Problem-1: (4 points) A particular security's default risk premium is 6 percent. For all securities, the inflation risk premium is 3 percent and the real interest rate is 2.5 percent. The security's liquidity risk premium is 1 percent and maturity risk premium is 2 percent. The security has no special covenants. What is the security's equilibrium rate of return?
Problem-2 (4 points) Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:
1R1 = 3.0%, E(2R1) = 4.0%, E(3R1) = 12.0%, E(4R1) = 14.0%, Using the unbiased expectations theory, what is the current (long-term) rate for four-year-maturity Treasury securities (1R4)?
Problem-3 (4 points) HydroTech Corp stock was $50 per share a year ago when it was purchased. Since then, it paid a $4 per share dividend. The stock price is currently $45. If you owned 500 shares of HydroTech, what was your percent return?
Problem-4: (4 points) Portfolio Return Year-to-date, Company X had earned a -3 percent return. During the same time period, Company Y earned 12 percent and Company Z earned 7 percent. If you have a portfolio made up of 50 percent Company X, 30 percent Company Y, and 20 percent Company Z, what is your portfolio return?
Portfolio return = 50%*(-3%) + 30%*12% + 20%*7% = 3.5%
Problem-5: 8 points) You hold the positions in the table below.
COMPANY PRICE # SHARES BETA
Goodmonth $25.00 120 1.5
Icestone $20.00 150 2.5 Bridgerock $40.00 100 – 1.0
A. What is the beta of your portfolio?
B. If you expect the market to earn 14 percent and the risk-free rate is 4 percent, what is the required return of the portfolio?
Problem-6: (4 points) TAB Inc. has a $1,000 (face value), 10 year bond issue selling for $1,184 that pays an annual coupon of 8.5 percent. What would be TAB's before-tax component cost of debt?
Problem-7: (4 points) Team Sports has 6 million shares of common stock outstanding, 1 million shares of preferred stock outstanding, and 200 thousand bonds ($1,000 par). If the common shares are selling for $24.50 per share, the preferred share are selling for $20 per share, and the bonds are selling for 65 percent of par, what would be the weight used for equity in the computation of Team's WACC?
Problem-8: (4 points) Suppose that TipsNToes, Inc.'s capital structure features 40 percent equity, 60 percent debt, and that its before-tax cost of debt is 9 percent, while its cost of equity is 15 percent. If the appropriate weighted average tax rate is 25 percent, what will be TipsNToes's WACC?
We = 40%, Ke = 15%
Wd = 60%, After tax Kd = 9%*(1-25%) = 6.75%
WACC = We*Ke + Wd*Kd = 40%*15% + 60%*6.75% = 10.05%
Problem-9: (4 points) Suppose you sell a fixed asset for $50,000 when its book value is $60,000. If your company's marginal tax rate is 40%, what will be the effect on cash flows of this sale (i.e., what will be the after-tax cash flow of this sale)?
Problem-10: (7 points) Your company has spent $500,000 on research to develop a new computer game. The firm is planning to spend $100,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $5,000. The machine has an expected life of 3 years, a $100,000 estimated resale value, and falls under the MACRS 5-Year class life. Revenue from the new game is expected to be $500,000 per year, with costs of $200,000 per year. The firm has a tax rate of 35 percent, an opportunity cost of capital of 10 percent, and it expects net working capital to increase by $100,000 at the beginning of the project. What will be the net cash flow for year one of this project?
Problem-11: (4 points) Compute the NPV for Project Y and accept or reject the project with the cash flows shown below if the appropriate cost of capital is 10 percent.
TIME: 0 1 2 3 4 5
CASH FLOW: -1000 -2,000 3,000 0 1,000 2,500
Problem-12: (5 points) Compute the Payback statistic for Project X and recommend whether the firm should accept or reject the project with the cash flows shown below if the appropriate cost of capital is 10 percent and the maximum allowable payback is 5 years.
TIME: 0 1 2 3 4 5
CASH FLOW: - 75 - 75 0 100 75 90
Problem-13: (4 points) Compute the IRR statistic for Project X and note whether the firm should accept or reject the project with the cash flows shown below if the appropriate cost of capital is 10 percent.
TIME: 0 1 2 3 4 5
CASH FLOW: - 75 - 75 0 100 75 90
Problem-14: (8 points) Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown below. The required rate of return on projects of both of their risk class is 8 percent, and that the maximum allowable payback and discounted payback statistic for the projects are 2 and 3 years, respectively.
TIME: 0 1 2 3
Project A CF: $ - 10,000 $ 10,000 $ 30,000 $ 3,000
Project B CF: $ - 30,000 $ 10,000 $ 20,000 $ 50,000
Use the Profitability Index (PI) decision rule to evaluate these projects; what is the PI for each project, and which one(s) should it be accepted or rejected?
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