Assume all risks involved in this question are idiosyncratic (firm-specific) so investors' discount rate is always the risk-free rate, 10%.  A firm currently has two assets: $60 million cash and a risky investment project A that lasts for one year. It also has $121 million debt payment due next year. The firm faces an additional risky investment B that also lasts one year, which requires initial investment of $60 million today.

                                                             Scenario 1 (50%)                    Scenario 2 (50%)

cash flow of Project A                                  $110  mil                              $44 mil

cash flow of Project B                                    $77  mil                              $33 mil

If the manager's objective is to maximize firm value, will they invest in project B?  If the manager's objective is to maximize shareholder value, will they invest in project B? Please explain.

 

 

2.Flagstaff Enterprises is expected to have $8 million free cash flow (CFFA) in the coming year, and this free cash flow is expected to grow at rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in the 35% corporate tax bracket. If Flagstaff Enterprises current debt to equity ratio is 0.5, the value of KYZ as an all equity firm would be ___ million.  

 

3.Christiam has 200,000 shares of common stock outstanding at a price per share of $47 and a rate of return of 15 %. The firm has 35,000 shares of preferred stock outstanding at a price of $30 a share. The preferred stock has a par value of $200, paying $4 dividend annually. The outstanding debt has a total face value of $4,500,000 and currently sells for 103 % of face. The yield-to-maturity on the debt is 8.5 %. The corporate tax rate is 30%. What is the firm's weighted average cost of capital (WACC) %? 

 

 

4.You work for Hedvig Mopeds Co., which manufactures the world's finest city mopeds.  After spending $1.5 million on marketing survey, your boss has decided to grow the firm by producing a new moped line "Ariel".

• The project has an anticipated economic life of 5 years. To produce "Ariel", your company will build a new factory in Lantau Island. The factory will cost HK$12 million today and has a salvage value of $3 million. You plan to use straight-line depreciation and depreciate the factory to a book value of $2 million in 5 years.
• You expect annual sales of mopeds to be $18 million in years 1 through 5 and total (fixed and variable) costs to equal 70% of annual sales. You also project that 40% of those revenues will come from your existing customers switching from old mopeds, which also had costs equal to 70% of sales.
• If the company goes ahead with the proposed project, it will require an immediate increase in current assets of $2.5 million but will also result in an immediate increase of $1 million in current liabilities. Any change in net working capital that occurs at the beginning of the project will be recovered at the end of the project. The company's annual interest expenses are $800,000.
• The corporate tax rate is 20%. Hedvig Moped's weighted average cost of capital is 11%.
• Assume all sales revenue is received in cash, all operating costs and income taxes are paid in cash, and all cash flows occur at the end of the year.

a) Calculate relevant cash flows for this project in years 0 through 5.

b) What is the net present value of this project? Should the company introduce this new product line? Why?

c) If instead managers choose to depreciate the factory to a book value of 0, would the NPV be higher or lower? Please briefly explain.

d) Assume that you have the option to sell the factory for $6 million at the end of Year 4 and quit the business (so no cash flows in year 5). What is the NPV of building the factory, running it for 4 years, and then selling the factory for $6 million at the end of year 4? (This question is independent of part c.)

e) It turns out that if the company introduces this new product line, it needs to use an existing structure that the company built 3 years ago for $4 million. You figure out that this existing structure can be rent for the equivalent of $0.3 million each year. Does this affect your decision? (This question is independent of part c and part d.)