Revision question - set 2 Question 1 Heavy Metal Corporation (HMC) is a leader in ship building industry. It is considering building a new shipyard facility. Currently, there is no outstanding debt in company's balance sheet. The new project will be financed by issuing new equity only. We have the following information about the company's equity and the stock market. The company's share is now trading at $100. The company paid dividend of $16 per share last year. The market expects that the company will maintain this dividend amount in the foreseeable future. The beta (B) of the company's shares is 1.25. The expected market return is 13% and the yield to maturity of government debt is 4%. A. Compute the cost of equity by the Capital Asset Pricing Model (CAPM). B. Compute the cost of equity by the dividend growth model (DGM). C. As the CFO of the company, you find that you have different values of the cost of equity by CAPM and DGM. How do you determine the cost of equity? Explain. D. Discuss the advantages and disadvantages of CAPM and DGM. E. The project manager of HMC suggests that the company should use more debt rather than equity to finance this project since debt is cheaper than equity. Will you take this advice? Explain your answer by using M&M capital structure theory. Suppose JD Ltd holds 1 million shares of SCB common stock, currently valued at $48. Joey, the Question 2 company's director, is concerned that over the next few months the value of the shares might decline and she would like to hedge that risk by supplementing the shares with one of the following two option strategies, all of which expire at the same point in the future. (1) A long position in a put option with an exercise price of $45 and a premium of $2. (ii) A short position in a call option with an exercise price of $45 and a premium of $4. a. Draw the payoff diagrams for the option strategies (i) and (ii) b. Based on the results in (a), which strategy is more appropriate for JD Lid? Please discuss in detail. Suppose that JD has arranged to borrow HKS100 million at HIBOR+0.2% for 3 years. The company's director, Joey, fears that the market interest rate will increase in the near future and she wants to convert the company's debt from floating rate to fixed rate. She arranges a swap agreement with TX Corp. TX Corp has a 3-year $100M loan outstanding on which it pays 5.3%. The details of the swap agreement are as follows: - JD will receive HIBOR p.a. and pay a fixed rate of 5% p.a. - Duration: 3 years Notional principal: HK$100 million - Counterparty: TX Corp c. Is the swap agreement effective in converting the nature of JD Ltd's debt? Explain your answer in detail and with appropriate diagram(s). Lenberg, Inc. believes in the residual dividend policy. This year's earnings are expected to total $10,000,000. Lenberg, a very conservative company, is financed solely with common stock. The Question 3 required rate of return on retained earnings is 12 percent , whereas the cost of newly raised capital is 14 percent because of issuance costs. a. If Lenberg has $6,000,000 of investment projects with expected returns greater than 12 percent, compute and explain the total amount of dividends that Lenberg pays. b. If Lenberg has $12,000,000 of investment projects with expected returns greater than 14 percent, compute and explain the total amount of dividends that Lenberg pays. c. Discuss the advantages and disadvantages of residual dividend policy. d. If most of the investors of Lenberg are pension funds and endowment trusts which are prohibited from spending capital, what kind of dividend policy is most suitable for Lenberg? Explain your answer in detail