Question:

The following predictions have been made regarding the economic states. Calculate the expected return and standard deviation for share A

State

Probability of the state

Share A rate of return

Recession

0.10

-0.20

Normal

0.50

0.10

Boom

0.40

0.70

Question: You are given the following information

Stock 1Stock 2

Expected Return30%15%

Standard Deviation20%12%

Assume that the correlation coefficient between stock 1 and stock 2 returns is 10%. Compute the portfolio expected return and standard deviation if you invest 10% of your wealth in stock 1.

The Treasury Bill rate is 5 percent. Which one of the two securities is overvalued relative to the other? Show your workings.

(2 Marks)

Question: Assume you observe the following situation:SecurityBetaExpected Return

A1.213%

B0.610%

SMIF Inc., a leading retail company, currently has a balance sheet that is as follows:

Liability

Assets

Long term Bonds

$1000

Fixed Assets

1700

Equity

$1000

Current Assets

300

Total

$1000

Total

1000

The firm's income statement looks as follows:

Revenues

1000

Cost of Goods Sold

400

Depreciation

100

EBIT

500

Long-term Interest

100

EBT

400

Taxes

200

Net Income

200

The firm's bonds are all 20-year bonds with a coupon rate of 10% which are selling at 90% of face value (the yield to maturity on these bonds is 11%). The stocks are selling at a P/E ratio of 9 and have a beta of 1.25. The six-month T.Bill rate is 6%.

a)What is the firm's current cost of equity?

b)What is the firm's current after-tax cost of debt

c)What is the firm's current weighted average cost of capital?

Question: A small, private firm has approached you for advice on its capital structure decision. It is in the specialty retailing business, and it had earnings before interest and taxes last year of $ 500,000.

The book value of equity is $1.5 million, but the estimated market value is $ 6 million.

The firm has $ 1 million in debt outstanding, and paid an interest expense of $ 80,000 on the debt last year. (Based upon the interest coverage ratio, the firm would be rated AA, and would be facing an interest rate of 8.25%.)

The equity is not traded, but the average beta for comparable traded firms is 1.05, and their average debt/equity ratio is 25%.

a)Estimate the current cost of capital for this firm.

b)Assume now that this firm doubles it debt from $1million to $2million, and that the interest rate at which it can borrow increases to 9%. Estimate the new cost of capital, and the effect on firm value.

Question

Gradient Ltd is evaluating a new project that has the same risk as the overall firm. The cost is estimated at $75,000 and the expected cash flows are:

Year Cash Flow

1$18,000

2$25,400

3$35,000

4$17,900

Currently the company has 50% debt and 50% equity. The cost of Spark's debt is 9% and T-bills are yielding 5%. The market risk premium is 10% and Spark Ltd has a beta of 1.2. Tax rate is 30%. Should the project be accepted or rejected? Briefly explain why.

Question: You are considering a new product. It will cost $966,000 to launch, have a 3-year life, and no salvage value. Depreciation is straight-line to zero. The required return is 20%, and the tax rate is 30%. Sales are projected at 80 units per year. Price per unit will be $40,000, variable cost per unit is $24,000 and fixed costs are $500,000 per year. Operating cash flows have been calculated for you as 642,600 per year.

a)Suppose that the sales units, price per unit, variable cost per unit, and fixed cost projections above are accurate to within 15%. What are the new variables for the best case and worst case scenarios?

b)What is the accounting break-even for this project?

What is the degree of operating leverage?

c)A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over a period exceeding one year. The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future. Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible.

Capital budgeting is hardly an exact science. If it were, companies would never make bad decisions about expansions, product development, equipment upgrades and other capital projects. The fact that companies do make these kinds of mistakes points to the limitations of capital budgeting. In your view, what are the limitations to capital budgeting?