Advanced corporate finance, assignment 1

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Advanced corporate finance, assignment 1

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a)What is the expected return for each stock?

E(rA) =  pi rAi with i[1;4]
E(rA) = 0.2 x 60% + 0.3 x 10% + 0.3 x (-5%) + 0.2 x (-15%)
E(rA) = 10.50%

E(rB) =  pi rBi with i[1;4]
E(rB) = 0.2 x 30% + 0.3 x 20% + 0.3 x 0% + 0.2 x (-10%)
E(rB) = 10.00%

 The expected return is 10.50% for stock A and 10.00% for stock B.

b) What is the standard deviation for each stock?

A = {  pi [rAi - E(rA)]² }1/2 with i[1;4]
A = [0.2 x (60% - 10.5%)² + 0.3 x (10% - 10.5%)² + 0.3 x (-5% - 10.5%)² + 0.2 x (-15% - 10.5%)²]1/2
A = 26.31%

B = {  pi [rAi - E(rB)]² }1/2 with i[1;4]
B = [0.2 x (30% - 10%)² + 0.3 x (20% - 10%)² + 0.3 x (0% - 10%)² + 0.2 x (-10% - 10%)²]1/2
B = 14.83%

Sommaire

Exercise 1
1. What is the expected return for each stock?
2. What is the standard deviation for each stock?
3. What are the expected return and the standard deviation of returns on her proposal portfolio?
4. Is Irene better or worse off by holding her proposed portfolio than investing only in stock A or is it impossible to say?
Exercise 2
1. What is Honeycutt's opportunity cost of capital?
2. What is Honeycutt's new opportunity cost of capital?
Exercise 3
1. What is meant by "opportunity cost of capital"? What assumptions are employed in arriving at a firm's opportunity cost of capital? What role do efficient financial markets play?
2. What sources are the least expensive? The most expensive? Why? What role do corporate taxes play?
3. Determine the cost of common equity using the three different approaches. Take an average of the three estimates for alliance's cost of equity. What is alliance's opportunity cost of capital?
4. What is the impact of flotation costs on the firm's cost of capital? Also, short-term debt financing?
5. What occurs if a firm-wide opportunity cost is employed when risk differs significantly among divisions?
6. What are the appropriate opportunity costs of capital for the three divisions?
Exercise 4
1. What is the purpose of capital budgeting? How does it relate to the firm's objective?
2. Calculate the payback period. net present value. and internal rate of return. Should the project be accepted?
3. Calculate the payback period. net present value. and internal rate of return for this second alternative. Which machine -the first or second- should be selected? Does a ranking problem exist?
4. Why is the net present value the preferred decision criterion for making capital investment decisions while the internal rate of return is not?
5. If we did not know the net present values for the two machines. how could we use the incremental IRR to make the correct decision? What is the incremental IRR between these two machines?
6. Explain the modified IRR to the manager. Then calculate modified IRRs for the two alternatives. Does the modified IRR lead to the correct decision in this case? In all cases?
Exercise 5
Exercise 6
Exercise 7
1. What is the firm's opportunity cost of capital and the NPV of the proposed project?
2. Determine the loan implied by NPV and the APV
3. Calculate the cash flows to the shareholders and the FTE. Why are the NPV, APV and FTE given by (a), (b), and (c) the same? Is this always the case when these three decision criteria are employed? Explain

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Extraits

[...] ( Flotation costs have more impact on short-term debt financing. What occurs if a firm-wide opportunity cost is employed when risk differs significantly among divisions? ( If a firm-wide OCC is employed when risk differs significantly among divisions, bad investment decisions are made because the required return depends on the division specific risk. What are the appropriate opportunity costs of capital for the three divisions? (UA = (LFA / + B/SA] (UA = 1.83 / + 0.3 ] (UA = 1.55 (LDA = (UA + B/S'A] (LDA = 1.55 + 0.2 ] (LDA = 1.75 ksA = kRF + (LDA (kM kRF) ksA = 11% + 1.75 x - ksA = OCCA = ksA + ki with = 1 / (1+B/S'A) = 1 / 0.2 ) = 83% OCCA = 83% x + 17% x OCCA = ( The appropriate OCC for the division A is (UB = (LFB / + B/SB] (UB = 1.35 / + 0.9 ] (UB = 0.83 (LDB = (UB + B/S'B] (LDB = 0.83 + 0.7 ] (LDB = 1.21 ksB = kRF + (LDA (kM kRF) ksB = 11% + 1.21 x - ksB = OCCB = ksB + ki with = 1 / (1+B/S'B) = 1 / 0.7 ) = 59% OCCB = 59% x + 41% x OCCB = ( The appropriate OCC for the division B is (UC = (LFA / + B/SC] (UC = 0.70 / + 1.0 ] (UC = 0.44 (LDC = (UC + B/S'C] (LDC = 0.44 + 1.1 ] (LDC = 0.75 ksC = kRF + (LDA (kM kRF) ksC = 11% + 0.75 x - ksC = OCCC = ksC + ki with = 1 / (1+B/S'C) = 1 / 1.1 ) = 48% OCCC = 48% x + 52% x OCCC = ( The appropriate OCC for the division C is Exercise 4 OCC = 15% Which machine should be purchased? [...]

[...] Bnp = ( I / (1+kb)t + M / (1+kb)n with M - Db - FCb = rb'M x / / kb + M / (1+kb)n 1000 - 30 - 20 = 1000 x 11% / / kb + 1000 / (1+kb)20 kb = kb ( + Bnp) / / + 0.60 (Bnp kb ( [1000 x 11% + (1000 950) / 20] / [1000 + 0.6 (950 1000)] kb ( ki = kb ki = x ki = kps = Dps / Pnp kps = (rps' Vps) / (Vps - Dps - FCps) kps = x 100) / (100 - 7 - kps = ke = D1 / Pnp + g ke = D1 / (P0 - FCs) + g ke = 5 / (75-12) + ke = OCC = ki Wb + kps Wps + ke Ws OCC = 30% x + 20% x + 50% x OCC = ( Honeycutt's opportunity cost of capital is Exercise 3 Wb = rb = T = 35% Wps = rps = 13% Ws = P0 = 40, ( = expected risk premium S/O = kM = kRF = 11% What is meant by "opportunity cost of capital"? What assumptions are employed in arriving at a firm's opportunity cost of capital? [...]

[...] ( The Opportunity Cost of Capital is the rate of return that the suppliers of capital (lenders, owners) require as compensation for their contribution of capital. It is the expected rate of return offered in capital markets by equivalent-risk-assets. It is the minimum acceptable rate of return on new investments of average risk. ( The assumptions employed in arriving at a firm's OCC are: -Risk of the project under examination must be approximately equal to the risk of the firm as a whole -no material change in the firm's financing policy. ( Efficient financial markets play an important role of trust in market prices. [...]

[...] What sources are the least expensive? The most expensive? Why? What role do corporate taxes play? ( The most expensive sources are common equity and preferred stock because of the payment risk. ( The least expensive sources are debt because of the deductibility of interests due to corporate taxes. [...]

[...] Advanced corporate finance, assignment 1 Exercise 1 P1 = 100% x A P2 = 75% x A + 25% x B a)What is the expected return for each stock? E(rA) = ( pi rAi with E(rA) = 0.2 x 60% + 0.3 x 10% + 0.3 x + 0.2 x E(rA) = E(rB) = ( pi rBi with E(rB) = 0.2 x 30% + 0.3 x 20% + 0.3 x + 0.2 x E(rB) = ( The expected return is for stock A and for stock B. [...]

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