question 1

XYZ Investment Fund has a total investment of $400 million in five stocks:

Stock Investment Beta

A $120 million 0.5

B 100 million 2.0

C ? 4.0

D 80 million 1.0

E 40 million 3.0

The risk free rate is 7%, and the market return has the following probability distribution:

Probability Market Return

0.1 8%

0.2 10

0.4 12

0.2 14

0.1 16

a. What is the estimated equation for the security market line (SML)?

b. Compute the required rate of return on the fund.

c. Suppose the management receives a proposal for a new stock. The investment needed to take a position in the stock is $50 million; it will have an expected return of 16%; and its estimated beta coefficient is 2.5. Should the new stock be purchased? At what expected rate of return would

management be indifferent to purchasing the stock?

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QUESTION 2:

Ellesmere Limited is considering bidding on a contract to supply 10 subway cars each year to the City of Toronto for the next 15 years. Use the following information to determine the bid price per subway car.

1. To build these cars the company has to upgrade the existing plant and equipment. Existing P& E has a current market value of $5,000,000 and an expected salvage value of $1,000,000 after 10 years. Upgrade will cost $10,000,000, and after 15 years, plant and equipment could be salvaged for $2,000,000.

2. If the company decided to build the subway cars then it will lose $1,200,000 per year of after tax operating income over a 10 year period from the current operations.

3. Labour and material cost is estimated to be $400,000 per subway car and the fixed cost $3,000,000 per year.

4. Subway car project will require an addition to net working capital of $3,000,000, which will be fully recovered after 15 years.

5. CCA rate is 25%, tax rate is 40% and the appropriate discount rate is 12%.

QUESTION 3:

Union Furniture Limited projects unit sales for a new line of office desk to be as follows:

Year 1 2 3 4 5

Sales 2,000 4,000 5,000 3,000 1,000

Production of office desks will require net working capital each year equal to 20% of the sales revenues of the following year. Any remaining net working capital will be fully recovered at the end of year 5. Total fixed costs are $100,000 per year, variable costs are $80 per unit, and the desks are priced at $400 each. The plant and equipment needed for production will cost $1,000,000, and will have CCA rate of 25% on declining balance, and at the end of 5 years can be sold for $100,000. Assume asset pool is closed (any gain or loss on the disposal of the plant and equipment will be taxable/tax deductible). The company has a marginal tax rate of 40% and requires a return of 15% on the projects of this type. Should the company go ahead with the new line of office desk project?

QUESTION 4:

a. Cocost Enterprises expects dividends to grow at 25% per year during the next 2 years, 15% during the 3rd year, 5% during year 4 and then will start declining at 5% per year indefinitely. Stock is currently selling for $28.85 per share, and the required rate of return is 12%. 1. What is the projected dividend for the coming year?

2. If you buy the stock 4 years from today and sell it after keeping for one year what will be the dividend yield, capital gain yield, and the total yield?

b. ShopityTechnologies Limited predicts that the company's earnings and dividends will continue to grow at 16% per year for ___ years, and after that growth will level off at 5% for the indefinite future. Shopity has just paid a dividend of $2 per share and the required rate of return on Shopity stock is 16%. If Shopity stock is currently trading at $41.09 per share, then how many years of 16% per year growth is the market predicting?

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QUESTION 5:

LonglastTechnologies Limited (LTL) an all equity firm has current EBIT of $1,000,000. It expects EBIT to increase at 5% per year forever. The corporate tax rate is 40%, and cost of unlevered equity is 12%.

LTL is considering replacing some of the equity with perpetual debt. It has been determined that risk of bankruptcy is a function of amount of debt. PV of bankruptcy related costs will be $5,000,000. LTL is considering the following debt levels.

Debt $3,000,000 $6,000,000 $9,000,000

Probability of Bankruptcy 0.10 0.30 0.60

a. Determine the optimal level of debt, and the value of the firm at that level.

b. If personal tax rate on stock income is 25%, and the personal tax rate on bond income is 43% at what debt level value of the firm be optimal

QUESTION 6:

EQ Limited and DEQ Inc are identical firms in all respects except for their capital structure.

EQ is an all equity firm with a market value of $10,000,000.

DEQ which also has a market value of $10,000,000 uses both stock and perpetual debt. DEQ has a debt/equity ratio of 3/5. Its cost of debt is 8%.

Both firms expect EBIT to be $1,500,000 per year forever. Ignore taxes.

a. Justine owns $200,000 worth of DEQ Inc. stock. What rate of return is she expecting?

b. Show how she could generate exactly the same cash flows and the rate of return by investing in EQ Limited and using the homemade leverage.

c. What is the cost of equity for EQ? For DEQ?

d. What is the rWACC for EQ? For DEQ? What is your conclusion?

QUESTION 7:

XYZ Limited is considering purchasing a widget maker. The widget maker will result in EBIT of $50,000 per year for 20 years. The widget maker will be depreciated over a 20 year period using straight-line method, and will have no salvage value. The widget maker will not add/reduce the risk of the firm. XYZ has cost of unlevered equity of 12%, and pays corporate tax at 40%. Risk free rate of return is 3%.

a. What is the maximum price XYZ should pay for the widget maker?

b. Suppose due to economic reasons provincial government is willing to lend XYZ $120,000 at 2% for 20 years. Only interest will be paid each year. Principal will be paid at the end of the 20th year. Using APV approach, what is the maximum price XYZ would be willing to pay for the widget maker if XYZ's cost of debt is 8%?

QUESTION 8:

Josee Fernandes owns 1000 shares of Axiom Limited, a multinational fertilizer company. Josee would like to remain invested in Axiom for 3 years. Axiom will pay a $5 per share dividend one year from today, $4 two years from today, and after that dividends will decline at 2% per year forever. The required rate of return on Muirga stock is 8%.

a. What is the current price of the stock?

b. Suppose Josee prefers to receive $6,000 dividend per year for the next three years. How can she accomplish this? What will be the value of her portfolio after 3 years?