Problem 5

5.1 Gordon’s model of equity valuation assumes k < g. (True / False)

5.2 High P/E multiple may indicate, all else equal:

              a. High growth

              b. Low systematic risk

              d. Overvaluation

              e. Any of the above

5.3 Under Gordon’s model of equity valuation, the same dividend amount is paid out in perpetuity. (True / False)

5.4 Retention ratio is the percentage of earnings that is paid out as dividends. (True / False)

5.5 Firm X is priced at $10 per share. Expected dividend next year is $1 per share, and the expected stock price next year is $11. Therefore, stock is expected to earn (11 + 1 – 10)/10 = 20%. This implies that the company has required rate of return that is also 20%. (True / False)

5.6 When ROE < k, increasing _______ should increase the intrinsic value of equity.

              a. Retention ratio

              b. Dividend payout

              c. Dividend growth rate

5.7 Present Value of Growth Opportunities PVGO can never be negative. (True / False)

5.8 Required rate of return on equity can be found from which formula?

              a. CAPM

              b. Gordon’s Model

              c. ROE

              d. Either of the above, depends on what information is provided

5.9 If the company is correctly priced under Gordon’s model, and changing dividend payout policy does not change stock price, it must be that

              a. ROE = k

              b. The company is a cash cow

              c. PVGO > 0

5.10 Growth in dividends can be represented as sustainable growth rate in Gordon’s model. (True / False)

Use the Black-Scholes formula for the following stock:

Recalculate the value of the call with the following changes:

Calculate each scenario independently. (Round your answers to 2 decimal places.)

Value of the Call Option

a.=

b.=

c.=

d.=

e.=

1. You are considering three independent projects: A, B, and C. Given the following free cash flow information, calculate the payback period for each. Required rate of return is 9%. (1 Mark)

If you require a 3-year payback before an investment can be accepted, which project(s) would be accepted? (0.5 Mark)

Kirk is a bright individual who is being groomed for the Controller’s position in a medium-sized manufacturing firm. After his first year as Assistant Controller, the officers of the firm were starting to include him in major company functions. For instance, today he was attending the monthly financial statement summary given at a prestigious consulting firm. During the meeting, Kirk was intrigued at how all the financial data he had been accumulating was transformed by the consultant into revealing charts and graphs. Kirk was generally optimistic about the session and the company’s future until the consultant started talking about the new manufacturing plant the company was adding to the current location and the costs per unit of the chemically plated products it produced. At that time, Bob (the President) and John (the chemical engineer) started talking about waste treatment and disposal problems. John mentioned that the current waste facilities were not adequate to handle the waste products that would be created by the “ultramodern” new plant in a manner that would meet the industry's fairly high standards, although they could still comply with federal standards. Kirk’s boss, Henry, noted that the estimated cost per unit would be increased if the waste treatment facilities were upgraded according to recent industry standards. While industry standards are presently more stringent than federal regulations, environmentalists are strongly pressuring for more stringent regulations at the federal level. Bob mentioned that since their closest competitor did not have the waste treatment facilities that already existed at their firm, he was not in favor of further expenditure in this area. Most managers at this meeting resoundingly agreed with Bob, and business continued on to another topic. Kirk did not hear a word during the rest of the meeting. He kept wondering how the company could possibly have such a casual attitude toward the environment. Yet he did not know if, how, or when he could share his opinion. Soon he started reflecting on whether this was the right firm for him. What should Kirk do? Putting Corporate Responsibility first, but recognizing the politics at play, what is the most ethical thing to do? The most practical? What strategy would you suggest to Kirk if he came to you for advice?

The price of Build A Fire Corp. stock will be either $52 or $83 at the end of the year. Call options are available with one year to expiration. T-bills currently yield 5 percent. a. Suppose the current price of the company's stock is $60. What is the value of the call option if the exercise price is $50 per share? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Value of the call option $ b. Suppose the exercise price is $80 and the current price of the company's stock is $60. What is the value of the call option now? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Value of the call option $

How do the institutional arrangements of local governments influence the services they provide?

It is your job to determine your company’s marginal cost of capital schedule. The firm’s current capital structure, which it considers optimal, consists of 30% debt, 20% preferred stock, and 50% common equity. The firm has determined that it can borrow up to $15 million in debt at a pre-tax cost of 7%, an additional $9 million at a pre-tax cost of 9%, and any additional debt funds at 11%. The firm expects to retain $25 million of its earnings; any additional income can be raised by issuing new common stock. The firm’s common stock currently trades at $30 per share, and it pays a $3.00 per share dividend. Dividends are expected to grow at a 5% annual rate over time. If the firm issues new common stock it will be sold to the public at a 10% discount. There will also be a $2.00 per share flotation cost. Preferred stock can be issued in unlimited quantities at a pre-tax cost of 12%. If the firm decides to raise more than $80m in capital, what is the cost of that capital? Assume a tax rate of 40%.

Question 12 options:

Sequoia Furniture Company’s sales over the past three months, half of which are for cash, were as follows:

a. Assume that Sequoia’s collection period is 60 days. What would be its cash receipts in May? What would be its accounts receivable balance at the end of May?

Cash receipts

Accounts receivable balance

b. Now assume that Sequoia’s collection period is 45 days. What would be its cash receipts in May? What would be its accounts receivable balance at the end of May?

What factors should be considered when deciding if a government should follow GAAP?

QUESTION 4

You are given the following data about expected returns on a security on the LUSE where different states of the economy have the same probability of occurrence:

State                                                  Return

Strong growth                                   9.0%

Normal growth                                  6.5%

Weak growth                                     2.5%

Recession                                         -4.5%

Required:

Compute and fully interpret the following for the investment:

1. The Expected return for the security.

                                                                                                            [3 Marks]

2. The volatility of the security returns using the semi deviation.

                                                                                                            [6 Marks]

3. Evaluate the security’s performance assuming a benchmark target rate of 3.5%.

                                                                                                            [4 Marks]

4. Explain the rationale behind the security performance evaluation method used in (c) above.

                                                                                                            [7 Marks]

Total 20 Marks

explain why the price of a bond and in the interest earned on the holding of a bond must move opposite direction.

Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 10 percent, and that the maximum allowable payback and discounted payback statistics for your company are 3.0 and 3.5 years, respectively. Time: 0 1 2 3 4 5 Cash flow –$351,000 $66,800 $85,000 $142,000 $123,000 $82,200 Use the PI decision rule to evaluate this project. (Do not round intermediate calculations. Round your final answer to 2 decimal places.) PI Should it be accepted or rejected? Rejected Accepted

Benton is a rental car company that is trying to determine whether to add 25 cars to its fleet. The company fully depreciates all its rental cars over five years using the straight-line method. The new cars are expected to generate $220,000 per year in earnings before taxes and depreciation for five years. The company is entirely financed by equity and has a 21 percent tax rate. The required return on the company’s unlevered equity is 15 percent and the new fleet will not change the risk of the company.

a. What is the maximum price that the company should be willing to pay for the new fleet of cars if it remains an all-equity company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

b. Suppose the company can purchase the fleet of cars for $655,000. Additionally, assume the company can issue $430,000 of five-year debt to finance the project at the risk-free rate of 6 precent. All principal will be repaid in one balloon payment at the end of the fifth year. What is the APV of the project?

Do you think companies should create a special marketing plan / strategy that focuses on first adopters and their adoption habits when a new product is launched? Why or why not?