Question
Question 2 Orange Inc. is considering two mutually exclusive projects (i.e., can choose either one but not both), Alpha in Country A, and Beta in
Question 2
Orange Inc. is considering two mutually exclusive projects (i.e., can choose either one but not both), Alpha in Country A, and Beta in Country B. Project Alpha requests an initial investment of $300,000 and has projected annual cash flows of $20,000, $50,000, $50,000 and $350,000 over 4 years. Project Beta requests an initial investment of $88,000 and has projected cash flows of $12,000 for the first year, and then the cash flows are projected to grow at a constant rate of 5 percent per year forever. Based on the project characteristics, the company requires an 15 percent return for Project Alpha but requires an 17 percent for Project Beta.
You require a 15 percent return on your investment and a payback period of 3 years.
- If the company requires a maximum payback period of 4 years, which investment will you choose according to the payback criterion? Why? (4 marks)
- If you apply the NPV criterion, which investment will you choose? Why? (5 marks)
- Name three disadvantages of the payback period (3 marks)
- Based on your answer in (a) and (b), which project will you finally choose? Why? (3 marks)
Question 3
Parker & Stone, Inc., is considering a new project that requires an initial fixed asset investment of 1.2 million. The project also requires an initial investment in net working capital of $250,000. The project is expected to generate $950,000 in sales and cost $400,000 every year for three years. The fixed asset follows a straight-line depreciation. After three years, the fixed asset has a zero book value but is estimated to have a market value of $200,000, and the net working capital will fully recovery. The corporate tax rate is 35%.
- What are the operating cash flows in each year? (3 marks)
- What are the cash flows from net working capital and the net capital spending in year 3? (3 marks)
- What are the CFFA in each year? (4 marks)
- If the required return is 10% for a similar risk level of project, should the company implement this project? (6 marks)
Question 4
At year beginning, you observed that the price of stock Apple was $100 and the price of Stock Orange was $900. To understand the relation between risk and return, you keep watching on the performance of the stock and the bond over the next three years. The information you observed is as follows:
| Stock Apple | Stock Orange | ||
Year | Year-end Price ($) | Dividend ($) | Year-end Price ($) | Dividend ($) |
1 | 115 | 5 | 915 | 20 |
2 | 110 | 1 | 925 | 20 |
3 | 145 | 10 | 930 | 30 |
- What is the stock Apples dividend yield in year 2? What is the Stock Oranges capital gains yield in year 3? (2 marks)
- During the 3-year observation period, what are the average annual total return of Apple and Orange? (4 marks)
- Based on the lessons learned from the capital market history, discuss your interpretation of higher risk and higher expected return. (2 marks)
Question 5
Consider the following stock information about Tencent and HSBC
State of Economy | Probability of State of Economy | Returns if State Occurs | |
| Tencent | HSBC | |
Bad | 0.30 | -10% | -5% |
Good | 0.70 | 15% | 12% |
- Whatre the expected return on each stock? (2 marks)
- Whatre the standard deviation on each stock? (4 marks)
- The risk free rate is 1.5%. Based on the CAPM, If Tencents market beta is 1.5, whats the beta of HSBC? (3 marks)
- If you invested 65 percent in Tencent and 35 percent in HSBC, what is your portfolio expected return? The standard deviation? (5 marks).
- Given the portfolio information in (d) and beta information in (c), what is the portfolios market beta? (3 marks).
Question 6
SmartCar Corporation has 1 million shares of common stock outstanding, 20,000 shares of preferred stock outstanding, and 40,000 corporate bonds outstanding. The common stocks sell for $25, with a market beta of 1.5. The corporate bonds sell for $950 and the current YTM is 5%. The preferred stock currently sells for $100, with an annual dividend payment of $8 per share. The risk-free rate is 2% and the market expected return is 8%. SmarCars corporate tax rate is 35%. What is SmartCars cost of capital?
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