Question

3. McCormick & Company is considering establishing new products in a new factory in Largo, Maryland. Theproject is expected to last for eight years. To determine the right financing option, you need to determine the appropriate discount based on the weighted average cost of capital. The cost of equity is estimated using the capital asset pricing model. Cash flows are assumed to be steady, the nominal risk-free rate for the short-term US government treasury bills is 1.5 percent, the 10-year government bonds rate is 2.5 percent, and the inflation rate is 2.54 percent. What is the real risk-free rate? Then, assume a beta of 1.2 and a market return of 5 percent. What is the cost of equity?

4. McCormick& Company is considering purchasing a new factory in Largo, Maryland. After you and your team have conducted an analysis of alternative investments and cost of capital, McCormick has decided that a risk premium of 13 percent is appropriate for the investment into a new factory. Adding the risk premium to the current risk-free rate of 7 percent, what is the minimum acceptable rate of return?

1.Liz is retiring from the US Postal Service and will turn 70 next year. After 39 years of service, her monthly pension is $7,500.  She does not qualify for Social Security.  Liz has accumulated $700,000 in her thrift savings plan.  The government requires that she convert it to an annuity or move it to a IRA.  All of the money is pretax and tax can be avoided if it is moved to the IRA.  The annuity will be calculated based on her life expectancy of 17.5 years after age 70. The current USTreasury long-term bond rate is 3 percent. How much will she get as an annuity monthly payment?  Should Liz take the annuity or move the money to the IRA? The tax regulations require that she take out 4 percent of the amount each year.

2. Kathy plans to move to Maryland and take a job at McCormick as the assistant director of HR. She and her husband, Stan, plan to buy a house in Garrison, MD, and their budget is $500,000. They have $100,000 for the down payment and McCormick will pay for closing costs. They are considering either a 30-year mortgage at 4.5 percent annual rate or a 15 year mortgage at 4 percent. Calculate the monthly payment for each. Property taxes and insurance will add $1,000 per month to which ever mortgage they choose. What should Kathy and Stan do?

Answer 1

3. McCormick & Company is considering establishing new products in a new factory in Largo, Maryland. Theproject is expected to last for eight years. To determine the right financing option, you need to determine the appropriate discount based on the weighted average cost of capital. The cost of equity is estimated using the capital asset pricing model. Cash flows are assumed to be steady, the nominal risk-free rate for the short-term US government treasury bills is 1.5 percent, the 10-year government bonds rate is 2.5 percent, and the inflation rate is 2.54 percent. What is the real risk-free rate? Then, assume a beta of 1.2 and a market return of 5 percent. What is the cost of equity?
Real Risk Free Rate = [(1 + Nominal risk free rate)/(1+ inflation)]-1
Real Risk Free Rate = [(1 + 2.50%)/(1+ 2.54%)]-1	-0.039%
Cost of Equity = Rf + Beta x (Rm -RF)
Calcuated Using Real Risk Free rate
Cost of Equity = -.039% + 1.2 x (5%--0.039%)	6.01%
Calcuated Using Nominal Risk Free rate
Cost of Equity = 1.5% + 1.2 x (5%-1.5%)	5.70%
* For calculating cost of equity Risk-Free rate is considered to equal a short term US government Treasury bill.
* The long-term rate is relevant because the cash flows being discounted have a longer duration. Ideally the risk-free rate duration should match the duration of the cash flows.
4. McCormick& Company is considering purchasing a new factory in Largo, Maryland. After you and your team have conducted an analysis of alternative investments and cost of capital, McCormick has decided that a risk premium of 13 percent is appropriate for the investment into a new factory. Adding the risk premium to the current risk-free rate of 7 percent, what is the minimum acceptable rate of return?
Minimum acceptable Rate of Return = Risk Premium + Risk free rate
Minimum acceptable Rate of Return = 13%+ 7%)	20.0%