Hello! I am looking for help on question 7 on this assignment. I am attaching the assignment, question 7 is the last question on the assignment.

ECON 255 Problem Set 3 1. Real Cash Flows (5 points) When Ned Stark died, wife Catelyn Stark vowed to place fresh flowers on her grave every Sunday as long as she lived. The week after he died in 1962, a bunch of fresh flowers that the former queen of the North thought appropriate for Ned Stark cost about $8. Based on actuarial tables, \"Catelyn\" could expect to live for 30 years after the king of North died. Assume that the EAR is 10.7 percent. Also, assume that the price of the flowers will increase at 3.5 percent per year, when expressed as an EAR. Assuming that each year has exactly 52 weeks, what is the real present value of this commitment? Catelyn began purchasing flowers the week after Ned died. 2. Growth Opportunities (15 points) The Bootleg Inc. currently has earnings per share of $8.25. The company has no growth and pays out all earnings as dividends. It has a new project which will require an investment of $1.60 per share in one year. The project is only a two-year project, and it will increase earnings in the two years following the investment by $2.10 and $2.45, respectively. Investors require a 12 percent return on Bootleg stock. a) What is the value per share of the company's stock assuming the firm does not undertake the investment opportunity? b) If the company does undertake the investment, what is the value per share now? c) Again, assume the company undertakes the investment. What will the price per share be four years from today? 3. Returns and Standard Deviations (10 points) Consider the following information State of Probability of Rate of return if State Occurs Economy State of Stock A Stock B Stock C Economy Boom 0.20 0.30 0.45 0.33 Good 0.35 0.12 0.10 0.15 Poor 0.30 0.01 -0.15 -0.05 Bust 0.15 -0.6 -0.30 -0.09 a) Your portfolio is invested 30 percent each in A and C, and 40 percent in B. What is the expected return of the portfolio? b) What is the variance of this portfolio? The standard deviation? 4. Covariance and Correlation (10 points) Based on the following information, calculate the expected return and standard deviation of each of the following stocks. Assume each state of the economy is equally likely to happen. What are the covariance and correlation between the returns of the two stocks? State of Stock A Stock B Economy Bear 0.082 -0.065 Normal 0.095 0.124 Bull 0.063 0.185 5. Multifactor Models (15 points) Suppose stock returns can be explained by a three-factor (1, 2, 3) model Ri = RF + 1F1 + 2F2 + 3F3 Assume there is no firm-specific risk and that the risk free rate is 2%. There are four securities in this economy 1 2 3 Stock A 0 0 1 Stock B 0 1 0 Stock C 0.5 0 0 Stock D 0.15 0.3 0.4 a) If your portfolio consists of 50% in stock A and 50% in stock B. i. What is the expression for the return in your portfolio as a function of the riskpremiums for the factors? ii. What is the return portfolio if the risk-premiums are 1 2 3 Risk-Premium 2% 3% 4% b) If your portfolio consists of 40% in stock A, 30% in stock B and 30% in Stock C. i. What is the expression for the return in your portfolio as a function of the riskpremiums for the factors? ii. What is the return portfolio if the risk-premiums are 1 2 3 Risk-Premium 4% 3% 2% c) If your portfolio consists of 100% in stock D. i. What is the expression for the return in your portfolio as a function of the riskpremium for the factors? ii. What is the return portfolio if the risk-premium are 1 2 3 Risk-Premium 4% 3% 2% 6. Arbitrage Pricing Theory (20 points) Assume that the returns on individual securities are generated by the following two-factor model Ri = E(Ri) + i1F1 + i2F2 Where Ri is the return on security i and F1t and F2t are market factors with zero expectation and zero covariance. Also assume that there is a capital market for four securities. Short sales, (i.e., negative positions) are permitted. Security 1 2 E(R) A 1.0 1.0 20% B 0.5 2.0 20% C 1.0 0.5 10% D 2 1.0 10% a) Construct a portfolio containing (long or short) securities A and B, with a return that does not depend on factor 1, F1, in any way.1 Compute the expected return and 2p coefficient for this portfolio. b) Following the procedure in (a), construct a portfolio containing securities C and D with a return that does not depend on factor 2, F2. Compute the expected return and 2p coefficient for this portfolio. c) If there is a risk-free asset with an expected return equal to 5%, describe a possible arbitrage opportunity in such detail that an investor could easily implement it. d) What effect would the existence of these kinds of arbitrage opportunities have on the capital markets for these securities in the short run and the long run? 7. Project Evaluation (25 points) You have been hired as a financial consultant for Crazy Inc. Apps (CIA), a publicly traded firm that is the leader in Apps for smartphones. The company is looking at setting up a new computer lab to produce the next generation of Apps. This will be a five-year project. The company bought some land three years ago; the value of the land today is $7.1 M. In five years, the after-tax value of the land will be $7.4 M. The company wants to build its new lab in this land. The cost of the building and equipment of the lab will be $40M. Here is some more info on CIA: Debt 260,000 bonds outstanding with 6.8% coupon, 25 years to maturity, selling for 103% of par; the bonds have a $1,000 par value each and make semiannual payments Common 9,500,000 shares outstanding, selling for $67 per share; the (CAPM) beta Stock is 1.25 Preferred 450,000 shares of 5.25% preferred stock outstanding, selling for $84 per Stock share and having a par value of $100 Market 7% expected market risk premium; 3.6% risk-free rate 1 Hint: Such a portfolio will have 1p = 0. CIA has decided to raise the funds needed to build the lab by issuing new shared of common stock, without any intermediary or underwriter. CIA's tax rate is 35%. The project requires $1,400,000 in initial net working capital investment to get operational. a) Calculate the project's initial Time 0 cash flow, taking into account all side effects. b) The new lab is somewhat riskier than a typical project for DEI, because it is a new untested idea. You should increase the discount rate of this project by 2% to account for the added risk. Calculate the appropriate discount rate to use when evaluating the project. c) The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (that is, the end of Year 5), the building and equipment can be scrapped for $8.5M. What is the after-tax salvage value of this plant and equipment? d) The company will incur $7,9M in annual fixed costs. The plan is to sell 20 M Apps per year and sell them for $1 each. The variable production costs for each App are zero. What is the annual operating cash flow (OCF) from this project? CIA's comptroller is primarily interested in the impact of CIA's investments on the bottom line of reported accounting statements. What is the accounting break-even quantity of Apps sold for this project? e) Finally, DEI's president is a humble man with humble tastes. All he wants to know is the Apps project's IRR and NPV