Problem 1: Enterprise Value (20 Marks) Jasper Holdings Ltd achieved sales of $400 million in 2019. Analysts expect Jasper Holdings Ltd's sales to grow at 10% p.a. in 2020 but this growth will slow by 1% p.a. to a long-run growth rate of 5% p.a. by 2025. EBIT is expected to be 9% of sales, increases in net working capital requirements to be 7% of any increase in sales, and net investment (capital expenditures in excess of depreciation) to be 6% of any increase in sales. Jasper Holdings Ltd has $45 million in cash, $66 million in long-term debt, and 13 million shares outstanding. Assume a tax rate of 30% and a weighted average cost of capital of 11%. Jasper's Free Cash Flows: 2019 400 (5 millions) Sales Growth versus prior year EBIT (9% of Sales) Less Income Tax (30% EBIT) Less Net Investment (6% ASales) Less: Inc. in NWC (7% ASales) FREE CASH FLOW 2020 2021 2022 2023 2024 2025 440.0 479.6 518.0 554.2 587.5 616.9 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 39.6 43.2 46.6 49.9 52.9 55.5 11.9 12.9 14.0 15.0 15.9 16.7 2.4 2.4 2.3 2.0 1.8 2.8 2.8 2.7 2.5 2.3 2.1 22.5 25.1 27.6 30.2 32.7 35.0 2.2 A. Using the free cash flow forecast and the assumed long-term growth rate of 5% p.a. after year 2025, calculate Jasper Holdings Ltds terminal enterprise value in year 2025. (4 marks) B. Calculate current Jasper's enterprise value. (6 marks) C. What is your estimate of the value per share of Jasper in early 2020? (4 marks) D. What is your estimate of Jasper's stock value per share in part (c) above if the free cash flow at the end of year 2020 is $22.5 million and such free cash flow will grow by 5% p.a. from year 2020 onwards? (6 marks) Problem 2: Investment Decision Rules (20 Marks) James is trying to figure out the optimal number of years to replace his machinery. The machinery will be replaced continously for the foreseeable future. The machinery costs $35,000. The maintenance costs for each respective year are shown in the table below together with the salvage value of the machinery if it were to be sold in that year. James has decided to keep the machinery for at least 4 years but is uncertain whether a 4 or 5 year replacement period is most appropriate. The discount rate is 10% per annum and assume zero taxes. 1 2 3 4 5 0 -35,000 Year Initial cost Maintenance costs Salvage value (if sold) -2,100 32,000 -3,200 28,000 -4,300 23,000 -5,400 17,000 -6,500 10,000 A. Using annuity equivalent method, determine the best replacement period for James (consider only 4 or 5 years). (9 marks) B. Using perpetuity method, determine the best replacement period for James (consider only 4 or 5 years). Do you arrive with the same conclusion as part (a) above? Explain why? (6 marks) C. If the salvage value of the machinery in year 5 turns out to be $15,000 rather than $10,000 as you initially expected, would you recommend James to replace the machinery in 4 or 5 years? (5 marks) Problem 3: Capital Budgeting (20 Marks) Jupiter Corporation is planning to undertake a new project that is expected to have a 5-year economic life. The project will have an initial equipment cost of $150,000. Installation and shipping charges for the equipment are estimated at $20,000. The equipment will be depreciated straight line to zero over a five year period. A working capital investment of $20,000 is required immediately to undertake the project. The working capital will be recovered at the end of the project. The revenues from the project in year 1 are expected to be $70,000 and remains constant till the end of the project life. Operating costs exclusive of depreciation are estimated to be $17,000 in year 1. These costs are expected to remain constant till the end of the project life. The firm's marginal tax rate is 40%. The expected salvage value of the equipment at the end of year 5 is $25,000. If the firm's cost of capital is 15%, should the project be undertaken? A. Calculate the initial investment of Jupiter Corporation. (3 marks) B. Calculate the depreciation per year. (2 marks) C. Calculate the book value of the equipment after three years. (3 marks) D. What is the after-tax salvage value of the equipment at the end of year 5? (4 marks) E. What are the annual free cash flows for this project in the first four years? (4 marks) F. What is the NPV of this investment? Would you accept or reject this new investment? (4 marks) Problem 4: Portfolio Theory (20 marks) Consider a market with two risky assets A and B. M is the market portfolio. F is the risk- free asset. This is a perfect market with no taxes or other frictions, and the prices given are equilibrium prices. All returns are annual returns. Expected Return Standard Deviation Beta (B) A B M F 5.97% 9.35% 9.00% 2.00% 17.00% 21.00% 12.00% 0.00% Correlation Matrix AB M F 1.00 0.20 0.40 0.00 0.20 1.000.600.00 0.40 0.60 1.00 0.00 0.00 0.00 0.00 1.00 ?? ?? 1.00 0.00 A. Calculate the beta of security A and B. If you are forming an equal weighted portfolio which consist of security A and B, what is the portfolio beta? (5 marks) B. Suppose that you are forming a portfolio (called portfolio 1) with 35% weighting on security A and 65% weighting on security B. Calculate the expected return and the standard deviation of return for portfolio 1. Show your calculations. (6 marks) C. Suppose that you intend to form a portfolio (called portfolio 2) which consists of the market portfolio (M) and the risk-free asset (F) with the expectation of obtaining the same expected return as portfolio 1 in part (b) above. What weights would achieve this result? Show your calculations. (4 marks) D. What is the difference between covariance and correlation? (2 marks) E. What is the role played by correlation in determining portfolio expected return and risk? Explain. (3 marks) Problem 5: CAPM and Cost of Capital (20 marks) Columbia Gas Company (CGC) is a publicly listed company with a current share price of $25 per share. CGC has 33 million shares outstanding and $100 million in long-term debt. CGC's long-term debt consists of bonds issued with a face value of $100 million with 10 years to maturity with annual coupon rate of 11%(APR). The long-term bonds are currently trading at par value. Columbia Gas Company (CGC) has a standard deviation of 36% and a correlation with the market of 0.85. Assume the risk-free rate is 4% and the market portfolio has an expected return of 13% and a standard deviation of 22%. The corporate tax rate is 30%. A. What are the three main assumptions of capital asset pricing model (CAPM)? Are these assumptions realistic in the real world? Explain. (6 marks) B. Calculate CGC's beta with the market? (3 marks) C. Calculate CGC's cost of equity? (3 marks) D. Calculate CGC's after-tax cost of debt? (3 marks) E. Calculate CGC's weighted average cost of capital (WACC)