fly-By-Night Couriers is analyzing the possible acquisition of Flash-in-the-Pan Restaurants. Neither firm has debt. The forecasts of Fly By-Night show that the purchases would increase its annual after-tax cash flow by $600,000 indefinitely (i.e., in perpetuity). The current market value of Flash-in-the-Pan is $20 million. The current market value of Fly-By-Night is $35 million. The appropriate discount rate for the incremental cash flows is 8 percent. Fly-By-Night is trying to decide whether it should offer 25 percent of its stock or $25 million in cash to Flash-in-the-Pan.
a. What is the synergy from the merger?
b. What is the value of Flash-in-the-Pan to Fly-By-Night?
c. What is the cost to Fly-By-Night of each alternative?
d. What is the NPV to Fly-By-Night of each alternative?
e. What alternative should Fly-By-Night use?



Chapter 19
1. (7th ed.) Define the following terms related to the issuance of public securities:
a. General cash offer
b. Rights offer
c. Registration statement
d. Prospectus
e. Initial public offering
f. Seasoned new issue
g. Shelf registration

4. (7th ed.) Define the following terms related to underwriting.
a. Firm commitment
b. Syndicate
c. Spread
d. Best efforts

2. (8th ed.) The Clifford Corporation has announced a rights offer to raise $50 million for a new journal, the Journal of Financial Excess. This journal will review potential articles after the author pays a non-refundable fee of $5,000.00 per page. The stock currently sells for $40.00 per share, and there are 5,200,000 (5.2 million) shares outstanding.
a. What is the maximum possible subscription price? What is the minimum?
b. If the subscription price is set at $35.00 per share, how many shares must be sold? How many rights will it take to buy one share?
c. What is the ex-rights price? What is the value of one right?
d. Show how a shareholder with 1,000 shares before the offering and no desire (or money) to buy additional shares is NOT harmed by the rights offer.


Problems to turn in on October 22, 2007

Chapter 15

1. (7th ed.), 20. (8th ed.) MM Proposition I without Taxes Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all-equity firm, has 5,000 shares of stock outstanding, currently worth $20 per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is $25,000, and its cost of debt is 12.00 percent. Each firm is expected to have earnings before interest of $35,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 12.00 percent per year.
a. What is the value of Alpha Corporation?
b. What is the value of Beta Corporation?
c. What is the market value of Beta Corporation’s equity?
d. How much will it cost to purchase 20.00 percent of each firm’s equity?
e. Assuming each firm meets its earnings estimates, what will be the dollar return to each position in part (d) over the next year? (Assume all earnings are paid at the end of the year and that returns are compounded annually.)
f. Construct an investment strategy in which an investor purchases 20.00 percent of Alpha’s equity and replicates both the cost and dollar return of purchasing 20.00 percent of Beta’s equity. (i.e., “homemade leverage)
g. Is Alpha’s equity more or less risky than Beta’s equity? Explain.


2. (7th ed.), 21. (8th ed.) Cost of Capital Acetate, Inc., has equity with a market value of $20 million ($20,000,000.00) and debt with a market value of $10 million ($10,000,000.00). Treasury securities that mature in one year yield 8.00 percent per year, and the expected return on the market portfolio over the next year is 18.00 percent. The beta of Acetate’s equity is 0.90. The firm pays no taxes.
a. What is Acetate’s debt-equity ratio?
b. What is the firm’s weighted average cost of capital?
c. What is the cost of capital for an otherwise identical all-equity firm?


18. (7th ed.) MM with Corporate Taxes The Holland Company expects perpetual earnings before interest and taxes (EBIT) of $4 million ($4,000,000.00) per year. The firm’s after-tax all-equity discount rate (ro) is 15.00 percent. Holland is subject to a corporate tax rate of 35.00 percent. The pre-tax cost of the firm’s debt capital is 10.00 percent per annum, and the firm has $10 million ($10,000,000.00) of debt in its capital structure.
a. What is Holland’s value?
b. What is Holland’s cost of equity (rs)?
c. What is Holland’s weighted average cost of capital (rWACC)?


Problems to turn in on October 29, 2007

Chapter 16 due October 29, 2007

1. (7th ed.), 8. (8th ed.) Financial Distress Good Time Company is a regional chain department store. It will remain in business for one more year. The probability of a boom year is 60.00 percent and the probability of a recession is 40.00 percent. It is projected that the company will generate a total cash flow of $250 million in a boom year and $100 million in a recession. The company’s required debt payment at the end of the year is $150 million. The market value of the company’s outstanding debt is $108,930,000.00. The company pays no taxes. Assume a discount rate of 12.00 percent.
a. What payoff do bondholders expect to receive in the event of a recession?
b. What is the promised return on the company’s debt?
c. What is the expected return on the company’s debt?

5. (7th ed. ) Due to large losses incurred in the past several years, a firm has $2 billion in tax-loss carry-forwards. This means that the next $2 billion of the firm’s income will be free from corporate income taxes. Security analysts estimate that it will take many years for the firm to generate $2 billion in earnings. The firm has a moderate amount of debt in its capital structure. The firm’s CEO is deciding whether to issue debt or equity in order to raise the funds needed to finance an upcoming project. Which method of financing would you recommend? Explain.

10. (8th ed.) Personal Taxes, Bankruptcy Costs, and Firm Value. Overnight Publishing Company (OPC) has $2 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity. The firm’s debt is held by one institution that is willing to sell it back to OPC for $2 million. The institution will NOT charge OPC any transactions costs. Once OPC becomes an all-equity firm, it will remain unlevered forever. If OPC does not retire the debt, the company will use the $2 million in cash to buy back some of its stock on the open market. Repurchasing stock also has no transaction costs. The company will generate $1,100,000 of annual earnings before interest and taxes (EBIT) in perpetuity regardless of its capital structure. The firm immediately pays out all earnings as dividends at the end of each year. OPC is subject to a corporate tax rate of 35 percent, and the required rate of return on the firm’s unlevered equity is 20 percent. The personal tax rate on interest income is 25 percent, and there are no taxes on equity distribution. Assume there are NO bankruptcy costs.
a. What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm?
b. What is the value of OPC if it decides to repurchase stock instead of retiring its debt?
c. Assume that expected bankruptcy costs have a present value of $300,000. { [C(B)] = $300,000. } How does this influence OPC’s decision?

For problem #10 (b), use the following equation to value a firm with personal taxes on debt income (tB) and corporate taxes (tC), but no taxes on equity income and NOT bankruptcy costs:
Since there are no bankruptcy costs, the value of the company as a levered firm is:
VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B

For problem #10 (c), use the following equation to value a firm with personal taxes on debt income (tB) and corporate taxes (tC), and bankruptcy costs [C(B)] but no taxes on equity income.
VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B – C(B)

Problems to turn in on November 14, 2007

Chapter 18

13. (8th ed.) Residual Dividend Policy Preti Rock (PR), Inc., predicts that earnings in the coming year will be $56 million. There are 12 million shares, and PR maintains a debt-equity ratio of 2.0.
a. Calculate the maximum investment funds available without issuing new equity, and calculate the increase in borrowing that goes along with it.
b. Suppose that the firm uses a residual dividend policy. (With a residual dividend policy the main idea is that a firm should focus on meeting its investment needs and maintaining its desired debt-equity ratio. Having done so, a firm pays out any leftover, or residual, income as dividends.) Planned capital expenditures total $72 million. Based on this information, what will the dividend per share be?
c. In part (b) how much borrowing will take place? What is the addition to retained earnings?
d. Suppose PR plans no capital outlays for the coming year. What will the dividends be under a residual policy? What will new borrowing be?


3. (7th ed.), 14. (8th ed.) Dividends and Stock Price The Mann Company belongs to a risk class for which the appropriate discount rate is 10.00 percent. Mann currently has 100,000 outstanding shares selling at $100.00 each. The firm is contemplating the declaration of a $5.00 per share dividend at the end of the fiscal year that just began Assume there are no taxes on dividends. Answer the following questions based on the Miller and Modigliani model, which is discussed in the text.
a. What will be the price of the stock on the ex-dividend date if the dividend is declared?
b. What will be the price of the stock at the end of the year if the dividend is NOT declared?
c. If Mann makes $2 million of new investments at the beginning of the period, earns net income of $1 million, and pays the dividend at the end of the year, how many shares of new stock must the firm issue to meet its funding needs?
d. Is it realistic to use the MM model in the real world to value stocks?


8. (7th ed.), 19. (8th ed.) Dividend Policy Gibson Co. has a current period cash flow of $1.2 million and pays no dividends. The present value of the company’s future cash flows is $15 million. The company is entirely financed with equity and has 1 million shares outstanding. Assume that the dividend tax rate is zero.
a. What is the share price of the Gibson stock?
b. Suppose that the board of directors of Gibson Co. announces its plan to pay out 50.00 percent of its current cash flow as cash dividends to its shareholders. How can Jeff Miller, who owns 1,000 shares of Gibson stock, achieve a zero payout policy on his own?


Problems to turn in on November 26, 2007 chapters 21, 21, 23

Chapter 21

* * 3. (7th ed.), 7. (8th ed.) Lease or Buy Super Sonics Entertainment is considering buying a machine that costs $340,000.00. The machine will be depreciated over five years by the straight-line method and will be worthless at that time. The company can lease the machine with year-end payments of $94,200.00. The company can issue bonds at a 9.00 percent interest rate. If the corporate tax rate is 35.00 percent,
a. What is the Net Advantage (Disadvantage) to Leasing? (The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows of Leasing vs. Buying.)
b. Should the company buy or lease?


2. (7th ed.), 8. (8th ed.) Setting the Lease Payment Quartz Corporation is a relatively new firm. Quartz has experienced enough losses during its early years to provide it with at least eight years of tax loss carry-forwards. Thus, Quartz’s effective tax rate is zero. Quartz plans to lease equipment from New Leasing Company. The term of the lease is five years. The purchase cost of the equipment is $650,000.00. New Leasing Company is in the 35.00 percent tax bracket. There are not transaction costs to the lease. Each firm can borrow at 7.00 percent.
a. What is Quartz’s reservation price?
b. What is New Leasing Company’s reservation price?
c. Explain why these reservation prices determine the negotiating range of the lease.


Chapter 22
3. (8th ed.) Calculating Payoffs and Profits Use the option quote information shown here to answer the questions that follow. The stock is currently selling for $114.00. Ignore commissions. (FYI, Listed options quotes can be found at http://online.wsj.com/mdc/public/page/2_3044-Opt_L_M-optninfo.html . )
Macrosft ( MACRSFT )
Underlying stock price*: 114.00

Expiration STRIKE:
Feb. 110
March 110
May 110
August 110
CALL:
Last Volume OpenInterest
Feb: 7.6 85 220
march:8.8 61 473
may: 10.25 22 1494
august: 13.05 3 4
PUT:
LAST VOLUME OPEN INTEREST
feb: .6 40 283
march: 1.55 22 981
may:2.85 11 1601
august: 4.7 3 2
a. Suppose you buy 10 contracts of the February 110 call option. How much will you pay (ignoring commissions)?
b. In part (a.) suppose that Macrosoft is selling for $140.00 on the expiration date. How much is your options investment worth? What if the terminal stock price is $125.00, how much is your options investment worth? Explain.
c. Suppose that you buy 10 contracts of the August 110 put option. What is your option investment worth? What is your net gain?
d. In part (c), suppose you sell 10 of the August 110 put contracts. What is your net gain or loss if Macrosoft is selling for $103.00 at expiration? What is your net gain or loss if Macrosoft is selling for $132.00 at expiration? What is the break-even price – i.e., the terminal stock price that results in a zero profit?


4. (8th ed.) Two-State (Binomial) Option Pricing Model The price of Ervin Corp. stock will be either $75.00 or $95.00 at the end of the year. Call options are available with one year to expiration. One-year Treasury securities currently yield 6.00 percent.
a. Suppose the current price of Ervin stock is $80.00. What is the value of the call option if the strike (“exercise price”) is $70.00 per share?
b. Suppose the strike is $90.00 in part (a). What is the value of the call option now?


6. (8th ed.) Put-Call Parity A stock is currently selling for $61.00 per share. A call option with a strike of $65.00 sells for $4.12 and expires in three months. If the risk-free rate of interest is 2.60 percent per year, compounded continuously, what is the price of a put option with the same strike?


10. (8th ed.) Black-Scholes What are the prices of a call option and a put option with the following characteristics?
Stock price = $38.00
Strike = $35.00
Risk-free rate = 6.00% per year, compounded continuously
Maturity = 3 months
Standard deviation = 54.00% per year


21. (8th ed.) Equity as an Option Sunburn Sunscreen has a zero coupon bond issue outstanding with a $10,000.00 face value that matures in one year. The current market value of the firm’s assets is $10,500.00. The standard deviation of the return on the firm’s assets is 38.00 percent per year, and the annual risk-free rate is 5.00 percent per year, compounded continuously. Based on the Black-Scholes model, what is the market value of the firm’s equity and debt?



Chapter 23
4. (7th ed.), 5. (8th ed.) Real Options Jet Black is an international conglomerate with a petroleum division and is currently competing in an auction to win the right to drill for crude oil on a large piece of land in one year. The current market price of crude oil is $55.00 per barrel, and the land is believed to contain 125,000 barrels of oil. If found, the oil would cost $10 million to extract. Treasury securities that mature in one year yield a continuously compounded interest rate of 6.50 percent, and the standard deviation of the returns on the price of crude oil is 50.00 percent. Use the Black-Scholes model to calculate the maximum bid that the company should be willing to make at the auction.

Problems to turn in on December 3, 2007 Chapter 24

Chapter 24

6. (8th ed.) Warrant Value A warrant gives its owner the right to purchase three shares of common stock at a strike of $32.00 per share. The current market price of the stock is $39.00. What is the minimum value of the warrant?

12. (7th ed.), 8. (8th ed.) Convertible Bond Value Sportime Fitness Center, Inc. issued convertible bonds with a conversion price of $25.00. The bonds are available for immediate conversion. The current price of the company’s common stock is $22.00 per share. The current market price of the convertible bonds is $990.00. The straight bond value of the convertible bonds is not known.
a. What is the minimum price for the convertible bonds?
b. Explain the difference between the current market price of each convertible bond and the value of the common stock into which it can be immediately converted.

15. (7th ed.) Convertible Bond Value MGH Medical Supplies, Inc., recently issued a single zero-coupon convertible bond due 10 years from today. The convertible bond, which is currently trading for $400 in the open market, has a face value of $1,000.00 and can be converted into 25 shares of common stock. Each share of MGH’s common stock is currently selling for $12.00, and otherwise identical non-convertible bonds yield 10.00 percent per annum (effective annual yield).
a. What is the straight bond value of the convertible bond?
b. What is its conversion value?
c. What is its option value?



Problems to turn in on December 10, 2007 Chapter 31

1. (8th ed.) Using Exchange Rates Look at Figure 31.1, page 870 in 8th edition, reprinted from The Wall Street Journal, of February 24, 2006, representing Late New York Trading on Thursday, February 23, 2006. (If you have a different edition of the text, try to get a photocopy of this page – or see it in my office.)
Using that Figure 31.1, answer the following questions, based on the prices for Thurs. (2/23/06).
a. If you have $100.00, how many euros can you get?
b. What is one euro worth?
c. If you have 5 million euros, how many dollars do you have?
d. Which is worth more (in US dollars), a New Zealand dollar or a Singapore dollar?
e. How many Mexican pesos can you get for one euro? What is this rate known as?

3. (8th ed.) Forward Exchange Rates Us the information in Figure 31.1, page 870 of the 8th edition of the text to answer the following questions:
a. What is the six-month forward rate for the Japanese yen in yen per U.S. dollar? Is the yen selling at a premium or a discount? Explain.
b. What is the three-month forward rate for British pounds in U.S. dollars per pound? Is the dollar selling at a premium or a discount? Explain.
c. What do you think will happen to the value of the dollar relative to the yen and the pound, based on the forward rates vs. the spot rates in Figure 31.1? Explain.

8. (8th ed.) Inflation and Exchange Rates Suppose that the current exchange rate for the Polish zloty is Z 3.84. Also suppose that the expected exchange rate in three years is Z 3.92. What is the difference in the expected annual inflation rates for the United States and Poland over this period? Assume that the anticipated rate is constant for both countries. What relationship are you relying on in answering this question?

11. (8th ed.) The International Fisher Effect You observe that the inflation rate in the United States is 3.50 percent per year and that Treasury securities currently yield 3.90 percent annually. What do you estimate the inflation rate to be in:
a. Australia if short-term Australian government securities yield 5.00 percent per year?
b. Canada if short-term Canadian government securities yield 7.00 percent per year?
c. Taiwan if short-term Taiwanese government securities yield l0.00 percent per year?

15. (8th ed.) Capital Budgeting Lakonishok Equipment has an investment opportunity in Europe. The project costs €12 million and is expected to produce cash flows of €2.7 million in year 1, €3.5 million in year 2, and €3.3 million in year 3. The current spot exchange rate is $1.22/€ and the current risk-free rate in the United States is 4.80 percent, compared to that in Europe of 4.10 percent. The appropriate discount rate for the project is estimated to be 13.00 percent, the U.S. cost of capital for the company. In addition, the subsidiary can be sold at the end of three years for an estimated €7.4 million. What is the NPV of the project?

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