Question

Question 2

Orange Inc. is considering two mutually exclusive projects (i.e., can choose either one but not both), Alpha in Country A, and Beta in Country B. Project Alpha requests an initial investment of $300,000 and has projected annual cash flows of $20,000, $50,000, $50,000 and $350,000 over 4 years. Project Beta requests an initial investment of $88,000 and has projected cash flows of $12,000 for the first year, and then the cash flows are projected to grow at a constant rate of 5 percent per year forever. Based on the project characteristics, the company requires an 15 percent return for Project Alpha but requires an 17 percent for Project Beta.

You require a 15 percent return on your investment and a payback period of 3 years.

1. If the company requires a maximum payback period of 4 years, which investment will you choose according to the payback criterion? Why?
2. If you apply the NPV criterion, which investment will you choose? Why?
3. Name three disadvantages of the payback period
4. Based on your answer in (a) and (b), which project will you finally choose? Why?

Question 3

Parker & Stone, Inc., is considering a new project that requires an initial fixed asset investment of 1.2 million. The project also requires an initial investment in net working capital of $250,000. The project is expected to generate $950,000 in sales and cost $400,000 every year for three years. The fixed asset follows a straight-line depreciation. After three years, the fixed asset has a zero book value but is estimated to have a market value of $200,000, and the net working capital will fully recovery. The corporate tax rate is 35%.

1. What are the operating cash flows in each year?
2. What are the cash flows from net working capital and the net capital spending in year 3?
3. What are the CFFA in each year?
4. If the required return is 10% for a similar risk level of project, should the company implement this project?

Question 4

At year beginning, you observed that the price of stock Apple was $100 and the price of Stock Orange was $900. To understand the relation between risk and return, you keep watching on the performance of the stock and the bond over the next three years. The information you observed is as follows:

	Stock Apple		Stock Orange
Year	Year-end Price ($)	Dividend ($)	Year-end Price ($)	Dividend ($)
1	115	5	915	20
2	110	1	925	20
3	145	10	930	30

1. What is the stock Apple’s dividend yield in year 2? What is the Stock Orange’s capital gains yield in year 3?
2. During the 3-year observation period, what are the average annual total return of Apple and Orange?
3. Based on the lessons learned from the capital market history, discuss your interpretation of “higher risk and higher expected return”.

Question 5

Consider the following stock information about Tencent and HSBC

State of Economy	Probability of State of Economy	Returns if State Occurs
		Tencent	HSBC
Bad	0.30	-10%	-5%
Good	0.70	15%	12%

1. What’re the expected return on each stock?
2. What’re the standard deviation on each stock?
3. The risk free rate is 1.5%. Based on the CAPM, If Tencent’s market beta is 1.5, what’s the beta of HSBC?
4. If you invested 65 percent in Tencent and 35 percent in HSBC, what is your portfolio expected return? The standard deviation? .
5. Given the portfolio information in (d) and beta information in (c), what is the portfolio’s market beta? .

Question 6

SmartCar Corporation has 1 million shares of common stock outstanding, 20,000 shares of preferred stock outstanding, and 40,000 corporate bonds outstanding. The common stocks sell for $25, with a market beta of 1.5. The corporate bonds sell for $950 and the current YTM is 5%. The preferred stock currently sells for $100, with an annual dividend payment of $8 per share. The risk-free rate is 2% and the market expected return is 8%. SmarCar’s corporate tax rate is 35%. What is SmartCar’s cost of capital?

Answer 1

Question 2:-

Answer

a)

Payback period

Alpha Country A

	Year	0	1	2	3	4
Alpha Project A	Net cash flow	- $ 300000	$ 20000	$ 50000	$ 50000	$ 350000
	Cumulative NCF	- $ 300000	- $ 280000	- $ 230000	- $ 180000	$ 170000

Beta Country B

	Year	0	1	2	3	4
Beta Project B	Net cash flow	- $ 88000	$ 12000	$ 12600	$ 13230	$ 13892
	Cumulative NCF	- $ 88000	- $ 76000	- $ 63400	- $ 50170	- $ 36278

The cash inflows will increase at the rate of 5 % per year forever

Therefore Year 2 CF = $ 12000 x 1.05 = $12600
Year 3 CF = $ 126000 X 1.05 = $ 13230
Year 4 CF = $ 13230 X 1.05 = $ 13891.5

If we consider maximum payback period of 4 years we should select Alpha Project A as it shows positive return of $ 170000 whereas the Beta Project B has shown a negative return of $ 36278 after the end of Year 4.

b)

The NPV criteria on Alpha Project A and Beta Project B

Alpha Project A return = 15 %
Beta Project B return = 17 %

NPV Alpha Project A = - $ 300000 + $ 20000 / 1.15 + $ 50000 / 1.15² + $ 50000 / 1.15³ + $ 350000 / 1.15⁴
= - $ 300000 + $ 17391.3 + $ 37807.18 + $ 32875.81 + $ 200114.35
= - $ 300000 + $ 288188.64
= - $ 11811.36  

NPV Beta Project B = - $ 88000 + $ 12000 / 1.17 + $ 12600 / 1.17² + $ 13230 / 1.17³ + $ 13892 / 1.17⁴ + ------- infinity

We have to note that since we get the cash flows forever in the Beta Project B therefore it will eventually have a positive NPV

Therefore Beta Project B will be selected under NPV criteria as the Alpha Project A has a negative NPV of $ 11811.36.

c)

The three disadvantages of payback period are

1) The payback period does not take into account either the time value of money or cash flows beyond the payback period
2) The terminal value or the salvage value of the project is not considered which is a drawback of the payback period
3) The disadvantage of payback period is that one cannot use this method as a measure of profitability where as we can get result in case of NPV.

d)

Based on the question options of a and b we should always consider the project which will give the positive NPV and not the one with payback period.

Therefore the Beta Project B which shows positive NPV should be considered rather than Alpha Project A as Beta Project B will show positive NPV whereas the Alpha Project A has negative NPV

Hence Beta Project B should be selected.

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