Financial Derivatives

40. Identify the formation of a butterfly spread, straddle and strangle. Identify the formation of Tunel, Condor, Ratio Spread Call and Put

The market value of Owl Fund Industries common stock is $125 million and the market value of its debt is $25 million. The beta of the company's common stock is 1.0 and the expected risk premium on the market portfolio is 6.5 percent. If the Treasury bill rate is 3 percent and the yield on its debt is 4%, what is the company's cost of capital assuming the tax rate is 0%.

You are asked to evaluate the following two projects for the Norton corporation. Use a discount rate of 14 percent. Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.

***Note: Answer is NOT $5,567,662

This is the predicted cash flow stream of an investment project related to the launch of a new automotive vehicle for a fictitious firm:

Be aware that this is a stylized Income Statement, designed for educational purposes, in order to force your critical thinking.  

Parameters considered in the DCF:

WACC = 9.5% (weighted average cost of capital)
Price = $22,000 /unit
Variable Costs = $18,700/unit
Fixed Costs = 150K
Investment = $3.5M (including the Cost of Equipment @$1M and R&D and Mkt expenses @$2.5M)

Supporting formulas:

a) free cash = unit contribution - Fixed Cost + Depreciation;

b) unit contribution = unit sales*(price - variable costs)

Note on the Investment and depreciation: the total initial investment was $3.5M, but $1M was paid in advance to purchase equipment and expand capacity. The remaining $2.5M was used in R&D and Marketing expenses paid at the end of Year #1. Manufacturing/sales effectively start in Year #2, so depreciation is initiated then for 5 consecutive years. The immediate investment cost of manufacturing is incurred in Time 0 and it is not affected by the discount rate (i.e., initial investment). Assume that production is interrupted in Year #10, with no residual value (the machinery cannot be sold due to high levels of specificity!).

Assignment Questions:

1) Based on the simplified information provided above, discuss whether you would support this investment. Why? or Why not? (Feel free to use Excel or a Financial Calculator)

Currently, Meyers Manufacturing Enterprises (MME) has a capital structure consisting of 35% debt and 65% equity. MME's debt currently has a 6.6% yield to maturity. The risk-free rate (r_RF) is 4.6%, and the market risk premium (r_M – r_RF) is 5.6%. Using the CAPM, MME estimates that its cost of equity is currently 10%. The company has a 40% tax rate.

a. What is MME's current WACC? Round your answer to 2 decimal places. Do not round intermediate calculations.

b. What is the current beta on MME's common stock? Round your answer to 4 decimal places. Do not round intermediate calculations.

c. What would MME's beta be if the company had no debt in its capital structure? (That is, what is MME's unlevered beta, b_U?) Round your answer to 4 decimal places. Do not round intermediate calculations.

d. MME's financial staff is considering changing its capital structure to 45% debt and 55% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 7.1%. The proposed change will have no effect on the company's tax rate.

e. What would be the company's new cost of equity if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations.

f. What would be the company's new WACC if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations.

Mary Smith, a CFA candidate, was recently hired for an analyst position at the Bank of Ireland. Her first assignment is to examine the competitive strategies employed by various French wineries.

Smith’s report identifies four wineries that are the major players in the French wine industry. Key characteristics of each are cited in the table below. In the body of Smith’s report, she includes a discussion of the competitive structure of the French wine industry. She notes that over the past five years, the French wine industry has not responded to changing consumer tastes. Profit margins have declined steadily, and the number of firms representing the industry has decreased from 10 to 4. It appears that participants in the French wine industry must consolidate to survive.

Characteristics of Four Major French Wineries

Smith’s report notes that French consumers have strong bargaining power over the industry. She supports this conclusion with five key points, which she labels “Bargaining Power of Buyers”:

• Many consumers are drinking more beer than wine with meals and at social occasions.
• Increasing sales over the Internet have allowed consumers to better research the wines, read opinions from other customers, and identify which producers have the best prices.
• The French wine industry is consolidating and consists of only 4 wineries today compared to 10 wineries five years ago.
• More than 65% of the business for the French wine industry consists of purchases from restaurants. Restaurants typically make purchases in bulk, buying four to five cases of wine at a time.
• Land where the soil is fertile enough to grow grapes necessary for the wine production process is scarce in France.

After completing the first draft of her report, Smith takes it to her boss, RonVanDriesen, to review. VanDriesen tells her that he is a wine connoisseur himself and often makes purchases from the South Winery. Smith tells VanDriesen, “In my report I have classified the South Winery as a stuck-in-the-middle firm. It tries to be a cost leader by selling its wine at a price that is slightly below the other firms, but it also tries to differentiate itself from its competitors by producing wine in bottles with curved necks, which increases its cost structure. The end result is that the South Winery’s profit margin gets squeezed from both sides.” VanDriesen replies, “I have met members of the management team from the South Winery at a couple of the wine conventions I have attended. I believe that the South Winery could succeed at following both a cost leadership and a differentiation strategy if its operations were separated into distinct operating units, with each unit pursuing a different competitive strategy.” Smith makes a note to do more research on generic competitive strategies to verify VanDriesen’s assertions before publishing the final draft of her report.

Smith knows that a firm’s generic strategy should be the centerpiece of a firm’s strategic plan. On the basis of a compilation of research and documents, Smith makes three observations about the North Winery and its strategic planning process. Which of these observation(s) least support the conclusion that the North Winery’s strategic planning process is guided and informed by its generic competitive strategy? (Select all that apply. In order to receive full credit, you must make a selection for each option. For correct answer(s), click the option once to place a check mark. For incorrect answer(s), click the option twice to place an "x".)

• North Winery's price and cost forecasts account for future changes in the structure of the French wine industry.unchecked
• North Winery is a list of unrelated action items that does not lead to a sustainable competitive advantage.unanswered
• North Winery places each of its business units into one of three categories: build, hold, or harvest.unanswered
• North Winery's price and cost forecasts account for future changes in the structure of the French wine industry.unanswered
• North Winery uses market share as the key measure of its competitive position.unanswered
• North Winery places each of its business units into one of three categories: build, hold, or harvest.unanswered
• North Winery uses market share as the key measure of its competitive position.unanswered

The following table shows the nominal returns on Brazilian stocks and the rate of inflation.

Year Nominal Return (%) Inflation (%)

2012 0.5 6.8

2013 -14.0 6.9

2014 -12.0 7.4

2015 -42.4 11.7

2016 67.2 7.3

2017 27.9 3.9

a. What was the standard deviation of the market returns?

b. Calculate the average real return.

Ebenezer Scrooge has invested 50% of his money in share A and the remainder in share B. He assesses their prospects as follows:

A B

Expected return (%) 18 19

Standard deviation (%) 20 24

Correlation between returns 0.3

a. What are the expected return and standard deviation of returns on his portfolio?

b. How would your answer change if the correlation coefficient were 0 or –0.30?

Compare all the company ratios with all the industry ratios. What does the ratios indicate

5.7 Calculating Profitability Index Bill plans to open a self serve grooming center in a storefront. The grooming equipment will cost $325,000, to be paid immediately. Bill expects after tax cash inflows of $67,000 annually for 7 years, after which he plans to scrap the equipment and retire to the beaches of Nevis. The first cash inflow occurs at the end of the first year. Assume the required return is 13 percent. What is the project’s PI? Should it be accepted?

1. Exchange Traded Funds have certain advantages over index mutual funds in terms of taxation

2. Private Equity Companies

3. Captive structures are created by intermediaries to

4. Assets that have been used to create asset-backed securities include all of the following except,

5. While life insurance companies have portfolios that are similar to pension plans, the portfolios of property casualty companies tend to be shorter term, fixed income securities.

Your brother has offered to give you either $50,000 today or$ 100,00 in 11years. If the interest rate is 5 %per​ year, which option is​ preferable?The present value of the future amount​ (amount received in11years) is ? ​(Round to the nearest​ dollar.)

Which option is​ preferable?  ​(Select the best choice​ below.)

Take the present amount offered because it is less than the future amount.

Take the future amount because it is twice as much as the amount offered today in present value terms.

Take the future amount because it is greater than the amount offered today

Take the present amount offered because it is greater than the present value of the future amount

what is a financial statement derivative.

Identify an example and how company’s use to leverage the business activities.

Problem 15-6 Additional Funds Needed (LG15-4)

Suppose that Wind Em Corp. currently has the balance sheet shown below, and that sales for the year just ended were $7.2 million. The firm also has a profit margin of 30 percent, a retention ratio of 20 percent, and expects sales of $8.2 million next year.

If all assets and current liabilities are expected to grow with sales, what amount of additional funds will Wind Em need from external sources to fund the expected growth? (Enter your answer in dollars not in millions.)