46) Suppose Autodesk stock has a beta of 2.10, whereas Costco stock has a beta of 0.75. If the risk-free interest rate is 5.5% and the expected return of the market portfolio is 14%, what is the expected return of a portfolio that consists of 70% Autodesk stock and 30% Costco stock, according to the CAPM? 47) What is the risk premium of a zero-beta stock? Does this mean you can lower the volatility of a portfolio without changing the expected return by substituting out any zero-beta stock in a portfolio and replacing it with the risk-free asset? 48) Your investment portfolio consists of $15,000 invested in only one stockMicrosoft. Suppose the risk-free rate is 5%, Microsoft stock has an expected return of 12% and a volatility of 40%, and the market portfolio has an expected return of 10% and a volatility of 18%. Under the CAPM assumptions, a. What alternative investment has the lowest possible volatility while having the same expected return as Microsoft? What is the volatility of this investment? b. What investment has the highest possible expected return while having the same volatility as Microsoft? What is the expected return of this investment?

50) A project with an initial cost of GH 10,000 has the following forecasted cash flows. Years Cash flows

1 4000

2 6000

3 5000

4 3000

The estimated project beta is 1.5 and the market return is 16%. The risk free rate is 7%. Estimate the opportunity cost of capital of the project. What is the CEQ cash flow of the project? What is the ratio of CEQ cash flow to the expected cash flow in each case? Why does this ratio declines?

51) Mining company can purchase a drilling machine for GH 50,000. It also has the option to lease the drilling machine for GH12,200 a year for a 5-year period. The expected life of the machine is given as 5 years and expected to have a salvage value of GH5000 in 5 years time. The mining company intends to buy the drilling machine a fair market value at that time. If the mining company decides to buy the machine, it can acquire financing at 20%. The tax rate is 34%. Assume depreciation is on straight line basis and lease rentals are tax deductible. Would you advice the mining company to lease the asset? (Assume payment is made at the end of the year) 52) Kunla Ltd and Cunta Ltd intend to merge. The following were observed just before the merger announcement.

Kunla Ltd Cunta Ltd

Market price per share GH 400 GH200

Number of shares 2,000,000 1,000,000

Market value of firm GH 800,000,000 GH 200,000,000

The proposed merger will create GH50,000,000 in synergies. Kunla Ltd intends to pay GH 130,000,000 cash for Cunta Ltd. What is the cost of the merger to Kunla Ltd? Compute the NPV of the merger. The managers of these firms have proposed to merge to diversify their activities and to reduce risk. Should you pay a premium for the merged firm? What convincing reasons can these managers give for the proposed merger? What roles do investment banks play in facilitating M&A deals?

53) K Ltd is contemplating the acquisition of B Incorporated. The value of the two companies as separate entities is GH 60 million and GH 20 million, respectively. K estimates that by combining the two companies, it will reduce marketing and administration cost by GH 1400,000 per year in perpetuity. K can either pay GH 30 million cash for B Inc. or offer B a 50% holding in K. The opportunity cost of capital is 10%. a) What is the gain from merger? b) What is the cost of the cash offer? c) What is the cost of the stock offer? d) What is the NPV of the acquisition under the cash offer? e) What is the NPV under the stock offer? f) When will managers prefer to finance a deal with stock?

54) You own all the equity of R.G.C. I Ltd. The company has no debt. The companys annual cash flow is GH900,000 before interest and taxes. The company tax rate is 35%. You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of GH2,000,000. What is the total cash flow to the investors? What is the value of the unlevered firm? What is the value of the levered firm? Assuming a bankruptcy cost of GH8000, what is the value of the levered firm after considering bankruptcy cost? 55) Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an all equity firm, has 15,000 shares of stock outstanding, currently worth GH 30 per share. Beta Corporation uses leverage in its capital structure. The market value of Betas debt is GH 65,000 and its cost of debt is 9 percent. Each firm is expected to have earnings before interest of GH 75,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow at 9 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 Corporations equity?

56) Consider the three factor APT model Factor Risk Premium Change in GNP 5% Change in energy prices -1 Change in long-term interest rates +2 Calculate the expected rate of return on the following stocks. The risk free interest rate is 7%. a. A stock whose return is uncorrelated with all three factors b. A stock with average exposure to each factor (i.e., with b = 1 for each) c. A pure play energy stock with high exposure to the energy factor (b=2) but zero exposure to the other two factors

57) A building contractor can purchase a truck from her local Toyota dealer for GH100,000. The Toyota dealer can also lease the truck for GH24,400 per year over five years. The truck has an expected life of five years. The truck is expected to be worth GH10,000 in five years and the contractor intends to buy it at fair market value at that time. If the contractor wants to purchase the truck, she must borrow the money from IBK Bank at a current rate of 20%. The contractors tax rate is 30% for simplicity, assume straight-line depreciation and the entire lease rentals are tax deductible. The contractor will incur GH5,000 in maintaining and insuring the truck. Would leasing be a better option? 58) What is the relative tax advantage of corporate debt if the corporate tax rate is Tc=0.35, the personal tax rate is Tp=0.35, but all equity income is received as capital gains and escapes tax entirely ( T pE =0)? How does the relative tax advantage change if the company decides to pay out all equity income as cash dividends that are taxed at 15%? 59) Pelamed Pharmaceuticals has EBIT of $325 million in 2006. In addition, Pelamed has interest expenses of $125 million and a corporate tax rate of 40%. a. What is Pelameds 2006 net income? b. What is the total of Pelameds 2006 net income and interest payments? c. If Pelamed had no interest expenses, what would its 2006 net income be? How does it compare to your answer in part b? d. What is the amount of Pelameds interest tax shield in 2006? 60) Grommit Engineering expects to have net income next year of $20.75 million and free cash flow of $22.15 million. Grommits marginal corporate tax rate is 35%. a. If Grommit increases leverage so that its interest expense rises by $1 million, how will its net income change? b. For the same increase in interest expense, how will free cash flow change?

61) An unlevered firm, U, operates in a perfect market and has a net operating income of 250,000.00 and required rate of return on assets for firms in the industry is 12.5%. The firm issues 1,000,000.00 worth of debt with a required return of 5% and uses the proceeds to repurchase outstanding shares. There are no corporate or personal taxes. Estimate the market value and required return of the firms shares before the repurchase transaction Estimate the market value and required return of the firms remaining shares after the repurchase transaction 62) Shop Right Plc has EBIT of 10 million and there is 60 million of debt outstanding with a required rate of return of 6.5%. The required rate of return on the industry is 10% and corporate tax is 30%. Assume there are corporate taxes but no personal taxes. Determine the present value of the interest tax shield of Shop Right Plc as well as the total value of the firm Determine the gain from leverage, if personal taxes of 10% on share income and 35% on debt income exists 63) Maroc Group of Companies (MGC) Ltd is considering an investment in an item of equipment costing GH80,000. The equipment would attract a 25% annual written down allowance. The operating cash flows are expected to be as follows: Year GH 1 30,000 2 40,000 3 20,000 The investment would also require additional working capital of GH25,000 in the year of investment which will be recovered at the end of the project. The project is expected to have a useful life of three years after which the investment would be scrapped at a value of GH50,000. The rate of tax on profits is 30%. The companys cost of capital is 8%. As a financial manager of MGC: Estimate the cost of capital for MGC Assess the viability of the investment using the Net Present Value (NPV) approach Determine the Modified Internal Rate of Return (MIRR) 64) Accra Hearts of Oak FC Ltd wants to invest in two projects, namely, A & B. The expected return on projects A & B are 20% and 50% respectively while the risk associated with project A is 13% and that of B is 71%. Accra Hearts of Oak FC Ltd planned to invest 70% of its available funds in project A and the remaining in project B. The correlation coefficient between the returns of the projects is -0.10. Estimate the returns from the proposed portfolio of projects A & B Calculate the risk of the portfolio Suppose the correlation coefficient between A & B was -1.0. How should Accra Hearts of Oak Ltd invest its funds to achieve a zero-risk portfolio? Explain what capital structure theory attempts to do and demonstrate useful lessons that can be learned from capital structure theory. Using the free cash flow valuation model, identify avenues by which capital structure can affect the weighted average cost of capital and firm value. Explain the difference between financial risk and business risk? What factors inuence a rms business and financial risk? Assume you have just been hired as business manager of EdiPizza, a pizza restaurant located adjacent to campus. The companys EBIT was GH500,000 last year, and since the universitys enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, EdiPizza plans to pay out all earnings as dividends. The management group owns about 50% of the stock, and the stock is traded in the over-the counter-market. The rm is currently nanced with all equity; it has 100,000 shares outstanding; and price of stock is GH25 per share. When you took your MBA corporate nance course, your instructor stated that most rms owners would be nancially better off if the rms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a rst step, assume that you obtained from the rms investment banker the following estimated costs of debt for the rm at different capital structures:

Percent Financed with Debt, wd Cost of debt (Rd)

0% 0

20% 8%

30% 8.5%

40% 10%

50% 12%

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. EdiPizza is in the 40% corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%. Now, to develop an example that can be presented to EdiPizza s management to illustrate the effects of nancial leverage, consider two hypothetical rms: Firm U, which uses no debt nancing, and Firm L, which uses GH10,000 of 12% debt. Both rms have GH20,000 in assets, a 40% tax rate, and an expected EBIT of GH5,000. Required: Construct partial income statements, which start with EBIT, for the two rms. Now calculate ROE for both rms. What does (ii) illustrate about the impact of nancial leverage on ROE? e) What happens to ROE for Firm U and Firm L if EBIT falls to GH3,000? What does this imply about the impact of leverage on risk and return? f) With reference to EdiPizza and for each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. g) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity.

There is a conflict of interest between stockholders and managers. In theory, stockholders are expected to exercise control over managers through the annual meeting or the board of directors. In practice, why might these disciplinary mechanisms not work? Stockholders can transfer wealth from bondholders through a variety of actions. Explain three (3) key actions that stockholders can undertake to transfer wealth from bondholders.

Union Pacific Rail road reported net income of GH770million after interest expenses of GH320 million in a recent financial year. (The corporate tax rate was 36%.) It reported depreciation of GH960million in that year, and capital spending was GH1.2 billion. The firm also had GH4billion in debt outstanding on the books, was rated AA (carrying a yield to maturity of 8%), and was trading at par (up from GH3.8 billion at the end of the previous year). The beta of the stock is 1.05, and there were 200 million shares outstanding (trading at GH60 per share), with a book value of GH5 billion. Union Pacific paid 40% of its earnings as dividends and working capital requirements are negligible. (The Treasury bill rate is 7%, and risk premium was 5.5%).

The Borstal Company has to choose between two machines that do the same job but have different lives. The two machines have the following costs:

Year Machine A $ Machine B $

0 40,000.00 50,000.00

1 10,000.00 8,000.00

2 10,000.00 8,000.00

3 10,000.00 + replacement 8,000.00

4

8,000.00 + replacement

These costs are expressed in real terms. a. Suppose you are Borstals financial manager. If you had to buy one or the other machine and rent it to the production manager for that machines economic life, what annual rental payment would you have to charge? Assume a 6% real discount rate and ignore taxes. b. Which machine should Borstal buy? c. Usually the rental payments you derived in part (a) are just hypotheticala way of calculating and interpreting equivalent annual cost. Suppose you actually do buy one of the machines and rent it to the production manager. How much would you actually have to charge in each future year if there is steady 8% per year inflation? (Note: The rental payments calculated in part (a) are real cash flows. You would have to mark up those payments to cover inflation.)

As a result of improvements in product engineering, United Automation is able to sell one of its two milling machines. Both machines perform the same function but differ in age. The newer machine could be sold today for $50,000. Its operating costs are $20,000 a year, but in five years the machine will require a $20,000 overhaul. Thereafter, operating costs will be $30,000 until the machine is finally sold in year 10 for $5,000. The older machine could be sold today for $25,000. If it is kept, it will need an immediate $20,000 overhaul. Thereafter, operating costs will be $30,000 a year until the machine is finally sold in year 5 for $5,000. Both machines are fully depreciated for tax purposes. The company pays tax at 35%. Cash flows have been forecasted in real terms. The real cost of capital is 12%. Which machine should United Automation sell? Explain the assumptions underlying your answer.

The presidents executive jet is not fully utilized. You judge that its use by other officers would increase direct operating costs by only $20,000 a year and would save $100,000 a year in airline bills. On the other hand, you believe that with the increased use the company will need to replace the jet at the end of three years rather than four. A new jet costs $1.1 million and (at its current low rate of use) has a life of six years. Assume that the company does not pay taxes. All cash flows are forecasted in real terms. The real opportunity cost of capital is 8%. Should you try to persuade the president to allow other officers to use the plane?

The following question illustrates the APT. Imagine that there are only two pervasive macroeconomic factors. Investments X, Y, and Z have the following sensitivities to these two factors:

Investments b1 b2

X 1.75 0.25

Y 1.00 2.00

Z 2.00 1.00

Assume that the expected risk premium is 4% on factor 1 and 8% on factor 2. Treasury bills offer zero risk premium. a. According to the APT, what is the risk premium on each of the three stocks? b. Suppose you buy $200 of X and $50 of Y and sell $150 of Z. What is the sensitivity of your portfolio to each of the two factors? What is the expected risk premium? c. Suppose you buy $80 of X and $60 of Y and sell $40 of Z. What is the sensitivity of your portfolio to each of the two factors? What is the expected risk premium? d. Finally, suppose you buy $160 of X and $20 of Y and sell $80 of Z. What is your portfolios sensitivity now to each of the two factors? And what is the expected risk premium? e. Suggest two possible ways that you could construct a fund that has a sensitivity of .5 to factor 1 only. (Hint: One portfolio contains an investment in Treasury bills.) Now compare the risk premiums on each of these two investments. f. Suppose that the APT did not hold and that X offered a risk premium of 8%, Y offered a premium of 14%, and Z offered a premium of 16%. Devise an investment that has zero sensitivity to each factor and that has a positive risk premium.

Percival Hygiene has $10 million invested in long-term corporate bonds. This bond portfolios expected annual rate of return is 9%, and the annual standard deviation is 10%. Amanda Reckonwith, Percivals financial adviser, recommends that Percival consider investing in an index fund that closely tracks the Standard & Poors 500 index. The index has an expected return of 14%, and its standard deviation is 16%. a. Suppose Percival puts all his money in a combination of the index fund and Treasury bills. Can he thereby improve his expected rate of return without changing the risk of his portfolio? The Treasury bill yield is 6%. b. Could Percival do even better by investing equal amounts in the corporate bond portfolio and the index fund? The correlation between the bond portfolio and the index fund is +0.1.

Consider the following simplified APT model:

Factor Expected Risk Premium

Market 6.4%

Interest Rate -0.6%

Yield Spread 5.1%

Factor Risk Exposures

Market Interest Rate Yield Spread

Stock Stock (b1) (b2) (b3)

P 1.0 -2.0 -0.2

P2 1.2 0 0.3

P3 0.3 0.5 1.0

Calculate the expected return for the above stocks. Assume risk free rate is 5%. Consider a portfolio with equal investments in stocks P, P 2 , and P 3 What are the factor risk exposures for the portfolio? What is the portfolios expected return?

A project has the following forecasted cash flows:

Cash flows

C0 C1 C2 C3

(100) 40 60 50

The estimated project beta is 1.5. The market return r m is 16%, and the risk-free rate r f is 7%. a. Estimate the opportunity cost of capital and the projects PV (using the same rate to discount each cash flow). b. What are the certainty-equivalent cash flows in each year? c. What is the ratio of the certainty-equivalent cash flow to the expected cash flow in each year? d. Explain why this ratio declines.

Yang Co. is expected to pay a $21.00 dividend next year. The dividend will decline by 10 percent annually for the following three years. In year 5, Yang will sell off assets worth $100 per share. The year 5 dividend, which includes a distribution of some of the proceeds of the asset sale, is expected to be $60. In year 6, the dividend is expected to decrease to $40 and will be maintained at $40 for one additional year. The dividend is then expected to grow by 5 percent annually thereafter. If the required rate of return is 12 percent, what is the value of one share of Yang?